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Ruling

Subject: Business expenses - legal costs

Question

Are you entitled to claim a tax deduction for legal costs incurred in defending a legal action?

Answer

Yes

This ruling applies for the following periods:

Year ending 30 June 2009

Year ending 30 June 2010

Year ending 30 June 2011

The scheme commences on:

1 July 2008

Relevant facts and circumstances

The arrangement that is the subject of this ruling is described below. The following documents have been relied upon to reach a decision:

§ Private ruling application

§ Statement of claim

§ Release of claim

You operate a masseur business.

You performed a massage on a client. Approximately 2 weeks later the client developed a serious medical condition.

The client commenced legal action against you, 3 doctors and a hospital. A Statement of Claim was lodged in court.

You paid legal fees to defend the action.

The claim was settled out of court with each of the defendants, including you, paying a lump sum to the plaintiff.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Summary

The legal costs you have incurred are directly related to your income-producing activity therefore they are deductible.

Detailed reasoning

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 97) provides that a loss or an outgoing is an allowable deduction if it is incurred in producing assessable income or in carrying on a business for the production of assessable income, unless that loss or outgoing is capital or of a private or domestic nature.

For legal costs to constitute an allowable deduction, it must be shown that they were incidental or relevant to the production of the taxpayer's assessable income (Ronpibon Tin NL & Tong Kah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 4 AITR 236; (1949) 8 ATD 431).

Therefore, payments as a result of legal action 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) 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).

Similarly, 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. The activities which produced the taxpayer's income were what exposed them to the liability against which they were defending themselves. No significance was placed by the court on the taxpayer's status as an employee.

Where an expense is incurred involuntarily, your motives in pursuing the action will be irrelevant to the determination of its deductibility. It is the objective circumstances which compel you to incur the expense which determine its deductibility (Shokker v. FC of T 99 ATC 4504; 42 ATR 257).

In Putnin v. FC of T 91 ATC 4097; (1991) 27 FCR 508 an accountant was trustee under a particular deed of arrangement. They 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. They were 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 his prosecution, in which they were defending their activities by which income had been earned and they were allowed a deduction for this legal expenditure.

Their Honours stated :

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.

In Elberg v FC of T 38 ATR 623; 38 ATR 623 a doctor was charged with dishonestly obtaining property by deception. The charges alleged they falsely held themselves to be on duty with their employment when they actually deriving income from their private practice. Merkel J said

In my view, as in Putnin, the present case is one which concerns expenditure which may relevantly be described as involuntary. Also, as in Putnin, and I would add Rowe, Magna Alloys and Herald and Weekly Times, the expenditure arose out of proceedings in which the taxpayer was defending her activities in a particular operation of her business, in the present case, as a doctor, by which she earned her income.

In your case the legal action against you arose out of the day to day activities of your massage business. The legal costs were incurred to defend your work practices and the way in which you worked. The legal costs have a direct connection to your business and were incurred in producing assessable income, therefore they are deductible