Edited version of private advice

Authorisation Number: 1012629660288

Ruling

Subject: Legal expenses

Question 1

Are you entitled to a deduction for legal expenses to protect you from bankruptcy?

Answer

No.

Question 2

Are you entitled to a deduction for legal expenses to relinquish the guarantees given for the company?

Answer

No.

Question 3

Are you entitled to a deduction for legal expenses relating to your non-performance as the director of the company?

Answer

No.

Question 4

Are you entitled claim a capital loss for legal expenses?

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

You and Party 1 as trustees for Trust 1, Party 2 and Trust 2 and others entered into a contract to buy and refurbish a property via a mortgage.

After some years, the project proved to be successful and party 1 suggested that you look at other options.

You travelled overseas with Party 2 to investigate opportunities.

Party 2 formed a company of which you and they were directors and shares were held by the two trusts.

You did not receive either salary and wages or director's fees from the company.

You purchased land overseas and the intention was to sell several lots as quickly as possible so that the bank loan could be re-paid. However, only one lot sold and Party 2 refused to pay down the loan.

In 200X and 200Y, you tried to get Party 2 to settle the loan.

You were unsuccessful in borrowing funds to pay off the loan.

Your relationship with Party 2 deteriorated and this caused the bank in Australia to call in the loan on the Australian property.

The Australian property was sold and the mortgage cleared which released you from the guarantee.

The court action continued against you as trustee for Trust 1 to recover costs associated with the failed activity overseas.

Court action was taken against you relating to your performance as director of the company.

You sold a property held by the trust to prevent Party 2 from bankrupting you as you cannot work in your usual occupation if you were bankrupt.

The court action was defended to protect your financial interests from being put under control of a trustee in bankruptcy and by Trust 1 to protect its assets from further erosion and attack by party 2.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 102-20

Reasons for decision

Summary

Legal expenses relating to protecting your financial solvency and in having guarantees relinquished are not deductible.

Furthermore, you are not entitled to a deduction for legal expenses relating to your non-performance as the director of the company because the expense was not in relation to producing your assessable income from that activity.

As the legal expenses do not relate to a CGT asset, you are not entitled to claim a capital loss for legal expenses against a capital gain.

Detailed reasoning

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for a loss or outgoing to the extent to which it is incurred in gaining or producing assessable income, except where the loss or outgoing is of a capital, private or domestic nature.

A number of significant court decisions have determined that for an expense to be an allowable deduction:

n 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), 

n 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

n 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.

Protecting you from bankruptcy

In Kratzman vs FC of T 70 ATC 4043 (Kratzman's case), the taxpayer sought to deduct legal expenses for proceedings instituted by him to prevent his public examination in the liquidation of his company in relation to transactions with which that company was concerned. In this case, the court found that the expenses were not deductible as they were not incurred in gaining assessable income. Rather, they were incurred to protect the taxpayer's personal reputation. As such the expense was clearly of a capital or private nature.

Your situation is analogous with Kratzman's case as you sought to protect against becoming bankrupt. Likewise, your expenses are capital or private in nature. As such, you are not entitled to a deduction for the legal expenses incurred in protecting you from bankruptcy.

Relinquishing the guarantees given for the company

Payments made under guarantee are capital in nature unless the provision of guarantees and the losses or outgoings arising under the guarantee are normal incidents of a taxpayer's income earning activities. A payment under a guarantee is deductible if the giving of the guarantee, the guarantor's payment and the incurring of the loss or outgoing have an income producing purpose. This would be the case if the guarantor is engaged in the business of giving guarantees for rewards, the giving of guarantees is a regular and normal incidence of a taxpayer's income earning activities or the guarantee is provided to customers.

However, no deduction is allowable for payments made under a guarantee by a director in respect of the company.

As legal expenses follow the nature of the nature or character of the advantage that is sought to be gained by incurring the expenses and the advantage for relinquishing the guarantees is capital the legal expenses incurred for this would not be deductible.

Non-performance as the director of the company

You incurred legal expenses in defending against action for non-performance in your role as director of the company.

As stated above, for a deduction to be allowable, the expense must be incurred in producing your assessable income from that activity. In your case, you did not produce assessable income from the company in your role as director. Therefore, legal expenses relating to your role are not deductible under section 8-1 of the ITAA 1997.

Capital losses

Under section 102-20 of the ITAA 1997 you make a capital gain or capital loss as a result of a capital gains tax (CGT) event.

CGT events are the different types of transactions or events involving a CGT asset.

A CGT asset is:

• any kind of property; or

• a legal or equitable right that is not property.

In your case, you are protecting your financial solvency, relinquishing the guarantees given for the company and defending an action for non-performance in your role as a director. However, not all things often referred to as rights will be assets for CGT purposes. To be an asset, a right must be recognised and protected by law. Personal liberties and freedoms, such as the freedom to work or trade, are not legal or equitable rights and accordingly will not be assets for CGT purposes.

Therefore as financial solvency, guarantees and defending non-performance are not considered CGT assets a CGT event does not occur and as a result you are not entitled to a capital loss for the legal expenses.