Edited version of private advice

Authorisation Number: 1052345561697

Date of advice: 4 March 2025

Ruling

Subject: Deductions - legal expenses

Question 1

Are the Damage amounts you received in accordance with the Court Order assessable under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Are the Interest amounts you received in accordance with the Court Order assessable under section 6-5 of the ITAA 1997?

Answer

Yes.

Question 3

Can you claim a deduction for all of the legal expenses you incurred as a result of the legal activities undertaken in relation to the Reviews under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 4

Can you claim a deduction for any part of the legal expenses you incurred as a result of the legal activities in relation to the Reviews under section 8-1 of the ITAA 1997?

Answer

Yes. You received amounts that are both revenue and capital in nature with deductions for legal expenses only being available to the extent that the legal expenses relate to the Interest amounts.

Question 5

Can you disregard the capital gain that resulted from the receipt of the Damages amounts under section 118-37 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ending 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

You are a XXXX professional and are a director of Company A which conducts a XXXX XXXX (the XXXX XXXX), at which you are the sole XXXX XXXX.

You are the owner of a Google Reviews page (the Google Reviews Page) under your professional name.

Several reviews (the Reviews) were uploaded on the Google Reviews Page by several XXXX members (collectively referred to as the XXXX Members) about you in your capacity as a XXXX XXXX. The Reviews were downloaded and read by numerous people.

After the XXXX Members refused to remove the Reviews you engaged the services of a legal firm (the Lawyers) to assist you with addressing the issue of removing the Reviews.

Some of the XXXX Members provided a signed apology, and the retraction of the Reviews, which were removed from the Google Review Page some weeks after they were published.

The Lawyers sought the payment of a specified amount for your legal expenses from the XXXX Members, with the legal representative of the XXXX Members indicating that the XXXX Members refused to make any payment. The apology provided by several of the XXXX Members was withdrawn in addition to the undertaking that they would not be publishing any further defamatory comments on the internet.

The Lawyers made several attempts to negotiate a settlement with the XXXX Members. However, the XXXX Members refused to negotiate a settlement and pay for your legal expenses.

You were convinced that the XXXX Members were not interested in a settlement and would continue to publish more defamatory comments about you in the future with the intention of destroying your reputation, your XXXX and your assessable income.

You decided that to prevent that from occurring you would take further legal action against the XXXX Members to protect your reputation and assessable income, and to prevent the defamation occurring in the future.

A writ was filed with the courts (the Court) to initiate court proceedings, with you listed as the plaintiff and the XXXX Members listed as the defendants.

An amended statement of claim was prepared by the Lawyers which included the following information:

•                     Loss and damage - The plaintiff has been gravely injured in their personal and professional profession, had been humiliated and embarrassed and has suffered loss and damage; and

•                     Plaintiff claims - A permanent injunction restraining the defendants or any of them from publishing or causing to be published or continuing to be published any of the matters complained of, damages including aggravated damages, costs, interest and such further costs as the Court saw fit.

You engaged the services of Company X to act as your counsel in relation to the court proceedings with a submission in relation to damages be prepared by Company X in relation to the following:

•                     general damages for non-economic loss should be assessed in accordance with the range of amounts as provided; and

•                     aggravate damages should be assessed at a specified amount.

The Court handed down its judgment in your favour in relation to the Court proceedings which included the ordering of several payments in relation to damages, which included aggravated damages (Collectively referred to as the Damages Amounts).

The Court's reasons for the decision included the following information in relation to damages:

•                     Damage to your reputation was presumed and did not need to be specifically proven.

•                     The principal function of an award of damages are reparation for harm done to your reputation, solatium for the distress and embarrassment occasioned to you by reason of the publication and vindication of your reputation.

•                     You made no claim for financial loss.

•                     Your evidence regarding the distress and embarrassment caused to you by the Reviews was accepted and that each of the defendants were motivated by malice; and

•                     It was the finding that there were aggravating factors that warranted an award of aggravated damages.

Court Orders were made in relation to the payment of the Damages amounts and specified amounts of interest (collectively referred to as the Interest amounts).

You received a payment of the Damages amounts and Interest amounts in accordance with the Court order during the ruling period.

Your legal expenses will not be covered by your indemnity insurance.

The payment of your costs as outlined in the Court Order will be considered in the Cost Court. You anticipate that the Cost Court will order the XXXX Members to pay your legal expenses in full in accordance with the Court Order.

You will not abandon the pursuit of the payment of your legal costs from the XXXX Members.

You incurred legal and mediation expenses in relation to court proceedings in several of the income years included in the ruling period.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 118-37

Reasons for decision

Question 1: Are the Damages amounts you received in accordance with the Court Order assessable under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Question 2: Are the Interest Amounts you received in accordance with the Court Order assessable under section 6-5 of the ITAA 1997?

Summary

The Interest amounts you received in accordance with the Court Order are assessable under section 6-5 of the ITAA 1997. However, the Damages Amounts you received in accordance with the Court Order are capital in nature and are therefore not assessable under section 6-5 of the ITAA 1997 but will be assessable under the capital gains tax provisions.

Detailed reasoning

Assessable income

Section 6-5 and section 6-10 of the ITAA 1997 provides that the assessable income of an Australian resident includes ordinary and statutory income derived directly and indirectly from all sources, whether in or out of Australia during the income year.

Section 6-5 of the ITAA 1997 refers to ordinary income however does not provide specific guidance on the meaning of ordinary income. Instead, we utilise the substantial body of case law which exists and can identify the characteristics of ordinary income. Amounts that are periodic, regular or recurrent and relied upon by the recipient for their regular expenditure are likely to be ordinary income, as are amounts that are the product of any employment of, or services rendered by, the recipient.

Section 6-10 of the ITAA 1997 provides that amounts that are not ordinary income but are included in assessable income by another provision, are called statutory income, such as capital gains, and are also included in assessable income.

An amount paid to compensate for loss generally acquires the character of that for which it is substituted (Federal Commissioner of Taxation v. Dixon (1952) 86 CLR 540; (1952) 5 ATR 443; (1952) 10 ATD 82). Compensation payments which substitute income have been held by the courts to be income under ordinary concepts (Federal Commissioner of Taxation v. Inkster 89 ATC 5142; (1989) 20 ATR 1516 and Tinkler v. Federal Commissioner of Taxation 79 ATC 4641; (1979) 10 ATR 411).

Lump sum damages or out-of-court settlements may be a compromise of a claim made up of a number of items, some being of a revenue nature and others of a capital nature.

Whether an amount received under a court order is assessable must be determined by looking to the nature of the cause of action in respect of which the payment is made.

If different components of a lump sum compensation payment can be identified, those components that are of an income nature are assessable as such.

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts considers the capital gains tax consequences for the recipient of a compensation amount, including a payment under a court order, and whether the amount should be included in the assessable income of the recipient under the CGT provisions.

TR 95/35 outlines that whether a lump sum or other compensation payment is assessable in the hands of the recipient depends on whether it is a receipt of a capital or income nature. This in turn depends upon consideration of all the circumstances surrounding the payment. It is the character of the receipt in the hands of the recipient that must be determined.

TR 95/35 outlines that interest awarded as part of a compensation amount is assessable income of the taxpayer under the general income provision. It is a question of fact to be determined in each case whether any part of the compensation received by a taxpayer is in the nature of interest. Any amount which is in the nature of interest, and which can be identified as interest, and whether paid as part of the compensation or separately, constitutes assessable income of the taxpayer under the general income provisions. It may also represent part of the consideration for the disposal of either the underlying asset or the right to seek compensation.

Whether a payment of compensatory damages is assessable must be determined by looking to the nature of the cause of action in respect of which the payment is made, rather than the way in which damages are calculated.

TR 95/35 outlines that amounts received in relation to damages for a personal wrong to a person are treated as capital in nature which are assessed under the capital gains tax provisions.

Application to your situation

In accordance with the Court Order, you received the Damages amounts and the Interest amounts.

Based on the information provided, and applying the principles contained in TR 95/35 to the facts of your situation it is viewed that:

•                     The Damages Amounts are capital in nature given the advantages you were seeking in your amended statement of claim. Therefore, they are not assessable under section 6-5 of the ITAA 1997, but will be assessable under the capital gains tax provisions (as discussed below): and

•                     The Interest amounts are revenue in nature and are therefore assessable under section 6-5 of the ITAA 1997. They will be included in your income tax return in the income year they were received.

Question 3: Can you claim a deduction for all of the legal expenses you incurred as a result of the legal activities undertaken in relation to the Reviews under section 8-1 of the ITAA 1997?

Question 4: Can you claim a deduction for any part of the legal expenses you incurred as a result of the legal activities in relation to the Reviews under section 8-1 of the ITAA 1997?

Summary

As outlined above, the Interest amounts you received in accordance with the Court Order are revenue in nature. Therefore, a deduction can be claimed to the extent that your legal expenses relate to the Interest amounts you received.

The Damages amounts are capital in nature. Therefore, you cannot claim a deduction for the legal expenses you incurred to the extent that they relate to the Damages amounts you received.

Accordingly, your legal expenses will need to be apportioned to account for the portion for which a deduction can be claimed.

Detailed reasoning

Deductions for legal expenses

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent that they are incurred in gaining or producing assessable income except where the outgoings of a capital, private or domestic nature, or relate to the earning of exempt income.

In determining whether a deduction for legal expenses is allowed under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; [1946] HCA 34; (1946) 3 AITR 436; (1946) 8 ATD 190). The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses. If 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.

The courts, on a number of occasions, have determined legal expenses to be an allowable deduction if the expenses arise out of the day-to-day activities of the taxpayer's business. The action out of which the legal expense arises has to have more than a peripheral connection to the taxpayer's business or income earning activities. The expense may arise out of litigation concerning the taxpayer's professional conduct.

In FC of T v. Rowe (1995) 60 FCR 99; (1995) 31 ATR 392; 95 ATC 4691, the court accepted that legal expenses incurred in defending the manner in which a taxpayer performed his employment duties were allowable. No significance was placed by the court on the taxpayer's status as an employee.

However, there must be an evident connection between the expenditure in instituting the proceedings and the taxpayer's earning activities. Legal expenses are capital or private in nature where the legal action taken is to protect the taxpayer's personal good name and reputation.

In Case U102 87 ATC 621; AAT Case 72 (1987) 18 ATR 3515 the taxpayer was a secretary-manager of a large sporting club. Comments about the management of the trust funds were made on television that were defamatory in nature in respect to the trustees. The trustees commenced proceedings for damages for defamation. The Administrative Appeals Tribunal (AAT) held that a deduction for the legal expenses incurred was not allowable. It was found that the events which gave rise to the expenses incurred were not regarded as what is normally expected of a secretary-manager of a club in the course of producing assessable income. The expenses were considered private in nature as the need for them arose out of the taxpayer's reaction to what he saw as a slur upon his personal good name and reputation. Alternatively, it was stated that the expenditure was capital in nature as it was incurred in an endeavour to retain and restore his position as a leading figure in the sports management industry and with it a standing sufficient to pursue his own interest away from the club in the future.

Defamation damages received by a company were held to be capital and not income in FCT v Sydney Refractive Surgery Centre Pty Ltd (2008) 73 ATR 28, because the damages were awarded for harm to the company's business reputation and not for lost profits (even though the damages were calculated by reference to lost profits).

The ATO's view on the deductibility of legal expenses when taking defamation action is contained in ATO Interpretative Decision ATO ID 2002/666 Income Tax: Legal Expenses - taking defamation action where the employee taxpayer took defamation action against the author of a published letter which allegedly contained defamatory comments about the taxpayer's abilities and experience. The claims listed in the action were damages, costs and interest. The basis of the taxpayer's action was that they had been held up to public ridicule and contempt and had suffered damage to their credit and reputation and continued to suffer damage to their credit and reputation. There was no indication that the taxpayer's employment was at risk. The matter was settled, and the taxpayer received a letter retracting the comments. In the course of the defamation action the taxpayer incurred legal expenses which were not viewed as being deductible as they were not sufficiently connected with the income earning activities of the taxpayer and were essentially private or capital in nature and character. The need for them arose out of the taxpayer's reaction to what they saw as damage to their credit and reputation.

The above ATO ID can be distinguished from ATO ID 2001/549 Income Tax Legal Expenses - Defamation Action where an employee's colleague disagreed with the taxpayer's work performance and began action to have the taxpayer replaced. The colleague sent the taxpayer abusive emails and a letter stating that the taxpayer was not fulfilling requirements in the position, copies of which were forwarded by the colleague to the taxpayer's manager. The taxpayer incurred legal expenses for legal advice and to send the colleague a warning letter that their actions were grounds for defamation action, requesting the actions cease. A deduction for the taxpayer's legal expenses was allowed as the taxpayer was an employee who incurred the expenses in defending actions undertaken in carrying out employment duties through which assessable income is gained and whose employment was at risk.

Apportionment of legal expenses

There will often be occasions where the legal expenses are incurred in relation to proceedings that relate both to amounts that are revenue in nature as well as amounts which are capital in nature.

Apportionment is a question of fact and involves a determination of the proportion of the expenditure that is attributable to deductible purposes. The Commissioner believes that the method of apportionment must be fair and reasonable in all the circumstances. Where legal expenses are not broken up into the relevant parts, you will need to calculate the deductible portion.

Taxation Determination TD 93/29 Income tax: if an employee incurs legal expense recovering wages paid by a dishonoured cheque, are these legal expenses an allowable deduction under section 8-1 of the Income Tax Assessment Act 1997? outlines the Commissioners view on apportionment of legal expenses at paragraph 7 as follows:

Where the solicitor's account is itemised, one reasonable basis for apportionment would be the time spent involving the revenue claim, relative to the time spent on the capital claim. If the solicitor's account is not itemised, a possible basis for apportionment would be either costing of the work undertaken by the solicitor in relation to the revenue claim, or, where this is not possible, an apportionment on the basis of the monetary value of the revenue claim relative to the capital claim.

Application to your situation

As outlined above, the nature of legal expenses follows the nature of the advantage sought in incurring the legal expenses.

The amended statement of claim outlined that you were seeking the restraint of the XXXX Members from publishing anything further in relation to you, damages which included aggravated damages, costs, interest and anything further the Court ordered.

It is stated in the ruling that you had not claimed any amount in relation to any financial loss as your aim was to prevent the defamation from happening again in the future. You had tried unsuccessfully on several occasions to resolve this issue but had no other choice except to take legal action and prevent any defamation from reoccurring. Harm done to your reputation had caused distress and embarrassment which affected your performance and consequently financial loss. The number of XXXX attending the XXXX had also fallen. A repeat of defamation by the XXXX Members in the future would have ultimately ruined your reputation, business and income. Therefore, legal action was necessary to prevent this from happening.

We have considered your eligibility to claim any deduction for your legal expenses in relation to the following amounts you received in accordance with the Court Order as follows:

•                     Damages amounts

You were awarded specified Damages amounts, being general damages amounts which included aggravated damages.

It was stated in the Court Order that you had not sought any financial loss. Therefore, it cannot be viewed that the advantage you were seeking in relation to the court proceedings were of a revenue nature.

The advantage sought by you in relation to the court proceedings was to preserve your name, reputation and professional career which relates to securing an enduring advantage, in addition to preventing any further reviews being written about you by the XXXX Members.

The occasion of the outgoing for legal expenses was not your income producing activities with the XXXX XXXX but had been incurred to protect your professional reputation and your ability to work in the future.

Therefore, your legal expenses were incurred in taking defamation action are not deductible under section 8-1 of the ITAA 1997 as they are considered to be insufficiently connect with your income earning activities and were of a private or capital nature. The need for them arose out of your reaction to what you saw as damage to your credit and reputation and to prevent any further reviews being written about you.

Therefore, you cannot claim a deduction for your legal expenses to the extent that they relate to the Damages amounts of $XX,000 and $XX,000 you received in accordance with the Court Order.

•                     Interest amounts

In accordance with the Court Order you received specified amounts of interest, being the Interest amounts.

The Court had made a ruling that interest at the rate of a specified percentage had been ordered and costs awarded on the Court scale of indemnity basis.

In accordance with the principles contained in TR 95/35, the Interest amounts you received are revenue in nature. Therefore, you can claim deduction to the extent that the legal expenses you incurred related to the Interest amounts received in accordance with the Court Order.

Note: As the legal expenses you incurred are both revenue and capital in nature, you will need to apportion the legal expenses in a reasonable manner. You should apply the above principles in paragraph 7 of TD 93/29 in undertaking the apportionment.

Question 5: Can you disregard the capital gain that resulted from the receipt of the Damages amounts under section 118-37 of the ITAA 1997?

Summary

In accordance with the principles contained in TR 95/35, you can disregard any capital gain made in relation to the receipt of the Damages under section 118-37 of the ITAA 1997 as the amounts are capital in nature that were received due to a wrong to you personally.

Detailed reasoning

Capital gains tax

Paragraph 108-5(1)(b) of the ITAA 1997 specifically includes a legal or equitable right within the definition of a capital gains tax (CGT) asset. A taxpayer's right to seek compensation is therefore classified as an intangible CGT asset which is acquired at the time of the compensable wrong or injury.

Section 104-25 of the ITAA 1997 provides that CGT event C2 happens on the ending of the right to seek compensation, that is, the right to take legal action, when it is satisfied, surrendered, released or discharged.

Parts 3-1 and 3-3 of the ITAA 1997 contain the capital gains and capital loss provisions commonly referred to as the CGT provisions.

Section 104-25 of the ITAA 1997 provides that CGT event C2 happens on the ending of the right to seek compensation, such as the right to take legal action, when it is satisfied, surrendered, released or discharged. You make a capital gain if the capital proceeds from the ending are more than the asset's cost base. You make a capital loss if those proceeds are less than the asset's reduced cost base.

A right to seek compensation is disposed of when the taxpayer agrees to a release, discharge, satisfaction or surrender of his or her right to seek compensation. This is generally at the final point of settlement of the claim and receiving the compensation as outlined at paragraph 158 of TR 95/35.

CGT exemption

Paragraph 118-37(1)(a) of the ITAA 1997 provides that a capital gain or capital loss is disregarded from a CGT event relating directly to:

             i.        compensation or damages (including in the form of non-monetary property) for any wrong or injury suffered by the taxpayer in their occupation; or

             ii.        compensation or damages for any wrong, injury or illness the taxpayer or a relative suffers personally.

A wrong suffered personally for the purposes of paragraph 118-37(1)(a) of the ITAA 1997 would include defamation as this is a wrong suffered by the taxpayer to their person.

Application to your situation

As outlined above, the Damages amounts you received are capital in nature.

The relevant CGT asset in this case was your right to seek compensation in relation to the Reviews. CGT event C2 occurred when the Court Order was made, and your CGT asset ended.

As the Damage amounts were received by you due to a wrong against you personally the CGT exemption under subparagraph 118-37(1)(a)(ii) of the ITAA 1997 will apply. Accordingly, you can disregard any capital gain or capital loss arising as a result of the CGT event C2 occurring and no amount is assessable under the CGT provisions.

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