Edited version of private ruling

Authorisation Number: 1011696252695

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Ruling

Subject: Capital gains tax

Question 1

Can a deduction be claimed under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for your legal expenses and settlement costs?

Answer

No.

Question 2

Are the expenses incurred for legal fees and settlement costs considered capital and thus able to be included under the fifth element of the cost base of the shares under subsection 110-25(6) of the ITAA 1997?

Answer

Yes.

Question 3

Can a deduction be claimed under section 8-1 of the ITAA 1997 for interest on a bank loan used to fund the above legal and settlement costs?

Answer

No

This ruling applies for the following periods:

The 2007-08 income year

The 2008-09 income year

The 2009-10 income year

The 2010-11 income year

The scheme commences on:

1 July 2007

Relevant facts and circumstances

You and your spouse were shareholders in a company that carried on a business. You owned all the shares between you.

You began negotiations with a third party (A) to sell your shares. These negotiations were ongoing and you were close to finalising a deal. There was no agreement with A that you would sell your shares to them.

The purchaser stepped in and signed contracts before A. You sold your shares in the company to the purchaser.

You declared the capital gain in your tax returns.

A was under the impression they had secured the right to purchase the shares in the business. A wanted compensation and indicated that they would sue.

You obtained legal advice saying that as nothing had been signed, there was no agreement and that the claim by A was not valid.

Legal action was ongoing for years.

You incurred legal fees defending your position.

You settled out of court as you could not borrow any more money. You paid a settlement as compensation to A.

The legal fees and settlement costs were funded mainly from a bank loan.

The loan is in the taxpayers names.

Your home is security for the loan.

You are currently employed by the purchaser.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1,

Income Tax Assessment Act 1997 section 25-25,

Income Tax Assessment Act 1997 subsection 25-25(1),

Income Tax Assessment Act 1997 section 100-20(1),

Income Tax Assessment Act 1997 Division 104,

Income Tax Assessment Act 1997 section 108-5 and

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

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 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 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 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, go to our website 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

All legislative references are to the ITAA 1997 unless otherwise specified.

Question 1

Summary

The legal expenses and settlement costs were not incurred in gaining or producing assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. Your legal expenses and settlement costs are not deductible as revenue expenses.

Detailed reasoning

Section 8-1 allows you to claim a deduction for a loss or outgoing to the extent that it is incurred in gaining or producing assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income.

To claim a deduction from your assessable income under section 8-1, the expense must fulfil one of the positive limbs of that provision. That is the loss or outgoing must be incurred in gaining or producing your assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However, you can not deduct a loss or outgoing to the extent that it is capital, or of a capital nature, private or of a domestic nature, incurred in gaining or producing exempt or non assessable income or if a provision of the Act prevents you from deducting it.

Regard is to be had to the situation which impelled the taxpayer to incur the expenses. For example, if legal expenses are incurred to defend the day to day business activities of the taxpayer, then they are deductible. However, the business had been sold prior to any legal or settlement expenses being incurred. At the times the legal and settlement expenses were incurred, you no longer owned the business, and could not expect assessable income from a business you no longer owned (except salary or wages as an employee, and the outcome of the legal action would not change this).

The legal and settlement expenses were not incurred in gaining or producing assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. Your legal and settlement expenses are not deductible as a revenue expense.

Question 2

Summary

Your legal fees and settlement costs are part of the cost base for the business. These expenses should be taken into account when calculating your capital gain or capital loss on the sale of the business.

Detailed reasoning

The Income Tax Assessment Act 1997 states at subsection 110-25(6) that the fifth element of the cost base is capital expenditure you incurred to establish, preserve or defend your title to the asset, or a right over the asset.

One of the rights associated with ownership is the right to sell your asset to whoever you choose.

You incurred legal fees and settlement costs in defending your right to sell the business to the purchaser. As such, your legal fees and settlement costs incurred become part of the calculation to determine the cost base. These expenses should be taken into account as part of the cost base when calculating the capital gain or capital loss on the sale of the business.

Question 3

Summary

As the borrowed funds were not used to gain or produce assessable income, the interest on the loan would not meet the requirements of Section 8-1. A deduction is not allowable for the interest on the loan used to fund your legal expenses and settlement costs in any year.

Detailed reasoning

The general deduction provisions are contained in section 8-1. You can deduct a loss or outgoing to the extent that the loss or outgoing is incurred in gaining or producing your assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However, you can not deduct a loss or outgoing to the extent that it is capital, or of a capital nature, private or of a domestic nature, incurred in gaining or producing exempt or non assessable income or if a provision of the Act prevents you from deducting it.

Section 25-25 specifically provides for deductions for borrowing expenses. Section 25-25(1) states you can deduct expenditure you incur for borrowing money, to the extent that you use the money for the purpose of producing assessable income.

While various cases (FC of T v. Brown 99 ATC 4600; (1999) 43 ATR 1 (Browns Case and Steele v. FC of T 99 ATC 4242; (1999) 41 ATR 139 (Steeles Case)) permit a deduction for interest after the asset has been disposed of, these cases consider the original purpose of the borrowed funds and the assessable income that the relevant outgoing would be expected to produce. As stated in Steeles Case (at par 46) the taxpayer may still be entitled to a deduction after the business ceased in respect of a recurrent liability for interest provided the occasion of a business outgoing is to be found in the business operations directed towards the gaining or production of assessable income generally. It is noted that the outgoing and the activities directed to gaining or producing assessable income, or the possibility of doing so, do not need to be contemporaneous. The simple question is was the loan originally taken out for the purposes of gaining or producing assessable income at some time?

During negotiations with A, there was no agreement reached, no option or right established. There was no guarantee that the business would be sold to A.

It was the sale of the business to the purchaser from when there was no prospect or possibility of deriving further assessable income that established the situation whereby the legal fees and subsequently the settlement costs were incurred. At the time the liabilities arose, there was no income producing asset and no prospect of generating income from the business.

Borrowing for legal fees

At the time legal action commenced the asset (the business) had already been sold to another party. The taxpayers only connection was that they were now employed by the new owners. It is stated that the legal fees were incurred in 'defending their position'. Considering the taxpayers no longer owned the business, it is difficult to see how the legal expenses were incurred with the view of gaining or producing assessable income in the past, present or future. Even if the taxpayers had not been required to pay settlement costs, not paying something (not incurring an outgoing) is not the same as gaining or producing assessable income. It appears that the legal fees were incurred to prevent an outgoing of settlement costs.

Borrowing for settlement

The nexus between the borrowed money and how it related to gaining or producing assessable income must be considered. There was no agreement at any time with party A that you would sell your shares to them. The business had already been sold to the purchaser. Your accountant advised that legal action had been ongoing for years and you settled out of court as you could not borrow any more money. You borrowed money in the form of a bank loan to pay settlement for compensation. You no longer owned the business, and the settlement costs did not relate to income earning activities in the past or in the future. Settlement costs were incurred to settle the legal action and prevent more legal fees being incurred. Not incurring an outgoing is not the same as gaining or producing assessable income. It appears that the settlement costs were incurred to prevent an outgoing of further legal fees, not with a view to gaining or producing assessable income.