Edited version of private ruling

Authorisation Number: 1011765490770

This edited version of your ruling will be published in the public Register of private binding rulings after 28 days from the issue date of the ruling. The attached private rulings fact sheet has more information.

Please check this edited version to be sure that there are no details remaining that you think may allow you to be identified. Contact us at the address given in the fact sheet if you have any concerns.

Ruling

Subject: legal expenses

Question

Are you entitled to a deduction for legal expenses?

Answer

No.

This ruling applies for the following period

Year ended 30 June 2009

Year ended 30 June 2010

Year ended 30 June 2011

The scheme commenced on

1 July 2008

Relevant facts

The arrangement that is the subject of the Ruling is described below. This description is based on the following documents. These documents form part of and are to be read with this description. The relevant documents are:

· the application for private ruling, and

· court documents.

The directors of a former company were spouses (director 1 and director 2). The directors separated.

Director 1 created another company following separation.

The Family Court of Australia made an injunction for director 1 to be restrained from selling the company's income generating assets other than in the normal course of business. Director 1 was also restrained from selling the matrimonial home.

The Family Court appointed an accountant to value the companies.

Director 2 asked the Court to stop director 1 from purchasing tools of trade for the company.

The Family Court Order required the company vehicle to be sold and half of the proceeds to go to director 2. Alternatively, director 1 may pay director 2 an amount of money equal to half the value of the motor vehicle.

Director 1 was not allowed to purchase a company car to carry out the business.

The company was not allowed to dispose of the tools of trade that were no longer required in the business.

The Court Orders negatively impacted on the company's income and caused additional costs forcing director 1 to rent rather than buy the tools of trade.

Director 1 incurred legal expenses.

Director 1 paid the legal bills with a credit card, which is used for both private and company expenses.

Director 1 sought legal advice in relation to fighting the Court Orders and to seek compensation.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

Summary

The legal expenses incurred are not sufficiently connected to the income earning activities of the business and are regarded as more private expenses of the director. The expenses are therefore not deductible.  

Detailed reasoning

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income or are 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.

A number of significant court decisions have determined that for an expense to be an allowable deduction:

· it must have the essential character of an outgoing incurred in gaining assessable income or, in other words, of an income-producing expense (Lunney v. FC of T; (1958) 100 CLR 478), 

· there must be a nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income (Ronpibon Tin NL v. FC of T, (1949) 78 CLR 47), and

· it is necessary to determine the connection between the particular outgoing and the operations or activities by which the taxpayer most directly gains or produces his or her assessable income (Charles Moore Co (WA) Pty Ltd v. FC of T, (1956) 95 CLR 344; FC of T v. Hatchett, 71 ATC 4184).

For legal expenses to constitute an allowable deduction, it must be shown that they are incidental or relevant to the production of the taxpayer's assessable income. Also, in determining whether a deduction for legal expenses 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 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 success or failure of the taxpayer's actions that led to the incurring of the legal expenses is irrelevant.

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) 2 ATD 169 (Herald and Weekly Times)) 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).

However, where the expenditure is incurred for the purpose of securing an enduring benefit, rather than a revenue purpose, the expenditure is capital in nature and is not deductible (Sun Newspapers Ltd v. FC of T (1938) 61CLR 337; 5 ATD 87; (1938) 1 AITR 403).

In FC of T v. Rowe (1995) 60 FCR 99; (1995) 31 ATR 392; 95 ATC 4691 (Rowe's case), 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.

In order to determine whether your legal fees are deductible under section 8-1 of the ITAA 1997, we first need to look at the reason for the legal fees and why they were incurred.

In the case of Herald and Weekly Times, legal expenses were held to be deductible because they were incurred in defending a charge of libel against statements published by the newspaper. The majority of the Full High Court allowed the deductions because publishing the newspaper was the source of income and the cause of the liability, and because the risk of libel was unavoidable or inherent in the activity of publishing. The expenses were incidental and relevant to the business activity of publishing a newspaper. Per Gavan Duffy CJ and Dixon J at 170:

 '...The liability to damages was incurred, or the claim was encountered, because of the very act of publishing the newspaper. The thing which produced the assessable income was the thing which exposed the taxpayer to the liability or claim discharged by the expenditure. ... this expenditure flows as a necessary or a natural consequence from the inclusion of the alleged defamatory material in the newspaper and its publication. ...'

In the case above, the expenses arose as a consequence of the day to day activities of the company or as a consequence of the income producing activity of the business.

In the present case, the expenses did not arise as a consequence of the company conducting its day to day workings or operations or the performance of company's income earning activities. That is, the restrictions given to the director are not directly related to the actual day to day income earning activities of the company. Consequently, the expenses are not incurred in gaining or producing assessable income.

The legal expenses in this case arose in defending proceedings in the Family Court and to seek compensation. That is, the legal fees were initiated following the breakdown of the relationship between director 1 and director 2 and were therefore incurred with respect to a range of matters arising out of their personal relationship.

Legal expenses incurred in defending Family Court proceedings relate to a private or domestic matter and are, therefore, not deductible under section 8-1 of the ITAA 1997.

As the legal expenses were incurred as a result of a private or domestic matter between director 1 and director 2 and the splitting of joint assets rather than the income earning activities of the company, there is insufficient nexus to the company's assessable income. Also the expenses are private or domestic in nature.

Furthermore, the invoice is in the director's name and not the company's and the payments made are from the director's credit card; that is, the expenses are not incurred by the company. Even if it could be argued that the company incurred the legal expenses in defending its assets, no deduction would be allowable on the basis that the expenses would be considered capital in nature.

Whilst we understand the relationship between the legal fees and the company's assets, we consider that this relationship is an indirect one.

Given regard to the full circumstances, it is considered that the legal expenses incurred in relation to Family Court matters are private and domestic in nature and not sufficiently related to the gaining or producing of assessable income. Accordingly no deduction is allowable under section 8-1 of the ITAA 1997 for the legal expenses incurred.