Edited version of your private ruling

Authorisation Number: 1012525675290

Ruling

Subject: Legal Expenses

Question 1

Will legal fees paid in respect of the Court Action be allowed as a tax deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Assuming the legal fees are not tax deductible, can they be included in the cost base of a CGT asset or claimed in any other way?

Answer

Not applicable as the legal fees are a deductible expense under section 8-1 of the ITAA 1997.

Question 3

If the legal fees are not deductible under section 8-1 of the ITAA 1997 and cannot be included in the cost base of a CGT asset, will the legal fees be deductible under section 40-880 of the ITAA 1997 or any other provision of tax law?

Answer

Not applicable as the legal fees are a deductible expense under section 8-1 of the ITAA 1997.

This ruling applies for the following periods:

Year ended 30 June 2012

Year ended 30 June 2013

The scheme commences on:

1 July 2011

Relevant facts and circumstances

The company sold products during the period 200X to 20XX under a distinctive logo.

Advertisements were placed describing the products as per the 'distinctive logo'. However the products sold were not from the source the distinctive logo purported them to be from. The directors/shareholders of the company also own another company with a different trading name. They also registered a trademark using this distinctive logo. There were advertisements printed by a local paper that omitted relevant additional detail. The omission was overlooked by the directors. The company was prosecuted for engaging in misleading and deceptive conduct. Considerable legal fees have been incurred by the company in defending against the Federal Court action. You claim that the legal fees have been incurred in direct relation to the past methods of trading and business operation processes of the company. Further, you submit that the legal fees are not capital in nature.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 40-880

Reasons for decision

Question 1

Summary

As a general proposition, legal expenses incurred by a business for defending itself from prosecutions involving breaches of the law committed in the course of carrying on a business are not allowable deductions. Nevertheless, where taxpayers conduct business in good faith and necessarily expose themselves to inadvertent breaches of the law, then any consequent legal expenses incurred may be deductible.

The facts of the case indicate that the legal expenses incurred have arisen as a direct result of advertising and trading as a business in good faith. Accordingly the legal expenses incurred are deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997).

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 except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.

For legal expenses to constitute an allowable deduction, it must be shown that they were incidental or relevant to the production of the taxpayer's assessable income (Ronpibon Tin NL & Tongkah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 4 AITR 236; (1949) 8 ATD 431).

In determining whether a deduction for legal expenses is allowed 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 of character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses. For example, 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 incurred as a result of the performance of a taxpayer's income earning activities are allowable as a deduction. In the case of Herald & Weekly Times v. Federal Commissioner of Taxation (1932) 48 CLR 113; 2 ATD 169, in which a newspaper company was allowed a deduction for damages paid in respect of libels and costs incurred in connection with the libel action. Gavan Duffy and Dixon JJ state;

The liability to damages was incurred, or the claim was encountered, because of the very act of publishing the newspaper. The thing which produced the assessable income was the thing which exposed the taxpayer to the liability or claim discharged by the expenditure this expenditure flows as a necessary or a natural consequence from the inclusion of the alleged defamatory matter in the newspaper and its publication.

Similarly in Case V116, 88 ATC 737; 19 ATR 3703, a director was allowed a deduction for costs incurred in defending a defamation action brought about by an ex-director against a board of directors of which the taxpayer was a member. The expenses incurred were held to be directly related to the performance of his duties as a director and thereby his income earning activities. There was no foundation for finding the alleged defamation was something private in nature.

It is clear from the above quoted cases that legal expenses will be an allowable deduction if the expenses arise out of the day to day activities of the taxpayer's business. The action out of which the legal expenses arise has to have more than a peripheral connection to the taxpayer's business and the expense may arise out of litigation concerning the taxpayer's professional conduct.

In your case, you have incurred legal expenses in defending the action brought against you. The facts of your case are similar to the above cases in that the legal expenses you have incurred have arisen as a direct result of your advertising and trading as a business, specifically the three advertisements you had published omitting relevant facts.

These cases, in conjunction with Taxation Ruling No. IT 149 (IT 149) indicate that the legal expenses you have incurred would be deductible under section 8-1 of the ITAA 1997. Paragraphs 5 and 6 of IT 149 provide the following:

5. In these circumstances the decision was taken that it would be consistent with the decision of the High Court in Herald & Weekly Times Ltd v FCT (1932) 48 CLR 113 to regard the expenditure as normal incident to which the taxpayer had been exposed in the day to day conduct of its business and which satisfied the tests for deductibility under section 51

6. The decision may be followed in other cases of a similar nature as, for example, where a reputable restaurant proprietor finds it necessary to incur legal expenses in connection with action taken against him for an accidental breach of the Government regulations relating to hygiene and cleanliness. It will not, however, extend to expenditure incurred in meeting fines imposed on the taxpayer or his employees or to legal expenses incurred by taxpayers such as transport operators who, as calculated risk, persistently take liberties with the law and incur fines regularly in the interests of the efficient operation of their business ….

We consider that there is sufficient nexus between the legal expenses you have incurred and the duties from which you derived your assessable income. We also consider the expenditure incurred to be a normal incident to which you have been exposed in the day to day operations of the business. It is clear that any breach committed was purely accidental.

Therefore you are entitled to claim a deduction under section 8-1 of the ITAA 1997 for legal expenses you have incurred in defending legal actions brought against you.

Question 2

Summary

Not applicable.

Detailed reasoning

This question has not been considered as the legal fees are a deductible expense under section 8-1 of the ITAA 1997.

Question 3

Summary

Not applicable.

Detailed reasoning

This question has not been considered as the legal fees are a deductible expense under section 8-1 of the ITAA 1997.