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Ruling

Subject: Deductibility of legal expenses

Question

Are you entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for legal expenses incurred by you?

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 ended 30 June 2012

The scheme commences on:

1 July 2006

Relevant facts and circumstances

You are a trust with a company trustee. An individual is the director of your trustee.

Several years ago, the individual engaged the services of an accountancy practice to assist with the accounting affairs of all of the entities which he managed the affairs of.

Subsequently, the accountancy practice issued an invoice to you, a work in progress statement and a letter requesting payment of the account. The invoice listed work performed for a number of entities associated with the individual.

The individual disputed the invoice however the issues were not resolved.

The individual wrote a letter of complaint to the accountancy practice and sent copies of the letter to several other bodies.

The accountancy practice instigated a claim for defamation against your trustee and the individual, and also took the individual to the minor debt court.

The legal expenses in relation to the above matters are being paid from the bank accounts of your trustee and the individual.

You are not reimbursing the individual for the legal expenses being paid by him.

You have provided a summary of the costs of the above legal actions.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA of the ITAA 1936 to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA of the ITAA 1936 applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: 'Part IVA: the general anti-avoidance rule for income tax'.

Reasons for decision

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, 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.

The legal expenses in your case arose as a result of an invoice issued by the accounting practice. This resulted in the accounting practice instigating a claim for defamation against you and the individual and also taking the individual to the minor debt court.

You have forwarded a summary of the costs which have been paid in relation to the above legal actions. The legal expenses are paid from several bank accounts, one of which is the account of your trustee, and the other accounts being personal accounts of the individual. You are not reimbursing the individual for the legal expenses being paid by him.

In order to determine whether any of the legal expenses are deductible under section 8-1 of the ITAA 1997, we will need to determine firstly whether all of the expenses as shown in the summary of the costs have been incurred by you, and secondly, determine whether the expenses which have been incurred by you are deductible under section 8-1 of the ITAA 1997.

Legal expenses incurred

The legal expenses must be incurred by you to be an allowable deduction. An expense is incurred by a taxpayer when the taxpayer pays the expense. An expense can also be incurred if there is a presently existing pecuniary liability existing, for example, when a taxpayer receives a bill or invoice for the expense for which they are liable and must pay.

The legal expenses paid from your trustee's account are clearly incurred by you and can be further considered for deductibility under section 8-1 of the ITAA 1997. The legal expenses which are being paid by the individual are, however, being incurred by the individual and not by you, and you will therefore not be able to claim a deduction under section 8-1 of the ITAA 1997 for these expenses.

Deductibility of the legal expenses incurred by you

The legal expenses must be related to the production of assessable income or the carrying on of a business to be deductible under section 8-1 of the ITAA 1997. Legal expenses are considered to be deductible if the expenses:

· are incidental or relevant to the production of the taxpayer's assessable income (Ronpibon Tin NL & Tong Kah Compound NL v. FC of T (1949) 78 CLR 47; (1949) 4 AITR 236); (1949) 8 ATD 431)

· arose from the duties that the taxpayer performs to derive his or her assessable income (FC of T v. Rose (1995) 60 FCR 99; 31 ATR 392; 95 ATC 4691)

· arose out of, or concerns the day to day income producing activities of the taxpayer (Herald & Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 2 ATD 169 (Herald & Weekly Times Ltd))

· were not undertaken to protect the taxpayer's profit-yielding subject

· have more than a peripheral connection to the taxpayer's business and may arise out of litigation concerning the taxpayer's professional conduct (Magna Alloys and Research Pty Ltd v. FC of T (1980) 49 FCR 183: (1980) 11 ATR 276; 80 ATC 4542 (Magna Alloys); Putnin v. Federal Commissioner of Taxation (1991) 27 FCR 508; 91 ATC 4097; (1991) 21 ATR 1245).

In determining whether the costs of legal proceedings are deductible, it is irrelevant whether the taxpayer is successful in those proceedings. The nature of the expenditure must be considered. The nature or character of legal expenses follows the purpose of incurring the expense.

Legal expenses in connection with libels was considered in Herald & Weekly Times Ltd. The Full High Court allowed the deduction since publishing the newspaper was both the source of income and the cause of liability, and the risk of libel was a regular and almost unavoidable incident or inherent risk of publishing.

In Case V116 88 ATC 737; AAT Case 4502 (1988) 19 ATR 3703, a member of a board of directors incurred expenses in defending himself against defamation proceedings brought by the dismissed chairman of directors. The Tribunal found, on the facts, that the taxpayer was defending himself against a claim that he had made defamatory remarks in the course of the performance of his duties, and the alleged defamation was not 'private' in character. The deduction was allowed.

In Magna Alloys, the Federal Court found that the interests of the taxpayer were inextricably involved with those of its directors and agents, and it is plainly in the taxpayer's own interests that the directors and agents be properly represented. The expenditure was therefore capable of being regarded as desirable and appropriate from the point of view of the pursuit of the business ends of the taxpayer. It was also stated that there is nothing which precludes a deduction in respect of the payment of legal costs incurred, not in the defence of the taxpayer itself, but in the defence of directors or employees of a taxpayer in criminal proceedings arising out of their activities on the taxpayer's behalf.

In your case, the legal action resulted from an invoice from the accountancy practice requesting payment of their final fee. This final fee was not paid and the individual, on behalf of your trustee company, disputed the invoice. This led to a subsequent letter, also on behalf of your trustee company, being forwarded to the accountancy practice, with copies being forwarded to other bodies.

These actions resulted in the defamation and debt legal actions being taken by the accountancy practice. The defamation action was taken against your trustee company and the individual, and the debt action was taken against the individual.

In your case, the need to pay legal expenses did not arise directly from any income producing activity or business being carried on. They arose from a failure to pay the final fee to the accountancy practice, and the sending of copies of a letter to the accountancy practice to other bodies. Neither action can objectively be viewed as a necessary or natural consequence of your income earning activities and can be better viewed as a reaction to the actions of the accountancy practice. Your situation can be distinguished from that in Herald & Weekly Times Ltd where the need to pay damages arose directly from the taxpayer's income producing activity.

Accordingly, any legal expenses incurred by you in relation to the above actions will not be deductible under section 8-1 of the ITAA 1997.

Conclusion

You can not claim any legal expenses which are paid by the individual under section 8-1 of the ITAA 1997 as these expenses are not incurred by you. The remaining legal expenses which are paid by you are not deductible under section 8-1 of the ITAA 1997 as these expenses are not incurred for the purpose of gaining or producing your assessable income or the carrying on of a business.

Note

An application for a private ruling can be made by the individual in relation to the deductibility of the legal expenses incurred by him in relation to the above actions.