Edited version of private advice

Authorisation Number: 1052337166182

Date of advice: 19 December 2024

Ruling

Subject: Deductibility of legal expenses

Question 1

Are the legal fees that you incurred in opposing an easement on your property deductible in the xx xx xx to xx xx xx income years under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Can the legal fees be included in the cost base of the land under subsection 110-25(6) of the ITAA 1997?

Answer:

Yes - you can include $xx.xx - being the amount of legal expenses that were not recouped by you for the purposes of subsection 110-40(3) of the ITAA 1997.

This ruling applies for the following periods:

1 July xx to 30 June xx

The scheme commenced on:

xx xx xx

Relevant facts and circumstances

1.    You are the registered owner of a property at the property (the property) that was acquired in xx xx xx.

2.    XXXXX conducts a business of primary production on the property (the business).

3.    You are a joint director of XXXXX with your spouse and beneficially hold XX% of the shares.

4.    The business is reliant upon water pumped directly from the XX River using mains power from a privately installed power pole and transformer on the banks of the XX River.

5.    Company C applied for an easement over your property to install and access mains power for an irrigation pump located adjacent to the XX River.

6.    Company C's easement allows them and their workers to traverse your property several times a day for irrigation coordination purposes, such as to set timers to regulate irrigation.

7.    During the xx xx xx to xx xx xx income years, you engaged the legal services of XX Lawyers to oppose Company C's easement over your property. A barrister, XX (the barrister) was retained by XX Lawyers to assist with the legal proceedings.

8.    You were the defendant in this litigation.

9.    You incurred legal fees of $xx.xx during the xx xx xx to xx xx xx income years. The expenses consist of solicitor's fees, barrister's fees and provision of legal services, including filing legal documents (the legal fees).

10.    Payment of the legal fees were sourced from your loan accounts in XX Pty Ltd and XX Pty Ltd, and through withdrawals of your spouse's superannuation balance (i.e. funds provided to you)

11.    You are a joint director of XX Pty Ltd and XX Pty Ltd. You are a controlling shareholder in XX Pty Ltd.

12.    You derived salary and wages from your role as an Administration Assistant of $X,XXX from XX Pty Ltd in the 20YY income year and $X,XXX from XX Pty Ltd in the 20YY income year.

13.    The Supreme Court of State A made the following Order on DD MM 20YY pursuant to a settlement negotiated between you and Company C:

•                     an easement was granted to Company C. In return for the creation of the easement, you would receive compensation of $XX,XXX, and

•                     Company C would pay your legal costs of $XXX,XXX.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 subsection 8-1(2)

Income Tax Assessment Act 1997 section 110-25

Income Tax Assessment Act 1997 subsection 110-25(6)

Income Tax Assessment Act 1997 section 110-35

Income Tax Assessment Act 1997 subsection 110-35(1)

Income Tax Assessment Act 1997 subsection 110-40(3)

Reasons for decision

Question 1

Summary

The legal fees were not incurred in the income earning activities of your business. The legal fees incurred in taking action to defend your right over the property are not an allowable deduction under section 8-1 as the expense is of a capital nature under paragraph 8-1(2)(a).

Detailed reasoning

Subsection 8-1(1) states that you can deduct a loss or outgoing to the extent that it is:

(a)          incurred in gaining or producing your assessable income, or

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

However, under subsection 8-1(2), you are not entitled to a deduction under section 8-1 where the loss or outgoing:

(a)          is of capital, or a capital nature

(b)          of a private or domestic nature

(c)          is incurred in relation to gaining or producing your exempt income, or

(d)          another provision of the Income Tax Assessment Act 1997 prevents it from being deductible.

Meaning of 'incurred'

You must incur the legal expenses in order for the expenditure to be deductible under section 8-1.

The Commissioner's views on when an expense is incurred is set out in Taxation Ruling TR 97/7 Income tax: section 8-1 - meaning of 'incurred' - timing of deductions (TR 97/7).

In the context of legal expenses, you incur a legal expense when you have a presently existing liability to pay a pecuniary sum equal to that expense, or when payment of that expense is made in the absence of such a presenting existing liability.[1]

It is a long-standing principle that section 8-1 cannot be satisfied merely by demonstrating some casual connection between the expenditure and the derivation of income. Rather, a closer and more immediate connection must be demonstrated. The expenditure must be incurred in gaining or producing assessable income.[2]

Nexus with assessable income or carrying on of a business

Relevantly, to be deductible under section 8-1, the legal expenses must have a sufficient connection with the carrying on of a business for the purpose of gaining or producing assessable income.

Whether there is the necessary nexus between your legal expenses and your income producing activities or carrying on your business is a question of fact to be determined by reference to all relevant facts and circumstances.

Several significant court decisions have determined that for an expense to be an allowable deduction, it must have:

•                     the essential character of an outgoing incurred in gaining assessable income or, in other words, of an income-producing expense[3]

•                     a nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income,[4] and

•                     it is necessary to determine the connection between the particular outgoing and the operations or activities by which you most directly gain or produce your assessable income.[5]

For legal expenses to constitute an allowable deduction, it must be shown that they are incidental or relevant to the production of your assessable income or business operations.[6] Legal expenses take their character from the cause or purpose of incurring the expenditure. In determining whether a deduction for legal expenses is allowable under section 8-1, the nature of the expenditure must be considered.[7]

Legal expenses tend to be of an income nature if:

•                     they arise as a consequence of the day-to-day activities of your business[8]

•                     the legal action has more than a peripheral connection to your income producing activities,[9] and

•                     they relate to the process by which assessable income of a non-capital nature is derived, such as producing and collecting assessable income.

The primary considerations in determining whether a legal expense is on revenue or capital account are:[10]

•                     whether the legal expenses relate to the profit-yielding subject and the process (which is indicative of a capital nature) or profit-yielding structure (which is indicative of an income nature), and

•                     whether the nature of the asset or advantage sought to be gained is of an enduring benefit, which is indicative of a capital nature.

Legal expenses incurred in establishing, preserving, perfecting or defending title to property or a right over an asset are capital in nature.

Expenses incurred by a shareholder

A company is a separate legal identity.

Neither the company's business nor its income are the business or income of the individual shareholder. A company and its individual shareholder are separate legal entities. (Sheil v FC of T 86 ATC 4731, and FC of T v Munro (1926) 38 CLR 153)

Expenses incurred by an individual shareholder with respect to company expenses are not deductible as the expenses are not incurred in gaining or producing assessable income of the individual shareholder. Rather, they are expenses of the company and its shareholders. They are incurred by the individual shareholder for the purpose of the earning of profits for the company.

Where expenses are incurred merely to increase the chance of receiving (greater) dividends from the company, the purpose of incurring those expenses is only secondary and incidental to the purpose of the expenditure, which was to produce greater income for the company. (See e.g. Sheil v FC of T 86 ATC 4731.)

The mere expectation of dividend income will not be sufficient for the purposes of section 8-1. The connection between the expenses incurred by the shareholder and the future dividends will be too remote. Furthermore, expenses incurred to preserve the individual's ability to derive future income from their investment in the company would be capital in nature. (See e.g. Case 48/97 97 ATC 500; (1997) 37 ATR 1208 - noting that the principles have broad application to cover other types of expenses incurred by an individual shareholder.)

Expenses incurred by an employee or director of a company

Even if the taxpayer were to derive assessable income in their capacity as an employee or director of a company, the expenses must be incidental and relevant to the derivation of that income. (see e.g.Bartlett & Anor v FC of T 2003 ATC 4962; [2003] FCA 1125.)

Generally, the requirement will be satisfied if the subject of the claim for income tax deduction is something that might ordinarily be expected to occur in carrying out the duties of the employment. (Taxation Ruling IT 2198Income tax: allowable deductions: expenditure voluntarily incurred by employee taxpayers)

Expenses incurred by an employee or a director on behalf of the company would not arise as a result of carrying out the duties of their employment or directorship. It is a step too far for a company to expect its employees or directors or for an employee or director to choose to incur expenses on behalf of the company. The expenses relate to the carrying on of the business of the company. Consequently, the expenses would not deductible for the purposes of section 8-1.

Application to your circumstances

The company was not a party to the legal proceedings. Therefore, it is only necessary to consider the legal expenses from your perspective as:

•                     owner of the property

•                     a director

•                     a shareholder, or

•                     employee.

The purpose for incurring the legal services provided by XX Lawyers during the xx xx xx to xx xx xx income years was to oppose Company C's easement over your property that allowed installation of a mains power for an irrigation pump along the XX River. This would enable Company C and their workers to access your property to set the controls. Company C's irrigation pump is connected to a privately installed power pole and transformer along the XX River, which has contributed to past grass fires that damaged your property (and affected the business operations of the Company).

You are the director of XX Pty Ltd, which carries on a business of primary production for the purpose of producing assessable income. Your duties and responsibilities as a director of XX Pty Ltd do not extend to incurring costs on behalf of the company. Where the expenses are more accurately connected with the income-producing activities or capital structure of XX Pty Ltd, you cannot deduct the amounts from 'your' assessable income. As such, the expenses you incurred in relation to opposing the easement application, even if they were related to the carrying on of the business of XX Pty Ltd would not be expenses incurred by you in gaining or producing your assessable income.

The expenses you incurred in opposing the easement in respect of your property of $xx.xx are not work-related expenses incurred in gaining or producing your wage as an Administration Assistant. The legal expenses in question were not incidental or relevant to the production of your assessable income as they do not relate to your normal day-to-day activities by which you earn income.

Expenses you incurred in opposing the easement in respect of your property of $xx.xx, even if they were to relate to the carrying on of the business of XX Pty Ltd, would not be expenses incurred by you in gaining or producing your assessable income as a shareholder. Furthermore, if they were incurred by you to preserve your ability to derive future income from their investment in the company, the legal expenses would be capital in nature.

Your purpose for incurring the legal expenses and the nature of the advantage being sought are relevant. The easement would allow Company C and their workers to navigate across your property several times a day for irrigation purposes. You were worried this would disrupt the farming operations and compromise the security of machinery used in the business. You were concerned about faulty electrical connections to the power poles installed by the energy supplier that may start a fire and cause damage to your property.

Your property is a profit-yielding asset and you incurred the legal expenses for the purpose of protecting your interest on the land. In determining the essential character of the expenses, the advantage sought was to protect against interference on the property.

As the advantage to be gained is of a capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature.

Therefore, the legal fees are not an allowable deduction under section 8-1.

Question 2

Summary

The expenditure for legal services to defend the granting of an easement properly has been incurred to establish, preserve or defend your interest in the property. Therefore, the legal fees will form part of the cost base of the property for the purpose of determining any capital gains or losses when it is sold pursuant to subsection 110-25(6) to the extent that they have not been recouped (see section 20-25).

Detailed reasoning

In certain circumstances, legal expenses may form part of the cost base for capital gains tax (CGT) purposes.

A capital gain or capital loss is made only if a CGT event happens.[11] CGT event A1 occurs when there is a change of ownership of a CGT asset, such as when it is disposed of to another person.[12]Land and buildings are CGT assets.[13]

The cost base of a CGT asset has 5 elements[14] and is generally the cost of the asset when you bought it. However, it also includes certain other costs associated with acquiring, holding and disposing of the asset.

The fifth element of the cost base of a CGT asset includes capital costs you incur to establish, preserve or defend your title to an asset, or a right over the asset.[15]

Legal fees relating to defending your title or right to an asset will generally fall within the fifth element of your cost base. It is immaterial, from the point of view of subsection 110-25(6), whether the action is settled out of court or is the subject of contested proceedings.

In Uratoriu v FCT [2010] FCA 1157, the Federal Court held that legal fees incurred in a dispute over real property were fifth element costs. The fees related to a dispute with a builder who, under an arrangement with the taxpayer, lived in the property while renovations were being carried out. The Court was satisfied that the taxpayer incurred the legal fees in defending his proprietary interest in the property.

Subsection 110-40(3) provides that, except so far as the amount is included in assessable income, expenditure does not form part of the cost base to the extent that it is recouped.

The term 'recoupment' is defined in section 20-25. Subsection 20-25(2) provides that where another entity pays an amount for you in respect of a loss or outgoing that you incur you are taken to receive the amount as recoupment of the loss or outgoing.

Application to your circumstances

You incurred legal expenses to prevent Company C from being granted an easement over your property. The legal fees incurred to oppose the easement constitutes defending a right over your property, which is a CGT asset - the legal expenses are capital in nature.

It is irrelevant that you were unsuccessful in your claim to deny Company C's application that ultimately created a right over your property. Of importance is that you nevertheless incurred the legal expenses in defending your proprietary interest in the property and for the purpose of protecting your interest in the property.

Accordingly, the legal fees that you incurred to preserve your right over the property will form part of the fifth element of the property's cost base when it is sold pursuant to subsection 110-25(6).

As the Plaintiff was required to pay part of your legal expenses, you are taken to have recouped those amounts. Therefore the $xx.xx paid by the Plaintiff will not form part of the property's cost base.

[1] TR 97/7 at paragraph 6.

[2] Lunney, which was affirmed by the High Court of Australia in Federal Commissioner of Taxation v. Payne [2001] HCA 3.

[3] Lunney v. Federal Commissioner of Taxation (1958) 100 CLR 478 (Lunney).

[4] Ronpibon Tin NL v. Federal Commissioner of Taxation (1949) 78 CLR 47 at 56 (Ronpibon Tin).

[5] Charles Moore Co (WA) Pty Ltd v. Federal Commissioner of Taxation (1956) 95 CLR 344.

[6] Ronpibon Tin.

[7] Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634.

[8] Herald & Weekly Times v. Federal Commissioner of Taxation (1932) 48 CLR 113.

[9] Magna Alloys and Research Pty Ltd v. Federal Commissioner of Taxation 80 ATC 4542.

[10] Sun Newspapers Ltd v. Federal Commissioner of Taxation (1939) 61 CLR 337.

[11] Section 102-20.

[12] Section 104-10.

[13] Section 108-5.

[14] Section 110-25.

[15] Section 110-25.

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