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Ruling

Subject: Deductibility of legal expenses and settlement sum

Question 1

Is the company entitled to deduct the legal costs it suffered in relation to legal action under section 8-1 of the Income Tax Assessment Act 1997?

Answer

Yes.

Question 2

Is the company entitled to deduct the settlement sum it outlaid in relation to legal action under section 8-1 of the Income Tax Assessment Act 1997?

Answer

Yes.

This ruling applies for the following period:

1 January 2010 to 31 December 2011

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 26-5

Relevant Facts

1. The company is an Australian resident company for income tax purposes.

2. The company carries on a business. The company has derived assessable income by carrying on this business in the relevant income years.

3. All of the company's income-producing assets are in Australia.

4. Legal action was brought against the company.

5. The applicant alleged they had suffered a loss due to the actions of the company.

6. The applicant to the legal action sought damages, interest and costs in relation to the allegations.

7. The company initially defended the legal action denying the allegations.

8. The company incurred legal costs in defending the legal actions and will incur further legal costs in relation to the legal action.

9. The company and applicant to the legal action agreed to settle the legal disputes out of court. The settlement was accepted by the Court. The company did not admit any liability in respect of the allegations as part of the settlement. The company considers the settlement a purely commercial decision, stating that settling the legal action allows it to continue to operate its business without the distraction of court action. The company paid a settlement sum, including applicant costs and interest.

10. The settlement deeds state that once the amount of the settlement sum has been paid the company has no right, title, interest in, or claim to any part of the settlement sum.

11. No regulatory body has taken any action in relation to the allegations that formed the basis of the legal action.

Reasons for decision

Question 1

Is the company entitled to deduct the legal costs it suffered in relation to legal action under section 8-1 of the Income Tax Assessment Act 1997?

Detailed reasoning

All legislative references are made to the Income Tax Assessment Act 1997 unless otherwise stated.

Section 8-1 allows a deduction for a loss or outgoing to the extent that it is incurred in gaining or producing your assessable income, or it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income (the positive limbs). However, you are not entitled to a deduction where the loss or outgoing is of capital, or a capital nature; of a private or domestic nature; is incurred in gaining or producing your exempt or non-assessable non-exempt income; or another provision of the ITAA 1997 denies you a deduction for the expenditure (the negative limbs).

Positive limbs

The company was served with legal action. In response to the legal action the company has incurred, and expects to incur, further legal expenses in defending and settling the legal action. In order to be deductible under section 8-1 the legal expenses must satisfy one of the positive limbs.

It must be determined that these outgoings were 'necessarily incurred in' carrying on the company's business. The reasons for decision in ATO Interpretative Decision ATO ID 2004/648 recognise that in Ronpibon Tin NL & Tongkah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 8 ATD 431; (1949) 4 AITR 236 (Ronpibon) the term 'necessarily incurred in' for the purposes of section 8-1 is taken to mean 'clearly appropriate or adapted for'.

In Putnin v. Federal Commissioner of Taxation (1991) 27 FCR 508; 91 ATC 4097; (1991) 21 ATR 1245 (Putnin) an accountant was a trustee under a particular deed of arrangement. The taxpayer administered the estate without obtaining an assignment of the debtor's share in a company and the share was subsequently dealt with by the debtor. The taxpayer was later charged with conspiring with the debtor to defraud the Commonwealth and incurred legal expenses in defending this action. The court found the expenditure arose out of the prosecution, in which they were defending their activities by which income had been earned and they were allowed a deduction for the legal expenditure. It was noted as part of the ruling that it may be a natural incident of the conduct of the operations of a particular kind of business that claims of the commission of torts, or even crimes, may arise, although it is to be hoped not often, and have to be repelled.

The company was served with legal action creating the potential for outgoings as a result of an unfavourable court decision and possible flow on effects for the company and its business. It is considered 'clearly appropriate' that the company incurred legal expenses to initially defend these claims, and once the decision was made to settle, 'clearly appropriate' to incur legal expenses in settling the legal action. This is supported by the findings in Putnin. For a company it is considered that from time to time legal expenses may be necessarily incurred as a result of carrying on the company's business.

It must also be determined whether the outgoings were necessarily incurred in carrying on the business of The Entity. In Elberg v Federal Commissioner of Taxation (1998) 82 FCR 440; 98 ATC 4454; (1998) 38 ATR 623 (Elberg) the judgement, in determining that legal expenses incurred by a doctor were deductible, included a statement that there is simply no basis in principle, or on the authorities, for confining business activities to the core activity by which income is earned rather than to the activities which constitute the conduct of the taxpayer's business which enables income to be earned.

In Ronpibon, it was found that for legal expenses to constitute an allowable deduction under section 8-1, it must be shown that they were incidental or relevant to the production of your assessable income.

Legal expenses are generally deductible if they arise out of the day to day activities of your 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 your income producing activities (Magna Alloys and Research Pty Ltd v. FC of T (1980) 80 ATC 4542; (1980) 11 ATR 276 (Magna Alloys)).

It is considered that the basis of the allegations of the legal action forms part of the day to day activities of the company's business. As such, it is considered that the legal expenses have more than a peripheral connection to the company's income producing activities. The legal expenses are considered incidental and relevant to the production of the company's assessable income.

Therefore, it is considered that the legal expenses that have been incurred, and will be incurred by the company are outgoings necessarily incurred in carrying on a business for the purpose of producing its assessable income, satisfying a positive limb of section 8-1.

Negative limbs

In determining whether a deduction for legal expenses is allowable under section 8-1 the nature of the expenditure must be considered (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 8 ATD 190; (1946) 3 AITR 436 (Hallstroms)). ATO Interpretative Decision ATO ID 2002/814 considers the deductibility of legal fees under section 8-1. The reasons for decision state that for legal expenses to be deductible they must clearly be of a revenue nature and not of a capital nature. The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses and is drawn from the cause or purpose of incurring the expenditure. Flowing from this, the cause of The Entity incurring the legal expenses, being the allegations upon which the class actions are based, must be determined to be either revenue or capital in nature, with the nature of the legal expenses following this determination.

The lead case for determining whether an outgoing is capital or revenue in nature is Sun Newspapers Ltd and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 87; (1938) 1 AITR 403 (Sun Newspapers). The decision in that case considers expenditure in establishing, replacing and enlarging a business structure is capital expenditure, in contrast to working or operating expenses that are revenue in nature. The reasons for decision in ATO Interpretative Decision ATO ID 2004/648 state that drawing from Sun Newspapers the following characteristics are accepted as an indication that an outgoing is on capital account:

· the expenditure is related to the business structure itself, that is, the establishment, replacement or enlargement of the profit yielding structure rather than the money earning process; or

· the nature of the advantage has a lasting and enduring benefit; or

· the payment is 'once and for all' for the future use of an asset or advantage rather than being recurrent and ongoing.

· In applying the indicators of capital expenditure to the company's facts, it is considered that:

· the expenditure on legal expenses is not related to the establishment, replacement or enlargement of the businesses profit yielding structure.

The nature of the advantage sought by incurring the legal expenses is not one that provides a lasting or enduring benefit. The primary purpose for incurring the expenses is to respond to the legal action brought against the company. Whilst it is recognised that the expenditure on legal expenses to defend and settle the allegations raised by the legal action may be associated with long term benefits to the reputation and goodwill of the company, it was noted in Magna Alloys that whilst expenditure on legal expenses may serve to protect the reputation and goodwill of a business, this will not make the expenditure one of capital if the taxpayer is defending the way in which it operated its commercial activities in the course of carrying on its business.

The legal expenses are not a 'once and for all' payment for the future use of an asset or advantage. The legal expenses were ongoing during the course of the legal action and will be ongoing until the legal action is finalised. At the point in time when the legal expenses cease there will be no future asset or advantage as a result of having incurred the legal expenses.

The discussion above indicates that based on the factors drawn from Sun Newspapers the legal expenses do not represent an outgoing of capital, or of a capital nature. Rather, they are related to the money earning process that the company adopts in operating its business. This is indicative of the expenses arising out of the day to day activities of the company's business and having a more than peripheral connection to its income earning activities. In accordance with the decision in Herald and Weekly Times and Magna Alloys this indicates the legal expenses would be generally deductible under section 8-1 as a revenue, rather than a capital expense.

In Federal Commissioner of Taxation v. Rowe (1995) 60 FCR 99; (1995) 31 ATR 392; 95 ATC 4691 (Rowe) 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. Whilst Rowe considers the deductibility of legal expenses incurred in performing the duties of an employee it was recognised in the reasons for decision of ATO Interpretative Decision ATO ID 2002/664 that the court placed no emphasis on the taxpayer's status as an employee. This implies that these principles could be applied to any taxpayer in carrying out their income producing activities.

In the Federal Commissioner of Taxation v. Snowden & Willson Pty Ltd (1958) 99 CLR 431; 11 ATD 463; (1958) 7 AITR 308 (Snowden) the taxpayer incurred legal expenses in defending itself against allegations made in Parliament and in front of a Royal Commission against its business methodology, in particular the pricing methods used by the taxpayer. The taxpayer incurred legal expenses in defending its reputation against the allegations. The court found that the legal expenses were deductible under the general deduction provisions as they were incurred in defending the way in which the taxpayer carried out its business for the purpose of producing assessable income.

The company's facts are similar to those in Rowe and Snowden where legal expenses arose from the defence of the method used in the day to day activities of operating the taxpayers business.

In AAT Case 5204 (1989) 20 ATR 3748; (1989) 89 ATC 572 the taxpayer was a company, formed to carry on the business of a group of companies in receivership. The taxpayer incurred legal expenses in response to actions by two companies within the group against the appointment of the receiver; a bank seeking judgment for possession of land occupied by the taxpayer; and by an unrelated company seeking delivery of equipment. The AAT held that the expenses were on revenue account and deductible, as they were necessitated by the business' ends and as a matter of expediency to preserve the taxpayer's capacity to carry on its day to day business operations.

As previously determined the legal expenses incurred by the company were necessitated as part of the operation of its business. Further, the company has stated that settling the legal action allows it to continue to operate its business without the distraction of a court action over an extended period. These circumstances surrounding the legal expenses incurred by the company are similar to those in AAT Case 5204.

In PBL Marketing Pty Ltd v. Federal Commissioner of Taxation (1985) 80 FLR 411; (1985) 16 ATR 679; (1985) 85 ATC 4416 (PBL) the taxpayer was granted exclusive rights by the Australian Cricket Board to televise and market cricket in Australia. The Australian Broadcasting Commission subsequently brought a legal action against the taxpayer, claiming the exclusivity of the rights breached the Trade Practices Act. The legal expenses in defending and settling the action and lodging documents with the Trade Practices Commission were held to be capital in nature as they were incurred in maintaining or defending the structure of the taxpayers business, for without the exclusive rights there would have been no business.

The nature of the company's legal expenses is distinguishable from those in PBL. The source of the legal action for the company is not vital to the profit making structure of its business. Rather, it is a consequence of the way in which the company operates its business.

Based on the above analysis, it is accepted that the legal expenses are not outgoings of capital, or a capital nature.

It is accepted that the legal expenses were not private or domestic in nature, or incurred in gaining or producing exempt or non-assessable non-exempt income.

Section 26-5 denies a deduction for an amount paid by way of penalty under an Australian or a foreign law; or an amount ordered by a court to be paid on the conviction of an entity for an offence against an Australian or foreign law. It is accepted that the legal expenses were not incurred in relation to any penalty imposed on the company as no action has been taken against the company by any regulatory body. Therefore, a deduction under section 8-1 for the legal expenses incurred is not denied to the company by section 26-5 or any other provision of the ITAA 1997. As such, the company is not denied a deduction by any of the negative limbs provided by section 8-1.

Conclusion

The legal expenses the company incurred in defending and settling the legal action is considered to have been necessarily incurred in carrying on a business for the purpose of gaining or producing its assessable income. Given that the company's legal expenses have arisen from its actions in operating its day to day business to produce assessable income, the expenses are revenue in nature and deductible under section 8-1.

Question 2

Is the company entitled to deduct the settlement sum it outlaid in relation to the legal action under section 8-1 of the Income Tax Assessment Act 1997?

Detailed reasoning

Section 8-1 allows a deduction for a loss or outgoing to the extent that it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income. However, you are not entitled to a deduction where the loss or outgoing is of capital, or a capital nature; of a private or domestic nature; is incurred in gaining or producing your exempt or non-assessable non-exempt income; or another provision of the ITAA 1997 denies you a deduction for the expenditure.

In order for the settlement sum to be deductible, it must be determined that the settlement sum has been 'incurred'. Taxation Ruling TR 94/26 and Taxation Ruling TR 97/7 provide that it is generally accepted that where a loss has been realised, or an outgoing made, that loss or outgoing has been 'incurred'. The amount of the settlement sum under the court approved agreement has been paid by the company in accordance with the settlement deeds. Under those settlement deeds the company has no right to any amount of the settlement sum. It is accepted that the outgoing of the settlement sum has been incurred for the purposes of section 8-1.

ATO Interpretative Decision ATO ID 2002/663 considers the deductibility of a sum paid in settlement of a harassment and victimisation claim. The reasons for decision recognise that for a 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). 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 also be considered (Hallstroms). It is recognised that generally the treatment of a settlement sum or damages payment will follow the treatment of the other legal expenses incurred in relation to the particular matter.

Expenses as a result of legal action are generally deductible if the expenses arise out of the day to day activities of the taxpayer's business (Herald and Weekly Times) and the legal action has more than a peripheral connection to the taxpayer's income producing activities (Magna Alloys).

Similarly, in Rowe 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.

As shown in response to question 1, the legal expenses the company incurred in relation to the legal action is deductible under section 8-1 as it was necessarily incurred in carrying on a business for the purpose of gaining or producing its assessable income and is considered revenue in nature.

Given that the deductibility of the settlement sum for the company will follow the deductibility of the legal expenses in relation to the relevant matter, it is considered that the settlement sum paid in relation to the legal action is also deductible under section 8-1 in accordance with ATO ID 2002/663.

Conclusion

Given the legal expenses incurred in relation to the legal action is deductible under section 8-1, the settlement sum will also be deductible.