Edited version of private advice

Authorisation Number: 1012641669507

Ruling

Subject: Compensation paid by company director

Questions and Answers:

1. Is the compensation paid by your company director deductible to them?

No.

2. Is the compensation paid by your company director a capital loss to them?

No (unless the amount becomes a debt owed by you and also becomes irrecoverable).

3. Is the compensation paid by your company director deductible to you?

No (unless you reimburse or owe them the amount).

4. Is the compensation paid by your company director a capital to you?

No.

This ruling applies for the following period:

Year ended 30 June 2011.

The scheme commences on:

1 July 2010

Relevant facts and circumstances

For the relevant income years, you were a company carrying on a business and had a contractual relationship with another entity governing the business you referred to them.

The other entity commenced legal action against you (the company), your director and certain clients in relation to those client transactions that occurred during certain income years, in which your director earned salary and wages but not directors' fees.

During the year ended 30 June 20XX, the legal action was settled, with your director paying the compensation themself.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Section 104-25

Reasons for decision

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) states that you can deduct from your assessable income any loss or outgoing to the extent that it is incurred in gaining or producing your assessable income and is not:

• Capital, private or domestic in nature,

• Incurred in gaining or producing exempt income, or

• Prohibited by a section of the ITAA 1997 or the Income Tax Assessment Act 1936 (ITAA 1936).

An outgoing is considered to be incurred in gaining or producing assessable income if:

• At the time, you owe a present money debt you cannot escape (Taxation Ruling TR 97/7).

• There is a sufficient connection between the outgoing and the activities which produce or are expected to produce assessable income (Ronpibon Tin NL v. FC of T (1949) 78 CLR 47).

• The loss or outgoing arises out of the day to day income earning activities of the taxpayer (Magna Alloys & Ltd v. FC of T 80 ATC 4542; (1980) 11 ATR 276).

• It is incurred in gaining or producing the assessable income of the taxpayer who incurs it (FC of T v Munro (1926) 38 CLR 153).

In Case U134 87 ATC 780; Case 92 (1987) 18 ATR 3646, the taxpayer was a shareholder and director of a family company who paid some of the company's expenses but was not reimbursed by the company for these expenses. The taxpayer did not receive any directors' fees from the company in the relevant income year. The Administrative Appeals Tribunal held that the expenses were not deductible as the taxpayer incurred the expenses in his capacity as a director but did not derive any assessable income in that capacity. The Tribunal said:

There is a long established line of Board of Review decisions in relation to claims to deduct travelling expenses voluntarily incurred by persons who were shareholders in, and directors of, proprietary companies, all of which in my respectful opinion were correctly decided… As was said by Dixon J. (as he then was) in North Australian Pastoral Co. Ltd. v. F.C. of T. (1946) 71 C.L.R. 623 at p. 635: "For the companies paying the dividends are independent entities taxable as such and no deduction would be allowed in the appellant's assessment for expenses incurred by the appellant for the purpose of the earning of profits for those companies." The need remains for a sufficient nexus to exist between the expenditure and the income. Total Holdings was a case in which, given the existence of a not uncomplicated corporate and business structure, with interlocking company loans, the Court was able to discern the existence of the required nexus. It is not in my view an authority that can be made to apply in this case.

The Tribunal thus finds that the expenses were incurred by the applicant in his capacity as a director for the purpose of gaining or producing assessable income for the family company. As he produced no assessable income for himself in that capacity the required nexus is not established and therefore the expenses are not deductible

Section 108-5 of the ITAA 1997 is about CGT assets and includes a debt owed to you as an example of a CGT asset. CGT event C2 in section 104-25 of the ITAA 1997 happens at the time when a debt owed to you become irrecoverable and thus ends.

In your case, the compensation paid is of a revenue nature because, similar to the case of Magna Alloys, it arose out of the day to day activities of how you (the company) earned your assessable income. It follows it would be expected the compensation would be deductible to you because the agreement between you and the other entity governed that specific income stream. However, since you did not pay the expense, they have not incurred it and therefore you cannot deduct it, unless you reimburse or owe it to your director.

If the compensation amount becomes a debt owed to your director and also becomes irrecoverable, they will make a capital loss (under section 104-25 of the ITAA 1997, CGT event C2) at the time the debt becomes irrecoverable.

Since your director incurred the outgoing in relation to the assessable income earned by you (the company) rather than in relation their own salary and wages as an employee of the company, there is no sufficient or direct connection between the outgoing and his assessable income for the relevant income years.

Even if the compensation paid was directly related to his actions in their capacity as company director (rather than as company employee), similar to the outcome in Case U134, your director produced no assessable income for themself in the capacity of a director in the relevant years. Therefore, the required nexus is not established and the outgoing is not deductible to them.