Edited version of private advice

Authorisation Number: 1052352115049

Date of advice: 21 January 2025

Ruling

Subject: Legal expenses

Question 1

Is the amount received for the settlement of the legal dispute capital proceeds for the purpose of determining capital gains tax (CGT) outcome for CGT event C2 under section 104-25 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer 1

Yes

Question 2

Are your legal expenses relating to the contract dispute included in the cost base of the CGT asset under section 110-25 of the ITAA 1997?

Answer 2

Yes

Question 3

Are the legal expenses relating to the mediation of disagreement in relation to the rental property deductible under section 8-1 of the ITAA 1997?

Answer 3

Yes

This ruling applies for the following periods:

30 June 20XX

30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

The property comprises of several units, of which you own 2 units. Unit A is your home and Unit B is your rental property.

Legal dispute

You entered a contract with a construction company to carry out the work for a contract price. In this contract you agreed that the work would be completed within a certain time frame and that it would be completed with a certain level of quality and professionalism.

The work was not completed as per the contract.

You engaged another company who completed the work.

You then engaged lawyers to pursue the construction company for breach of contract and to seek financial damages.

A settlement was reached and you agreed to discontinue all proceedings and all further claims arising out of or in any way related to the subject matter of the proceedings. In return, you would receive a settlement payment.

Disagreement with your neighbour

You identified issues that came from your neighbour's unit which affect both your home and your rental property. You engaged lawyers to help negotiate a resolution regarding these issues. The legal engagement aimed to compel the neighbour to make the appropriate adjustments to remedy the issues.

Eventually you instructed the lawyer to abandon the dispute. Requests made by you to meet in mediation were ignored by the neighbour.

Relevant legislative provisions

The Income Tax Assessment 1997 section 8-1

The Income Tax Assessment 1997 section 102-5

The Income Tax Assessment Act 1997 section 102-20

The Income Tax Assessment Act 1997 section 104-25

The Income Tax Assessment Act 1997 section 110-25

The Income Tax Assessment Act 1997 section 110-35

The Income Tax Assessment Act 1997 subsection 110-35(2)

Reasons for decision

Question 1

Summary

The amount you received for the settlement of the legal dispute is considered capital proceeds from a C2 CGT event.

Detailed Reasoning

Section 102-5 of the ITAA 1997 states that your assessable income includes your net capital gain for the income year. Your net capital gain is calculated by reducing your capital gains by net capital losses and then discounting that amount by your eligible discount percentage. Then you apply any relevant concessions to that amount to obtain your net capital gain.

Section 102-20 of the ITAA 1997 states that you can make a capital gain or capital loss if and only if a CGT event happens. The CGT events are listed in section 104-5 of the ITAA 1997 and detail the situations in which a capital gain or loss may occur.

Section 104-25 of the ITAA 1997 states that a CGT event C2 happens if your ownership of an intangible CGT asset ends by the asset:

a)            Being redeemed or cancelled; or

b)            Being released, discharged or satisfied; or

c)            Expiring; or

d)            Being abandoned, surrendered or forfeited; or

e)            If the asset is an option - being exercised; or

f)             If the asset is a convertible interest - being converted.

The time of the event is:

a)            When you enter into the contract that results in the asset ending; or

b)            If there is no contract - when the asset ends

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 capital proceeds are less than the asset's reduced cost base.

Taxation Ruling TR 95/35 CGT: treatment of compensation receipts (TR 95/35) details how compensation receipts are treated specifically regarding CGT.

A right to seek compensation is an asset that is acquired at the time of the compensable wrong or injury and includes all the rights arising during the process of pursuing the compensation claim.

The right to seek compensation is disposed of when it is satisfied, surrendered, released, or discharged. If the amount of compensation is not received in respect of any underlying asset, the amount relates to the disposal by the taxpayer of the right to seek compensation.

In your case, you brought the litigation case against the construction company originally due to them breaching their contract with you. At that moment, you possessed a right to compensation. Eventually you received the settlement amount to release the construction company from any further proceedings, thus disposing of your right to compensation. Therefore, the amount you received for the settlement of the legal dispute is capital proceeds for CGT event C2.

Question 2

Summary

Under section 110-25 of the ITAA 1997, your legal expenses relating to the contract dispute against the construction company will be included in the cost base of the CGT asset.

Detailed Reasoning

Section 110-25 of the ITAA 1997 lists the 5 elements of the cost base. They are:

1.            The total of the money you paid, or are required to pay, in respect of acquiring it; and the market value of any other property you gave, or are required to give, in respect of acquiring it (worked out as at the time of the acquisition).

2.            The incidental costs you incurred.

3.            The costs of owning the CGT asset you incurred.

4.            Capital expenditure for the purpose or the expected effect of which is to increase or preserve the asset's value; or that relates to installing or moving the asset.

5.            Capital expenditure that you incurred to establish, preserve, or defend your title to the asset, or a right over the asset.

Section 110-35 of the ITAA 1997 details the second element of the costs base, incidental costs. Incidental costs are the costs you may have incurred to acquire a CGT asset or that relate to a CGT event.

Subsection 110-35(2) of the ITAA 1997 details the first example of incidental costs as the remuneration for the services of a surveyor, valuer, auctioneer, accountant, broker, agent, consultant, or legal adviser.

TR 95/35 details what constitutes the cost base for the disposal of the risk to seek compensation cases. The consideration in respect of the acquisition of the right to seek compensation includes the total acquisition costs incurred as a result of which the right to seek compensation arose.

Example 8 in paragraphs 283 to 285 of TR 95/35 details a situation where the relevant asset is the right to seek compensation. In this case, the cost base was the acquisition costs plus legal costs associated with pursuing the claim against the offending party.

In your case, you engaged a lawyer to seek compensation for the construction company's breach of contract and for the losses you incurred as a result. The legal fees you incurred were directly related to compensation you received and therefore would be included in your cost base as an incidental cost under section 110-35 of the ITAA 1997.

You did not incur any other costs to 'acquire' the asset as the right to seek compensation arose when the breach of contract was discovered and did not result in any direct costs for you.

Under section 110-25 of the ITAA 1997, your legal expenses relating to the contract dispute against the construction company will be included in the cost base of the CGT asset.

Question 3

Summary

Your legal expenses relating to the mediation of disagreement in relation to your rental property will be deductible under section 8-1 of the ITAA 1997.

Detailed Reasoning

Section 8-1 of the ITAA 1997 allows a deduction for a loss or outgoing to the extent it is:

•                     incurred in gaining or producing the taxpayer's assessable income, or

•                     necessarily incurred in carrying on a business for the purpose of gaining or producing the taxpayer's assessable income.

Even if these conditions are satisfied, a deduction is not permitted if the loss or outgoing is:

•                     capital, or of a capital nature

•                     private or domestic in nature

•                     incurred in gaining or producing the taxpayer's exempt income or non-assessable non-exempt income, or

•                     otherwise prevented from being deducted by a specific provision of the ITAA 1997 or the Income Tax Assessment 1936 (ITAA 1936).

In determining if legal expenses are deductible under general provisions, it is irrelevant whether the taxpayer is successful in those proceedings. Instead, the purpose of incurring the expense must be considered and the character of the advantage being sought.

Generally, legal expenses are deductible under section 8-1 of the ITAA 1997 if the:

•                     Expenditure arose out of, or concerned the day-to-day activities of the taxpayer's business

•                     Expenditure is not undertaken to alter the organisation or structure of the taxpayer's profit yielding subject

•                     Legal action has more than a peripheral connection to the taxpayer's income producing activities

When considering the essential character of the advantage being sought in regard to a capital asset it is important to consider if a new benefit had been created or the purpose is to return the asset to a previous state for continued enjoyment (ATO Interpretative Decision ATO ID 2002/799 Income Tax Legal Expenses - Strata Title Common Property).

The wording of 'to the extent' in section 8-1 of the ITAA 1997 suggests that in certain cases the deduction may need to be apportioned. The idea of apportionment is defined in Ronpibon Tin NL v FC of T (1949) 8 ATD 431; (1949) 78 CLR 4 (Ronpibon). One kind of item of expenditure which needs apportionment involves a single outlay or change which serves both objects indifferently. In these cases, there must be some fair and reasonable assessment of the extent of the relation of the outlay assessable income (Ronpibon).

You incurred legal expenses to mediate the disagreement with your neighbour to resolve issues that affect your rental property.

This expense is considered revenue in nature as it has sufficient connection to your income earning activities and does not providing an enduring benefit.

However, as your legal expenses affect both your private property and your rental property, your legal expense is only partially related to your income earning activities.

Therefore, your legal expenses relating to the mediation of disagreement in relation to your rental property will be deductible under section 8-1 of the ITAA 1997.

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