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Subject: Deductions- Settlement payment and legal fees

Question 1

Is an amount that is, part of an agreed settlement amount to be paid by the taxpayer to the financier, under a Deed of Release and Settlement (The Deed), the value of a balancing adjustment event for a depreciating asset pursuant to section 40-295 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Question 2

If the answer to question 1 is 'No', will the amount that is part of an agreed settlement amount of to be paid by the taxpayer to the financier under the Deed be deductible under:

a) section 8-1 of the ITAA 1997?

b) section 25-110 of the ITAA 1997 which provides a deduction for capital expenditure to terminate leases etc.?

c) section 40-880 of the ITAA 1997 which provides a deduction for business related costs incurred on or after 1 July 2005?

Answer

a) No

b) No

c) Yes

This ruling applies for the following period

1 July 2008 to 30 June 2009

1 July 2009 to 30 June 2010

The scheme commenced on

1 July 2008

Relevant facts

The taxpayer entered into a rental agreement for equipment to be repaid over 60 months. The agreement was financed for the taxpayer by the financier and was a standard operating lease.

The taxpayer received a proposal from a consultant of a third party for new equipment. The proposal promised to:

· pay out the lease with the financier

· roll over the payments into the new lease agreement to be repaid with the instalments on the new network over a shorter period.

· negotiate with the financier for the taxpayer to retain title of the one item of equipment,

· negotiate with the new finance company for the taxpayer to retain title of the new equipment at the end of the lease.

The taxpayer executed a new lease with another finance company for new equipment for a shorter period and entered into a new agreement with the consultant to install upgrade and maintain that equipment. The consultant also promised to secure title to one item of the old equipment and ownership of the new equipment at the end of the lease.

On or about this date the old equipment with the exception of one item was removed from the taxpayer's premises by the consultant and the replacement equipment subject to the new lease was installed by them.

The equipment removed from the taxpayer's premises was not returned to the financier as the legal owner. The financier never pursued its rights as owner of the equipment to discover its whereabouts and explained that it was not cost effective to do so in an email to the taxpayer.

In the same email the financier also confirmed that the taxpayer never paid a contribution in satisfaction of ownership of the leased equipment.

The new lease agreement did not provide for the taxpayer to gain title of the new equipment at the end of the lease. Title remains with the new financier.

The financier's statement of account for the taxpayer provides the dates for the first default on monthly instalments until the account was terminated by the financier.

The financier issued the taxpayer with a Notice of Termination and Demand for the outstanding lease balance, arrears, interest and GST. The document also advised of the financier's policy to report account defaulters to a credit agency.

The financier commenced action against the taxpayer for the outstanding balance under for a breach of contract.

A Deed of Release and Settlement (the Deed) between the parties was signed and an amount was agreed to in full settlement of the claim with an upfront payment and the remainder to be paid in instalments. The financier agreed to file a notice of discontinuance and not list any default or complaint with any credit agency.

The financier later issued a tax invoice to the taxpayer for the settlement amount describing amounts as for settlement and for reimbursed legal fees.

The taxpayer claimed a deduction for legal fees in the first year and in the second year:

The GST exclusive amount identified in the financier's tax invoice as the amount for settlement of the agreement has been treated in the taxpayer's records as the agreed payout on the first lease for the cost of a depreciating asset.

The equipment under the first lease had never been depreciated by the taxpayer.

The tax invoices for the legal expenses indicated payment was for 2 separate legal actions.

Relevant legislative provisions

Income Tax Assessment Act 1997

Section 8-1

Section 25-110

Section 40-40

Section 40-295

Section 40-880

Taxation Administration Act 1953

Section 359-20 of schedule 1

Subsection 357-105(2) of schedule 1

Reasons for decision

Issue 1

Question 1

Section 40-295 of the ITAA 1997 identifies when a balancing adjustment event occurs in respect of a depreciating asset. This occurs when the taxpayer:

· ceases to hold the depreciating asset

· ceases to use a depreciating asset and never expects to use it again

· does not use the depreciating asset and decides never to use it, or

· changes their holding or interests in the depreciating asset (only relevant to assets which are partnership assets).

The taxpayer ceased using equipment it leased from the financier when a consultant removed the equipment and replaced it with new gear under a new lease with a new financier. The owner of the former equipment, the financier, instigated legal action against the taxpayer for default on lease payments as a breach of contract. A Deed of Release and Settlement was subsequently entered into by the parties.

The settlement amount was required under the terms of the Deed to be paid by the taxpayer to the financier as remedy for the unpaid rent and interest on the standard operating lease for the former equipment. The equipment was not trading stock and was integral to its business operations. The taxpayer had ceased using the leased equipment (with the exception of one item) when the consultant physically removed the old equipment. The removal date is therefore the date that the taxpayer ceased to use the assets with the exception of one item.

The Uniform Capital allowance system in Division 40 of the ITAA 1997 applies to the holder of an asset acquired under a contract entered into on or after 30 June 2001. The taxpayer entered into an operating lease with the financier for equipment.

In considering the meaning of a balancing adjustment event under section 40-295 of the ITAA 1997 we have to consider whether the taxpayer 'held' the depreciating assets, being the equipment.

Section 40-40 defines the meaning of 'hold' a depreciating asset and employs a table to identify who holds such an asset. Item 10 of the table in section 40-40 states that a depreciating asset is held by the owner or the legal owner if there is both a legal and equitable owner.

The taxpayer claimed a depreciation deduction for the equipment when it claimed an amount which was part of the agreed payout under the Deed, as a balancing adjustment event for depreciating assets. The lease did not make provision for ownership of the equipment to be transferred to the taxpayer at any point in time. A clause stated that the financier had the right to enter the premises where the equipment was stored and retake possession of the equipment once the financier terminated the lease because of certain defaults that included that occasioned by the taxpayer of failure to pay rental instalments. One item remained on the taxpayer's premises because the financier chose not to exercise its rights under a clause to regain possession explaining it was not cost effective to do so. Despite the understanding between the taxpayer and the consultant, one item left on the taxpayer's premises remained the property of the financier who retained legal and equitable right to all the equipment leased from them by the taxpayer. The Deed did not provide the taxpayer with title to any of the equipment.

The equipment that was leased by the taxpayer under a standard operating lease was not held as a depreciating asset by the taxpayer at any time. Legal ownership of the assets was held by the financier. Therefore Section 40-295 of ITAA 1997 which allows a deduction for a balancing adjustment event when you stop holding an asset does not apply as the equipment was never owned and held as a depreciating asset by the taxpayer in the relevant financial year.

The amount paid by the taxpayer under the Deed, to the financier is not the value of a balancing adjustment event for the depreciating assets pursuant to section 40-295 of the ITAA as the taxpayer did not own and hold the assets (being the equipment) in the relevant financial year.

Question 2

(a) Section 8-1 of the ITAA 1997

Section 8-1 of the ITAA 1997 allows a deduction for losses or outgoings to the extent to which they are incurred in gaining or producing assessable income, except where the outgoings are capital, private or domestic in nature.

The rental agreement entered into by the taxpayer for equipment that was financed by the financier was a standard operating lease as there were no options or rights for the lessee to obtain ownership of the equipment during or at the end of the lease arrangement.

After the taxpayer defaulted on its lease repayments for equipment that it used to run its business, it signed a deed of release with the lessor, the financier. The Deed required the taxpayer to pay the financier an amount in full and final satisfaction of all suits, claims and/or demands whatsoever which the financier has or may have in or arising out of the lease agreement or its termination.

The financier itemised the full settlement amount in its tax invoice to the taxpayer as settlement and reimbursed legal costs plus the GST for each item. The amount was noted as the remedy for the taxpayer's breach of contract that was based on the arrears and the outstanding balance on the taxpayer's account with the financier. The remaining amount was described as the remedy for legal fees incurred by the financier when it pursued legal action against the taxpayer.

The amount identified as reimbursed legal fees on the financier's tax invoice to the taxpayer cannot be a deduction to the taxpayer as it forms part of the agreed settlement amount for its breach of contract with the financier. The taxpayer agreed that the amount that it wished to claim as a deduction for legal fees is part of the remedy owed to the financier for breach of contract.

In considering whether the settlement being paid by the taxpayer as remedy for a breach of contract is income or capital expenditure, we need to consider the true character of the consideration given and whether the advantage obtained amounts to an enduring benefit of trade.

In Sun Newspaper Ltd & Anor. v Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 87; (1938) 1 AITR 403, a case concerning income or capital expenditure under section 8-1 of Income Tax Assessment Act 1997, Dixon J said

In the attempt … the courts have relied to some extent upon the difference between an outlay which is recurrent, repeated or continual and that which is final or made "once for all", and to a still greater extent upon a distinction to be discovered in the nature of the asset or advantage obtained by the outlay… The result or purpose of the expenditure may be to bring into existence or procure some asset or advantage of a lasting character which will endure for the benefit of the organization or system or "profit-earning subject." ...

But the idea of recurrence and the idea of endurance or continuance over a duration of time both depend on degree and comparison. As to the first it has been said it is not a question of recurring every year or every accounting period; but "the real test is between expenditure which is made to meet a continuous demand, as opposed to an expenditure which is made once for all"…

Again, the cases which distinguish between capital sums payable … which are referable to capital expenditure or income expenditure according to the true character of the consideration given, that is, whether on the one hand it is a capitalized sum payable by deferred instalments or on the other hire or rent accruing de die in diem , or at other intervals, for the use of the thing…

Dixon J also provided three matters to be considered:

(a) the character of the advantage sought, and in this its lasting qualities may play a part,

(b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and

(c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment.

The settlement expense was incurred as a result of breaching an operating lease that provided the taxpayer with the use of equipment integral to running of its business. Whilst the lease payments under the lease arrangement were on-going payments incurred in gaining or producing assessable income and the breach was for the result of non-payment of the lease payments, the settlement amount was agreed to by the taxpayer in order to discharge itself from any further legal action in relation to the dispute and to protect its business reputation by avoiding a bad credit rating. The business is the 'profit yielding structure' and payments to protect that structure provide an enduring advantage.

By agreeing to pay a once and for all settlement amount, the taxpayer sought to avoid or minimise damages payable in the event of an unfavourable legal outcome. Averting potentially unfavourable legal action through this agreement, the taxpayer attained a lasting or enduring benefit.

Although the settlement was broken down into a lump sum and monthly instalments which appear to be recurrence payments, it is seen as a capital sum payable by deferred instalments. The taxpayer settled the dispute by agreeing to a final payment. The option of using a periodical outlay to conclude the lease had been rescinded by the financier when it issued the taxpayer with a Notice of Termination and Demand.

By agreeing to payment of a final settlement amount, the taxpayer protected its profit yielding structure by securing its business reputation and gained the cessation of legal action over the breached contract. Therefore, the settlement expenditure is an outgoing of a capital nature and cannot be a deduction pursuant to paragraph 8-1(2)(a) of the ITAA 1997.

In coming to our decision we have taken into account ATO Interpretative Decision ATO ID 2002/928 Deductibility of settlement payment- breach of employee service agreement, it was concluded that an out of court settlement paid for breach of an agreement is not deductible under section 8-1 of ITAA 1997 because for the settlement to constitute an allowable deduction, it must be shown that it was incidental to the production of assessable income (Ronpibon Tin NL & Tong Kah Compound NL v Federal Commissioner of Taxation (1949) 78 CLR 47). The settlement amount the taxpayer is paying is not incidental to its business. The full settlement amount is damages paid for a breach of contract that is not an allowable deduction under section 8-1 of the ITAA 1997 as it was not incurred in gaining or producing assessable income.

The amount included in the settlement amount that is being paid by the taxpayer to the financier is therefore not a deduction under section 8-1 of the ITAA 1997.

(b) Section 25-110 of the ITAA 1997

Section 25-110 of ITAA1997 provides deductibility for capital expenditure to terminate leases etc that results in the termination of the lease or licence if the expenditure is incurred:

(a) in the course of ^*carrying on a ^*business; or

(b) in connection with ceasing to carry on a business.

In this case, the taxpayer agreed to pay a settlement to the financier for a breach of contract in full and final satisfaction of all suits, claims and/or demands from the financier. It did not pay the settlement amount to terminate the lease it had with the financier as the financier had already terminated the lease when it issued the taxpayer with a Notice of Termination and Demand. The settlement amount was not paid to terminate the lease but to protect the business's reputation and from ongoing litigation i.e. to protect its profit yielding structure. Therefore section 25-110 that allows a deduction for expenditure on termination of a lease in certain circumstances will not apply.

(c) Section 40-880 of the ITAA 1997

As explained, the amount forms part of the settlement amount of that the taxpayer agreed to pay in full and final satisfaction of a breach of contract and is of a capital nature. Subject to the limitations and exceptions contained in subsections 40-880(3) to 40-880(9) of the ITAA 1997, subsection 40-880(2) of the ITAA 1997 provides that you can deduct, in equal proportions over a period of five income years starting in the year in which you incur it, capital expenditure you incur:

(a) in relation to your business, or

(b) in relation to a business that used to be carried on, or

(c)  in relation to a business proposed to be carried on, or

(d) to liquidate or deregister a company of which you were a member, to wind up a partnership of which you were a partner or to wind up a trust of which you were a beneficiary, that carried on a business.

It is necessary to consider the legislative context of subsection 40-880(2) of the ITAA 1997 in order to determine whether there is a sufficient and relevant connection between the expenditure incurred and the taxpayer's business. In discussing the types of business capital expenditure to which subsection 40-880(2) of the ITAA 1997 applies, the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No. 1) Bill 2006 (the EM) states:

Expenditure on the structure by which an entity carries on (or used to or proposes to carry on) their business and on the profit yielding structure of the business would ordinarily be expected to be of a capital nature. Capital expenditure can also relate to a business's trading operations or the entity that will carry on the business.

The structure covers the legal entity (such as a company) or the legal relationship (such as a partnership or trust) that is the entity that carries on the business for a taxable purpose and that holds the business assets.

These paragraphs indicate that capital expenditure incurred on the structure by which an entity carries on (or used to or proposes to carry on) their business, on the profit yielding structure of the business, or relating to the business's trading operations, are capable of being described as capital expenditure incurred 'in relation to' that business for the purposes of subsection 40-880(2) of the ITAA 1997. Whether such capital expenditure is incurred 'in relation to' the particular business will depend on whether there is a sufficient and relevant connection between the incurring of the expenditure and that business on the facts of the particular case.

In this case, the taxpayer incurred capital expenditure on a settlement amount to finalise all of the claims between the parties to the Deed of Release and protect the profit yielding structure of an ongoing business. There is a sufficient and relevant connection between the taxpayer's incurrence of the capital expenditure on the settlement amount and the business the taxpayer carries on. Accordingly, the expenditure the taxpayer incurred on the settlement amount is capital expenditure the taxpayer incurred in relation to its business for the purposes of paragraph 40-880(2)(a) of the ITAA 1997.

Section 40-880 of the ITAA 1997 provides a deduction over five income years for certain business related capital expenditure. However, paragraph 40-880(5) (d) of the ITAA 1997 provides that you cannot deduct anything under section 40-880 of the ITAA 1997 for an amount of expenditure you incur to the extent that it is in relation to a lease or other legal or equitable right.

The phrase 'in relation to' was considered by the High Court in PMT Partners Pty Ltd (In Liquidation) v. Australian National Parks & Wildlife Service (1995) 184 CLR 301. Brennan CJ, Gaudron and McHugh JJ observed, in considering the application of the Commercial Arbitration Act 1985 (NT), at 313:

   Inevitably, the closeness of the relation required by the expression 'in or in relation to' in s 48 of the Act, indeed, in any instrument - must be ascertained by reference to the nature and purpose of the provision in question and the context in which it appears.

In that case, Toohey and Gummow JJ also observed:

   It is apparent that the words 'in or in relation to' are particularly wide. ... Cases concerning the interpretation of this phrase in other statutory contexts are of limited assistance. However, the cases do show that the words are prima facie broad and designed to catch things which have sufficient nexus to the subject. The question of sufficiency of nexus is, of course, dependent on the statutory context. (at 330) ...

   The connection which is required by the phrase 'in relation to' is a question of degree. There must be some 'association' which is 'relevant' or 'appropriate'. The question of the relevance or appropriateness of the connection is a question which cannot be divorced from the particular statutory context. (at 331)

In First Provincial Building Society Limited v. Federal Commissioner of Taxation (1995) 56 FCR 320; 95 ATC 4145; (1995) 30 ATR 207, Hill J considered the phrase 'in relation to' within the context of paragraph 26(g) of the Income Tax Assessment Act 1936. He considered the words 'in relation to' in that context included a relationship that may either be direct or indirect, provided that the relationship consisted of a real connection, but that a merely remote relationship is insufficient.

Thus, whether capital expenditure is incurred to any extent 'in relation to' a lease or other legal or equitable right will depend on whether there is a sufficient and relevant connection between the incurrence of the expenditure and in this case, the lease.

The Commissioner provides his view on how paragraph 40-880(5)(d) is to apply in Taxation Ruling TR 2011/6 Income tax: business related capital expenditure - section 40-880 of the Income Tax Assessment Act 1997 core issues

235. In the absence of a definition or guidance in the 2006 Explanatory Memorandum the expression 'in relation to a lease or other legal or equitable right' takes on its ordinary meaning shaped by the context of the provision. That context shows that paragraph 40-880(5)(d) relates to rights granted over the use of physical and intangible business assets and that at a practical level the paragraph does not have a wide operation because the other, more specific exceptions in subsection 40-880(5) capture the majority of expenditure relating to leases or other legal or equitable rights.

236. The rights to which paragraph 40-880(5)(d) is directed are those similar to leases in that they give the taxpayer a right to exploit the asset with which the right is associated. In other words, the right is carved out of an asset but falls short of full ownership of the asset. Examples of such rights include profits à prendre, easements and other rights of access to land. The rights however are not limited to rights associated with land.

The taxpayer did not obtain a right to exploit or own any of the equipment it leased from the financier when it paid the settlement amount. Although it was the taxpayer's default of its lease payments that precipitated the legal action taken by the financier for a breach of contract, the lease did not form part of the core business being carried on by the taxpayer. The settlement amount was paid to prevent further litigation and to preserve the business' reputation, thus its profit yielding structure and is clearly in relation to the business. The financier had already terminated the lease before it commenced legal action against the taxpayer. The capital expenditure of the settlement amount was paid in full and final satisfaction of a breach of contract rather than in relation to a lease or other legal or equitable right. In these circumstances, there is not a sufficient and relevant connection between the capital expenditure and the lease and section 40-880(5)(d) of the ITAA 1997 will not deny the taxpayer a deduction for the settlement amount under section 40-880.

In conclusion, the settlement amount will be a deduction for the taxpayer pursuant to section 40-880 of the ITAA 1997. Subsection 40-880(2) provides for the amount to be deducted in equal portions over five years commencing in the year in which the expenditure was incurred.