Edited version of private ruling

Authorisation Number: 1011676650533

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Ruling

Subject: Legal expenses

Question 1

Can you deduct legal expenses you incurred for services during the period 4 June 2009 to 6 May 2010 from your assessable income under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Question 2

Can you include the legal expenses you incurred for services during the period 4 June 2009 to 6 May 2010, in the cost-base of your shares under section 110-25 of the ITAA 1997?

Answer

No

This ruling applies for the following period

Year ended 30 June 2009

Year ended 30 June 2010

The scheme commenced on

15 April 2008

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

From 3 December 2004 to 14 April 2008 you were the sole director and shareholder of Company A (A Co).

On 15 April 2008 you sold 149 shares to Company B (B Co)

In May 2009 you were asked to buy back the shares from B Co, but were not in a position to buy back the shares.

On or around 21 May 2009, you received a letter advising that B Co intended to sell their 149 shares to a competitor in the Industry.

On 17 September 2009, B Co made an application to the Supreme Court of Victoria, Commercial and Equity division, Commercial Court (the Supreme Court), applying for an order that:

· you buy back the shares, or

· A Company buyback the shares, or

· A Company is wound up by the Court.

Prior to this time there had been no discussion about A Co buying back the shares or being wound up.

On 26 November 2009, the Supreme Court ordered that A Co be wound up.

Your lawyers assisted you with the legal requirements of applying for an Intervention Order against B Co's director and sole shareholder.

You paid the legal expenses from your own money and were not reimbursed by A Co.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 subsection 8-1(2)

Income Tax Assessment Act 1997 Division 40

Income Tax Assessment Act 1997 Part 3-1

Income Tax Assessment Act 1997 Part 3-3

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 section 104-135

Income Tax Assessment Act 1997 section 104-145

Income Tax Assessment Act 1997 subsection 110-25

Income Tax Assessment Act 1997 subsection 110-25(2)

Income Tax Assessment Act 1997 subsection 110-25(3)

Income Tax Assessment Act 1997 subsection 110-25(4)

Income Tax Assessment Act 1997 subsection 110-25(5)

Income Tax Assessment Act 1997 subsection 110-25(6)

Income Tax Assessment Act 1997 section 110-35

Reasons for decision

Question 1

Summary

Can you deduct legal expenses you incurred for services during the period 4 June 2009 to 6 May 2010 from your assessable income under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

No, the legal fees were not incurred in gaining or producing your assessable income or any future income and are not an allowable deduction under section 8-1 of the ITAA 1997.

Detailed reasoning

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) says that you can deduct from your assessable income any expense 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.

However, you cannot deduct an expense under section 8-1 of the ITAA 1997 to the extent that:

(a) it is a loss or outgoing of capital, or of a capital nature; or
(b) it is a loss or outgoing of a private or domestic nature; or
(c) it is incurred in relation to gaining or producing your exempt income; or
(d) a provision of the Act prevents you from deducting it.

Taxation Ruling 1999/10 at paragraph 93 explains that considerable discussion of the topic in Courts of law has established that for an expense to be deductible:

(a) it must have the essential character of an expense incurred in gaining your assessable income or, in other words, of an income producing expense,

(b) there must be a nexus, or link, between the expense and your assessable income so that the expense is incidental and relevant to the gaining of the assessable income; and

(c) it is necessary to determine the connection between the particular expense and the operations or activities by which you more directly gain or produce your assessable income.

Taxation Ruling TR 95/33 at paragraph 5 explains if it can be concluded that the expenses are 'genuinely, and not colourably', used in an assessable income producing activity, a deduction is allowable for the expense.

However, if an expense is used for an income-producing purpose, and for some other purpose(s), the expense must be apportioned. Only the amount incurred in the course of gaining or producing "your" assessable income will be allowed as a deduction.

Legal Expenses

Characterisation of legal expenses is determined by taking into consideration the reasons and purposes for which you incurred the expenses; the situation which impelled or provoked you to seek professional legal services, and also the objective you sought in engaging them.

Taxation Ruling TR 1999/10 explains a deduction is allowable for legal expenses incurred where they arise out of day-to-day activities through which your assessable income is gained or produced (work-related activities) so long as the expenses are not capital, private or domestic in nature.

Company directors and/or shareholders - examples in courts of law

In Case T84 86 ATC 1116 (Case T84), the applicant was a company director and incurred legal expenses. The company had borrowed money, and after repayments had been missed, the financier appointed a receiver/manager to take control of company assets.

The applicant sought legal advice as he was "unversed in the various legal problems which arose from appointment of a receiver/manager". He obtained advice in relation to:

· Directors' obligations and responsibilities

· The extent of detail required to be provided

· The rights of directors to be granted access to company's records in the care and control of the receiver.

· Potential conflicts of interests relating to his position as a director of [the company] and another family company.

The legal advice related to matters of revenue produced by the company, and the company (business) profit-making structure, as well as matters related to its director. The AAT stated:

We accept this … and in ordinary circumstances that would involve an obligation to separate those items which would be characterised as ``company'' matters from those which were matters relating to the proper discharge of the duties of a director faced with the extraordinary problems which resulted from the appointment of a receiver/manager.

However, in this case the amount of the legal expenses billed was such a small amount that the Court concluded that the amount billed represented only the potion of the total cost that related to the director, and that he could deduct the whole amount.

Are your legal expenses deductible under section 8-1 of the ITAA 1997?

In your case, two separate entities are involved - you, individually, and A company (A Co) as a company. Companies have their own legal identity and can own assets, borrow money, earn income and incur expenses, with separate legal rights and obligations from those of its shareholders. Additionally, in this case, your situation must be considered in terms of your various roles:

· a shareholder,

· an employee manager/director, and

· in your personal, domestic role.

A Co earned income during the year ended 30 June 2010, from carrying on business in the security industry. Also, A Co owned the business capital structure (assets, liabilities and equity) necessary to carry out those activities. You earned wages income for your activities and responsibilities as director of A Co. You did not earn any dividend income from your shareholding in the company.

You engaged professional legal advisors (your lawyer) in June 2009 and over 13 months incurred legal expenses. Your lawyer was providing services to you in various roles, and also to address company matters. Where the expenses are more accurately connected with the income-producing activities or capital structure of A Co, you cannot deduct the amounts from 'your' assessable income.

The purpose for incurring the legal services provided by your lawyer changed over the duration of the dispute and as a consequence the characterisation of the expenses varied.

Where the legal services provided by your lawyer were to:

· defend against the perceived threat to the intellectual knowledge of the business - total expenses incurred - $X,

· obtain the information required for consideration of the offer to sell A Co shares which did not belong to you - total expenses incurred - $X,

· prepare for and attend mediation and court to:

· resolve the dispute over B Co's investment in A Co, and

· negotiate and consent to the wind up order

- total expenses incurred - $X

· liaise with the liquidator, company accountant, and shareholders in relation to winding up A Co - total expenses incurred - $X, and

· negotiate the return to work of B Co's director and sole shareholder - expenses incurred - $X,

the services were in relation to company matters, for which A Co itself is responsible and obliged to manage, connected with the business capital and/or revenue production. Your duties and responsibilities as a director of A Co, do not extend to incurring costs on behalf of the company.

As such, the expenses you incurred in relation to these matters, in the amount of $X are not work-related expenses, incurred in gaining or producing your wage as a director, nor are these expenses sufficiently connected with earning of any future dividend income. These expenses do not meet the requirements of section 8-1 of the ITAA 1997 and are not allowed as a deduction from your assessable income.

The legal expenses incurred in relation to your offer to sell your A Co shares to the competitor, $X, are expenses connected to your shareholding. However, as you have not earned any dividend income and are not sufficiently connected to any future dividend income. The expenses were not incurred in gaining or producing your assessable income, and are not allowed as a deduction under section 8-1 of the ITAA 1997.

You applied for the Intervention Order for your personal protection. As such, the legal expenses are of a personal domestic nature. As such, the expenses incurred in relation to the Intervention Order in the amount of $X, are excluded under subsection 8-1(2) of the ITAA 1997 and are not allowed as a deduction from your assessable income.

As such, it is the Commissioner's view that the legal fees of $X were not incurred in gaining or producing your assessable income or any future income and are not an allowable deduction under section 8-1 of the ITAA 1997.

Question 2

Summary

No, the legal expenses incurred do not meet the requirements of any of the 5 elements of cost base as provided in section 110-25 of the ITAA 1997.

Detailed reasoning

A capital gain or capital loss in most cases is determined by reference to the proceeds received and the assets cost base or reduced cost base. You can make a capital gain or loss only if a CGT event happens. As such, calculating the assets cost base becomes relevant when a CGT event happens.

Section 110-25 of the ITAA 1997 tells us that the cost base of a CGT asset consists of 5 elements:

1. money paid or the market value of property given to acquire the asset;

2. incidental costs incurred;

3. non-capital costs of ownership if asset acquired after 20 August 1991;

4. capital expenditure to increase the asset's value;

5. capital expenditure to establish preserve or defend title to the asset.

First element

The first element of the cost base is the total of the money paid, or required to be paid, and the market value of the property given, or required to be given, in respect of the acquisition of the asset (subsection 110-25(2) of the ITAA 1997).

The legal expenses are not acquisition costs within the meaning of this provision as they are not money paid in respect of acquiring your shares.

Second element

The second element of the cost base is the incidental costs you incurred (subsection 110-25(3) of the ITAA 1997). Section 110-35 of the ITAA 1997 provides that incidental costs are costs you may have incurred:

(a) "to acquire" the CGT asset, or

(b) that "relate to" a CGT event that happens to the asset.

Remuneration for the services of a legal adviser are included in the list of incidental costs under subsection 110-35(2) of the ITAA 1997.

You engaged your lawyer in June 2009 and over 13 months incurred a total of $X in legal expenses. Your lawyer was providing services to you in various roles, and also to address company matters. Where the expenses are more accurately connected with the income-producing activities or capital structure of A Co, you cannot deduct the amounts from 'your' assessable income.

The purpose for incurring the legal services provided by your lawyer changed over the duration of the dispute and as a consequence the characterisation of the expenses varied.

As discussed above, where the legal services provided by your lawyer were to:

· defend against the perceived threat to the intellectual knowledge of the business - total expenses incurred - $X,

· obtain the information required for consideration of the offer to sell A Co shares which did not belong to you - total expenses incurred - $X,

· prepare for and attend mediation and court to:

· resolve the dispute over B Co's investment in A Co, and

· negotiate and consent to the wind up order

- total expenses incurred - $X

· liaise with the liquidator, company accountant, and shareholders in relation to winding up A Co - total expenses incurred - $X, and

· negotiate the return to work of B Co's director and sole shareholder - expenses incurred - $X,

the services were in relation to company matters, for which A Co itself is responsible and obliged to manage, connected with the business capital and/or revenue production. The legal expenses relating to this matter are not incidental costs incurred "to acquire" your shares, or that "relate to" a CGT event that has or may happen to your shares.

Where the legal services provided were in connection with the Intervention Order they are of a personal nature as they were providing for your personal protection. The expenses incurred are not incidental costs incurred "to acquire" your shares, or that "relate to" a CGT event that has or may happen to your shares.

Where legal services were provided in relation to your offer to sell your A Co shares to the competitor were in connection with your shares, however, as they were not incidental costs incurred "to acquire" your shares, we must consider CGT events that have or may happen your shares.

There are three CGT events which may happen to your CGT asset in the near future:

· CGT event A1 - Disposal of a CGT asset

· CGT event G1 - Capital payment for shares, and/or

· CGT event G3 - Liquidator or administrator declares shares worthless

Section 104-10 of the ITAA 1997 explains that CGT event A1 happens if you dispose of a CGT asset.

CGT event A1 would have happened on sale of your shares to the competitor, however, as this did not eventuate, CGT event A1 did not happen. As such, the legal expenses are not incidental costs incurred in relation to CGT event A1 happening to your shares when you offered your shares to sale to your competitor, or if it happens in the future.

Section 104-135 of the ITAA 1997 explains that CGT event G1 happens if:

(a) a company makes a payment to you in respect of a share you own in the company (except for CGT event A1 or C2 happening in relation to the share); and


(b) some or all of the payment (the non-assessable part) is not a dividend, or an amount that is taken to be a dividend under section 47 of the Income Tax Assessment Act 1936; and


(c) the payment is not included in your assessable income.

CGT event G1 may happen on winding up A Co in the future. However, the legal expenses you incurred in offering your A Co share for sale to the competitor were not in relation to winding up the company and as such, are not incidental costs that will relate to CGT event G1 if it happens in the future.

Section 104-145 of the ITAA 1997 explains that CGT event G3 happens if you own shares in a company and a liquidator or administrator of the company declares in writing that the liquidator or administrator has reasonable grounds to believe (as at the time of the declaration) that there is no likelihood that shareholders in the company, or shareholders of the relevant class of shares, will receive any further distribution for their shares.

CGT event G3 may happen on winding up A Co in the future. However, the legal expenses you incurred in offering your A Co share for sale to the competitor were not in relation to winding up the company and as such, are not incidental costs that will relate to CGT event G3 if it happens in the future.

As such, none of the $X in legal expenses you incurred are second element 'incidental costs' under subsection 110-25(3) of the ITAA 1997.

Third element

The third element of the cost base is the costs of owning your CGT asset (subsection 110-25(4) of the ITAA 1997) including:

· interest on money the taxpayer borrowed to acquire the asset

· costs of maintaining, repairing or insuring the asset

· rates or land tax, if the asset is land

· interest on money the taxpayer borrowed to refinance the money the taxpayer borrowed to acquire the asset, and

· interest on money the taxpayer borrowed to finance the capital expenditure incurred by the taxpayer to increase the asset's value.

The legal expenses you incurred are not costs of ownership within the meaning of this provision, but were for purposes of the company, personal purposes, and in connection with selling of your shares.

Fourth element

Legal expenses can be included in the fourth element of the cost base if it is capital expenditure you incurred:

(a) the purpose or the expected effect of which is to increase or preserve the asset's value; or

(b) that relates to installing or moving the asset, but not

(c) in relation to goodwill (subsection 110-25(5) of the ITAA 1997).

As discussed above, you incurred legal expenses to protect the assets and income of A Co (company matters); for your personal protection; and to offer your shares for sale. The expenses were not incurred to increase or preserve the value of your shares.

Fifth element

The fifth element of the cost base is capital expenditure incurred to establish, preserve or defend your title to the asset, or a right over the asset (subsection 110-25(6) of the ITAA 1997).

As discussed above, you incurred legal expenses to protect the assets and income of A Co (company matters); for your personal protection; and to offer your shares for sale. The expenses were not incurred to establish, preserve or defend your title to your shares.

As such, no part of the legal expenses you incurred can be added to the cost base or reduced cost base of your shares under section 110-25 of the ITAA 1997.