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Ruling

Subject: Legal expenses

Question 1

Are you entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for legal expenses incurred in relation to the defamation proceedings?

Answer

Yes

Question 2

Are you entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for the full amount of legal expenses incurred in relation to the minor debt proceedings?

Answer

No

This ruling applies for the following period

Year ended 30 June 2007

Year ended 30 June 2008

Year ended 30 June 2009

Year ended 30 June 2010

Year ended 30 June 2011

Year ended 30 June 2012

The scheme commenced on

1 July 2006

Relevant facts

You are a trust with a company trustee. An individual is the director of your trustee.

Several years ago, the individual engaged the services of an accountancy firm to assist with the accounting affairs of several entities which he managed the affairs of and later engaged the firm for other entities.

Subsequently, the accountant that usually dealt with the accounting affairs of these entities left the firm and the individual requested that all files be transferred to the accountant's new place of employment.

The accountancy firm issued an invoice to you, a work in progress statement and a letter requesting payment of the account before the files were released. The invoice listed work performed for various entities.

Subsequently, the accountancy firm issued an invoice to you, which included work in progress for all of the entities associated with the individual and a letter requesting payment of the account before the files were released.

The individual, in his capacity of trustee director, disputed the invoice as part of his day to day income producing activities which required that quality records are kept and maintained for income tax and GST.

The individual was aware of ATO regulation in regards to what constitutes a proper tax invoice and he did not believe that the trust was liable for the amount invoiced.

Some invoices had already been paid for some of the entities and one entity had been deregistered.

The accountancy firm provided tax invoices which failed to supply:

1) their registered Australian Business Number (ABN)

2) their registered business name; and

3) details of supply of service breakdowns for invoices over $x.

The individual estimated that only two thirds of the invoice was for work performed on the accounts of the trustee.

The individual made a number of requests to the accountancy firm on trustee letterhead for valid tax invoices to be provided.

The individual is still disputing a number of invalid tax invoices issued.

The individual wrote a letter of complaint regarding their poor quality tax agent accounting and sent copies of the letter to several other bodies with the expectation that these bodies would encourage the accountancy firm to issue individual invoices with an ABN on them.

As a result of these copies being sent to third parties, a defamation claim was commenced against your trustee and the individual.

The accountancy firm took your trustee and two partly-owned companies to the minor debt court.

The individual agreed to pay a settlement amount prior to the hearing.

Your trustee settled the minor debt claims. This amount was invoiced solely to the trust but in the absence of a clear dissection of work conducted by the accountancy firm two-thirds of the settlement payment was reimbursed by the two other entities. This was an attempt for distribution equally across the three minor debt entities.

Legal fees were incurred by the trustee in defending the defamation action brought against your trustee and the individual. The individual, at all times was defending the trustee in his role as director of the trustee.

The legal expenses in relation to the above matters are being paid from the bank accounts of your trustee and the individual.

The expenses paid by the individual will be claimed for reimbursement from your trustee.

You have provided a summary of the costs of the above legal actions and copies of the legal expense invoices.

You have provided copies of the accounting invoices issued to the trust and other entities during the period the trust and other entities used the services of the accounting firm.

Apart from the defamation action and the minor debt proceedings, there were no other legal proceedings. No counterclaims have been lodged.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

Summary

With regards to the legal expenses relating to the defamation case, we have concluded that they are characterised as having the requisite connection with your assessable income as the costs were incurred in the defence of your trustee and trustee director in proceedings arising out of their activities on your behalf.

Therefore, you are entitled to a deduction for the legal expenses you incurred in relation to this action.

You are also entitled to a deduction for the legal expenses you incurred in defending the minor debt claims to the extent that they relate to the minor debt proceedings against your trustee.

Detailed reasoning

Section 8-1 of the 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.

The legal expenses in your case arose as a result of attempts by your trustee director to have valid tax invoices and individual accounts for each entity issued by an accounting firm. This resulted in the accounting firm instigating a claim for defamation against you and your trustee director and also taking your trustee and other entities to the minor debt court.

The legal expenses are paid from several bank accounts, one of which is the account of your trustee, and the other accounts being personal accounts of the individual.

The individual has indicated that the expenses paid by him will be reimbursed by your trustee.

Legal expenses incurred

The legal expenses must be incurred by you to be an allowable deduction. An expense is incurred by a taxpayer when the taxpayer pays the expense. An expense can also be incurred if there is a presently existing pecuniary liability, for example, when a taxpayer receives a bill or invoice for the expense for which they are liable and must pay.

When a director of a company which is a trustee of a trust incurs expenditure on behalf of the trust, he or she is not allowed a deduction for this expenditure in his or her own tax return. This is because the expenditure is in respect of an expense of the trustee of the trust and is only an allowable deduction in the tax return of the trust,

Therefore, the legal expenses in relation to the defamation case have been incurred by you and can be further considered for deductibility under section 8-1 of the ITAA 1997.

The legal expenses in relation to the minor debt claim have not been incurred by you to the extent that they relate to the other parties to the claim.

Deductibility of the legal expenses incurred by you

The legal expenses must be related to the production of assessable income or the carrying on of a business to be deductible under section 8-1 of the ITAA 1997. Legal expenses are considered to be deductible if the expenses:

· 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)

· arose from the duties that the taxpayer performs to derive his or her assessable income (FC of T v. Rose (1995) 60 FCR 99; 31 ATR 392; 95 ATC 4691)

· arose out of, or concerns the day to day income producing activities of the taxpayer (Herald & Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 2 ATD 169 (Herald & Weekly Times Ltd))

· were not undertaken to protect the taxpayer's profit-yielding subject

· have more than a peripheral connection to the taxpayer's business and may arise out of litigation concerning the taxpayer's professional conduct (Magna Alloys and Research Pty Ltd v. FC of T (1980) 49 FCR 183: (1980) 11 ATR 276; 80 ATC 4542 (Magna Alloys); Putnin v. Federal Commissioner of Taxation (1991) 27 FCR 508; 91 ATC 4097; (1991) 21 ATR 1245).

In determining whether the costs of legal proceedings are deductible, it is irrelevant whether the taxpayer is successful in those proceedings. The nature of the expenditure must be considered. The nature or character of legal expenses follows the purpose of incurring the expense.

Legal expenses in connection with libels was considered in Herald & Weekly Times Ltd. The Full High Court allowed the deduction since publishing the newspaper was both the source of income and the cause of liability, and the risk of libel was a regular and almost unavoidable incident or inherent risk of publishing.

In Case V116 88 ATC 737; AAT Case 4502 (1988) 19 ATR 3703, a member of a board of directors incurred expenses in defending himself against defamation proceedings brought by the dismissed chairman of directors. The Tribunal found, on the facts, that the taxpayer was defending himself against a claim that he had made defamatory remarks in the course of the performance of his duties, and the alleged defamation was not 'private' in character. The deduction was allowed.

In Magna Alloys, the Federal Court found that the interests of the taxpayer were inextricably involved with those of its directors and agents, and it is plainly in the taxpayer's own interests that the directors and agents be properly represented. The expenditure was therefore capable of being regarded as desirable and appropriate from the point of view of the pursuit of the business ends of the taxpayer. It was also stated that there is nothing which precludes a deduction in respect of the payment of legal costs incurred, not in the defence of the taxpayer itself, but in the defence of directors or employees of a taxpayer in criminal proceedings arising out of their activities on the taxpayer's behalf.

Cases where legal expenses were held to be incurred in gaining or producing assessable include the following:

In FCT v. Rowe (1995) 60 FCR 9995; 95 ATC 4691; (1995) 31 ATR 392, the court accepted that legal expenses incurred in defending the manner in which a taxpayer performed his employment duties were allowable.

It is clear that legal expenses may be deductible where they arise out of litigation concerning a taxpayer's professional conduct.

In the High Court decision in Federal Commissioner of Taxation v. Day [2008] HCA 53; (2008) 70 ATR 14; 2008 ATC 20-064 (Days case), Mr Day was charged with breaching the standards of conduct and failing to fulfil his duty as an officer. It was found that the requisite connection with his assessable income was present and that he was exposed to the charges by reason of his office.

The common thread throughout these cases is that the conduct or activity giving rise to the charges was transparently and intrinsically part of the day to day activities by which each party earned their assessable income.

Where an expense is incurred involuntarily, your motives in pursuing the action will be irrelevant to the determination of its deductibility. It is the objective circumstances which compel you to incur the expense which determine its deductibility (Shokker v. FC of T 99 ATC 4504; 42 ATR 257).

Application to your circumstances - Defamation claim

In your case, the action alleging defamation was initiated by the other party and the expenses the trust incurred were involuntary. As a consequence, you were required to defend your trustee director's actions concerning letters sent regarding the failure to obtain valid tax invoices for the correct amount of your outstanding liabilities. It is accepted you incurred the legal expenses with this objective purpose.

The legal expenses in relation to the defamation case arose from the individual seeking to satisfy correct tax accounting as a day to day activity undertaken in the course of carrying on his duties as trustee director.

As a consequence of the charges, you were required to defend the individual's actions concerning decisions that were a normal incident of the day to day activities undertaken in the course of carrying on his role. The office of trustee director included with it an obligation to make decisions in the interests of the trust.

Therefore, the essential character of the legal expenses, arising from the nature of the allegations defended, is such that the expenses have sufficient connection with the activities that gained or produced assessable income from that office.

The legal expenses you incurred were not directed toward acquiring, preserving or expanding any capital asset, nor resulted in any alteration of business structure. The expenditure was of a defensive nature and not made to provide you with any benefit. Accordingly, the legal expenses are not of a capital nature.

We have concluded on the facts provided that the legal expenses in relation to the defamation proceedings are characterised as having an income nature. Therefore, you are entitled to a deduction for the legal expenses you incurred.

Application to your circumstances -Minor debt proceedings

You will also be entitled to your portion of the legal expenses relating to the minor debt proceedings. Due to the fact that the minor debt proceedings involved other entities, we have determined that a portion of the expenses relating to these proceedings are not properly referrable to this entity.

Accordingly, you will need to apportion the legal expenses relating to the minor debt proceedings in a reasonable manner as these expenses are referrable to other entities and are not deductible to you.