Edited version of your private ruling

Authorisation Number: 1012646264740

Ruling

Subject: Section 40-880 minority shareholder dispute & liquidation

Questions and Answers:

1. Are your legal fees incurred in relation to defending allegations brought against you by a unit holder about unfair payment and non-payment of interest and profit entitlements deductible over 5 years under section 40-880 of the Income Tax Assessment Act 1997 (ITAA1997)?

Answer: Yes.

2. Are your legal fees incurred in relation to liquidation, selling your assets to one unit holder and removing another unit holder deductible over 5 years under section 40-880 of the ITAA 1997?

Answer: No.

3. Are the following legal fees deductible over 5 years straight line write off under section 40-880 of the ITAA 1997?

(a) Legal Fees incurred to remove an inactive unit holder which held 20% of the units in the unit trust?

Answer: No.

(b) Legal fees incurred in asking advice regarding the interest rate used on the minority unit holder's loan and second ranking debenture security?

Answer: Yes.

(c) Legal fees incurred in business valuation and the contract of sale of business?

Answer: No.

(d) Legal fees incurred in answering questions about equity loans/contributions?

Answer: Yes, subject to the apportionment in questions 1 and 2.

(e) Legal fees incurred in dealing with an equity/debenture issue (a disagreement between units holders)?

Answer: Yes, subject to the apportionment in questions 1 and 2.

(f) Valuation of units for the purpose of buying the units from the minority unit holder?

Answer: No.

(g) Discussion on proposals to buy out the minority unit holder; discussions and replies to the minority unit-holder's lawyer on queries regarding the business & proposals?

Answer: No.

(h) Advice on using proxies at annual general meetings?

Answer: Yes.

4. Are the following legal fees deductible under section 8-1 of the ITAA 1997?

(a) Owners' Corporation (OC) issues and appointment of a New Owners' Corporation Manager?

Answer: Yes.

(b) Preparation of a report on the Management Performance for the OC Manager and advice on their performances?

Answer: Yes.

(c) Legal expense for advice on a building order and the council demands during the year when the properties become ready for sale?

Answer: Yes.

(d) Advice on using proxies at annual general meetings?

Answer: No.

This ruling applies for the following periods:

Year ended 30 June 2013

The scheme commences on:

The scheme has commenced

Relevant facts and circumstances

Unitholder dispute issue

You had two unitholders: a minority inactive unitholder and a majority unitholder. You, as a business, were directed by the directors of the majority unitholder. At your formation, the respective unitholders made commensurate capital contributions to your business.

There came a time when the minority unitholder began demanding payment of UPEs and interest on a debenture loan. They also alleged your directors caused you to pay large amounts of interest and capital repayments to your majority unitholder while they, the minority unitholder, had never received any UPE, interest or capital repayments. You dispute their loan was a debenture.

As a result, you (the business) sought and paid for legal and accounting advice about your minority unitholder's claim, which quickly become extensive legal and accounting advice about strategies to remove the minority unitholder, by means of purchase of their units by the majority unitholder, sale of your business and assets to the majority unitholder or liquidation to achieve these objectives.

What followed was you resolved, at an annual meeting, to liquidation or otherwise offer your assets for sale to the majority unitholder. Accounting advice found the unitholders would receive back only part of their original investments in liquidation.

As a result of this resolution, your minority unitholder holder initiated legal action based on the grounds: (i) your resolutions passed at the shareholder meeting were null and void since there was only one unitholder present; (ii) your board lacked independence to effect the sale of your business to the majority unitholder; and (iii) they would write to your proposed liquidator to not take any steps to administer your affairs until the issues are resolved.

Your minority unit holder also alleged and notified the proposed liquidator: (i) you granted a charge in favour of the majority unitholder to shore up their position as a lender to benefit them in a liquidation and sale of your assets; (ii) you demanded them (the minority unitholder) to make contributions to the business, which they were unable to do, while majority unitholder was in a much better position to continually fund you due to your repayments to them of interest and capital; and (iii) you made many breaches of the corporations and tax acts, such as selling assets to members of the director's family at below market value and incurred very large legal expense in another dispute for the benefit of the majority unitholders .

Soon after, your majority unitholder demanded repayment of their loans, which resulted in you being placed into administration. The minority unitholder continued to make their allegations against you to the liquidator.

As a result, a deed of settlement was entered into where the minority unitholder accepted an offer from the majority unitholder for the repayment of its loans, interest, unpaid profit entitlements and units, which included warranties that the minority unitholder not make any complains to ASIC, the ATO or any other regulatory body or authority. The settlement amount was double that estimated by previous accounting advice.

In your private ruling application, you stated:

The directors decided that in the interest of the business, the ownership of the company should be restructured to replace the inactive unit holder and allow the majority unitholder to be 100% unit holder for the future growth of the business. The trust entered an administration phase to try and encourage the inactive unitholder to let go of their units held. The process met with resounding success. It resulted in a settlement with the inactive unitholder giving up its units in the trust.

Owners' Corporation (OC) issue

The term of the Owners' Corporation Manager expired in the next AGM. Consideration was made to continue with the current manager or look for a new one. The current manager's performances needed to be assessed and debated in order for further action. Some issues in the past required certain forms of legal aids to solve.

Management performance issue

Due to the upcoming expiry of the term for the OC Manager, CEO Management had to seek proper advice on preparation of the OC Manager's performance report to the committee in a legitimate form. Based on unsatisfactory performance levels in the past year, the report would have to be worded carefully in order not to create doubt in the committee as the OC seek to renew the OC's contract or find another OC Manager in the upcoming AGM.

Building order issue

Matters were brought forward by the local council on certain parts of a building (built for resale of apartments) which required amendments and alterations to the satisfaction of the council.

Proxies issue

The legal advice was to ensure the company properly handles proxies and proxy votes at any annual general meetings so as not to disqualify any of these proxies when in the meetings. The company was challenged by other owners of the use of proxies, and therefore, we needed some legal advice.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 70-15

Income Tax Assessment Act 1997 Section 40-880

Income Tax Assessment Act 1997 Section 110-25

Reasons for decision

Unitholder dispute

In determining the tax treatment of legal expenses, 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 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.

Legal expenses may be of a revenue nature and therefore deductible if they arise out of the day to day activities of the taxpayer's business or income producing activity (Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 2 ATD 169). Where however, expenditure is devoted towards a structural rather than an operational purpose, the expenditure is of a capital nature and the expenses are not deductible (Sun Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 87; (1938) 1 AITR 403).

Outgoings incurred in the preservation of an existing capital asset have been held to be capital in nature (John Fairfax & Sons Pty Limited v. Federal Commissioner of Taxation (1959) 101 CLR 30; (1959) 7 AITR 346; (1959) 11 ATD 510).

In the case Kennedy Holdings and Property Management Pty Ltd v. Federal Commissioner of Taxation (1992) 39 FCR 495; (1992) 92 ATC 4918; (1992) 24 ATR 321, a payment by a lessor to the lessee to terminate the lease in order to grant a new and more profitable lease to a new tenant, was held to be capital in nature and not deductible. The payment secured a permanent advantage, that is, the surrender of the lease with the option to renew.

Section 40-880 of the ITAA 1997 is a provision of last resort which allows a deduction over five income years for certain business capital expenditure incurred after 30 June 2005 which is not otherwise taken into account or denied a deduction by some other provision.

Subject to the limitations and exceptions contained in subsections 40-880(3) to 40-880(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.

For example, paragraphs 131 to 134 of Taxation Ruling TR 2011/6 Income tax: business related capital expenditure - section 40-880 of the Income Tax Assessment Act 1997 state:

Unlike paragraphs 40-880(2)(a) to 40-880(2)(c) which use the expression 'in relation to' to link the expenditure to the business, paragraph 40-880(2)(d) uses the preposition 'to' as the connector. To come within the scope of this paragraph, the expenditure must be meant directly to initiate or advance the process of bringing to an end, the structure through which the business is or was carried on.

The types of expenditure covered by this paragraph are the costs directly referable to the liquidation of a company or the winding up of a partnership or trust; for example, the legal and administration costs of the winding up application and any government fees or charges for deregistration.

Expenditure incurred by a shareholder, partner or beneficiary prior to making the decision to liquidate or wind up an entity does not have the relevant connection under paragraph 40-880(2)(d) because it is not incurred directly in the process of bringing the entity to an end. This type of expenditure may nevertheless be considered under paragraph 40-880(2)(b).

If expenditure to wind up the company, partnership or trust is incurred by the company, partnership or trust, it will need to be considered under paragraph 40-880(2)(b) because paragraph 40-880(2)(d) only applies to expenditure incurred by shareholders, partners and beneficiaries themselves, not the company, partnership or trustee which carries on the business in which they hold an interest.

In considering the phrase 'in relation to' contained within subsection 40-880(2) of the ITAA 1997, paragraph 2.25 of the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No. 1) Bill 2006 (the EM) states:

The provision is concerned with expenditure that has the character of a business expense because it is relevantly related to the business. The concept used to establish this character or requisite relationship between the expenditure incurred by the taxpayer and the business carried on (current, past or prospective) is 'in relation to'. The connector 'in relation to' allows the appropriate latitude to enable the deductibility of qualifying capital expenditure incurred before the business commences or after it has ceased.

The phrase 'in relation to' was considered by the High Court in PMT Partners Pty Ltd (In Liquidation) v. Australian National Parks & Wildlife Service (1995) 184 CLR 301. Brennan CJ, Gaudron and McHugh JJ observed, in considering the application of the Commercial Arbitration Act 1985 (NT), at 313:

Inevitably, the closeness of the relation required by the expression 'in or in relation to' in s 48 of the Act, indeed, in any instrument - must be ascertained by reference to the nature and purpose of the provision in question and the context in which it appears.

In that case Toohey and Gummow JJ also observed:

It is apparent that the words 'in or in relation to' are particularly wide. ... Cases concerning the interpretation of this phrase in other statutory contexts are of limited assistance. However, the cases do show that the words are prima facie broad and designed to catch things which have sufficient nexus to the subject. The question of sufficiency of nexus is, of course, dependent on the statutory context. (at 330) ...

The connection which is required by the phrase 'in relation to' is a question of degree. There must be some 'association' which is 'relevant' or 'appropriate'. The question of the relevance or appropriateness of the connection is a question which cannot be divorced from the particular statutory context. (at 331)

In First Provincial Building Society Limited v. Commissioner of Taxation (1995) 56 FCR 320; 95 ATC 4145; (1995) 30 ATR 207, Hill J. considered the phrase 'in relation to' within the context of paragraph 26(g) of the Income Tax Assessment Act 1936. He considered the words 'in relation to' in that context included a relationship that may either be direct or indirect, provided that the relationship consisted of a real connection, but that a merely remote relationship is insufficient.

It is therefore necessary to consider the legislative context of subsection 40-880(2) of the ITAA 1997 in order to determine whether there is a sufficient and relevant connection between the expenditure incurred and the taxpayer's business.

TR 2011/6, in paragraphs 86 to 91, provides the following two examples:

Wayne and Blayne are shareholders in X Pty Ltd. As their personal relationship deteriorates Blayne considers whether or not to sell his shares and incurs capital expenditure on professional advice. The sale does not proceed because they resolve their relationship issues. Blayne's expenditure is not in relation to the business for the purpose of paragraph 40-880(2)(a).

XYZ Pty Ltd carries on a medical research and supply business. The shareholders' involvement in the business includes providing medical expertise and services to the company. Because of other commitments one of the shareholders has been and will continue to be unable to devote resources to the business. The directors of XYZ Pty Ltd decide that in the interests of the business the ownership of the company should be restructured to replace the inactive shareholder with a private equity investor with the business acumen to push the company forward and inject capital for the purpose of future growth. To facilitate the restructure XYZ Pty Ltd paid $200,000 to the shareholder as an incentive to agree to the sale of his shares to the equity investor. The expenditure is capital expenditure of the company in relation to the business for the purpose of paragraph 40-880(2)(a).

In your case, we consider your legal expenses incurred and paid in relation to the minority unitholder are capital in nature and are of two types, namely: (i) the first type of legal expenses incurred in relation to your business with the advantage sought of protecting your working capital from claims of unpaid interest and profits to the minority unitholder; and (ii) the 2^nd type of legal expenses incurred unrelated to your business with the advantage sought of providing the majority unitholder with a 100% ownership interest in your trust assets.

We note that ordinarily, as provided for in paragraph 134 of TR 2011/6, expenditure incurred by a company or trust prior to making the decision to liquidate or wind up may be considered for deductibility under paragraph 40-880(2)(b).

However, in your case, the impression gained is soon after your business related issue arose about the minority unitholder claims to UPE and interest payments (which may have included the prospect of liquidation to resolve the minority unitholder claims), you incurred legal and accounting expenses with the primary objective of effecting an outcome for the advantage of the majority unitholder via the repurchase of the minority unitholder units and/or the sale of your business assets to the majority unitholder.

Your invoices show your initial legal advice was a telephone conversation about the minority unitholder accusations and liquidation. Ordinarily, such expenditure may be deductible to a business under section 40-880.

However, in your case, as your invoices show, only two weeks later, it became quite clear the goal of your expenditure was the effect the repurchase of shares from the minority unitholder, with the result of the majority unitholder becoming the sole owner of your business assets.

The strategy of purchasing the units from the minority unitholder is mentioned in numerous invoices and ultimately affirmed in your private ruling application, where it was stated:

…to try and encourage the inactive unitholder to let go of their units held. The process met with resounding success. It resulted in a settlement with the inactive unitholder giving up its units…

In your private application and other submissions, you asserted you incurred the expenditure because the minority unitholder claims against you were incurring enormous costs for you and hindering the efficient operation of your business. You further asserted the minority unitholder non-attendance at meetings and allegations of your breaches of corporations and tax law as further grounds that your expenditure for his removal as a unitholder related to your business.

Our view is the costs were not enormous in relation to your business income. More importantly, we consider the issues of non-attendance at meetings, threats of ASIC action, etc, were intrinsically unrelated to the expenditure you incurred.

Your relevant expenditure commenced when the minority unitholder made his claims for UPE and interest payments. The minority unitholder allegations about quorum at meetings and his threat of ASIC action, etc, only began after your decision to sell your assets or liquidate was made at your EGM. Their letter soon after your EGM and further letters from their solicitor, including letters to your liquidator, show this to be the case.

When a company is threatened with or in liquidation, it is common for minority shareholders to make claims to protect their capital and income entitlements that proceed from liquidation. In your case, the minority unitholder allegations about quorum and breaches of corporations and tax law (such as you selling and leasing business assets to family members of your directors at below market value and you incurring enormous sums in a legal dispute that also benefited the majority unitholder) arose from your action to liquidate. It is common for minority shareholders to approach liquidators about transactions they believe erode the capital and income entitlements in liquidation. The legal actions by the minority unitholder were not independent of your resolutions to liquidate but inherently related to them.

It follows your 2nd type of legal and accounting expenses were related directly to your proposed liquidation for the benefit or advantage of the majority unitholder rather than directly related to hindrances to your ordinary business operations, such as establishing quorum at meetings or protecting yourself from allegations of misconduct. For many years, your business continued its operations and decision making despite lacking the disputed quorum.

In summation, the advantage or benefit and dispute related to your incurring your 2nd type of legal and accounting expenses was demonstrated by the settlement. If your expenses were related to your business then the settlement would have resulted in compensation paid by your business to the minority unitholder. For example, if a court of law ruled you were required to pay UPEs and interest payments to the minority unitholder then such a settlement was have been paid you.

However, what actually occurred was compensation was paid to the minority unitholder by the majority unitholder. This settlement shows your 2nd type of expenditure was incurred in relation to the majority unitholder and not in relation to your business. As already mentioned, it was shown in your invoices that this outcome of the majority unitholder acquiring the minority unitholder units was the primary objective of your expenditure from the beginning of your legal inquiries.

As for the two examples mentioned from TR 2011/6, we consider your 2nd type of legal expenses were incurred following a similar scenario to that in the example of Wayne and Blayne, namely, as a result of relationship issues. We consider they were additional to your 1st kind of legal expenses and the matter of the 1st kind of legal expenses did not require incurring the 2nd kind of legal expenses for its resolution (since the legal and accounting advice contained affirmed the view you were unable to pay interest and profits to the minority unitholder; that the majority unitholder was not 'milking' your working capital; that quorum at the meetings did exist; and that the majority unitholder would welcome the minority unitholder's challenge in court).

We consider the example of XYZ Pty Ltd in TR 2011/6 does not apply to your case because we consider your 2nd type of legal expenses were not incurred in the interests of your business to replace the inactive shareholder with another investor to inject capital for the purpose of future growth, where you paid an incentive to the minority unitholder to depart. Instead, your 2nd type of legal expenses incurred did not result in any new funding since the majority unitholder remained, as it was beforehand, the sole (recent) funder.

Therefore, no real change (but merely a cosmetic change) occurred to your business structure because no new assets were injected into your business by the change of the unitholders. (The concept of 'business structure' is usually made in reference to a collection of capital assets; see Taxation TR 2001/14 Income tax: Division 35 - non-commercial business losses, paragraph 103). What occurred was the majority unitholder paid the minority unitholder a significant amount to extinguish your loan and other obligations towards the minority unitholder, which were replaced by new but similar obligations for you towards the majority unitholder.

As previously stated, in summation, the advantage sought in your incurring the 2nd type legal expenses came to fruition by the majority unitholder (rather than you) acting to place you into administration by demanding payment of its loan and the majority unitholder (rather than you) making a settlement payment to the minority unitholder. Both the majority unitholder placing you in administration (following the strategic advice you paid for) and the majority unitholder making the settlement payment show you incurred the 2nd type of legal expenses for the purposes, benefit and advantage of the majority unitholder rather than in relation to your business.

The circumstances here are not the same as described in paragraph 134 of TR 2011/6, where expenditure to wind up the company or trust is incurred by the company or trust.

Instead, your circumstances are similar to paragraph 133 of TR 2011/6, where expenditure is incurred by a shareholder or beneficiary prior to making the decision to liquidate or wind up an entity (however, in your case, you incurred the expenditure rather than the unitholder/shareholder).

In summary, the wish of the majority unitholder to be the sole owner of your business property and assets dated back to the start of your legal inquiries and particularly to your EGM, where your meeting held resolved to either liquidate the company or sell your business property and assets to the majority unitholder.

Whilst your dispute with the minority unitholder about the UPE and debenture issue is shown to date back to at least six months to initiating legal solutions, your resolution to either liquidate the company or sell your business property and assets to the majority unitholder appeared to have ignited your dispute with the minority unitholder, as shown by their letter. It appears obvious that the resolution to either liquidate the company or sell your business property and assets served the interests of the majority unitholder (rather than your corporate interests).

This is evidenced by your own claims that the minority unitholder never before disputed the validity and quorum of your business meetings until your EGM that resolved liquidation. Thus, we consider the major issue of the minority unitholder was not the quorum at your business meetings but the majority unitholder intention to force you into liquidate you and acquire your assets.

It follows your 2nd type of legal expenses are not deductible to you under any provision (including section 40-880) and do not fall into your CGT cost base because they were not incurred in relation to your business and not incurred in relation to any CGT asset you acquired and/or held.

As for your 1st kind of legal expenses, they are deductible over 5 years under section 40-880 of the ITAA 1997 because they are capital in nature, they were incurred in relation to your business and they do not form part of the CGT cost base of any CGT asset you held since items such as loans owed by you, working capital and cash in bank are not CGT assets.

Manager matters

Taxation Ruling TR 2000/5 Income tax and fringe benefits tax: costs incurred in preparing and administering employment agreements states: (i) costs of drawing up employment agreements for existing employees and new employees of an existing business and (ii) costs incurred in the settling of disputes arising out of existing employment agreements incurred by an employer are an allowable deduction.

However, where a business is establishing itself and an employee is entering new employment, a deduction is not allowable to either the employer or the employee as the expense is incurred at a point too soon to be considered as being incurred in the carrying on of the business or the production of assessable income and, further, it is a capital expense.

In your case, your legal and other costs in relation to the employment of a manager are deductible to you under section 8-1 of the ITAA 1997 since you were an existing business.

Building order matter

Taxation Determination TD 92/124 Income tax: property development: in what circumstances is land treated as 'trading stock'? explains land is treated as trading stock for income tax purposes if it is held for the purpose of resale and a business activity which involves dealing in land has commenced.

Section 70-10 of the ITAA 1997 defines 'trading stock' to mean anything produced, manufactured or acquired that is held for purposes of manufacture, sale or exchange in the ordinary course of a business; and livestock.

ATO Interpretative Decision ATO ID 2009/97 explains a thing can only be trading stock where it is capable of sale or exchange in the ordinary course of a business. Taxation Ruling IT 2450 further explains work-in-progress is not considered to represent trading stock.

Section 70-15 of the ITAA 1997 tells you in which income year to deduct under section 8-1 an outgoing incurred in connection with acquiring an item of trading stock. It states:

If the item becomes part of your trading stock on hand before or during the income year in which you incur the outgoing, deduct it in that income year.

Otherwise, deduct the outgoing in the first income year:

a) during which the item becomes part of your trading stock on hand; or

b) for which an amount is included in your assessable income in connection with the disposal of that item.

Section 70-25 of the ITAA 1997 states an outgoing you incur in connection with acquiring an item of trading stock is not an outgoing of capital or of a capital nature.

In the decision of Federal Commissioner of Taxation v. Kurts Development Ltd (1998) 86 FCR 337; (1998) 39 ATR 493; 98 ATC 4877 (Kurts Development ), infrastructure and external costs were allocated to the value of trading stock. In discussing the allocation of external costs, the court in Kurts Development used a 'but for' test. In that case the question was whether the external costs were properly characterised as part of the cost price of the individual subdivided lots. They were all expenses which had to be incurred in order to create the individual subdivided lots and, but for that expenditure, those lots would not have been created. For that reason the external costs were also part of the cost price of the individual lots. (ATO Interpretative Decision ATO ID 2003/150 discusses this case).

In your case, your relevant legal expenses were in relation to the construction and completion of properties for resale, which are trading stock. It follows your relevant legal expenses will be deductible under section 8-1 however only in accordance with the rule under section 70-10 of the ITAA 1997, namely, during the income year in which the relevant apartments have been approved for sale by the local council and thus become your trading stock on hand.

Proxies matter

The right to vote at meetings is one of a bundle of rights held by a unitholder. Voting rights have been considered by the courts to be a form of property. For example, William J in Grimwade v. Federal Commissioner of Taxation (1949) 78 CLR 199; (1949) 9 ATD 52 at CLR 206 states that

The right to vote has been said to be a right of property.

Taxation Ruling TR 94/30 Income tax: capital gains tax implications of varying rights attaching to shares deals with the capital gains tax implications of varying rights attached to shares. This ruling discusses whether a shareholder disposes of a right, or a share with a right attached, when the rights that comprise their share are varied. Paragraph 26 states:

Accordingly while shares are comprised of a bundle of rights, those rights are not separate pieces of property capable of being divided out and held separately.

In your case, the legal expenses you incurred in relation to using proxies at annual general meetings will be capital in nature and thus not deductible under section 8-1 but deductible under section 40-880 of the ITAA 1997 since they are not incurred in relation to earning assessable income, since they are not related to a CGT cost base, since they are capital in nature in they relate to both shareholder and company rights and since they were incurred in relation to your business.