Edited version of private ruling

Authorisation Number: 1011663993787

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Ruling

Subject: Deductibility of legal expenses under section 8-1 of the ITAA 1997

Question 1

Are legal expenses incurred by Company D in defending proceedings brought against Companies A, B and C, which are members of the tax consolidated group of which Company D is the head company, by Company X deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

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.

Company A

Company A is an Australian resident company for income tax purposes.

Company A's business activities primarily involves manufacturing activities as well as other activities.

Company A (through its subsidiaries) had developed Product 1 which at the time was unique.

Company A is the registered owner of intellectual property including patents and designs applicable to Product 1.

Company A did not and does not sell intellectual property associated with its developed products either to internal or external parties. However, it did enter into various licence agreements with foreign manufacturers to manufacture products to its designs and specifications and to sell those products into foreign markets.

Company B

Company B is an Australian resident company for income tax purposes.

Company B began as an internal division of Company A and subsequently was incorporated as a separate company and wholly-owned by Company C. Company B was responsible for product development and manufacturing.

Company C

Company C is an Australian resident company for income tax purposes. It was the holding company of Companies A and B.

Company D

Company D is an Australian resident company for income tax purposes and is the head company of the Company D tax consolidated group, of which Companies A, B and C are members.

Accordingly, under the single entity rule, Company D, as the head company of the Company D tax consolidated group, is the only entity in the group recognised for income tax purposes.

Company X

Company X is an Australian company for income tax purposes.

Company X had developed and was marketer of Product 2 which could, subject to development of a suitable interface, be compatible with Product 1.

The agreements

Company X and Company A entered into dealings whereby Company A would re-brand and sell Product 2 and several associated products (Original Products). The parties negotiated two initial agreements to facilitate those dealings including:

§ Collaboration Agreement pursuant to which Company X agreed to provide to Company A sufficient information about Product 2 to enable Company A to develop an interface to make Product 1 compatible with Product 2.

§ Supply Agreement pursuant to which Company X agrees to grant Company A the right to market and sell Product 2 products re-branded on its own account as part of its Product 1 range.

Subsequently, the parties determined to collaborate to improve Product 2 which was currently marketed together with several associated products by Company A. The scope of the parties' co-operation was limited, the parameters of which were agreed in a written scope of works which confined the project to the development of an improved iteration of the Original Products (Improved Products).

Company X and Company A entered into a Heads of Agreement (HOA) for the purpose of developing the Improved Products.

The Improved Products were manufactured by Company A and sold by both parties on the terms set out in the HOA.

Pursuant to the HOA, Company A made an advance payment to Company X. When Company A made sales of the Improved Products, the licence fees payable to Company X were calculated, and deducted from the balance of that advance.

In addition to the Improved Products, Company A continued to develop a number of other products (Unilateral Products). Company X had no involvement in, and made no contribution towards, the development of those products. Company A is the registered owner of the intellectual property associated with a number of these products.

The legal proceedings

Following a change in ownership, Company X asserted ownership over Company A's Product 1, and subsequently terminated the HOA. The current proceedings ensued.

In the current proceedings, Company X has made a number of claims against Companies A, B and C.

The legal expenses

The legal expenses which are the subject of this application have been incurred, and continue to be incurred, by Company A in defending these claims.

Relevant legislative provisions

Income Tax Assessment Act 1997 8-1.

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA of the ITAA 1936 to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA of the ITAA 1936 applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA of the ITAA 1936, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: Part IVA: the general anti-avoidance rule for income tax.

Reasons for decision

While these Reasons for decision are not part of the private ruling, we provide them to help you to understand how we reached our decision.

General deductions are allowable under section 8-1 of the ITAA 1997. Subsection 8-1(1) of the ITAA 1997 contains the positive limbs of the test for general deductions.

If an outgoing satisfies one of the positive limbs, a deduction is not allowed to the extent that it satisfies one of the negative limbs of the test for general deductions as contained in subsection 8-1(2) of the ITAA 1997.

Company D (as Head Company of the tax consolidated group) may deduct the costs of legal proceedings if it satisfies one of the positive limbs and none of the negative limbs of the test contained in section 8-1 of the ITAA 1997.

The positive limbs

Subsection 8-1(1) of the ITAA 1997 relevantly provides as follows:

You can deduct from your assessable income any loss or outgoing to the extent that:

a) it is incurred in gaining or producing your assessable income; or

b) it is necessarily incurred in carrying on a *business for the purpose of gaining or producing your assessable income.

To be deductible under the first positive limb, there needs to be a connection between the expenditure and the production of assessable income. A 'very wide application' should be given to the expression 'incurred in gaining or producing the assessable income' (Amalgamated Zinc (de Bavay's) Ltd v. FCT (1935) 54 CLR 295 at 309). However, the connection must be relevant and incidental to gaining or producing assessable income (Ronpibon Tin NL v. FC of T (1949) 78 CLR 47).

In relation to the deductibility of legal fees, the High Court in Herald & Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113) held that the legal costs incurred in defending a defamation suit brought against a publisher of a newspaper did have the requisite nexus as an ordinary incident of the business of conducting a newspaper. Gavan Duffy CJ and Dixon J stated (at 188):

The liability to damages was incurred, or the claim was encountered, because of the very act of publishing the newspaper. The thing which produced the assessable income was the thing which exposed the taxpayer to the liability or claim discharged by the expenditure.

It is also noted that the success or failure of a taxpayer's claim or defence is not relevant to the question of the deductibility of the legal fees (Federal Commissioner of Taxation v. Snowden & Willson Pty Ltd (1958) 99 CLR 431 at 436 (Snowden)).

Based on the facts provided, Company A's production of assessable income is principally from the development, manufacture and supply of products. Company A's business necessitates the entering into and performance of various licensing and joint venture agreements with third parties in the pursuit of new and improved products that can be manufactured and sold for profit. In this case, the thing which produced Company A's assessable income, namely the entering into and performance of one of these commercial agreements (HOA), was arguably something that exposed Company A to the claim the subject of the expenditure. Therefore, the costs incurred in defending legal proceedings arising from the HOA are relevant and incidental to Company A's income-producing activities as it was incurred in the course of producing profits from the sale of, or licensing of, products developed and sold pursuant to the respective agreement.

Accordingly, at least one of the positive limbs in subsection 8-1(1) of the ITAA 1997 has been satisfied.

The negative limbs

A loss or outgoing will not be deductible if it satisfies any of the negative limbs contained in subsection 8-1(2) of the ITAA 1997. In the present case, the capital negative limb requires particular consideration, which provides:

However, you cannot deduct a loss or outgoing under this section to the extent that:

a) it is a loss or outgoing of capital, or of a capital nature;…

A fundamental issue is whether any of the legal expenses incurred by Company A are characterised as a loss or outgoing of capital or of a capital nature. The differentiation between revenue and capital is assisted by a considerable amount of case law.

The leading Australian test which distinguishes between revenue and capital outgoings was formulated by Dixon J (as he then was) in Sun Newspapers Ltd and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337 (Sun Newspapers). In the course of his judgment, Dixon J reviewed both the 'once and for all' and 'enduring benefit' tests of the United Kingdom and then developed his own criteria for distinguishing between revenue and capital expenditure by focusing on the purpose of the expenditure in the context of the taxpayer's business (at 359-360):

The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure, or organization set up or established for the earning of profit and [on the other hand] the process by which such an organization operates to obtain regular returns by means of regular outlay, the difference between the outlay and returns representing profit or loss…

As general conceptions it may not be difficult to distinguish between the profit-yielding subject and the process of operating it. In the same way expenditure and outlay upon establishing, replacing and enlarging the profit-yielding subject may in a general way appear to be of a nature entirely different from the continual flow of working expenses which are or ought to be supplied continually out of the returns or revenue…For the one concerns the instrument for earning profits and the other the continuous process of its use or employment for that purpose…

In applying this test, Dixon J pointed to three relevant factors, although none is in itself decisive (at 363):

There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) 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, and (c) the means adopted to obtain it, that is, by providing a periodical reward 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 use or enjoyment.

Dixon J's 'business entity' test has been approved and applied in later cases and is considered below.

Character of the advantage sought

In relation to the first factor, the following cases provide guidance as to whether the legal expenses incurred by Company A seek to secure an advantage that is properly characterised as an enduring benefit, or otherwise of a capital nature.

Firstly, the High Court in Hallstroms decided that the legal expenses incurred in opposing a competitor's petition to renew a patent, sought to simply maintain the taxpayer's position as it already existed and protect existing rights, thus it was a deductible revenue outgoing. However, in his dissenting judgment, Dixon J dissented by concluding that the expenses were capital in character because they related to the protection of the taxpayer's income-earning structure. Of note, Dixon J pointed to the fact that the competitor's patent had caused a severe decline in the taxpayer's fortunes, and that, without access to the patent, the taxpayer would 'have had to go out of business or into some other form of manufacture'.

Dixon J's dissenting judgment was later elevated to become binding law in Broken Hill Theatres Pty Ltd v. FC of T (1952) 85 CLR 423 (Broken Hill). In Broken Hill, the taxpayer incurred legal expenses opposing a licence application by a potential competitor which if successful, granted the taxpayer protection from competition for 12 months. The nature of the taxpayer's business was of a kind that can only be carried on by persons who are licensed to exhibit motion pictures. The High Court under the leadership of Dixon CJ characterised the expense as a capital outlay based on the income earning process or income earning structure test.

Nevertheless, in the later High Court case of Snowden, the majority which included Dixon CJ held that legal costs incurred by the taxpayer in defending itself against allegations regarding the integrity of the taxpayer's conduct of its business as well as other matters did not imperil the existence or the capital assets of the company and were therefore deductible.

Legal expenses incurred by a taxpayer arising out of dealings from which the taxpayer's income is derived was again touched on by Brennan J in Magna Alloys & Research Pty Ltd v. Federal Commissioner of Taxation (1980)11 ATR 276 (Magna Alloys) at 290:

The capital of the business was in no way increased by the expenditure incurred. True it is that the expenditure protected the reputation and goodwill of Magna's business, but the attack which was made arose out of the day to day selling activities of that business and it was the business purpose of vindicating the methods by which it was conducted that brings the expenditure within s 51(1)…Expenditure incurred in attempting to vindicate the business methods of the taxpayer, overcoming the obstacle to its trading which had been raised by the prosecutions is properly to be regarded as a cost on revenue account.

Further, in Smithkline Beecham Laboratories (Australia) Ltd v. FCT (1993) 26 ATR 260 (Smithkline), the taxpayer unsuccessfully claimed deductions for expenses incurred in the course of two legal proceedings. Hill J found that the purpose of the taxpayer in commencing and prosecuting the proceedings was a desire to exclude, so far as possible, competitors from gaining approval of competing cimetidine products.

From the long line of case law on point, several relevant factors arise that aid in the distinction between capital and revenue. Firstly, legal fees that are incurred to overcome an obstacle to a taxpayer's day-to-day business activities lend weight to it being revenue expenditure. However, legal fees that are incurred to free a taxpayer from competition, or to protect its monopoly over a significant part of its business, or otherwise imperils the existence of the business or the capital structure of the business will lend weight to it being capital expenditure.

The legal expenses incurred by Company A in defending the majority of the claims brought against it, relate to the process of the derivation of Company A's assessable income. This expenditure does not result in the establishment, replacement or enlargement of a profit-yielding subject of the business. Thus, the advantage sought in incurring this portion of the expenditure is not of a capital nature. In addition, in relation to the legal expenses incurred to defend Company A's ownership in certain assets, the same conclusion is reached.

Accordingly, the legal fees incurred by Company A in defending these claims are not of a capital nature.

The manner in which it is to be used, relied upon or enjoyed

The second guidepost towards the characterisation of the advantage sought from incurring the expenditure is the manner in which it is to be used, relied upon or enjoyed by the taxpayer.

Dixon J in Sun Newspapers indicated that recurrence may play a part in relation to this factor. His Honour provided the following view in relation to the concept of 'recurrence' (at 362):

But the idea of recurrence and the idea of endurance or continuance over a duration of time both depend on degree and comparison…but "the real test is between expenditure which is made to meet a continuous demand, as opposed to an expenditure which is made once for all" (per Rowlatt J., Ounsworth v. Vickers Ltd. (2)). By this I understand that the expenditure is to be considered of a revenue nature if its purpose brings it within the very wide class of things which in the aggregate form the constant demand which must be answered out of the returns of a trade or its circulating capital and that actual recurrence of the specific thing need not take place or be expected as likely…Recurrence is not a test, it is no more than a consideration the weight of which depends upon the nature of the expenditure.

Dixon J goes on to say in relation to a payment to remove finally a competitor (at 363):

It could be regarded as recurrent only in the sense that the risk of a competitor arising must always be theoretically present and that the reality or imminence of the risk depends upon circumstances which can never clearly be foreseen.

Similarly, in Broken Hill, the majority including Dixon CJ concluded in respect of immunity from competition for twelve months (at 433):

…the expenditure in the present case cannot be regarded as "recurrent" in the relevant sense. At the time when it was made, nobody could say whether Boulus or anybody else would or would not make another application in two or five or ten years' time. The expenditure in connection with each application between 1938 and 1948 was made on a particular and isolated occasion. Similar occasions might or might not arise in the future. Experience might suggest a probability that similar occasions would arise, but no such consideration could affect the essential nature of the expenditure, which was incurred in each case for the purpose of preserving and protecting the company's business.

However, both of the cases mentioned above can be distinguished from the facts of the present case. Firstly, as discussed above, Company A's business includes the regular entry into agreements with third parties. The expenditure was not incurred for the purpose of preserving and protecting Company A's business structure, rather it was incurred in removing a hindrance to the profit-earning operations of its business and to defend itself from a business threat.

Therefore, the second matter supports the characterisation of the advantage as having a revenue character.

The means adopted to get the advantage

The last factor looks at the means adopted to obtain the advantage. By this, a distinction is drawn between the provision of a periodical reward or outlay to cover the use or enjoyment of the advantage for periods commensurate with the payment, and the making of a final provision or payment so as to secure future use or enjoyment (Dixon J in Sun Newspapers at 363).

Based on the facts, the legal fees have been incurred and continue to be incurred on a periodical basis when legal proceedings were issued against Company A. Company A's legal advisors have invoiced, and continue to invoice Company A on a periodical basis. Further, the expenses have been incurred, and are still being incurred by Company A on a continuing basis until such time as the legal proceedings have been concluded. Accordingly, this ongoing expenditure cannot be characterised as a 'final provision or payment' and does not secure future use or enjoyment.

This factor lends weight to the expenditure being of a revenue nature.

Conclusion

For the reasons stated above, the legal expenses incurred by Company D in defending proceedings brought against Companies A, B and C, by Company X are outgoings of a revenue and not of a capital nature, and are therefore deductible under section 8-1 of the ITAA 1997.