Edited version of your private ruling

Authorisation Number: 1012494687644

Ruling

Subject: Legal expenses

Question

Are you entitled to a deduction for legal expenses incurred?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

The scheme commenced on:

1 July 2010

Relevant facts

The arrangement that is the subject of the Ruling is described below. This description is based on the following documents. These documents form part of and are to be read with this description. The relevant documents are:

§ the application for private ruling and

§ additional information and relevant documents.

You are a sole director and shareholder of entity A.

You have invested significant funds into the company by way of loan. The company has not yet repaid these funds nor paid interest on such amounts, although you have a right to charge.

Since the relevant income year it was agreed that you would derive a weekly director's fee for your management of the company.

Due to the company incurring trading losses, the company did not always have sufficient funds to pay the agreed directors fees. Therefore, on a quarterly basis, any amounts that were unpaid were credited to your loan account with the company and/or offset against other amounts loaned between you and the company.

You hope to receive dividends from the company in the future.

Entity B claimed that you had made public statements which were detrimental to them and they were seeking damages.

You have incurred legal expenses defending yourself and an associated asset.

The costs incurred were an attempt to defend and maintain the business operations, to protect your future income from the business in the way of dividends as well as the loan repayments.

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, or relate to the earning of exempt income, or a provision of the ITAA 1997 prevents it.

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) (Lunney's case), 

§ 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.

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). Legal expenses incurred in order to protect a business asset are capital in 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 (Rowe's case), the court accepted that legal expenses incurred in defending the manner in which a taxpayer performed his employment duties were allowable.

In Case U102 87 ATC 621 the taxpayer was a secretary-manager of a large sporting club. The taxpayer was appointed trustee of money raised to care for a member of the sporting club who had been injured. Comments about the management of the trust funds were made on television that were defamatory in nature in respect to the trustees. The trustees commenced proceedings for damages for defamation. The Administrative Appeals Tribunal (AAT) held that a deduction for the legal expenses incurred by the taxpayer was not allowable

It was found that the events which gave rise to the expenses incurred were not regarded as what is normally expected of a secretary-manager of a club in the course of producing assessable income. The expenses were considered private in nature as the need for them arose out of the taxpayer's reaction to what he saw as a slur upon his personal good name and reputation. Alternatively, it was stated that the expenditure was capital in nature as it was incurred in an endeavour to retain and restore his position as a leading figure in the sports management industry and with it a standing sufficient to pursue his own interest away from the club in the future.

In contrast Case V116, AAT Case 4502 (1988) 88 ATC 737; 19 ATR 3703 (Case V116), related to a solicitor who was member of a board of Directors of a company. The taxpayer incurred expenses in defending himself against defamation proceedings brought by the dismissed chairman of directors. The AAT held that a deduction for legal expenses was allowable on the grounds that the taxpayer in this case was defending himself against a claim that he had made defamatory remarks in the course of the performance of his duties. Therefore, the expenditure was incidental and relevant to the producing or gaining of the taxpayer's assessable income and was not private in nature.

On the other hand, in Case N9 81 ATC 56; 24 CTBR (NS) Case 81, the taxpayer's legal expenses incurred in defending himself against charges brought against him as a result of his activities as a director were held not to be deductible. The expenses in issue were essentially private in character in that they were incurred by the taxpayer for the purposes of protecting his personal good name and reputation.

The proper characterisation of legal expenses depends upon the circumstances of why the proceedings were necessary. It is not sufficient to rely on what was intended or expected to be achieved by the proceedings, for example, to protect one's reputation or keep one's job. The relevant issue is what gave rise to the circumstances that made it necessary to incur the expenses. However, the character of legal expenses is not determined by the success or failure of the legal action (No. 3 Board of Review Case B31, 70 ATC 148).

Directors of a company would not ordinarily be expected to incur expenses relating to the business's operations. Such expenses 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.

It is a long standing principle that a taxpayer does not satisfy section 8-1 of the ITAA 1997 merely by demonstrating some casual connection between the expenditure and the derivation of income. What must be shown is a closer and more immediate connection. The expenditure must be incurred in gaining or producing your assessable income (Lunney's case). These principles have been affirmed by the High Court in Commissioner of Taxation v Payne [2001] HCA 3.

In your case, you incurred legal expenses in relation to comments made. Such comments were made outside of and beyond your director's duties and responsibilities. That is, your legal expenses did not arise in defending actions undertaken in carrying out your director duties through which you gain or produce assessable income nor were your duties as a director the cause of the expenditure. The need for the legal action arose after entity B sought damages in relation to your statements.

You contend that the legal expenses related to maintaining the business operations. Expenses relating to the operation of the business relate more to the company and their assessable income. Such expenses do not sufficiently relate to your day to day income earning activities as a director or to your future assessable dividends. Although the successful operation of the business will enable you to derive assessable income in the form of director's fees and dividends, the legal action taken does not have the necessary connection with your assessable income.

It is acknowledged that defending the allegations related to an asset. However, legal expenses incurred in preserving an asset 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 associated legal expenses are considered to be capital in nature and the expenses are not deductible under section 8-1 of the ITAA 1997.

In your case, your legal expenses do not have a direct effect on your current assessable income as found in Herald and Weekly Times case, Rowe's case and Case V116. The expenditure is directed more at your future income from the company, and as such, the expenses come at a point too soon to be regarded as an allowable deduction.

As the legal action did not arise as a result of your day to day activities as a director, and are not sufficiently related to any future dividend income, it is not considered that there is sufficient connection between the legal costs incurred and the derivation of your assessable income. Consequently, you are not entitled to claim a deduction for the legal expenses under section 8-1 of the ITAA 1997.