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Ruling
Subject: Legal expenses
Question 1:
Are you entitled to a deduction for legal expenses for recovery of a loan to a relative?
Answer:
No.
Question 2:
Are you entitled to a deduction for legal expenses for loss of interest income?
Answer:
Yes
This ruling applies for the following period
Year ended 30 June 2012
The scheme commences on
1 July 2011
Relevant facts and circumstances
You loaned money withdrawn from your home loan account to a family member and their spouse.
You have not provided loans to any other parties.
You had a verbal agreement that they would repay you the principal and interest after a term of several years.
The interest on the loan was calculated at a per annum rate which is greater than the interest rate applied to your home loan.
No interest was ever received in respect of the loan.
Your family member and their spouse subsequently separated and you requested that the loan and interest be repaid in full.
You incurred legal expenses to recover the principal amount of the loan and interest.
As a result of the court order you were paid a lesser amount of the principal loan and no interest.
Relevant legislative provisions
Income Tax Assessment Act 1997 Section 8-1.
Reasons for decision
Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for a loss or outgoing to the extent to which it is incurred in gaining or producing assessable income, except where the loss or outgoing is of a capital, private or domestic nature, or relates to the earning of exempt income.
Generally, legal expenses have been held to be deductible if the expenses are directly related to the earning of income.
In Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 3 AITR 436; (1946) 8 ATD 190, the Court established that in determining whether a deduction is allowable under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered. The nature or character of the legal expenses follows the advantage which is sought to be gained by incurring the expenses. Dixon J stated at CLR 647 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 purposes 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.
If the advantage to be gained is of a capital nature then the expenses incurred in gaining the advantage will also be of a capital nature.
Consequently, it is necessary to consider the reason for which your legal expenses were incurred, that is, the object in view when the legal proceedings were undertaken.
You incurred legal expenses in an attempt to recover both the principal amount of a loan and interest. The principal amount of the loan is considered to be capital. Therefore, it follows that the legal expenses incurred to recover the loan is capital in nature. However, the interest on the loan is considered to be revenue in nature.
The apportionment of legal expenses is dealt with in Taxation Determination TD 93/29. This determination states that where legal expenses are incurred in relation to proceedings that relate both to amounts that are revenue in nature as well as amounts which are capital in nature; there must be some fair and reasonable assessment of the extent of the relation of the outlay to assessable income.
TD 93/29 states:
Where the solicitors account is itemised, one reasonable basis for apportionment would be the time spent involving the revenue claim, relative to the time spent on the capital claim. If the solicitors account is not itemised, a possible basis for apportionment would be either a reasonable costing of the work undertaken by the solicitor in relation to the revenue claim, or, where this is not possible, an apportionment on the basis of the monetary value of the revenue claim relative to the capital claim.
Therefore, the proportion of legal expenses incurred in pursuing interest is deductible. However, the proportion of the legal expenses relating to pursuing the capital amount is not deductible under section 8-1 of the ITAA 1997.