Edited version of private ruling

Authorisation Number: 1011486966768

This edited version of your ruling will be published in the public Register of private binding rulings after 28 days from the issue date of the ruling. The attached private rulings fact sheet has more information.

Please check this edited version to be sure that there are no details remaining that you think may allow you to be identified. Contact us at the address given in the fact sheet if you have any concerns.

Ruling

Subject: Deductibility of administrator's fees and legal expenses

Question 1

Is the company entitled to an immediate deduction for the total amount of administrator's fees and legal fees relating to the company's insolvency administration?

Answer

No.

Question 2

Is the expenditure on administrator's fees and legal fees capital expenditure incurred 'in relation to your business' for the purpose of paragraph 40-880(2)(a) of the Income Tax Assessment Act 1997 (ITAA 1997) and deductible over five years?

Answer

Yes.

Relevant facts and circumstances

The company operated a business.

The company traded until a voluntary administrator was appointed. It then ceased trading operations and did not continue to trade under the administrator.

A creditor's meeting was held where a majority of creditors approved the terms of a Deed of Company Arrangement (DCA).

The DCA also stated that should any of the estimated amounts detailed at (i) to (iii) increase, the Deed Fund will not increase and as a result the dividend to unsecured creditors will decrease.

A further creditor's meeting was held to consider the request of one creditor to terminate the DCA.

Despite the majority of creditors present voting against the termination of the DCA, the creditor continued to progress an application to the Supreme Court for the DCA to be terminated and the company placed into liquidation.

This application was defended by the administrator's lawyers on behalf of the company and after numerous adjourned hearings the matter was finally resolved when the creditor withdrew their application.

As a result the company became formally subject to the terms of the DOCA which were no longer being contested.

The administrator's Report to Creditors and the DOCA estimated an ordinary unsecured dividend but stated that should the amounts that had payment priority (including the administrator's disbursements) increase, the dividend ultimately payable would decrease.

The administrator notified the creditors that as a result of the legal fees incurred in defending the winding up proceedings brought by one of the creditors, it was unlikely that a dividend would be payable to the ordinary unsecured creditors once all of the obligations of the Deed Fund had been made and the legal fees reimbursed to the administrator.

Later the administrator advised the creditors that the DCA was effectuated and as expected, there were no monies for distribution to creditors.

The company borrowed monies from a director in order to meet its payment obligations under the DCA.

The company remained in existence after the finalisation of the DCA and re-activated its ABN to re-commence trading operations.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.
Income Tax Assessment Act 1997 Section 40-880.

Reasons for decision

Summary

We have determined in your circumstances that you are not entitled to an immediate deduction under section 8-1 of the ITAA 1997 for the administrator's expenses or legal expenses incurred in defending the winding-up proceedings. This is because these outgoings are not incurred in, nor did they arise out of, the day to day income-earning activities of the company.

We consider that the expenditure is capital in nature and there is a sufficient and relevant connection between the incurrence of the capital expenditure and the business the company carries on. Accordingly, the expenditure is capital expenditure incurred in relation to its business for the purposes of paragraph 40-880(2)(a) of the ITAA 1997. As none of the limitations and exceptions contained in subsections 40-880(3) to 40-880(9) of the ITAA 1997 apply, the capital expenditure is deductible over a period of five years.

Detailed explanation

Section 8-1 of the ITAA 1997 allows a deduction for losses and outgoings to the extent they are incurred in gaining or producing assessable income (the 'first limb'), or necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income (the 'second limb'). However, a deduction is not allowed under section 8-1 if the loss or outgoing is of a capital, private or domestic nature, or is incurred in producing exempt income or where another provision of the ITAA 1997 prevents a deduction.

Administrator's expenses

For an outgoing to be deductible, it must be incidental or relevant to the production of the taxpayer's assessable income or business operations: Ronpibon Tin NL & Tong Kah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 4 AITR 236; (1949) 8 ATD 431).

With regards to the second limb, the High Court in John Fairfax & Sons Pty Ltd v. FC of T (1959) 101 CLR 30 at 48; 11 ATD 510 at 519 said that an outlay must be part of the cost of trading operations to produce income, that is, it must have the character of a working expense.

The payments made by the company to the administrator are not deductible under section 8-1 of the ITAA 1997 because they arose at a time when the company had ceased business operations and the company was subject to voluntary administration. The expenses were not directed to gaining assessable income nor were they a cost of trading.

In any case, even if the administrator's expenses met one of the two positive limbs of section 8-1 of the ITAA 1997, a deduction under that section would not be allowable as the capital exclusion would apply. The expenditure is considered to be capital in nature as:

· it is a 'one-off' type expenditure rather than a recurrent business expense;

· it was incurred in order to provide an enduring benefit, that is, to secure the continued existence of the company; and

· it was expenditure directed to the profit-yielding subject rather than the operation of the business.

Legal Expenses

In determining whether a deduction for legal expenses is allowed under section 8-1, the nature of the expenditure must be considered: (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (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 not of a capital nature, then the expenses incurred in gaining the advantage will also not be of a capital nature. It is irrelevant whether the legal action is successful or not. It is the nature and character of the expense and the advantage to be gained by incurring it that is important.

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) 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. Federal Commissioner of Taxation 80 ATC 4542; (1980) 11 ATR 276).

Legal expenses of companies in resisting winding-up petitions are not deductible as the expenses are directed at forestalling the extinction of the company as a profit-yielding subject and are therefore capital in nature ((1957) 7 TBRD Case G87; (1957) 8 TBRD Case H60; (1964) 14 TBRD Case P55)).

Other cases concerning companies defending winding-up proceedings include the following:

In (1957) 7 CTBR (NS) Case 4, costs incurred by a company in resisting winding-up proceedings were held not to be deductible.

In (1964) 11 CTBR (NS) Case 70, the taxpayer company claimed a deduction in respect of legal expenses incurred in resisting a petition to wind it up or, alternatively, to obtain an order requiring the company to distribute dividends. The Board of Review disallowed the taxpayer's claim and Mr N Dempsey said at 419 that:

[I]t is my view that the legal expenses were incurred not in the course of earning the profits of the business but in defence of the directors' methods of dealing with profits already earned. It is surely not normal to expect that directors of a company are in ordinary circumstances to be faced with a legal action calling for the winding up of the company so as to make such an action one of the ordinary risks associated with the earning of the income of the business.

The taxpayer in ITC 535, 21 SATC 419 carried on business as an insurance broker. Disputes arose between it and one of the insurance companies it represented, culminating in an application by the latter for liquidation of the taxpayer. The taxpayer opposed the application, and the matter was settled on terms which included payment by the taxpayer of costs of the insurance company. As a result of the successful opposition, the taxpayer was enabled to continue its business. It was held that the costs so paid in protection of the taxpayer's business were not deductible.

In the present case, the company incurred the legal expenses in defending an application by a creditor to the Supreme Court for the DCA to be terminated and the company placed into liquidation. The legal expenses in relation to defending these claims are similarly capital in nature and not an allowable deduction under section 8-1 of the ITAA 1997.

Section 40-880

Subject to the limitations and exceptions contained in subsections 40-880(3) to 40-880(9) of the ITAA 1997, subsection 40-880(2) of the ITAA 1997 provides that you can deduct, in equal proportions over a period of five income years starting in the year in which you incur it, capital expenditure you incur:

· in relation to your business; or

· in relation to a business that used to be carried on; or

· in relation to a business proposed to be carried on; or

· 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 beneficiary, that carried on a business.

In considering the phrase 'in relation to' contained within subsection 40-880(2) of the ITAA 1997, paragraph 2.25 of the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No. 1) Bill 2006 states:

The provision is concerned with expenditure that has the character of a business expense because it is relevantly related to the business. The concept used to establish this character or requisite relationship between the expenditure incurred by the taxpayer and the business carried on (current, past or prospective) is 'in relation to'. The connector 'in relation to' allows the appropriate latitude to enable the deductibility of qualifying capital expenditure incurred before the business commences or after it has ceased.

The phrase 'in relation to' was considered by the High Court in PMT Partners Pty Ltd (In Liquidation) v. Australian National Parks & Wildlife Service (1995) 184 CLR 301. Brennan CJ, Gaudron and McHugh JJ observed, in considering the application of the Commercial Arbitration Act 1985 (NT), at 313:

Inevitably, the closeness of the relation required by the expression 'in or in relation to' in s 48 of the Act, indeed, in any instrument - must be ascertained by reference to the nature and purpose of the provision in question and the context in which it appears.

In that case Toohey and Gummow JJ also observed:

It is apparent that the words 'in or in relation to' are particularly wide. ... Cases concerning the interpretation of this phrase in other statutory contexts are of limited assistance. However, the cases do show that the words are prima facie broad and designed to catch things which have sufficient nexus to the subject. The question of sufficiency of nexus is, of course, dependent on the statutory context. (at 330) ...

The connection which is required by the phrase 'in relation to' is a question of degree. There must be some "association" which is "relevant" or "appropriate". The question of the relevance or appropriateness of the connection is a question which cannot be divorced from the particular statutory context. (at 331)

In First Provincial Building Society Limited v. FC of T 95 ATC 4145; (1995) 30 ATR 207, Hill J. considered the phrase 'in relation to' within the context of paragraph 26(g) of the Income Tax Assessment Act 1936 . He considered the words 'in relation to' in that context included a relationship that may either be direct or indirect, provided that the relationship consisted of a real connection, but that a merely remote relationship is insufficient (at ATC 4155; ATR 218).

It is therefore necessary to consider the legislative context of subsection 40-880(2) of the ITAA 1997 in order to determine whether there is a sufficient and relevant connection between the incurrence of the expenditure and the taxpayer's business. In discussing the types of business capital expenditure to which subsection 40-880(2) of the ITAA 1997 applies, the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No. 1) Bill 2006 states:

2.19. Expenditure on the structure by which an entity carries on (or used to or proposes to carry on) their business and on the profit yielding structure of the business would ordinarily be expected to be of a capital nature. Capital expenditure can also relate to a business's trading operations or the entity that will carry on the business.

2.20. The structure covers the legal entity (such as a company) or the legal relationship (such as a partnership or trust) that is the entity that carries on the business for a taxable purpose and that holds the business assets.

These paragraphs indicate that capital expenditure incurred on the structure by which an entity carries on (or used to or proposes to carry on) their business, on the profit yielding structure of the business, or relating to the business's trading operations, are capable of being described as capital expenditure incurred 'in relation to' that business for the purposes of subsection 40-880(2) of the ITAA 1997. Whether such capital expenditure is incurred 'in relation to' the particular business will depend on whether there is a sufficient and relevant connection between the incurring of the expenditure and that business on the facts of the particular case.

The administration of the company involved preparation of a proposed DCA and defence of that arrangement which would affect whether the structure by which the taxpayer carried on its business continued, the profit yielding structure of that business and the business's trading operations. The administration of the company also involved legal expenses to avoid the winding up of the company so it could continue the business. Additionally, the taxpayer's business's trading operations were to be affected so as to allow business trading operations to continue. On the facts, there is a sufficient and relevant connection between the taxpayer's incurrence of the capital expenditure on administration and legal costs relating to the administration process and the taxpayer's business.

Accordingly, the capital expenditure was incurred by the taxpayer in relation to its business for the purposes of paragraph 40-880(2)(a) of the ITAA 1997. None of the limitations and exceptions contained in subsections 40-880(3) to 40-880(9) of the ITAA 1997 apply. Therefore the capital expenditure is deductible over a period of five years.