Edited version of private ruling

Authorisation Number: 1011800466250

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Ruling

Subject: Accounting and legal work related expenses

Question 1

Are your legal expenses in relation to the Director Penalty Notice an allowable deduction?

Answer: Yes.

Question 2

Are your accounting and legal expenses for defending the bankruptcy action an allowable deduction?

Answer: No.

Question 3

Are your accounting and legal expenses for seeking to annul the bankruptcy an allowable deduction?

Answer: No.

Question 4

Are your accounting and legal expenses for preparing a private ruling application querying the deductibility of expenses incurred in relation to the Director Penalty Notice, defending the bankruptcy action and the annulment of the bankruptcy, an allowable deduction?

Answer: Yes.

This ruling applies for the following periods:

Year ended 30 June 2008

Year ended 30 June 2009

Year ended 30 June 2010

Year ending 30 June 2011

The scheme commences on:

1 July 2007

Relevant facts and circumstances

You were the director of Companies A. B, C and D.

An administrator was appointed for the companies.

You were served a writ of summons whereby the Deputy Commissioner of Taxation claimed that Company C had unpaid company liabilities with respect to PAYG withholding amounts.

The creditors of the four companies resolved that all of them were to be wound up. All four companies went into voluntary liquidation with the administrator now becoming the liquidator.

The Deputy Commissioner of Taxation obtained judgement against you for the unpaid liabilities of Company C.

The Deputy Commissioner of Taxation served you a bankruptcy notice, in regards to the director penalties.

The Deputy Commissioner of Taxation issued a creditors petition to you for the amount outstanding including an interest charge.

The Deputy Commissioner of Taxation filed a petition in the Federal Magistrates Court seeking a sequestration order against you.

You, a relative and the Deputy Commissioner of Taxation entered into an agreement whereby your relative promised to pay the debt owed.

Your relative paid a sum of money to the Deputy Commissioner of Taxation as a gesture of good faith.

The liquidator swore an affidavit that you owed money to Company A and B.

A sequestration order was made on your estate.

The Official Trustee in Bankruptcy became your trustee in bankruptcy pursuant to the sequestration order.

The Official Trustee in Bankruptcy admitted each of the proof of debts for the four companies.

You sought reasons from the Official Trustee in Bankruptcy for admitting each of the proof of debts.

You commenced legal proceeding in the Federal Magistrates court against the Official Trustee in Bankruptcy, and Company A, B, C and D.

Out of the legal proceeding you are seeking:

· An order that your bankruptcy pursuant to the sequestration order be annulled, and

· An order compelling the Official Trustee in Bankruptcy to reject various proofs of debts lodged by the administrator/liquidator of the various companies.

All of the accounting and legal fees were incurred in relation to Company C as a result of the Director Penalty Notice issued against you by the Deputy Commissioner of Taxation.

Some of the accounting and legal expenses you incurred were paid for by a relative who was and continues to act as your agent during your bankruptcy. Some of the advisors issued tax invoices in the name of your relative due to your bankruptcy. Your relative paid the invoices solely as agent for you.

Reasons for decision

Summary

You are entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for the cost of legal advice in relation to the Director Penalty Notice as it is considered to have been incurred in earning your assessable income as a director. However, a deduction is not allowed under section 8-1 of the ITAA 1997 for your bankruptcy expenses as they are considered to be too remote from the income earning process. Also, your bankruptcy expenses are considered to be private and capital in nature.

A deduction is not allowable for your bankruptcy expenses under section 25-5 of the ITAA 1997 as the matter is not related to your income tax affairs.

A deduction is allowable under section 25-5 of the ITAA 1997 for the cost of preparing your private ruling application querying the deductibility of expenses as this is a cost of managing your tax affairs.

Detailed reasoning

General principles

Agency

Taxation Ruling TR 2004/5 states that where an agent incurs a liability on a principal's behalf and that liability otherwise meets the criteria for deductibility under a provision of the income tax legislation, the principal is entitled to a deduction in respect of that liability.

Section 8-1

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which 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.

The courts have considered the meaning of 'incurred in gaining or producing assessable income'. In Ronpibon Tin NL Tong Kah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; 56 ALR 785; 8 ATD 431 the High Court stated that:

For expenditure to form an allowable deduction as an outgoing incurred in gaining or producing assessable it must be incidental and relevant to that end. The words incurred in gaining or producing the assessable income mean in the course of gaining or producing such income.

It is a long standing principle that a taxpayer does not satisfy section 8-1 of the ITAA 1997 merely by demonstrating a connection between the expenditure and the income earning activity. The connection must be close and immediate. Where the nexus between the expense and the income earning activity is considered to be remote, a deduction will not be allowed.

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 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.

In Herald & Weekly Times Ltd v. FCT (1932) 48 CLR 113, the High Court dealt with a claim for legal expenses incurred by a newspaper proprietor in defending a charge of libel. In allowing the claim the Court stated: 

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 charged by the expenditure.  

In FC of T v. Rowe (1995) 31 ATR 392; 95 ATC 4691 the taxpayer, an employee, was suspended from normal duties and was required to show cause why he should not be dismissed after several complaints were made against him. A statutory inquiry subsequently cleared him of any charges of misconduct or neglect. The court accepted that the legal expenses incurred by the taxpayer in defending the manner in which he performed his duties, in order to defend the threat of dismissal, were allowable. Since the inquiry was concerned with the day to day aspects of the taxpayer's employment, it was concluded that his costs of representation before the inquiry were incurred by him in gaining assessable income.

Likewise, in Elberg v. FC of T 98 ATC 4454, a medical practitioner who earned income in private practice and as an employee was charged with dishonestly obtaining property by deception. The legal expenses in defending the charges were held to be deductible as it was involuntary expenditure where the taxpayer was defending her activities in the operation of her business as a doctor.

The cases mentioned above, as well as those included in your private ruling application, have shown that accounting and legal expenses are an allowable deduction under section 8-1 of the ITAA 1997 if the expenses are incurred in relation to the taxpayer's income earning activity. However, if it is determined that your expenses are of a capital nature then no deduction will be allowed.

In Case N9 24 CTBR (NS) Case 81; 81 ATC 56 (Case N9) the taxpayer who was director of a number of companies, was disallowed a deduction for legal expenses incurred in defending himself on charges under the Companies Act that stood to affect his future appointment as a director. The expenses were held to be essentially private in nature as they were incurred to protect his good name and reputation.  In affirming the legal expenses were not allowable, the Board stated that: 

At all events, it seems to us that the happenings which gave rise to the expenditure, irrespective of whether convictions were recorded against the taxpayer, could not be regarded as normally to be expected in ordinary business transactions or, as in the instant case, to be resorted to as a matter of course by a director or an employee working in the interests of his employer in the course of gaining or producing his personal assessable income.  In these circumstances we take the view that the expenses in issue were essentially private in character in that the need for them arose out of the taxpayer's actions above-mentioned and were incurred by him for the purposes of protecting his personal good name and reputation.

In Case V140 88 ATC 874; AAT Case 4596 (1988) 19 ATR 3859 ( Case V140 ), a solicitor was denied a deduction for legal expenses incurred in defending certain allegations before the Statutory Committee of the Law Society of New South Wales, concerning the solicitor's trust account. The Committee ordered the taxpayer be suspended from practice for a period of twelve months, and to pay the costs of the Law Society. The Administrative Appeals Tribunal (AAT) held that the payments made by the taxpayer were not deductible under section 8-1 of the ITAA 1997 as the payments were characterised as capital expenditure.

Further, in Case X84 90 ATC 609; AAT Case 6528 (1990) 21 ATR 3721 (Case X84), the AAT held that legal expenses incurred by a medical practitioner in defending charges brought against him at a Medical Disciplinary Tribunal inquiry, were not deductible under section 8-1 of the ITAA 1997 because the expenditure was incurred to protect a structural asset, that is, their registration as a medical practitioner, and was of a capital nature.

Section 25-5

Subsection 25-5(1) of the ITAA 1997 states that:

You can deduct expenditure you incur to the extent that it is for:

· managing your tax affairs; or

· complying with an obligation imposed on you by a Commonwealth law insofar as that obligation relates to the tax affairs of an entity

'Tax affairs' is defined in section 995-1 of the ITAA 1997 as affairs relating to tax. 'Tax' is defined in this section as meaning income tax as assessed under the income tax assessment acts.

Application to your circumstances

Agency

Although your relative was invoiced and paid some of your legal and accounting expenses, this does not preclude a deduction being available to you for these expenses if they meet the criteria for deductibility under either section 8-1 or section 25-5 of the ITAA 1997. This is because your relative incurred the liabilities on your behalf as your agent.

Cost of obtaining legal advice in relation to the Director Penalty Notice

The director penalty imposed under section 222AOC of the Income Tax Assessment Act 1936 is not an 'income tax'. Also, PAYG withholding, which led to the imposition of the director penalty is not an 'income tax'. As these amounts are not 'income tax', the expenditure you incurred with regards to the Director Penalty Notice was not in relation to 'tax affairs' as it is defined for the purposes of section 25-5 of the ITAA 1997. Therefore, you are not allowed a deduction for this expenditure under this provision.

However, it is accepted that the director penalty is directly related to your income earning activities as a director. Therefore, the cost of obtaining legal advice in relation to the Director Penalty Notice is considered to have been incurred in earning your assessable income. Also, the cost is not considered to be private or capital in nature. Therefore, this cost is deductible under section 8-1 of the ITAA 1997.

Expenses incurred in defending the bankruptcy action and in seeking to have your bankruptcy annulled

In your situation you were issued a director penalty in regards to unpaid PAYG withholding liabilities for a company of which you were the sole director. As a consequence of not paying the penalty, a bankruptcy notice was issued against you.

You contend that as the bankruptcy action resulted from the director penalty, your bankruptcy expenses are deductible under section 25-5 of the ITAA 1997 as tax related expenses.

However, as discussed previously, neither a director penalty nor PAYG withholding is an 'income tax'. Therefore, expenditure you incurred with regards to these amounts are not in relation to 'tax affairs' as it is defined for the purposes of section 25-5 of the ITAA 1997. Therefore, you are not allowed a deduction for your bankruptcy expenses under this provision.

You also contend that your bankruptcy expenses are deductible under section 8-1 of the ITAA 1997. However, bankruptcy expenses are not considered to be incurred in earning assessable income. Although the non-payment of a liability arising from an income earning activity may eventually lead to bankruptcy, the bankruptcy expenses are being incurred in relation to a matter that is one step removed from the income earning process. Bankruptcy expenses are considered to be too remote to be incurred in the course of earning assessable income.

Also, bankruptcy is a matter related to an individual's personal financial position and is subsequently considered to be inherently private in nature. Although the non-payment of the director penalty led to your bankruptcy, this is not considered sufficient to change the character of your bankruptcy expenses from being private to income earning in nature.

In addition, expenses incurred in order to avoid, or to be removed from, bankruptcy are expenses of a capital nature as they incurred in order to gain an enduring benefit, that being, the avoidance of, or removal from, bankruptcy.

For all of the reasons discussed above, it is considered that the expenses you incurred in relation to your bankruptcy are not deductible under section 8-1 of the ITAA 1997.

Expenses incurred for the preparation of your private ruling application

Unlike a director penalty or PAYG withholding, the deductibility of expenses is an income tax matter. Therefore, the cost you incurred for the preparation of your private ruling querying the deductibility of expenses is a cost incurred in managing your income tax affairs and is deductible under section 25-5 of the ITAA 1997.