Edited version of your private ruling

Authorisation Number: 1012570235159

Ruling

Subject: legal expenses

Question 1

Are you entitled to a deduction for the total of your legal and other expenses incurred in relation to defending the winding up of the company?

Answer

No.

Question 2

Are you entitled to one fifth of your legal and other expenses incurred in relation to defending the winding up of the company?

Answer

Yes.

This ruling applies for the following period

Year ended 30 June 2014

The scheme commenced on

1 July 2013

Relevant facts

Entity A applied for a winding up order for a company.

The company incurred costs in defending the winding up. Costs were incurred for liquidator fees, solicitor fees, barrister fees, accountant fees and court fees.

The company was successful in defending the case and is currently trading as usual.

Relevant legislative provisions

Income Tax Assessment Act 1997 - section 8-1.

Income Tax Assessment Act 1997 - section 40-880.

Reasons for decision

Allowable deductions

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. Federal Commissioner of Taxation (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. Federal Commissioner of Taxation (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. Federal Commissioner of Taxation (1956) 95 CLR 344; Federal Commissioner of Taxation v. Hatchett, 71 ATC 4184).

For legal and other 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. Also, in determining whether a deduction for legal and other 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 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.

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 expenses have more than a peripheral connection to the taxpayer's income producing activities (Magna Alloys and Research Pty Ltd v. Federal Commissioner of Taxation 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. Federal Commissioner of Taxation (1938) 61CLR 337; 5 ATD 87; (1938) 1 AITR 403).

Taxation Ruling TR 95/33 considers the decision of the Full High Court of Australia in Fletcher & Ors v. Federal Commissioner of Taxation 91 ATC 4950; (1991) 22 ATR 613 and in particular, considers situations in which a taxpayer's subjective purpose, intention or motive is relevant in determining the availability of an income tax deduction.

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

In this case legal and other expenses were incurred in relation to stopping the winding up of the company. The expenditure was incurred to protect the business and to enable it to continue trading. Such expenses do not sufficiently relate to the day to day income earning activities of the company. That is, the liquidator and the other fees were not incurred as a normal revenue expense in running the business.

The expenses can be regarded as having been incurred once and for all and are regarded as being capital in nature. Therefore, the company is not entitled to a deduction under section 8-1 of the ITAA 1997 for the associated costs incurred.

Business related costs

Subject to the limitations and exceptions contained in subsections 40-880(3) to (9) of the ITAA 1997, subsection 40-880(2) of the ITAA 1997 provides that you can deduct, in equal proportions over a period of five income years starting in the year in which you incur it, capital expenditure you incur:

(a) in relation to your business; or

(b) in relation to a business that used to be carried on; or

(c) in relation to a business proposed to be carried on; or

(d) to liquidate or deregister a company of which you were a member, to wind up a partnership of which you were a partner, or to wind up a trust of which you were a beneficiary, that carried on a business. 

That is, subsection 40-880(2) of the ITAA 1997 prescribes that 20% of the qualifying expenditure is deductible for the income year in which the expenditure is incurred and then 20% for each of the next four income years.

Subject to the application of the non-commercial loss provisions in Division 35 of the ITAA 1997, the deduction allowable under section 40-880 of the ITAA 1997 for any particular income year cannot be greater than 20% of the qualifying expenditure for any income year or to alter the timing of that deduction.

The capital expenditure as outlined above is capital expenditure incurred in relation to your business for the purpose of paragraph 40-880(2)(a) of the ITAA 1997. 

The limitations and exceptions found in subsection 40-880(3) to (9) of the ITAA 1997 do not apply to limit the amount you can deduct under section 40-880 of the ITAA 1997.

As the company has incurred qualifying expenditure in the 2013-14 income year, it is entitled to deduct 20% of the expenditure. That is, the capital expenses such as the liquidator, solicitor, barrister, court and accountant fees that were incurred in defending the winding up of the company can be claimed under section 40-880 of the ITAA 1997. You can claim 20 per cent of the eligible expenses in the year they were incurred. The balance of the eligible expenditure is claimed over the next four years.