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Ruling

Subject: Legal costs

Question:

Can you claim a deduction for legal fees in relation to an international security and immigration incident?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 2012

The scheme commences on:

1 July 2011

Relevant facts and circumstances

You carry on a business. Your directors/employees were on a business trip and were subject to international security and immigration breaches. Your directors/employees incurred the legal expenses and, to date, you have not reimbursed them nor raised a liability in your books of account. Your business insurance policy did not cover the breaches.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Summary

You not entitled to a deduction under paragraph 8-1(1)(b) of the ITAA 1997 for the legal expenses because you have not incurred the expenses. The business cannot claim a deduction and then use the taxation refund obtained to repay expenses it is claimed have been paid on their behalf. The business would be considered to have incurred the expenses when they repay the amount that was paid on their behalf.

Although, the expenses had not been paid by you, as the operator of the flight, may ultimately have been held liable for the costs and could have been entitled to a deduction on that basis. For this reason, it is accepted that it is arguable that the business would be entitled to a deduction in respect of the passengers once the expenses have actually been incurred.

Detailed reasoning

To qualify for a deduction a loss or outgoing must have been incurred. The interpretation of the meaning of "incurred" has been the subject of many court decisions and is reflected in Taxation Ruling TR 97/7, which explains the meaning of 'incurred' for the purposes of section 8-1.

The case law in relation to when a loss or outgoing has been incurred can be summarised as follows:

· an outgoing that is paid (i.e. defrayed, discharged or borne) is incurred (FC of T v Raymor (NSW) Pty Ltd 90 ATC 4461);

· an outgoing that is not paid is incurred when the taxpayer has 'completely subjected itself' to the loss or outgoing (FC of T v. James Flood (1953) 88 CLR 492) that is, the taxpayer has a 'presently existing liability' (Nilsen Development Laboratories Pty Ltd (1981) 144 CLR 616) not an 'impending, threatened or expected liability' (New Zealand Flax Investments Ltd v. FC of T (1938) 61 CLR 179);

· an outgoing will not be incurred when it is no more than contingent, threatened or expected, no matter how certain it may be that the loss or expenditure will occur in the future (Coles Myer Finance Ltd v FCT (1993) 176 CLR 640; 25 ATR 95; 93 ATC 4214).

In your case, the expenses arose in relation to your directors/employees ('the individuals') being arrested and charged with various offences. You did not have any insurance that could be used. The individuals arranged the necessary legal representation and undertook to pay the costs, using funds sourced from various accounts they controlled, including both personal and business accounts. Your business accounts do not show that any liability has been incurred. Accordingly, you have not incurred the expenses.

It is considered that when the charges were brought against the individuals, this was an event from which pecuniary liabilities would likely arise in respect of the individuals. However, at that point, they were only contingent, threatened or expected liabilities. No-one was under a present liability to make a payment until certain events happened.

It is the happening of critical events that brings home an obligation. The critical events included the individuals engaging legal representation and undertaking responsibility for the costs. The invoices were issued to the individuals and not to you. The liability to make a payment of money happened when the invoices were issued; it was only at this point that any presently existing liability could be said to exist. The presently existing liability clearly lay with the individuals; if they had not paid the invoices it is arguable as to whether the law firm would have had any recourse against you. It is unlikely that this would have been the case as there is no evidence that you provided any guarantee or surety to the law firm.

In summary, there is no evidence you have accepted a liability in your books of account or shown the individuals as creditors. Your current proposal to repay the costs, in the event of a favourable ruling, remains informal. Thus, it is considered you do not have a present legal liability and that any obligation you may presently have is based on moral grounds rather than obligation; which remains a contingent, threatened or expected liability only.

It is accepted that the business could be entitled to a deduction once an amount has actually been incurred by you. If the funds are repaid to the individuals, then an amount would have been paid and, on this basis, it could be said to have been incurred.

Taxation Ruling IT 149

Taxation Ruling IT 149 deals with the deductibility of legal expenses incurred for fines and/or breaches of the law in the course of carrying on a business. At paragraph 6 it recognises that there is a marginal type of case in which a taxpayer who is carrying on a business in good faith and in a reputable manner necessarily exposes himself to some risk of occasional prosecution because, in the day to day conduct of his business, he must operate through employees and there is always a risk that more or less inadvertently he may fall into a breach of the law.

In your case, it is accepted you are claiming a legitimate business purpose in making the trip. On that basis, IT 149 would not deny deductibility of the expenses.