Edited version of your private ruling

Authorisation Number: 1012438664032

Ruling

Subject: Legal expenses

Question 1

Are you entitled to a deduction for legal expenses incurred?

Answer

No.

Question 2

Does the legal fees form part of the cost base for capital gains tax (CGT) purposes?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 2012

Year ended 30 June 2013

Year ended 30 June 2014

The scheme commenced on:

1 July 2010

Relevant facts

You are a partner in a partnership that operates a business.

You purchased an asset.

In the same year, a relation gifted you another asset.

You were the legal owner of the assets.

Soon after, another relation took a caveat over each asset, claiming a financial interest in the assets.

As a consequence of the caveats, you have been unable to use the assets for income producing purposes.

Developments to enhance the earning capacity of the assets were also delayed due to the caveats, having a detrimental effect on future earnings.

You incurred legal expenses in attempting to have the caveats removed, so you can use the assets for income producing activities.

You incurred legal expenses.

The matter was resolved in your favour and the caveats removed. Income producing activities have commenced in the relevant income year.

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 all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income or are 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.

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).

However, where the expenditure is incurred for the purpose of securing an enduring benefit, rather than a revenue purpose, the expenditure is capital in nature and is not deductible (Sun Newspapers Ltd v. FC of T (1938) 61CLR 337; 5 ATD 87; (1938) 1 AITR 403).

In order to determine whether your legal fees are deductible under section 8-1 of the ITAA 1997, we first need to look at the reason for the legal fees and why they were incurred.

You have incurred legal expenses in having the caveats removed. The expenses did not arise as a consequence of your day to day income earning activities and do not sufficiently relate to your assessable income.

It is acknowledged that the caveat stopped you from expanding your business. However, legal expenses incurred in preserving an asset or defending your ownership rights are not deductible as they are considered to provide an enduring advantage and are therefore capital in nature. As such, the expenses are not deductible under section 8-1 of the ITAA 1997.

Furthermore, your legal expenses arose as a result of a family dispute. The associated expenses relate to a private or domestic matter and are, therefore, not deductible under section 8-1 of the ITAA 1997.

As the legal expenses incurred relate to the caveat and are capital and private in nature, no deduction is allowable under section 8-1 of the ITAA 1997.

Cost base of a capital asset

Your asset is regarded as a CGT asset and the CGT provisions apply on the future sale of your assets. Any net capital gain is included in your assessable income.

A capital gain is made if the capital proceeds (amounts received from the CGT event) are more than the cost base (the total costs associated with that event). Cost base of a CGT asset includes the capital expenditure you incurred to establish, preserve or defend your title to the asset, or a right over the asset (subsection 110-25(6) of the ITAA 1997). Therefore the legal costs to remove the caveats form part of the cost base of your properties.