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Ruling

Subject: Legal expenses and settlement sum

Question 1:

Are you entitled to a deduction for legal expenses?

Answer:

No.

Question 2:

Are you entitled to a deduction for the settlement sum?

Answer:

No.

This ruling applies for the following period

Year ended 30 June 2012

Year ended 30 June 2013

The scheme commenced on

1 July 2011

Relevant facts

You were a principal and share holder of the Company

The Company was in the business of providing financial services.

Associated was an independently operated insurance and finance dealer group owned by its principals as a co-operative. Company 2 was the holder of a financial license.

The Company was a corporate authorised representative of Company 2 and operated its business under the financial license of Company 2. Clients were serviced under Company 2 and the Company would receive a commission from Company 2.

The plaintiff was a director and shareholder of Company 3. Company 3 was in the business of selling insurance and investment products.

Company 3 had dealings with the company and operated under the Company's license with Company 2. Company 2 would pay commissions to the Company which would then be passed onto Company 3. Furthermore, Company 3 shared the Company's resources.

Principles of Company 2 were invited to acquire shares in Company 2. This arrangement was exclusive to principles.

As the plaintiff was not selected to become a principle, he/she was excluded from acquiring shares in Company 2.

You entered an arrangement with the plaintiff whereby you would reward him/her by giving him/her shares in Company 2 as well as monetary rewards for referring clients to the Company.

The plaintiff requested that you give him/her with shares in Company 2 which you would hold as he/she was excluded from holding shares in his/her own name.

You entered into further arrangements. You sold shares in Company 2 to the plaintiff which were held in your name.

The plaintiff acquired shares in Company 2 from a third party. These shares were also held in your name.

The arrangement of giving shares was not usual practice. However, it had been undertaken once previously with another person.

You agreed with no admission to liability by either party to pay the plaintiff an amount of which approximately half represented the plaintiff's legal costs.

The value of the shares at the time of the transactions is unknown.

Action was taken against you alleging that;

The plaintiff was to introduce clients to you and you would manage their financial affairs. In return, you would give the plaintiff some of your shares in Company 2

the plaintiff could not hold the shares in their own name

The shares were to be set aside and held by you as a trustee of an express bare trust for the plaintiff as beneficiary, the shares constituting the trust property.

The plaintiff later purchased and paid for, a further amount of shares in Company 2 from you and you continued to hold them in your own name

The plaintiff purchased a further amount of shares in Company 2 from another principal of Company 2. The plaintiff requested and you agreed to hold the shares on trust for them.

You and the plaintiff agreed that you would sell a portion of the shares and you would pay the plaintiff the value of the offer.

You failed to account to the plaintiff for the sale of the shares

Another company merged with Company 2 and shared in Company 2 were exchanged for shares in the other company by way of a share swap

You received dividend payments for and on behalf of the plaintiff from Company 2 and/or the company

The plaintiff claimed dividends and compound interest on the basis that the dividends should have been reinvested in the company

The plaintiff demanded the transfer of the shares to them.

You informed the plaintiff that you had sold the shares, without authority, as you had a cash flow problem.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Section 8-1 of the Income Taxation Assessment Act 1997 (ITAA 1997) allows a deduction for all losses and outgoings to the extent they are incurred in gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature.

For legal expenses 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).

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. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 39 ALR 46; (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) 49 FLR 183; (1980) 11 ATR 276; 80 ATC 4542).

When the principal reason for incurring the legal expenses is defending the actions of the taxpayer in carrying out their employment duties through which they gain or produce assessable income, such expenses are characterised as being of a revenue nature and are deductible (Inglis v. FC of T 87 ATC 2037; and Case V116 88 ATC 737; AAT Case 4502 (1988) 19 ATR 3703).

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/her employment duties were allowable.

In your case, the legal action was not a result to your activities as a director or in carrying out your employment duties. Rather, the action was the result of you not fulfilling your agreement to the plaintiff and selling shares that you held on trust for him/her and not paying him/her the proceeds of the sale. As such, it is considered that the action was a result of your personal behaviour and not incurred in conducting the business. Therefore, you are not entitled to a deduction for legal expenses.

Settlement sum

The amount required to pay to the plaintiff represented both an amount for the value of the shares you held for him/her and also his/her legal costs.

The amount that represents the value of the shares you owed to the plaintiff is considered to be capital in nature as you were effectively paying him/her what you owed him/her. The amount is not deductible.

As with your own legal expenses, the amount of the plaintiff's legal expenses you paid arose out of your personal behaviour in selling the shares you held on trust for him/her and not paying him the proceeds of the sale, and not as a result of conducting your duties as a director or employee. These expenses are considered to be private in nature and are not deductible.