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Ruling

Subject: Legal expenses

Question:

Is the settlement sum an allowable deduction under section 8-1 of the ITAA 1997 in the year of income ended 30 June 2010?

Answer:

No.

Question:

Are the legal expenses allowable deductions under section 8-1 of the ITAA 1997 in the years of income in which they were paid?

Answer:

Yes, in part. The legal expenses which relate to the preparation of the settlement deeds are not allowable deductions.

This ruling applies for the following periods:

Year ended 30 June 2010

Year ended 30 June 2011

The scheme commenced in:

1 July 2009

Relevant facts and circumstances

The taxpayer was previously a director of a number of companies (the Group). The taxpayer was involved in the day to day management of the Group.

The taxpayer derived assessable income over a number of years from his position as director.

· As a director, the taxpayer had certain duties under the Corporations Act 2001.

There was a dispute between the Group and the taxpayer regarding the manner in which the taxpayer performed his duties as a director. The dispute was settled.

The taxpayer incurred legal expenses in relation to the dispute and paid a settlement sum to the Group.

Relevant legislative provisions

Section 8-1 of the ITAA 1997

Reasons for decision

Section 8-1 of the Income Tax Assessment Act 1997 (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.

Positive limbs of section 8-1:

For expenditure to constitute allowable deductions, it must be shown that they 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).

Also, in determining whether a deduction for the expenses is allowable under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered (Hallstroms Pty Ltd v. FC of T (1946) 72 CLR 634; (1946) 3 AITR 436; (1946) 8 ATD 190 (Hallstroms)). The nature or character of the expenditure follows the advantage that is sought to be gained by incurring the expenditure.

Legal expenses are generally deductible if they arise out of the day to day activities of the taxpayer's business (Herald and Weekly Times Ltd v. FC of T (1932) 48 CLR 113; (1932) 39 ALR 46; (1932) 2 ATD 169) (the Herald and Weekly Times case) 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 80 ATC 4542; (1980) 11 ATR 276).

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 duties were allowable deductions. The activities that 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.

In FC of T v Day [2008] HCA 53; 2008 ATC 20-064; (2008) 70 ATR 14 (Day's case), a public servant had disciplinary charges brought against him by his employer, the Australian Customs Service, under the Public Service Act 1922. The charges related to the alleged failure of Mr Day to fulfil his duty as an officer in a number of separate incidents. The Court determined that a determination of what is productive of assessable income in a particular case may need to take account of any number of positive and negative duties to be performed or observed by an employee or other salary earner. It was determined that Mr Day's position as an officer subject to the Public Service Act 1922 obliged him to observe standards of conduct extending beyond those in the performance of the tasks associated with his office and exposed him to disciplinary procedures within the Service which might have consequences for the retention of his office or his salary. It was determined that the charges could not be considered remote from his office.

Application to your circumstances:

In the taxpayer's situation, the dispute with the Group has occurred as a direct result of his previous position as a director of the Group. The dispute relates to the manner in which the taxpayer performed his duties as a director.

It can be seen that, as with Day's case, there were certain obligations on the taxpayer as a result of his position as a director.. It is accepted that there is a direct nexus between the expenditure incurred on the legal expenses to the taxpayer's income producing activities as a director of the Group and thus what is commonly called the 1^st limb of section 8-1 of the ITAA 1997 (incurred in gaining or producing assessable income) is satisfied.

It is not considered detrimental that the income producing activities were in the past at the time of incurring the expenditure as the required nexus to those activities is clear. Placer Pacific Management Pty Ltd v FC of T 31 ATR 253 supports this view.

The 2^nd limb of section 8-1 of the ITAA 1997 (that the expenditure is necessarily incurred in carrying on a business) is not relevant in this situation as the taxpayer was not carrying on a business.

Negative limbs of section 8-1:

The negative limbs of section 8-1 must also be considered to ensure whether or not a deduction is properly allowable. That is, whether the expenditure is of a capital, private or domestic nature.

The question of whether legal fees are capital in nature has been the subject of much judicial consideration. The classic exposition of the test was by Dixon J in Sun Newspapers Ltd & Associated Newspapers Ltd v. FC of T (1938) 61 CLR 337; (1938) 5 ATD 87; (1938) 1 AITR 403. In his judgment he referred to three tests:

There are, I think, 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.

In Hallstroms, Dixon J said that legal expenses:

… take the quality of an outgoing of a capital nature or of an outgoing on account of revenue from the cause or purpose of incurring the expenditure. We are, therefore, remitted to a consideration of the object in view when the legal proceedings were undertaken, or of the situation which impelled the taxpayer to undertake them.

Application to your circumstances:

In the taxpayer's situation, the Commissioner believes that there were actually two purposes in the incurring of the legal expenses.

In incurring expenditure in determining whether or not the taxpayer could in fact have a liability because of his obligations as a director, it is accepted that this is similar principles to that considered in Day's case.

Therefore, the legal expenses incurred in respect of determining his position in respect to a potential liability arising from his position as a director are allowable deductions.

The settlement deed was entered into for a different purpose. There was an element of both capital and personal expenditure in relation to the settlement

Therefore, the legal expenses incurred in negotiating and preparing the settlement deed is not deductible under section 8-1 of the ITAA 1997.

The settlement sum itself will also not be deductible for the same reasons given above.