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Edited version of private ruling
Authorisation Number: 1011747422972
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Ruling
Subject: Legal expenses
Question 1
Are you entitled to a deduction for legal expenses?
Answer
Yes.
Question 2
Are you entitled to a deduction for the residual amount you were left to pay after the insurance paid some of the settlement amount?
Answer
Yes.
This ruling applies for the following period
Year ended 30 June 2008
Year ended 30 June 2009
Year ended 30 June 2010
Year ended 30 June 2011
The scheme commenced on
1 July 2007
Relevant facts
You received a salary, commissions, bonuses and other remuneration as an employee.
As the result of advice you gave to a client, they suffered a considerable loss as a result of acting on the advice and took legal action against you and the company for losses and damages suffered.
Both you and the company were covered by a Professional Indemnity (PI) insurance policy for losses and legal fees, taken out by the company.
The defense of the legal action was funded under the PI insurance policy until 2004, at which time the insurers no longer accepted responsibility for legal costs in respect to matters involving a particular product.
Given the company's financial position, the legal action by the client focused primarily on pursuing you personally.
A settlement was reached.
The insurance company agreed to pay three quarters.
The policy had an excess which meant the insurer paid the lesser amount.
You were personally liable for the additional one quarter which you have already paid.
You are required to pay the excess to satisfy the terms of the settlement agreement but have not done so yet.
You incurred legal expenses.
Relevant legislative provisions
Income Tax Assessment Act 1997 Section 8-1
Reasons for decision
Section 8-1 of the Income Taxation Assessment Act 1997 (ITAA 1997) allows a deduction for all losses and outgoings to the extent they are incurred in gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature.
For legal expenses to constitute an allowable deduction, it must be shown that they were incidental or relevant to the production of the taxpayer's assessable income (Ronpibon Tin NL & Tong Kah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 4 AITR 236; (1949) 8 ATD 431).
Legal expenses are generally deductible if they arise out of the day to day activities of the taxpayer's business (Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 39 ALR 46; (1932) 2 ATD 169) and the legal action has more than a peripheral connection to the taxpayer's income producing activities (Magna Alloys and Research Pty Ltd v. FC of T (1980) 49 FLR 183; (1980) 11 ATR 276; 80 ATC 4542).
When the principal reason for incurring the legal expenses is defending the actions of the taxpayer in carrying out their employment duties through which they gain or produce assessable income, such expenses are characterised as being of a revenue nature and are deductible (Inglis v. FC of T 87 ATC 2037; and Case V116 88 ATC 737; AAT Case 4502 (1988) 19 ATR 3703).
Similarly, in FC of T v. Rowe (1995) 60 FCR 99; (1995) 31 ATR 392; 95 ATC 4691, the court accepted that legal expenses incurred in defending the manner in which a taxpayer performed his employment duties were allowable.
In your case, a client took action against you because of losses incurred resulting from your advice. As the action directly related to the day to day activities the necessary connection exists. Therefore, you are entitled to a deduction for legal expenses.
Residual amount after insurance payment
You were required to pay an amount for damages resulting from advice you provided to a client. As this payment was incurred in producing your assessable income, you are entitled to a deduction under section 8-1 of the ITAA 1997.