Edited version of private ruling

Authorisation Number: 1011596034102

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Ruling

Subject: Legal Expenses

1. Will you be entitled to a deduction under section 8-1 of the Income Tax Assessment Act (ITAA 1997), for legal expenses incurred in defending legal action against you?

No.

2. Will you be entitled to a deduction under section 8-1 of the ITAA 1997, for legal expenses awarded against you by the Court as a consequence of the decision referred to in the preceding question?

No

This ruling applies for the following period

Year ended 30 June 2009

Year ended 30 June 2010

Year ended 30 June 2011

The scheme commenced on

1 July 2008

Relevant facts

Facts describing the circumstances based on the pleadings of the respective parties to the legal proceedings (the Proceedings) and the Judgement of the Trial Judge in relation to the Proceedings.

You are a chartered accountant and at the relevant time, you were a partner in a firm of Chartered Accountants and Business Advisors.

The Plaintiffs in the Proceedings owned 100% of the issued shares in and operated the institute.

The Plaintiffs made allegations against you.

You disputed these allegation by the Plaintiffs and you counter claimed.

You were sued in your personal capacity notwithstanding your status as a partner in the Firm.

Costs were awarded against you.

Your have incurred costs in defending legal action against you.

Pursuant to the Judgement, you are also liable to pay the costs of the Plaintiffs.

You have provided the following documents which are to be read with and form part of these facts:

· Further Amended Statement of Claim

· Amended defence to Further Amended Statement of Claim

· Transcript of decision

· Reconciliation of Legal Expenses

· Shareholders Agreement

· Draft Ruling.

Relevant legislative provisions:

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

The relevant legislation is the Income Tax Assessment Act 1997 (ITAA 1997). All references to legislation is to ITAA 1997 unless otherwise stated.

Section 8-1 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income, or necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income, except where the outgoings are of a capital, private or domestic nature.

For legal expenses to constitute an allowable deduction, it must be shown that they are incidental or relevant to the production of the taxpayer's assessable income or business operations. (Ronpibon Tin N.L.Tongkah Compound N.L. v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 8 ATD 431; (1949) 4 AITR 236 (Ronpibon Tin N.L)).

Also, in determining whether a deduction for legal expenses is allowable 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) 8 ATD 190; (1946) 3 AITR 436 (Hallstroms)). The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses.

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) 2 ATD 169 (Herald and Weekly Times)) and the legal action has more than a peripheral connection to the taxpayer's income producing activities (Magna Alloys & Research Pty Ltd v. FC of T 80 ATC 4542; (1980) 11 ATR 276 (Magna Alloys)).

Where the principal reason for incurring the legal expense is defending the actions of the taxpayer in carrying out the employment duties through which they gain or produce assessable income, such expenses are characterised as being of a revenue nature and are deductible.

To determine the deductibility of an expense. it is therefore necessary under the first limb of section 8-1, to examine the character of the expense to see if it was incurred in earning assessable income and then, whether it is of a capital, private or domestic nature under the second limb of that section.

The relation between the character of an expense and deductibility has been well established in landmark cases such as Ronpibon Tin NL. The expense must be incurred in the course of gaining or producing assessable income, to have that connection with the activities that produce the income. As it was stated in Charles Moore & Co (WA) Pty Ltd v. Federal Commissioner of Taxation (1956) 95 CLR 344; (1956) 11 ATD 147; (1956) 6 AITR 379:-

What matters is their connection with the operations which more directly gain or produce the assessable income.

Therefore, it is necessary to establish the connection between the expense incurred and the activities that produce the income to characterise that expense as being incurred in the production of that income.

Once that connection is established, then the purpose or motivation of the taxpayer in incurring the expense needs to be examined, irrespective of whether the expense was voluntarily or involuntarily incurred. In those situations where it is involuntarily incurred, the argument may be stronger to establish the link to the production of assessable income, but that is not the crucial or only test to characterise the expense.

In Herald and Weekly Times, it was established that the activities which generated the income of the taxpayer were the occasion which gave rise to the legal expenses incurred in defending libel charges. Similarly in Magna Alloys case legal expenses in defending the actions of its directors were considered deductible as they were incurred in the normal activities of the business through which income was earned.  

In Federal Commissioner of Taxation v. Rowe (1995) 60 FCR 99; 95 ATC 4691; (1995) 31 ATR 392 (Rowe) the earlier case was cited by Burchett J at p.4702 to state in language borrowed from the judgement in Putnin:-

the liability in question was incurred, or the claim was encountered, because of the very act of performing the work by which the respondent earned assessable income. The activities, which produced the assessable income, were what exposed the taxpayer to the liability discharged by the expenditure. As the court said in Putnin at 513, so here the proceedings arose from the activities by which the taxpayer earned his income, the mode of his performance of a particular task carried out in the course of business operations.

It therefore follows that, if the action goes beyond the normal employment duties, then there may be doubt about the nexus with income earning activities and the character of the associated expense changes from income earning to being of a private, domestic or capital nature.

Both Hallstrom and Sun Newspapers Limited v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 23; (1938) 1 AITR 403 (Sun Newspapers), considered the deductibility of legal expenses. The latter case established three criteria to help decide on the deductibility of legal expenses, viz:

· The character of the advantage sought, and in this case it's lasting qualities may also play a part.

· 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.

· The means adopted to obtain it: that is, by providing periodical regard 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 loss or enjoyment.

In using these criterion, the purpose of the taxpayer in incurring the expense must necessarily be examined, irrespective of whether the expense was voluntarily or involuntarily incurred.

In view of the above legal principles established through case law, the facts of your situation may be summarised as follows. In making their finding the court accepted the allegations made against you. Even though your normal duties through which you earned assessable income was as an advisor and broker to the Plaintiffs, you went beyond your normal duties.

Your purpose in incurring this expense is relevant here. You incurred the liability to defend your actions in the performance of something beyond your normal duties, in a matter which was not normal or routine. You did not incur the legal expenses in defending your normal activities through which you earn assessable income. Thus, there is no connection between the expenses and your assessable income, which then denies the character of the expense as having been incurred in earning assessable income.

You were defending your part in a transaction which was not expected of you in your normal employment. You were defending yourself against failing in your fiduciary duty to the clients by obtaining a shareholding in their business. This is not part of your normal employment duties. Your employment was merely the setting in which you undertook these actions.

These factors were the main reason for incurring the expenses.

Your circumstances are to be distinguished from those in Magna Alloys, Herald and Weekly Times and Sun Newspapers and Rowe's cases, in all of which the expenses were considered to have been incurred because of the normal activities through which assessable income was earned. 

Your legal expenses are not deductible under section 8-1 as the expenses were incurred in defending an allegation of a breach of fiduciary duty which was not related to the derivation of your assessable income. The legal expenses are capital in nature.

In Smithkline Beecham Laboratories (Australia) Ltd v. FC of T 93 ATC 4629; (1993) 26 ATR 260, Hill J stated that expenditure incurred to preserve or protect a business as such will ordinarily be expenditure of capital. Here, the investigation and legal expenses were incurred to preserve the firm's reputation with existing and potential clients. The expenditure was incurred for the purpose of securing an enduring benefit to the firm, namely its client base, and is therefore capital in nature.

Therefore, the purpose of the legal expenditure, being to preserve the reputation of the firm, was primarily a capital expense. The expenses were in large a measure to protect and enduring benefit. In the circumstances the expenditure in relation to both the forensic accountants and the legal expenses for the purpose of meeting the fraud are of a capital nature and therefore non-deductible.

Conclusion

Question 1

Will you be entitled to a deduction under section 8-1, for legal expenses incurred in defending legal action against you?

No. Your legal expenses are not deductible under section 8-1 as the expenses were incurred in defending an allegation of a breach of fiduciary duty which was not related to the derivation of your assessable income.

In addition, the legal expenses are capital in nature. Therefore, the legal expenses are not deductible under section 8-1.

Question 2

Will you be entitled to a deduction under section 8-1, for legal expenses awarded against you by the Court as a consequence of the decision referred to in the preceding question?

No. Your legal expenses are not deductible under section 8-1 as the expenses were incurred in defending an allegation of a breach of fiduciary duty which was not related to the derivation of your assessable income.

In addition, the legal expenses are capital in nature. Therefore, the legal expenses are not deductible under section 8-1.