Edited version of private ruling

Authorisation Number: 1011653152961

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Ruling

Subject: Legal expenses

Question and Answer

Are you entitled to a deduction for 50 percent of legal expenses incurred in pursuing your share of the partnership profits after you ceased to be a partner in the partnership?

Yes

This ruling applies for the following periods:

Year ended 30 June 2008

Year ended 30 June 2009

Year ended 30 June 2010

The scheme commences on:

1 July 2007

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

You were a partner in a partnership.

You entered in the partnership in year A and left in year B which was many years ago.

You commenced legal action in a Court against your previous partners of the partnership, seeking your share of the partnership assets and a share of the continuing profits under section 42 of the Partnership Act.

Section 42 of the Partnership Act deals with the rights of an outgoing partner and states that the outgoing partner is entitled to a share of the profits made since dissolution as the Court may find to be attributable to the use of their share of the partnership assets, or to interest at the rate of six per cent per annum on the amount of their share of the partnership assets.

The litigation ran from year B to year C, which was a considerable period. You incurred significant legal expenses over this period, including the payment of defendants' costs.

You lost the legal action. There was no decision by the Court as to your share of the partnership assets on dissolution of the partnership or your share of the continuing profits

You invested $X in year A when you entered the partnership. Applying the Supreme Court interest rates, you estimate that the capital component would be at most 50 percent of the claim as the capital damages are based on the claim of $X invested in year A subject to damages at the Supreme Court interest rates.

By contrast, you estimate your entitlement to revenue under section 42 of the Partnership Act, after you left the partnership, to far exceed your entitlement to your share of the assets. When you were a partner in the partnership, you were earning approximately $Y per year. Had you continued being a partner in that partnership, you would have earned at least $Y each year for the period between year B and year C.

You consider 50 percent of your total legal expenses relate to your share of the continuing income of the partnership and 50 percent relate to your share of the partnership assets on dissolution. You believe this to be fair, reasonable and conservative.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for Decision

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.

Claiming a deduction after income producing activities have ceased

The operation of section 8-1 of the ITAA 1997 may include a taxpayer being entitled to an allowable deduction, despite the fact their relevant income producing activities have ceased. This will occur when the occasion of the relevant expense arose out of the previous business operations. The body of taxation law holds an expense is incurred if a taxpayer is 'definitively committed' or has 'completely subjected' itself to the liability even though it has not paid the amount (Federal Commissioner of Taxation v. James Flood Pty Ltd (1953) 88 CLR 492; (1953) 10 ATD 240; (1953) 5 AITR 579).

For example, in the Full Federal Court case of Placer Pacific Management Pty v. Federal Commissioner of Taxation 95 ATC 4459; (1995) 31 ATR 253, the taxpayer was sued by a customer for supplying an allegedly defective conveyor belt. The customer commenced proceedings shortly after the taxpayer sold its conveyor belt business. About four years later, the action was settled by the taxpayer paying the customer a sum of money. The Full Federal Court allowed the taxpayer a deduction for that sum plus its legal fees, on the basis that the occasion of the loss or outgoing was the business arrangement entered into between the taxpayer and its customer for the supply of the conveyor belt. The fact that the conveyor belt division had been sold and its active manufacturing business terminated did not deny deductibility.

In your case, you were a partner in a partnership for many years. You undertook legal action with a Court after you ceased to be a partner. You incurred legal expenses. The legal expenses related to your share of the partnership assets on dissolution as well as your share of the continuing income of the partnership as provided for under section 42 of the Partnership Act.

You lost the legal action. There was no decision by the Court as to your share of the partnership assets and yours share of the continuing profits under section 42 of the Partnership Act.

We now need to consider if the legal expenses are deductible, and if so, to what extent.

Nature or character of the expense

For legal expenses to constitute an allowable deduction, it must be shown they are incidental or relevant to the production of the taxpayer's assessable income and arise as a consequence of the day-to-day activities of producing assessable income. The character of legal expenses is not determined by the success or failure of the legal action (No. 3 Board of Review Case B31, 70 ATC 148).

A leading case on the matter of legal expenses is The Herald and Weekly Times v Federal Commissioner of Taxation, 2 ATD 169; (1932) 48 CLR 113 (Herald and Weekly Times), which was about the proprietor of an evening newspaper claiming legal expenses in connection with libels the newspaper had published. The Full High Court allowed the deduction, as publishing the newspaper was both the source of income and cause of the liability and secondly, the risk of libel was a regular and almost unavoidable incident or inherent risk of publishing.

By contrast, where legal expenses is devoted towards a structural rather than an operational purpose, the expenditure is of a capital nature and the expenses are not deductible (Sun Newspapers Ltd v. FC of T (1938) 61 CLR 337; 5 ATD 87; (1938) AITR 403).

In Hallstrom's case, the taxpayer incurred expenses in opposing an application by a competitor to extend registration of a patent for a period of 10 years beyond its expiry date. It was held that the expenditure was made to enable them to continue as they had in the past. The company merely succeeded in maintaining an existing position.

Outgoings incurred in the preservation of an existing capital asset have been held to be capital in nature (John Fairfax & Sons Pty Ltd v. Federal Commissioner of Taxation (1959) 101 CLR 30; (1959) 7 AITR 346; (1959) 11 ATD 510).

Dissolution of partnership

Where there is a change in the composition of a partnership, for example if a partner leaves, the partnership is dissolved. As a general rule, legal expenses arising out of a decision to dissolve a former partnership and to form a new partnership are considered to be of a capital nature as they are related to the business structure. Legal expenses for resolving a dispute about entitlements and the subsequent transfer of assets are not incurred in the day to day running of a business and are therefore of a capital nature.

Your case

You were a partner in a partnership for many years and left the partnership in year B. As there was a change in the composition of the partnership, the partnership was dissolved. You commenced litigation against your previous partners seeking your share of the assets and a share of profits. The legal expenses pertaining to the ascertainment of your share of the assets are of a capital nature and thus not deductible.

The legal expenses which you incurred to determine your entitlements to the income or profits from the partnership, after you ceased to be a partner, are of a revenue nature and thus deductible under subsection 8-1 of the ITAA 1997.

Apportionment of legal expenses

Section 42 of the Partnership Agreement specifies the profit entitlements in the event of a partner leaving a partnership. The section requires the outgoing partner be entitled to such share of the profits made since dissolution as the Court finds attributable to the use of their share of the partnership assets, or to interest at the rate of 6 percent per annum on the amount of their share of the partnership assets.

Share of partnership assets

You invested $X in year A when you entered the partnership. Applying the Supreme Court interest rates, you estimate that the capital component would be at most 50 percent of the claim as the capital damages are based on the claim of $X invested in year A subject to damages at the Supreme Court interest rates.

Share of continuing income of the partnership

By contrast, you estimate your entitlement to revenue under section 42 of the Partnership Act, after you left the partnership, to far exceed your entitlement to your share of the assets. When you were a partner in the partnership, you were earning approximately $Y per year. Had you continued being a partner in that partnership, you would have earned at least $Y each year for the period between year B and year C, which was a considerable period. This is lost income which you would have been entitled to receive.

Given the length of time since you left the partnership, the revenue or section 42 claim of $Y would outweigh the claim for capital damages. On this basis, we consider the apportionment of 50/50 (revenue/capital) to be reasonable for purposes of calculating your legal expenses deduction.

Conclusion

You are entitled to a deduction of 50 percent of your legal expenses incurred in pursuing your share of the partnership profits after you ceased to be a partner in the partnership.