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Ruling

Subject: Legal expenses

Question 1:

Are you entitled to a deduction for legal expenses you incurred prior to purchasing an investment property off the plan?

Answer:

No

This ruling applies for the following period

Year ended 30 June 2012

The scheme commences on

1 July 2011

Relevant facts and circumstances

You purchased an off the plan investment property.

The developer changed the floor space without reducing the purchase price or offering compensation.

You sought legal advice and incurred expenses to defend your income producing investment.

You accepted the loss of the space.

You settled your contract and later rented your investment property.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1 and

Income Tax Assessment Act 1997 Section 110-25

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, except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.

For legal expenses to constitute an allowable deduction it must be shown that they were incidental and relevant to the production of the taxpayer's assessable income (Ronpibon Tin NL & Tong Kah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR47; (1949) 4 AITR 236; (1949) 8 ATD 431).

In determining whether a deduction for legal expenses is allowed, the nature of the expenditure must be considered (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 3 AITR 436; (1946) 8 ATD 190). The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses. If the advantage to be gained is of a capital nature, then the expense incurred in gaining the advantage will also be of a capital nature.

It also follows that the character of legal expenses is not determined by the success or failure of the legal action.

Where legal expenses arise as a consequence of the day to day activities of a business, that is, they are incurred in gaining or producing assessable income, the object of the expenditure is devoted towards a revenue end and the legal expenses are deductible (Herald & Weekly Times v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 2 ATD 169).

However, where the expenditure is devoted towards a structural rather that an operational; purpose, that is, they relate to the profit yielding structure, the expenditure is of a capital nature and the expenses are not deductible (Sun Newspapers Ltd & Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 87; (1938) 1ATR 403).

In your case, the legal action you undertook was about a dispute with the developer prior to purchasing an investment property, related to the construction of property constituting capital assets that you own, from which income is derived. The advantage which was sought to be gained by incurring the expenses was to preserve or increase your income earning potential from the property. As such, your legal expenses are deemed to be capital in nature and are not deductible under section 8-1 of the ITAA 1997.