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Ruling

Subject: Deductions - legal expenses incurred in relation to property that is trading stock

Question 1

Can X Co Pty Ltd (X Co) deduct legal expenses, incurred in relation to land that is trading stock, under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

If the answer to question 1 is 'No', can X Co deduct these legal expenses, incurred in relation to land that is trading stock, under section 40-880 of ITAA 1997?

Answer

As the answer to question 1 is 'Yes', it is not necessary to answer this question.

This ruling applies for the following period:

Year ended 30 June 2010

The scheme commences on:

1 July 2010

Relevant facts and circumstances

The scheme

X Co is a company which carries on the business of property development.

Shareholder details have been provided.

Information in relation to the directors has been provided.

X Co holds land that is 'trading stock' within the meaning of trading stock under section 70-10 of the ITAA 1997.

That land is treated as trading stock in X Co's accounts.

X Co is entitled to the profits in relation to the land.

There has been some legal action in relation to the land that X Co holds as trading stock. X Co incurred legal expenses in relation to that action.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 40-880

Income Tax Assessment Act 1997 Subsection 40-880(1).

Reasons for decision

Question 1

Detailed reasoning

General discussion of the law

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. However no deduction is allowable if the outgoing is of a capital, private or domestic nature.

The courts have considered the meaning of 'incurred in gaining or producing assessable income'. In Ronpibon Tin NL Tong Kah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; 56 ALR 785; 8 ATD 431 (Ronpibon Tin case) the High Court stated that:

For expenditure to form an allowable deduction as an outgoing incurred in gaining or producing assessable income it must be incidental and relevant to that end. The words "incurred in gaining or producing the assessable income" mean in the course of gaining or producing such income.

In John Fairfax & Sons Pty Limited v. Federal Commissioner of Taxation (1959) 101 CLR 30; (1959) 32 ALJR 370; (1959) 11 ATD 510 it was held that outgoings incurred in the preservation of an existing capital asset are capital in nature.

Further, in British Insulated & Helsby Cables v. Atherton (Inspector of Taxes) (1926) AC 205 it was demonstrated that expenditure which is made once and for all to obtain an enduring advantage will ordinarily have the character of capital.

Legal expenses

ATO Interpretive Decision ATO ID 2003/484 discusses legal expenses incurred in defending against a claim for damages. Although differing from your circumstances, the same principles can be applied.

In particular, ATO ID 2003/484 discusses that the purpose for which the legal expenses were incurred must be examined to determine whether those expenses are of a capital or revenue nature. Further, that there must be a connection between the legal expenses and the generation of assessable income. ATO ID 2003/484 draws upon certain case law, some of which is discussed in the following paragraphs.

In Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) ALR 434; (1946) 8 ATD 190 it was indicated that in determining whether a deduction for legal expenses is allowable under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered.

The principles within Magna Alloys & Research Pty Ltd v. Federal Commissioner of Taxation (Cth) (1980) 49 FLR 183; 33 ALR 213; 11 ATR 276; 80 ATC 4542; (Magna Alloys case) indicate that the nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses. For example, if the advantage to be gained is of a capital nature, then the legal expenses incurred in gaining the advantage are also of a capital nature and not deductible.

Legal expenses are generally deductible if the legal action:

· arose out of, or concerned the day to day income producing activities of the taxpayer, as was proposed in 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, as discussed in Magna Alloys case and Putnin v. Commissioner of Taxation (1991) 27 FCR 508: 91 ATC 4097; (1991) 21 ATR 1245).

Application of the law

You state that you carry on a business of property development.

You state that the land is 'trading stock' within the meaning of trading stock under section 70 of the ITAA 1997. Further you state that you have treated the land as trading stock and have made record within your financial accounts to reflect that treatment.

However it is noted that you were not the legal owner of this land. In particular, you merely had a right conveyed upon you by the way of agreement. As a result of this agreement you commenced development of the land for the purpose of sale.

Further, you state that you were entitled to profit from the venture of developing the land.

You incurred legal expenses to clarify your rights in relation to the land as against a third party.

As the land is trading stock, and without that trading stock you would not be able to conduct your income earning activities, expenditure in relation to maintaining your rights in relation to that trading stock is also considered to be concerned with day to day income producing activity. In applying the principles proposed within Herald and Weekly Times case your legal expenses incurred in relation to that trading stock is considered to be concerned with the day to day income producing activities.

Further, as discussed in Ronpibon Tin case, it is considered that the legal expenses you incurred are incidental and relevant to producing your assessable income, rather than being of a capital nature.

In addition, while applying the principles discussed in Magna Alloys, the legal expenses you incurred are considered to have more that a peripheral connection to your income producing activity, in that without such expenditure you would cease to produce assessable income in the same way.

Therefore, X Co can deduct legal expenses, incurred in relation to land that is trading stock, under section 8-1 of the ITAA 1997.

Question 2

Detailed reasoning

Section 40-880 of the ITAA 1997 applies to make certain business capital expenditure deductible over time. Subsection 40-880(1) of the ITAA 1997 sets out the object of this section is to make certain business capital expenditure deductible over five years if:

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

(b) a deduction is not denied by some other provision; and

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

As it has been determined that X Co can deduct legal expenses, incurred in relation to land that is trading stock, under section 8-1 of the ITAA 1997; section 40-880 of the ITAA 1997 does not apply.

Therefore, as the answer to question 1 is 'Yes', deductibility under section 40-880 of ITAA 1997 will not be further considered.