Edited version of private ruling

Authorisation Number: 1011860714735

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Ruling

Subject: Legal expenses

Question

Is Company X entitled to claim a deduction for the legal expenses incurred in defending legal action?

Answer

No.

This ruling applies for the following periods

Year ended 30 June 2007

Year ended 30 June 2008

Year ended 30 June 2009

Year ended 30 June 2010

Year ended 30 June 2011

Year ending 30 June 2012

The scheme commenced on

I July 2006

Relevant facts and circumstances

The arrangement that is the subject of the private 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 Private Ruling application

· copy of letter from the previous accounting firm

· copy of invoice

· further information received including a statement of claim for damages.

Company X is the trustee of Trust X. A is the director of Company X.

A manages the accounting affairs of several entities.

Several years ago, A engaged the services of an accountant employed by an accounting firm (AF) to assist with the accounting affairs of all of the entities which he managed the affairs of.

Later, the accountant left AF. A requested that all files be transferred to the new place of employment of his accountant.

AF issued an invoice to Trust X, a work in progress statement and a letter requesting payment of the account before the files were released. The invoice listed work performed for several of the entities.

A disputed the invoice as he was unsure that the entities owed AF the sum requested. Accounts had recently been paid for some of the entities. One entity was deregistered 12 months prior to the invoice issuing.

A requested a tax invoice with an ABN, as the invoice he received did not have one. A requested individual accounts for each entity because he believed that there were a number of discrepancies in the final statement, and he had paid several of the accounts.

Further invoices were issued; however they still did not have an ABN. A again requested invoices with an ABN.

A wrote a letter of complaint to AF and sent copies to the Chartered Professional Accountants, Australian Institute of Company Directors and a financial institution. A believed these bodies would encourage AF to issue individual invoices with an ABN on them.

AF took A to the minor debt court. A agreed to pay an amount as settlement of the debt prior to the Magistrates hearing.

AF instigated a claim for defamation against Company X and A for a sum plus interest.

A has documentation stating that the other side will settle if Company X and A pay a sum to settle. A has declined to settle and will proceed to court.

A stated that a forensic accountant has found a number of errors in the accounts that AF provided to him. A and Company X will use this evidence as a defence against the defamation action.

A estimates that two thirds of the original invoice was for work performed on the accounts of Company X.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Summary

A managed the accounting affairs of several entities including Company X. He had engaged an accounting firm to assist with the accounting affairs of all of these entities. He changed accounting firms and became involved in a dispute with the previous accounting firm over an invoice for the work in progress on the entities that had yet to be paid for. He requested individual account statements for each entity he represented but this was not provided. The legal expenses resulted due to the escalation of the dispute.

It is considered that the legal expenses arose due to the conduct of A acting in his role in managing the accounting affairs of all of the entities. The legal action resulted due to A's relationships to multiple entities which caused the consolidation of accounts for the various entities. The legal expenses do not have a direct connection with the earning of Company X's assessable income. Therefore, Company X is not entitled to a deduction for these expenses.

Detailed reasoning

Section 8-1 of the Income Tax Assessment Act 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.

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.

The courts, on a number of occasions, have determined legal expenses to be an allowable deduction if the expenses arise out of the day to day activities of the taxpayer's business. The action out of which the legal expense arises has to have more than a peripheral connection to the taxpayer's business or income earning activities. The expense may arise out of litigation concerning the taxpayer's professional conduct.

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. No significance was placed by the court on the taxpayer's status as an employee.

However, there must be an evident connection between the expenditure in instituting the proceedings and the taxpayer's earning activities.

In Case U102 87 ATC 621; AAT Case 72 (1987) 18 ATR 3515 the taxpayer took defamation action against comments made with regard to the management of a trust fund of which he was a trustee. It was found that the expenses were not incidental to the proper execution of the office of trustee but rather were to maintain the taxpayer's personal reputation.

In Case W94 89 ATC 792; AAT Case 5376 (1989) 20 ATR 4001 the taxpayer, a public servant incurred legal fees in defending and then appealing against disciplinary charges of improper conduct resulting from his compulsive gambling. It was found that the expenses incurred where not incidental or relevant to the gaining of the taxpayer's assessable income. It was the conduct of the taxpayer through his compulsive gambling which led to the charges which, in turn, led to him incurring legal costs. The expenses incurred were not incidental or relevant to the gaining of the taxpayer's assessable income.

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 116 88 ATC 737; AAT Case 4502 (1988) 19 ATR 3703).

Application to your circumstances

The legal expenses incurred by Company X are not sufficiently connected with the income earning activities of the business. The expenses have arisen out of the action taken when a final account was issued by the previous accounting firm. According to A's records the final account was incorrect and included accounts for other entities which were the responsibility of A not Company X. A request was made to the accounting firm to issue correct invoices, for each separate entity. This was not done. A sent a letter of complaint to the accountant relating to the invoicing issues with copies being sent to various accounting bodies. This action has lead to legal expenses in defending defamation charges brought against Company X and A by the accounting firm.

The defamation action has no direct connection to the income producing activities of Company X; rather it is a result of A's relationships to multiple entities that caused the consolidation of accounts for the various entities. It follows that the legal expenses for the defamation action are also as a result of A's relationship to multiple entities with no connection to the income earning activities of Company X. Therefore the legal expenses are not deductible.