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Ruling

Subject: Legal expenses

Question 1

Are you entitled to a deduction for legal expenses incurred?

Answer

No.

Question 2

Are you entitled to a deduction for satisfying the company's expenses as a guarantor?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 2011

Year ended 30 June 2012

The scheme commenced on:

1 July 2010

Relevant facts

You were a director and employee of entity A.

You received a salary from entity A.

Due to fraudulent acts of a co-director, entity A ceased to trade. The co-director removed the company's cash supplies, much of which was borrowed from various lenders, thereby decimating the company's cashflow position.

As a director, you, with the remaining directors, were required to repay any loans, together with the associated fees and interest.

You undertook legal proceedings against the fraudulent director in an attempt to regain the funds initially stolen. Receipt of such funds would have allowed the company to continue trading and for you to remain in employment.

You were also prosecuted by entity B in respect of an outstanding credit agreement between entity A and entity B. As a director you were required to give a personal guarantee on all borrowings. You incurred significant legal fees, together with additional interest charged by entity B, which ordinarily would have been payable by entity A.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

Legal expenses

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for a loss or an 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.

A number of significant court decisions have determined that for an expense to be an allowable deduction:

· it must have the essential character of an outgoing incurred in gaining assessable income or, in other words, of an income-producing expense (Lunney v. FC of T; (1958) 100 CLR 478), 

· there must be a nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income (Ronpibon Tin NL v. FC of T, (1949) 78 CLR 47), and

· it is necessary to determine the connection between the particular outgoing and the operations or activities by which the taxpayer most directly gains or produces his or her assessable income (Charles Moore Co (WA) Pty Ltd v. FC of T, (1956) 95 CLR 344; FC of T v. Hatchett, 71 ATC 4184).

For legal expenses to constitute an allowable deduction, it must be shown that they are incidental or relevant to the production of the taxpayer's assessable income or business operations. Also, in determining whether a deduction for legal expenses is allowable under section 8-1 of the ITAA 1997, 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 expenses incurred in gaining the advantage will also be of a capital nature.

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 (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 employment duties were allowable.

You have incurred legal expenses in settling entity A's loans and attempting to regain the stolen funds. Such expenses do not sufficiently relate to your day to day income earning activities. They more directly belong to the company. Therefore, no deduction is allowable under section 8-1 of the ITAA 1997 for the associated legal expenses.

It is acknowledged that recovering the stolen funds would have allowed the company to continue trading and allow you to remain in employment. However, legal expenses incurred in preserving employment are not deductible as they are considered to provide an enduring advantage and are therefore capital in nature. The advantage sought is the restoration of a capital asset, that is, your means of producing income. As such, the character of the legal expenses associated with this action are considered to be capital in nature and the expenses are not deductible under section 8-1 of the ITAA 1997 (Taxation Determination TD 93/29; Case Y24 91 ATC 268; AAT Case 6942 (1991) 22 ATR 3184).

Expenses as a guarantor

Taxation Ruling TR 96/23 discusses the deductibility of payments made under guarantee. The ruling states that liabilities arising under contracts of guarantee will not be deductible under section 8-1 of the ITAA 1997 if the provision of guarantees and the losses or outgoings under the guarantees are not regular and normal incidents of the taxpayer's income earning activities. The ruling further states that if the provision of guarantees is not a regular and normal incident of the taxpayer's income earning activities, any payments made under those guarantees will be capital in nature.

Directors of a company would not ordinarily be expected to guarantee a business's debts. Debts are normally incurred by a business in relation to their operations and, thus, the earning of the business's assessable income. As highlighted in FCT v. Munro (1926) 38 CLR 153, a loss or outgoing will not be deductible if it is incurred in gaining or producing the assessable income of an entity other than the one who incurs it.

In your case, you provided a guarantee to the borrowings of entity A. Entity A has since ceased trading. You incurred interest and legal expenses in relation to entity A's loans.  

The purpose of your action was not to directly produce any assessable income for yourself, but to fulfil your commitment as guarantor. You were not in the business of entering into contracts of guarantee. It is not considered that the provision of guarantees was undertaken by you as a regular and normal incident of your income earning activities. Therefore a deduction for paying the company's loan and the associated interest and fees is not allowable under section 8-1 of the ITAA 1997 as it relates to the company's affairs and not your assessable income.