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Ruling

Subject: Business expenses

Question:

Are you entitled to a deduction for the settlement amount paid to satisfy a debt under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer: No.

This ruling applies for the following period

Year ended 30 June 2011

The scheme commenced on

1 July 2010

Relevant facts

The partnership conducts a business providing professional services including acting as executor of deceased estates.

A percentage of the partnership business income is derived from fees earned by the individual partners acting as executors of deceased estates.

While acting as executor of a deceased estate, one of the partners agreed to take out a mortgage over the estate property for the sole benefit of fellow executor and beneficiary of the estate.

The will did provide the executors with the power to borrow against the estate property.

The two executors were joint signatories on the loan, which was secured by the estate property.

The partner admits that he did not review the loan documents in detail before signing, in his capacity as executor of the estate, and was not aware that his liability under the loan extended beyond the assets of the estate.

When the estate property was sold, there were insufficient funds available to repay the loan.

The executor that received the loan funds was unable to repay the shortfall and the mortgage company sought to recover the shortfall amount from the partner.

The shortfall amount was reduced by agreement with the mortgage company and this was paid by the partnership.

Neither the partner nor the partnership received any benefit from the borrowings and was not involved in any way with the activities of the other executor.

Relevant legislative provisions

Income Tax Assessment Act 1997 - Section 8-1.

Reasons for decision

Under section 8-1 of the ITAA 1997 you can claim deductions for expenses 'to the extent' they are incurred in gaining or producing your assessable income, or they are necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

You cannot claim deductions under section 8-1 of the ITAA 1997 for expenses 'to the extent' to which they are of a capital, private or domestic nature or they are incurred in gaining or producing exempt income.

The partnership voluntarily paid a settlement amount on behalf of one of the partners who had been held personally liable for a loan shortfall amount owed on a loan to which he was a joint borrower.

This expense is not deductible under the first limb of section 8-1 of the ITAA 1997 as it was not incurred in gaining or producing the partnership's assessable income. For the expense to be deductible under the second limb, you must be able to show that it was 'necessarily incurred' in carrying on the partnership business for the purpose of gaining or producing assessable income.

Necessarily incurred

The phrase 'necessarily incurred' does not mean that the expense was unavoidable or logically necessary. The expense must be clearly and appropriately adapted for the ends of the business.

Where the expense is voluntary, the controlling factor is whether the expense can objectively be seen to be appropriate to the business activity (Magna Alloys & Research v. FC of T 80 ATC 4542; (1980)11 ATR 276 (Magna Alloys)).

It may be necessary to examine the taxpayer's subjective purpose where there is no obvious commercial connection with the business activity or where the expense does not achieve its intended result (Taxation Ruling TR 95/33).

The test in the second limb of section 8-1 of the ITAA 1997 requires that the relevant outgoing be characterised as necessarily incurred in carrying on the business of the taxpayer for the specified purpose. In other words, the expenditure in question must have the necessary connection with the operations or activities which more directly gain or produce assessable income if it is to meet the statutory criterion of being a loss or outgoing necessarily incurred in gaining or producing assessable income (see Hill J in FC of T v. Roberts & Smith 92 ATC 4380 at 4386; (1992) 23 ATR 494 at 502).

In cases where an examination of the objective facts and circumstances does not disclose an obvious commercial connection between the loss or outgoing and the carrying on of the taxpayer's business, it may be necessary and relevant to have regard to the taxpayer's subjective purpose, motive or intention, at least on an evidentiary basis, for determining whether the expenditure was incurred in carrying on the business of the taxpayer for the purpose of gaining or producing assessable income.

In Magna Alloys, Deane and Fisher JJ commented upon the relevance of subjective purpose. At 80 ATC 4558; 11 ATR 294, their Honours said:

'There are some statements in the authorities which support the view that, in a case where the outgoing is voluntary in the sense that it was volitionally incurred in the pursuit of a particular advantage or object, the taxpayer's subjective purpose or motive or assessment of appropriateness to the ends of the business is of critical importance to the decision whether the outgoing was necessarily incurred in carrying on the relevant business.'

In this case, the partnership conducts a business providing professional services including acting as executor of deceased estates.

A percentage of the partnership business income is derived from fees earned by the individual partners acting as executors of deceased estates.

As discussed above, where the expense is incurred voluntarily, the controlling factor is generally whether the expense can objectively be seen to be appropriate to the business activity but, if there is no obvious commercial connection with the business activity, it may be necessary to examine the taxpayer's subjective purpose for incurring the expense.

In this case, one of the partners agreed to become joint borrower on a mortgage taken out over the estate property for the sole benefit of a fellow executor and a beneficiary of the estate. While the will did provide the executors with the power to borrow against the estate property, the actions of the partner, in becoming a joint borrower, were not strictly undertaken in order for him to fulfil his duties as an executor of the estate. Further, agreeing to a mortgage without reviewing the loan documents in detail and being fully aware of the liabilities created under the loan, would be considered to be outside the duties required of an executor of a deceased estate.

There is no obvious commercial connection between the expense and the partnership business. Neither the partnership nor the partner benefited from the loan and the actions of the partner fall outside those generally required to carryout the duties of an executor of a deceased estate.

Therefore, the expense paid by the partnership is not considered to have be 'necessarily incurred' in producing the partnership income under section 8-1 of the ITAA 1997 and is not deductible.