Edited version of private advice

Authorisation Number: 1052306542549

Date of advice: 25 September 2024

Ruling

Subject: Deductibility of settlement payment and legal fees

Question 1

Is the Trust entitled to an allowable deduction pursuant to section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for the Settlement Payment made to the Original Trustee in the year ended 30 June 2024?

Answer

Yes.

Question 2

Is the Trust entitled to an allowable deduction pursuant to section 8-1 of the ITAA 1997 for legal fees incurred in the year ended 30 June 2024?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 2024

The scheme commenced on:

1 July 2023

Relevant facts and circumstances

The Trust is a unit trust established by a deed of constitution.

The Trust is an unregistered scheme with XX unrelated unit holders.

The Trust owns a property which derives income.

The trustee at the time of the establishment of the Trust (Original Trustee) managed the Property and the Trust.

The unitholders of the Trust voted to remove the Original Trustee and appointed, the Interim Trustee as trustee.

Before exiting as trustee, the Original Trustee paid themselves the Removal Fees in the amount of $XX.

The Interim Trustee retired and appointed the New Trustee in accordance with a clause of the constitution of the Trust.

The relevant clause of the Trust constitution provides that if the Trustee wishes to retire as trustee of the Trust, then it may do so and appoint a replacement trustee.

The New Trustee was a related entity of the Interim Trustee.

The Original Trustee made a claim for Performance Fees from the New Trustee after being removed as trustee of the Trust. The New Trustee disputed the Original Trustee's entitlement to the Removal and Performance Fees.

The Original Trustee commenced legal proceedings against the Interim Trustee.

An Amended Claim was subsequently filed, amending the defendant from the Interim Trustee to the New Trustee and addressing the amount of monies due and owning pursuant to the clauses of the Trust constitution plus costs.

The Trust constitution defines both the Trustee Removal and Performance Fees.

The retirement or removal clause of the Trust constitution provides that the Original Trustee is entitled to a certain percentage of the gross value of all property of the Trust which is payable on the day they retire or removed from the Trust. No succeeding trustee is entitled to this benefit.

The performance fee clause of the Trust constitution provides that for consideration of past and successful management of the Trust, the Trustee is entitled to a payment, based on a specified formular.

The parties agreed to an out of court settlement and signed the Deed of Settlement (Deed).

The parties to the Deed agreed that all previous claims will be rescinded, previous invoices issues will be withdrawn, and a new invoice issued with respect to the payment outlined in the Deed. The amount of the settlement payment plus GST will then be paid.

The New Trustee incurred legal fees for their defence and counterclaims.

The Original Trustee issued an invoice to the New Trustee for the settlement payment amount including GST.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Question 1

Summary

The settlement payment was incurred for the performance fees owed to the Original Trustee for the management of the business of the Trust, therefore, a deduction is allowable pursuant to section 8-1 of the ITAA 1997.

Detailed reasoning

Subsection 8-1(1) of the ITAA 1997 provides that you can deduct from your assessable income any loss or outgoing to the extent that:

(a)  it is incurred in gaining or producing your assessable income; or

(b)  it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

(collectively referred to as "the positive limbs")

However, subsection 8-1(2) of the ITAA 1997 prevents deductions for a loss or outgoing to the extent that:

(a)  it is a loss or outgoing of capital, or of a capital nature; or

(b)  it is a loss or outgoing of a private or domestic nature; or

(c)   it is incurred in relation to gaining or producing your exempt income or your non-assessable non-exempt income; or

(d)  a provision of this act (the ITAA 1997) prevents you from deducting it.

(collectively referred to as "the negative limbs")

The Settlement Payment will be deductible under section 8-1 of the ITAA 1997 if either of the positive limbs in subsection 8-1(1) of the ITAA 1997 are satisfied and it does not fall within the negative limbs in subsection 8-1(2) of the ITAA 1997.

The Positive Limbs

To be deductible under section 8-1 of the ITAA 1997, the positive limbs in subsection 8-1(1) of the ITAA 1997 require there to be a nexus between the payment paid by the Trust under the Deed and the gaining or production of its assessable income, or the carrying on of its business for that purpose.

In determining whether a loss or outgoing is characterised as having been incurred in gaining or producing assessable income, the courts have considered whether the loss or outgoing is incidental and relevant to the operation, or activities regularly carried on by the taxpayer for the production of income.

The High Court in Ronpibon Tin NL v Federal Commissioner of Taxation [1949] HCA 15; (1949 78 CLR 47 (Ronpibon) at 57 said that:

For expenditure to form an allowable deduction as an outgoing incurred in gaining or producing the assessable income it must be incidental and relevant to that end. The words "incurred in gaining or producing the assessable income" means in the course of gaining or producing such income.

Notwithstanding the difference in other respects in the present provision, the expression "incurred in gaining or producing the assessable income" has been left unchanged and bears the same meaning. In brief substance, to come within the initial part of the sub-section it is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income or, if none by produced, would be expected to produce assessable income.

The purpose of the Settlement Payment was for the performance fees of the Original Trustee which is for the consideration of the past and successful management of the Trust pursuant to the Trust Constitution. Therefore, it is considered that the Settlement payment incurred by the Trust is an outgoing necessarily incurred in gaining or producing its assessable income, satisfying the positive limb of section 8-1 of the ITAA 1997.

To determine whether the payment is deductible under section 8-1 of the ITAA 1997, it must also be determined whether any of the exclusions under the negative limbs of section 8-1 of the ITAA 1997 apply.

The Negative Limb

In determining whether the Settlement Payment is capital or revenue in nature, the test formulated by Dixon J. in Sun Newspaper Ltd & Associated Newspapers Ltd v Federal Commissioner of Taxation (1938) 5 ATD 87; (1938) 61 CLR 337 must be considered. His Honour stated, at 363:

There are, I think, three matters to be considered:

(a)  the character of the advantage sought, and in this its lasting qualities may play a part;

(b)  the manner which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part; and

(c)   the means adopted to obtain it; that is, by providing a periodical regard or outlay to cover its use or enjoyment for periods commensurate with the payment or making a final provision or payment so as to secure future use or enjoyment.

In the High Court decision in Hallstroms Pty Ltd v FCT (1946) 72 CLR 634, Dixon J incorporated his reasons in Sun Newspapers and elaborated upon them, stating at 648 'What is an outgoing of capital and what is an outgoing on account of revenue depends on what the expenditure is calculated to effect from a practical and business point of view.'

In GP International Pipecoaters Pty Ltd v Federal Commissioner of Taxation (1990) 170 CLR 124, the High Court determined at 137 that 'the character of the advantage sought by the making of the expenditure is the chief, if not the critical, factor in determining the character of what is paid.'

In considering the character of the advantage sought, the High Court provided the following guidance in Federal Commissioner of Taxation v Sharpcan Pty Ltd (2019) 373 ALR 414 at 421-422:

Authority is clear that the test of whether an outgoing is incurred on revenue account or capital account primarily depends on what the outgoing is calculated to effect from a practical and business point of view. Identification of the advantage sought to be obtained ordinarily involves consideration of the manner in which it is to be used and whether the means of acquisition is a once-and-for-all outgoing for the acquisition of something of enduring advantage or a periodical outlay to cover the use and enjoyment of something for periods commensurate with those payments. Thus, an indicator that an outgoing is incurred on capital account is that what it secures is necessary for the structure of the business.

However, as Dixon J explained in Sun Newspapers at 362, whilst recurrence and enduring benefit are relevant considerations, they are not determinative factors:

But the idea of recurrence and the idea of endurance or continuance over a duration of time both depend on degree and comparison. Recurrence is not a test, it is no more than a consideration the weight of which depends upon the nature of the expenditure.

Again, the lasting character of the advantage sought is not necessarily a determining factor.

Character of the advantage sought

The payment made by the Trust under the Deed related to the performance fees owed to the Original Trustee after their removal as Trustee of the Trust. Even though the payment is payable out of the assets of the Trust does not make it an outgoing of capital or of a capital nature.

The payment was made for how the Original Trustee performed at his responsibilities in gaining the assessable income of the Trust. Therefore, the payment was not an outgoing of capital or of a capital nature.

The manner the expenditure was used

The Settlement Payment was not of a capital nature because it did not relate to the establishment, replacement or enlargement of the Trust profit yielding structure. The purpose for incurring the expense has a connection to the taxpayer's income producing activities. As a result, the Settlement Payment was incurred in gaining or producing assessable income for the purpose of section 8-1 of the ITAA 1997.

The means of payment - recurrent v. one-off lump sum payment

Finally, we need to consider the manner in which the Settlement Payment was made, and the criteria listed by Dixon J in Sun Newspapers, being recurrent and periodical as opposed to one-off lump sum.

Although the Settlement Payment was a one-off lump sum payment to the Original Trustee and will not re-occur in the future, this does not mean that it is capital in nature. Dixon J. explained in Sun Newspapers (at 362) that the actual recurrence of expenditure need not take place nor be expected as likely for such expenditure to be in the nature of revenue. It is enough that there be a potential for such an outgoing to be met by the business (Commissioner of Taxation v. Consolidated Fertilizers Ltd (1991) 22 ATR 281 at 293).

In conclusion, the payment was not incurred to develop, replace or protect the profit-yielding structure of the Trust and did not bring into existence an asset or an advantage (tangible or intangible) to the enduring benefit of the Trust. Therefore, the Settlement Payment is not capital or in the nature of capital.

Considering the remaining criteria in subsection 8-1(2) of the ITAA 1997, the Settlement Payment is also not:

•         of a private or domestic nature; or

•         incurred in relation to producing exempt or non-assessable non-exempt income; or

•         subject to another provision in ITAA 1997 that would prevent the deduction.

Accordingly, the Settlement Payment meets the requirements to be an allowable deduction under subsection 8-1(1) of the ITAA 1997 and is not excluded by subsection 8-1(2) of the ITAA 1997.

Question 2

Summary

Yes, the legal fees are deductible under section 8-1 of the ITAA 1997.

Detailed reasoning

For legal expenses to constitute an allowable deduction, it must be shown that they were incidental or relevant to the production of the taxpayer's assessable income, (Ronpibon Tin NL & Tong Kah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; [1949] HCA 15; (1949) 4 AITR 236; (1949) 8 ATD 431).

Also, in determining whether a deduction for legal expenses is allowed under section 8-1 of the ITAA 1997, the nature of the expenses must be considered (Hallstroms Pty Ltd v Federal Commissioner of Taxation (1946) 72 CLR 634). The nature or character of the legal expenses follows the advantage which is sought to be gained by incurring the expenses, that is, whether the legal expenses are incurred for a capital or revenue purpose. The outcome of the legal action does not affect the deductibility of the legal expense, rather the nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses.

Legal expenses are generally deductible if they arise out of the day-to-day activities of the taxpayer's business. (Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; [1932] HCA 56; (1932) 39 ALR 46; (1932) 2 ATD 169) and the legal action has more than a peripheral connection to the taxpayer's income producing activities (Magna Alloys and Research Pty Ltd v. FC of T (1980) 49 FLR 183; [1980] FCA 150; (1980) 11 ATR 276; 80 ATC 4542).

The legal fees the Trust incurred in defending and settling on the legal action for the amount owed to the Original Trustee for their performance fees have arisen from past and successful management of the Trust's day-to-day business to produce assessable income. Therefore, the legal fees incurred are revenue in nature and deductible under section 8-1 of the ITAA 1997.

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