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Edited version of private ruling
Authorisation Number: 1011754034937
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Ruling
Subject: settlement sum
Question
Are you entitled to a deduction for the settlement sum you paid as a result of legal action taken against you?
Answer
Yes.
This ruling applies for the following period
30 June 2010
The scheme commenced on
1 July 2009
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.
You imported devices from overseas and distributed them in Australia. Normally you are required to pay licensing fees to upload products on the devices.
You found an illegal copy of the upload material on the internet and downloaded this onto the devices you were selling.
The supplier of the devices found out about your activities and sued you.
As a one-time offer, the supplier would accept a set percentage of your profits and their legal costs to date.
Your accountant provided your trading figures and an out of court settlement was agreed upon.
The settlement payment agreed upon includes one large payment and X smaller amounts payable each month.
Relevant legislative provisions
Income Tax Assessment Act 1997 Subsection 8-1.
Reasons for decision
These reasons for decision accompany the Notice of private ruling.
While these reasons are not part of the private ruling, we provide them to help you to understand how we reached our decision.
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, or necessarily incurred in carrying on a business for the purpose of 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.
For the settlement sum to constitute an allowable deduction, it must be shown that it was 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).
Also, in determining whether a deduction for the settlement sum is allowable 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 settlement sum follows the advantage that is sought to be gained by incurring the expenditure.
Therefore, payments as a result of legal action 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) 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) 11 ATR 276; 80 ATC 4542).
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. The activities which produced the taxpayer's income were what exposed them to the liability against which they were defending themselves. No significance was placed by the court on the taxpayer's status as an employee.
In your case, the supplier took action against you for losses incurred as a result of your use of an illegal version of their software. As the action directly relates to the day to day activities of your business, the necessary connection exists. Therefore, you are entitled to a deduction for the settlement sum.
The settlement sum can be claimed in the year in which the payment was made.