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Edited version of private ruling
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Ruling
Subject: Deductions - legal expenses
Question 1
Are you entitled to a deduction for legal expenses related to lost income?
Yes.
Question 2
Are you entitled to a deduction for legal expenses related to diminished earning capacity?
No.
This ruling applies for the following period:
Year ended 30 June 2011
The scheme commences on:
1 July 2010
Relevant facts and circumstances
You suffered an injury during an international air flight and sued the airline company. The flight was to perform business.
In your statement of claim you stated that you suffered economic loss as a result of being unable to complete your contemplated overseas business activities. You also suffered a diminished capacity to earn in your occupation as a company director and employee.
The claim was unsuccessful.
You incurred legal fees, and were required to pay the defendant's legal fees.
Relevant legislative provisions
Income Tax Assessment Act 1997 Section 8-1 and
Income Tax Assessment Act 1997 Section 6-5.
Reasons for decision
Legal expenses
Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for all losses and outgoings to the extent that 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.
In determining whether a deduction for legal expenses is allowed under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 3 AITR 436; (1946) 8 ATD 190). The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses. If the advantage to be gained is of a capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature.
The courts, on a number of occasions, have determined legal expenses to be an allowable deduction if the expenses arise out of your day to day income producing activities of the taxpayer (The Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113). The action out of which the legal expense arises must have more than a peripheral connection to the business or income earning activities.
Taxation Determination TD 93/58 deals with the circumstances under which a receipt from a lump sum compensation/settlement payment is assessable income. A receipt is assessable:
a) if the payment is compensation for loss of income only
b) to the extent that a portion of the lump sum payment is identifiable and quantifiable as income.
Compensation
In your case it is accepted that the claim for damages relates to your business. However, we must also examine the advantage that is sought to be gained by incurring the legal expenses.
The compensation you requested for loss of earnings would have been to replace income that would have been earned, expected, relied upon and would have had an element of periodicity, recurrence or regularity. Accordingly, the element of the compensation payment relating to your economic loss as a result of not being able to complete your overseas business activities would be considered income and therefore assessable. Legal expenses related to this amount are therefore deductible under section 8-1 of the ITAA 1997.
The portion of the compensation payment that would have related to loss of future earning capacity would not have been to replace income. The ability to earn income is treated as an asset of a capital nature, therefore damages awarded to you in respect of that loss would also be treated as being capital. Legal expenses related to this amount are therefore not deductible under section 8-1 of the ITAA 1997.
Apportionment
As your legal expenses relate to both deductible and non-deductible amounts, a reasonable apportionment is required to determine the portion of the legal expenses that are deductible. Paragraph 7 of Taxation Determination TD 93/29 states that:
Where the solicitor's account is itemised, one reasonable basis for apportionment would be the time spent involving the revenue claim, relative to the time spent on the capital claim. If the solicitor's account is not itemised, a possible basis for apportionment would be either a reasonable costing of the work undertaken by the solicitor in relation to the revenue claim, or, where this is not possible, an apportionment on the basis of the monetary value of the revenue claim relative to the capital claim.
You should apply the above principles in determining the portion of the legal expenses that relate to your claim for lost income.