Edited version of private advice

Authorisation Number: 1052380146903

Date of advice: 7 April 2025

Ruling

Subject: Deductibility - settlement payment

Question 1

Is the settlement payment made by Company X deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)in the year ended 30 June 20XX?

Answer 1

No.

Question 2

If the answer to Question 1 is no, is Company X entitled to claim a deduction for the settlement payment in equal proportions over a period of five years commencing in the year ended 30 June 20XX pursuant to section 40-880 of the ITAA 1997?

Answer 2

Yes.

This ruling applies for the following periods:

Year ended 30 June 20XX

The scheme commenced on:

1 July 202X

Relevant facts and circumstances

Company X is an Australian proprietary company.

Individual X is the sole shareholder and director of Company X.

Company X engaged Individual Y to provide services to Company X as a contractor through Company Y.

Company X terminated their business association with Company Y and Individual Y.

Company X and Individual X commenced proceedings against Company Y and Individual Y. Company Y and Individual Y made a subsequent cross claim against Company X and Individual X.

During the proceedings, a mediation was held where Company X negotiated a settlement amount to end the dispute between Company Y.

Company X and Individual X entered into a Deed of Settlement to settle the dispute between Company Y and Individual Y.

Company X paid Company Y the settlement amount in the 20XX year.

The payment was a lump sum payment and there was no apportionment of the settlement amount paid to Company Y.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 40-880

Question 1

Summary

The settlement payment made by Company X pursuant to the Deed of Settlement is not deductible under section 8-1 of the ITAA 1997in the year ended 30 June 20XX.

Reasons for decision

Subsection 8-1(1) of the ITAA 1997states that you can deduct a 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.

Subsection 8-1(2) of the ITAA 1997 states however, you cannot deduct a loss or outgoing under this section to the extent that:

(a)           It is a loss or outgoing of capital, or 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 prevents you from deducting it.

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) are satisfied and it does not fall within any of the negative limbs in subsection 8-1(2).

Nexus with assessable income or carrying on of a business

Relevantly, to be deductible under section 8-1 of the ITAA 1997, the settlement payment must have a sufficient connection with the carrying on the business for the purpose of gaining or producing assessable income.

Payments which arise from legal settlements are generally deductible if the expenditure:

•                     arose out of, or concerned the day-to-day income producing activities of the taxpayer (Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 39 ALR 46; (1932) 2 ATD 169)

•                     is not undertaken to protect the taxpayer's profit yielding subject

•                     has more than a peripheral connection to the taxpayer's business (Magna Alloys and Research Pty Ltd v. Commissioner of Taxation (1980) 49 FLR 183 (Magna Alloys); (1980) 11 ATR 276; 80 ATC 4542; (1980) 33 ALR 213; Putnin v. Commissioner of Taxation (1991) 27 FCR 508; 91 ATC 4097; (1991) 21 ATR 1245 (Putnin))

•                     may arise out of litigation concerning the taxpayer's professional conduct (Magna Alloys and Putnin).

A settlement payment to resolve or finalise a legal dispute would be of an income nature if:

•                     they arise as a consequence of the day-to-day activities of the business.

•                     the dispute in which the settlement payment relates has more than a peripheral connection to the income producing activities, and

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

Subsection 8-1(1) positive limbs - Conclusion

The settlement payment does not have a sufficient connection with the carrying on of a business for the purpose of gaining or producing assessable income.

Neither of the positive limbs under subsection 8-1(1) of the ITAA 1997 are satisfied. Further, we consider that the outgoing is capital, or of a capital nature.

Subsection 8-1(2) - the negative limbs

Paragraph 8-1(2)(a) - Capital in nature

A loss or an outgoing is not deductible to the extent that it is of capital, or of a capital nature (paragraph 8-1(2)(a) of the ITAA 1997).

The High Court decision in Sun Newspapers Ltd. and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 23; (1938) 1 AITR 403 (Sun Newspapers) is the leading authority on the distinction between revenue and capital expenditure. In Sun Newspapers, Dixon J stated:

'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 in 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 reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment.'

The primary considerations in determining whether a settlement payment to resolve or finalise a legal dispute is on revenue or capital account are:

•                     whether the settlement payment relates 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).

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

•                     A settlement payment incurred in establishing, preserving, perfecting, or defending title to property or a right over an asset are capital in nature.

Conclusion

The settlement payment is not deductible under section 8-1 of the ITAA 1997. The settlement payment does not meet either of the positive limbs in subsection 8-1(1). The settlement payment is also of a capital nature and falls within the negative limb in paragraph 8-1(2)(a) of the ITAA 1997.

Question 2

Summary

Company X will be entitled to claim a deduction for the settlement payment in equal proportions over a period of five years commencing in the year ended 30 June 20XX pursuant to section 40-880 of the ITAA 1997.

Detailed reasoning

Subsection 40-880(1) of the ITAA 1997 states the object of this sectionis to make certain business capital expenditure deductible over 5 years if:

(a)           the expenditure is not otherwise taken into account, and

(b)           a deduction is not denied by some another provision, and

(c)           the business is, was or is proposed to be carried on for a taxable purpose.

Taxation Ruling TR 2011/6 Income tax: business related capital expenditure - section 40-880 of the Income Tax Assessment Act 1997 core issues sets out the Commissioner's views on the interpretation of the operation and scope of section 40-880 of the ITAA 1997.

Paragraph 23 of TR 2011/6 states that determining the amount allowable as a deduction under section 40-880 of the ITAA 1997is a multi-step process:

•                    first it is necessary to determine initial entitlement under subsection 40-880(2); and

•                    then the limitations and exceptions in the subsequent subsections must be considered.

Under subsection 40-880(2):

You can deduct, in equal proportions over a period of 5 income years starting in the year in which you incur it, capital expenditure you incur:

(a)           in relation to your business; or

(b)           in relation to a business that used to be carried on; or

(c)           in relation to a business proposed to be carried on; or

(d)           to liquidate or deregister a company of which you were a member, to wind up a partnership of which you were a partner or to wind up a trust of which you were a beneficial, that carried on a business

The settlement payment was incurred by Company X in relation to their current business for the purpose of paragraph 40-880(2)(a) of the ITAA 1997.

Limitations and exceptions on the amount of expenditure allowable as a deduction

Subsections 40-880(3) and (4) of the ITAA 1997both contain a 'taxable purpose' test which applies to the expenditure identified in subsection 40-880(2). Subsections 40-880(3) and (4) may apply to limit the deductibility of capital expenditure under subsection 40-880(2) to the extent that it relates to that business being carried on for a taxable purpose.

Taxable Purpose

Company X's business was carried on for a taxable purpose, as required by subsection 40-880(3) of the ITAA 1997.

Subsection 40-880(4)

Subsection 40-880(4) of the ITAA 1997 is not applicable to the present case as it relates to the deductibility of capital expenditure for a business that another entity used to carry on or proposes to carry on.

Exceptions to allowing a deduction

Once entitlement is initially established under section 40-880(2) of the ITAA 1997 and the limitations in subsections 40-880(3) or 40-880(4) are considered, further restrictions may be placed on the amount of expenditure which is deductible under section 40-880(2). There are further restrictions contained in subsections 40-880(5), 40-880(8) and 40-880(9).

Subsection 40-880(5)

You cannot deduct anything under this section for an amount of expenditure you incur to the extent that:

•                     it forms part of the cost of a depreciating asset that you hold, used to hold or will hold; or

•                     you can deduct an amount for it under a provision of this Act other than this section; or

•                     it forms part of the cost of land; or

•                     it is in relation to a lease or other legal or equitable right; or

•                     it would, apart from this section, be taken into account in working out:

­        a profit that is included in your assessable income (for example, under section 6-5 or 15-15); or

­        a loss that you can deduct (for example, under section 8-1 or 25-40); or

•                     it could, apart from this section, be taken into account in working out the amount of a capital gain or capital loss from a CGT event; or

•                     a provision of this Act other than this section would expressly make the expenditure non-deductible if it were not of a capital nature; or

•                     a provision of this Act other than this section expressly prevents the expenditure being taken into account as described in paragraphs (a) to (f) for a reason other than the expenditure being of a capital nature; or

•                     it is expenditure of a private or domestic nature; or

•                     it is incurred in relation to gaining or producing exempt income or non-assessable non-exempt income.

None of the restrictions in the paragraphs of subsection 40-880(5) of the ITAA 1997 apply to limit the deduction.

Subsections 40-880(6) and 40-880(7)

It is not necessary to consider the operation of subsection 40-880(6) of the ITAA 1997 because a deduction is not limited by paragraphs 40-880(5)(d) or (5)(f).

Subsection 40-880(7) of the ITAA 1997 also has no application because the Settlement Payment was not made in relation to a business proposed to be carried on.

Subsection 40-880(8)- The expenditure is excluded from the cost of a depreciating asset or the cost base or the reduced cost base of a CGT asset because of a market value substitution rule

The settlement payment does not form part of the cost base or reduced cost base of any CGT assets or of the cost of a depreciating asset. As such, a market value substitution rule does not apply in this situation.

Subsection 40-880(9) - The expenditure is an amount previously received, or a return on or of debt or equity

Subsection 40-880(9) does not apply to exclude the settlement payment from deductibility under section 40-880. The settlement payment is not a return of an amount previously received by Company X or a return on or of an equity interest or a debt interest for the purpose of subsection 40-880(9) of the ITAA 1997.

Conclusion

The limitations and exceptions contained in subsection 40-880(3) to subsection 40-880(9) of the ITAA 1997 will not apply to limit the deductibility of the settlement payment under section 40-880.

As a result, the settlement payment is deductible over a period of 5 income years in equal proportions, commencing in the year ended 30 June 20XX, pursuant to section 40-880 of the ITAA 1997.

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