Edited version of your private ruling

Authorisation Number: 1012516965545

Ruling

Subject: Legal Expenses

Question and answer

1. Will the Commissioner treat the payments by the company during the financial year to finance the legal expenses paid by the Estate for the spouse, as set out in clause 3(c) of the first court order and clause 3 of the second court order, as dividends for the purposes of section 6(1) of the Income Tax Assessment Act 1936?

2. No.

3. If the amounts are treated as dividends, will the Commissioner treat them as fully franked dividends, in accordance with section 202-5(c)of the Income Tax Assessment Act 1997 (ITAA 1997), and allow further time to issue a distribution statement under section 202-75(5) of the ITAA 1997?

4. No.

5. If the amounts are not treated as ordinary dividends, will the Commissioner treat them as deemed dividends for the purposes of Division 7A of the Income Tax Assessment Act 1936 (ITAA 1936), and if so will he exercise his discretion under section 109RB(2) of the ITAA 1936 to disregard the deemed dividends and/or allow them to be treated as fully franked dividends?

6. Not applicable

7. If the Commissioner makes a decision under section 109RB(2) of the Income Tax Assessment Act 1936 to disregard the deemed dividends, will any conditions be imposed?

Not applicable

This ruling applies for the following periods

1 July 2009 to 30 June 2011

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

The taxpayer passed away.

After a lengthy dispute over the estate it was established that the taxpayer's spouse would be entitled to the income of the estate during their lifetime.

The spouse did not receive income as a shareholder, an associate or a former associate of the company.

The spouse is the life tenant of the estate and is entitled to income of the state during their lifetime.

The estate, the deceased and the company are and at all times were residents of Australia for taxation purposes.

Shares in the company are held by the Trustee of the Estate.

The Supreme Court issued a consent order.

The consent order in relation to the income entitlement was that;

- A specified amount would be paid to the spouse and treated as fully franked dividend and as part of their income entitlement from the estate;

- The trustees of the Estate were to pay the spouse a specified amount per month as fully franked dividend, on account of their income entitlement; and

- The relevant companies would be caused to pay their net income to the estate every 6 months, as fully franked divided, and that the Estate must pay that amount to the spouse, by way of income.

The consent orders also specified payments to cover legal expenses.

The parties to the court proceedings were;

- The spouse - of the deceased

- The director of the companies and Executor of the Will and Trustee of the Estate

- Executor of the Will and Trustee of the Estate

The directions given in the Consent Order were made to director of the companies and Executor of the Will and Trustee of the Estate and the Executors of the Will and Trustees of the Estate.

At the time the consent order was granted, one of the two directors of the company was a defendant in the Consent Order and so aware of the details of the order.

The two directors were replaced.

After the directors were replaced it was discovered the payments by the company during two financial years were not treated as dividends and that the previous directors did not declare the amounts to be franked.

The accounting treatment of the amounts increased the loan account to the estate in the non-current assets section to the balance sheets.

A private ruling was issued to the applicant in which the Commissioner considered that the income entitlement should be treated as fully franked dividends and therefore assessable under section 44 of the Income Tax Assessment Act 1936.

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not considered the application of Part IVA to the arrangement you asked us to rule on.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 44

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 subsection 20-20(2)

Reasons for decision

Taxation Ruling "TR 2012/8 income tax and fringe benefits tax: assessability of amounts received to reimburse legal costs incurred in disputes concerning termination of employment" contains a discussion on the taxation treatment of legal costs. Notwithstanding that this ruling is about legal costs incurred in disputes concerning termination of employment, it sets out the Commissioners views generally in relation to cases in relation to legal expenses where the advantage sought is of a revenue nature and not a capital nature.

TR 2012/8 at [38] explains that legal cost payments or awards are made to reimburse the legal costs incurred in engaging in legal proceedings. Legal costs take their quality as an outgoing of capital or revenue nature from the cause or purpose of incurring the expenditure (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 3 AITR 436; (1946) 8 ATD 190 per Dixon J at CLR 647).

If the advantage to be gained is of a revenue nature, then the costs incurred in gaining the advantage will also be of a revenue nature. It is noted that the character of legal costs is not determined by the success or failure of the legal action.

In the previous ruling that has been issued to the applicant, the Commissioner considered that the income entitlement should be treated as fully franked dividends and would therefore be assessable under section 44 of the Income Tax Assessment Act 1936 (ITAA 1936).

A franked dividend is considered to be of a revenue nature; accordingly the legal costs in this case will also be of a revenue nature.

The basis on which payments for legal expenses should be included as assessable as ordinary income is considered in TR 2012/8 at [46] to [54]:

Assessable recoupment

46. Although a court ordered award or settlement sum identifiable as an amount paid in relation to legal cost is not an ETP, those costs may be an assessable recoupment if the recipient's underlying legal costs were deductible.

47. The High Court held in FC of T v. Rowe (1997) 187 CLR 266; 97 ATC 4317; (1997) 35 ATR 432 that there is no general principle that amounts received by way of reimbursement or compensation

48. If an amount is not ordinary income, the amount may still be included in assessable income by another provision of the tax law (statutory income). Particular types of statutory income are listed in Guide material in section 10-5. Included in that list is Subdivision 20-A which deals with amounts received by way of recoupment for deductible losses or outgoings.

49. Under Subdivision 20-A, certain amounts received by way of insurance, indemnity or other recoupment are assessable income if the amounts are not income under ordinary concepts or otherwise assessable. Amounts included in assessable income under Subdivision 20-A are statutory income within the meaning of section 6-10.

50. Subsection 20-20(2) of the ITAA 1997 provides that an amount received as recoupment of a loss or outgoing is an assessable recoupment if the taxpayer received the amount by way of insurance or indemnity; and the amount of the loss or outgoing is or was deductible under any provision of the ITAA 1997 or ITAA 1936.

Indemnity

51. For an award of legal costs to be an assessable recoupment it must be a recoupment. Recoupment as defined in paragraph 20-25(1)(a) includes an indemnity in respect of the loss or outgoing.

52. In the decision of Cachia v. Hanes [1994] HCA 14; (1994) 179 CLR 403; (1994) 120 ALR 385; (1994) 68 ALJR 374 the High Court considered an appeal on the disallowance of the appellant's claim for compensation for the loss of his time spent in the preparation and conduct of his case and for out of pocket expenses, being travelling expenses associated with the preparation and conduct of his case. In the preliminary observations of the law the Full Court stated at paragraph 11:

...It has not been doubted since 1278, when the Statute of Gloucester ((4) 6 Edw.I c.1.) introduced the notion of costs to the common law, that costs are awarded by way of indemnity (or, more accurately, partial indemnity) for professional legal costs actually incurred in the conduct of litigation.

53. Particularised legal costs are awarded to the successful party by way of indemnity; they are awarded to indemnify the successful party for the cost of the litigation. They are an assessable recoupment under subsection 20-20(2) of the ITAA 1997 if the amount recouped is or was deductible under any provision of the ITAA 1997 or ITAA 1936.

54. Similarly, if an amount is recouped by way of settlement of a claim for legal costs, it will be an assessable recoupment under subsection 20-20(2) where the purpose of the settlement is to indemnify the recipient for professional legal costs actually incurred in the conduct of litigation, where the legal costs were deductible.

From the reasoning in the above paragraphs, the payments for legal expenses would be considered an assessable recoupment provided that they are deductible to the taxpayer.

The deductibility of legal costs is considered in TR 2012/8 at [38] to [45]. Broadly, section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for losses and outgoings to the extent to which they are incurred in gaining or producing assessable income except to the extent the outgoings are of a capital or private or domestic nature, or relate to the earning of exempt income or non-assessable non-exempt income.

Application to your circumstances

The details of the orders indicate that the amounts are a reimbursement of costs and not a settlement lump sum payment.

The legal expenses were incurred to enforce an income entitlement of the taxpayer. On that basis it is considered that the requisite connection exists between the legal expenses and incurring of assessable income.

The taxpayer will therefore be entitled to a deduction under section 8-1 of the ITAA.

Accordingly the payments for legal expenses are considered to be an assessable recoupment under subsection 20-20(2) of the ITAA 1997. It is unnecessary to treat the payments as ordinary dividends in order to assess them as ordinary income.