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Authorisation Number: 1011596322158

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Ruling

Subject: Legal expenses

Question:

Are your legal expenses in relation to your dispute with a business partner deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Relevant facts and circumstances

You sold a one half share in your business to a third party. Due to major personal conflicts, you sought legal advice about how the end the business relationship however none of the issues raised were adequate grounds for the ending of the business relationship stipulated under contract. At a later time, you used the non-payment of some shared expenses as grounds to end the relationship. The third party lodged a counter claim for dual rights to all of the business assets. You eventually settled the dispute out of court, where, pursuant to the settlement deed, you paid a lump sum to terminate the business arrangement and joint lease of the premises.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Summary

In order to justify a deduction under section 8-1 of the ITAA 1997, the outgoing in question must be actually incurred in gaining or producing assessable income. In your case, you commenced incurring legal expenses due to personal disputes with a business partner, which lead to your investigating or pursuing a means to end that business relationship via either the repurchasing or disposing of the relevant business assets. The escalation of the dispute led to your defending a counter claim for the ownership of the business assets. Legal expenses incurred in relation to loss of reputation or personal pain and suffering are not revenue in nature and cannot be deducted under section 8-1 of the ITAA 1997. Similarly, legal expenses incurred in relation to acquiring, disposing of or defending business assets cannot be deducted under section 8-1 of the ITAA 1997, as they are capital in nature.

Detailed reasoning

Section 8-1 of the ITAA 1997 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. However, a deduction will not be allowed where the outgoings are of a capital, private or domestic nature.

The nature or character of legal expenses follows the advantage which is sought to be gained by incurring the expenses.

Where legal expenses arise as a consequence of the day to day income earning activities of a business, the object of the expenditure is devoted towards a revenue end and the legal expenses are deductible (Herald & Weekly Times v. Federal Commissioner of Taxation (1932) 48 CLR 113; 2 ATD 169).

Where the expenditure is devoted towards a structural rather than an operational purpose, that is, the creation of any benefit or advantage of an enduring nature, the expenditure is of a capital nature and the expenses are not deductible (Sun Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; 5 ATD 87; (1938) 1 AITR 403).

Court cases distinguishing revenue and capital

In the case of Herald and Weekly Times, deductions for legal expenses were allowed in connection with libels the taxpayer, a proprietor and publisher of an evening newspaper, had published. A majority of the Full High Court held the risk of libel was a regular and almost unavoidable incident or inherent risk of day-to-day publishing.

Deductions for legal expenses were allowed in Federal Commissioner of Taxation v Snowden and Willson Pty Ltd (1958) 99 CLR 431; 11 ATD 463, where legal expenses were incurred in relation to defending allegations of overcharging and unfair business practices by taxpayer's building operations; and also in Magna Alloys and Research Pty Ltd v Federal Commissioner of Taxation (1980) 33 ALR 213; (1980) 80 ATC 4542; (1980) 11 ATR 276; (1980) 49 FLR 183, where legal expenses were incurred in relation to defending criminal charges laid against the company's directors and agents in relation to marketing practices adopted in selling its products. In both of these cases, the legal expenses arose as a consequence of the day-to-day activities of producing assessable income.

Deductions for legal expenses were disallowed in Case U102, 87 ATC 621. Here, the taxpayer was a secretary-manager of a sporting club who was also a trustee of a fund set up to care for an injured member. The taxpayer claimed legal costs associated with prosecuting a person who allegedly made defamatory remarks about the management of the fund and commenced proceedings for defamation. The Administrative Appeals Tribunal held that a deduction for the legal expenses incurred by the taxpayer for the defamation proceedings was not allowable, as these expenses were not incidental to the proper execution of the office of trustee. The proceedings were instituted to maintain the taxpayer's personal reputation.

In the case of Sun Newspapers Ltd, the taxpayer agreed to pay £86,500 to those interested in the production of a new competing newspaper for their interest in the competing newspaper and for them not becoming associated for a period of three years with the publication of any other newspaper in Sydney or within 300 miles thereof. It was held that the moneys so paid were in the nature of capital. The features of the Sun Newspapers case which led Dixon J to the conclusion that the outgoings were on capital account included the fact that the outgoings were of a large sum, that they were incurred to remove competition and that the chief object of making the outgoings was to strengthen and preserve the taxpayer's existing business organisation and to acquire an asset.

Dixon J was to reaffirm his approach in Hallstroms Pty Ltd v FC of T (1946) 72 CLR 634 at p 646, and again in John Fairfax & Sons Pty Ltd v FC of T (1959) 101 CLR 30. In the former case, he also said (at 72 CLR pp 646-647):

...it may be useful to recall the general consideration that the contrast between the two forms of expenditure corresponds to the distinction between the acquisition of the means of production and the use of them; between establishing or extending a business organization and carrying on the business; between the implements employed in work and the regular performance of the work in which they are employed; between an enterprise itself and the sustained effort of those engaged in it.

Court cases about payment for cancellation or breach of agreement

In the High Court of Australia case of W Nevill & Co Ltd v. Federal Commissioner of Taxation (1937) 56 CLR 290; 4 ATD 187, a deduction was allowed for the expense incurred in the effecting the resignation of a company co-director's five year contract of employment. The system of joint management did not work out satisfactorily and impaired the efficient management of the business. The main object in making the arrangement for the resignation was to effect a saving of salary expense and at the same time increase the efficiency of the company. Although it was clear to the court the expense was not capital in nature, it was still required of the court to justify that the expense in question must actually be incurred in gaining or producing the assessable income. In his judgment, Latham CJ said:

No asset was acquired by the expenditure of the sum of PD2,500. The agreement between the company and King for the employment of King was not something affecting the whole structure of the company's business. Its cancellation cannot be regarded as involving the acquisition of a capital asset. The cancelled agreement was an agreement for the employment of a servant made in the ordinary course of the company's business. I am unable to discern any reason which would justify the conclusion that the PD2,500 was a capital expenditure.

But in order to justify a deduction under s. 23 (1) (a) the outgoing in question must be actually incurred in gaining or producing the assessable income.

In contrast to W Nevill & Co Ltd is the case of Foley Bros Pty Ltd v. Commissioner of Taxation (Cth) (1965) 13 ATD 474; (1965) 38 ALJR 430. In this case, the taxpayer company entered into a 20 year agreement containing an undertaking not to reduce the scope or extent of its trading activities. It breached this undertaking when financial difficulties forced it to undergo a major rationalisation and reorganisation of its activities. The other party to the agreement commenced legal proceedings. The Full High Court took the view that the freedom acquired to carry out the reorganisation was an enduring advantage and not merely a freedom to make day-to-day decisions in the course of carrying on income producing activities.

Application of law in your case

In your case, following the reasoning in the case of W Nevill & Co Ltd, you have been unable to justify a nexus between your initial grievances against the third party and your gaining or producing of your assessable income. The impression gained is your initial grievances were personal conflicts between your directors and the third party. This is summed in the statement of one of your directors, who said she had "no wish to perpetuate the pain anymore". Although these personal issues initially provided insufficient grounds to terminate the POA, you continued to pursue these matters with the intention of ending the business agreement, that is, via buying out the third party or by the third party buying you out. Eventually, you found some valid grounds to terminate the POA. However, your demonstrated intent throughout the whole affair was to change the business structure that resulted from your sale of half of your business to the third party.

Similar to Case U102, where a deduction was disallowed, your legal action was motivated by matters relating to your director's personal reputation. Similar to the case of Sun Newspapers Ltd, where a deduction was disallowed, your legal action was motivated by your wish to reacquire the business asset you sold to the third party. Similar to the case of Foley Bros Pty Ltd, where a deduction was disallowed, your legal action was to acquire the freedom to carry out a reorganisation. Unlike the case of W Nevill & Co Ltd, where a deduction was allowed, there was no on-going cost saving or increase in taxable income that would result from your legal expenses as you would no longer have a business partner to share in your rental, employment, advertising and other expenses.

Regarding the grievances that lead to the initial incurring of your legal expenses, such as the registration of the practice name, the internet advertising and the Christmas cards, these were largely resolved prior to your legal action, with one of your directors agreeing with the third parties actions.

Other matters, such as new guidelines and protocols, allegations about 'inferior' operating standards, staff issues, an antenna, accounting structure, floor plan and taxi transport for staff after social functions do not have a relationship with your earning of assessable income. These were simply personal disagreements between respective company directors about matters unrelated to the day-to-day earning of assessable income.

Regarding the landlord issues, these are not related to you as a company but rather related to your landlord as an individual.

Regarding your legal expenses incurred for defending and settling claims lodged against you by the third party, these are capital in nature. The legal action brought against you by the third party was a claim for ownership of the business assets. You were required to defend and settle this claim.

As for your termination of the POA based on non-payment of the service fee and the third party changing details of a client booking from one director to himself, whilst these matters are revenue in nature, you commenced your legal inquiries well before these events occurred. Your salient intention throughout the whole affair was to end the business relationship through either the disposal or acquisition of half of the business. Your use of the non-payment of the service fee and the client booking matter as grounds for dispute were merely incidental to the primary intent of the legal action.

For example, in the Full Federal Court case of Putnin v. Federal Commissioner of Taxation (1991) 27 FCR 508; 91 ATC 4097; (1991) 21 ATR 1245, legal expenses that included the defending of the taxpayer's business registration (which is a matter of capital) were held to be deductible because the registration issue was an indirect consequences of the primary criminal proceedings which arose from the activities by which the taxpayer earned his income and his mode of his performance of his employment duties. In your case, your legal expenses were primarily incurred to find a possible way to end your business relationship and your use of the non-payment of the service fee and the client booking were merely an incidental or indirect consequence of your primary objective.

In conclusion, you began incurring legal expenses due to personal issues with your business partner, which were not sufficient to terminate the agreement. However, you continued to pursue these personal issues, with the intention to end the business relationship, until a time you found sufficient grounds to do so. Then, at a later time, you incurred the majority of your legal expenses in defending a counter legal action initiated by the other party, which was exclusively about the ownership of business assets. As none of the primary issues mentioned are related to the earning of assessable income but, to the contrary, concerned with the acquisition, disposal or defence of business assets, a deduction for your legal expenses is not available to you under section 8-1 of the ITAA 1997.