Edited version of your written advice

Authorisation Number: 1012749694271

Ruling

Subject: Deductibility of legal expenses

Question 1

Are the legal fees incurred relating to the recovery of the employee loan during the year 1 July 2013 to 30 June 2014 deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No. The legal fees are not deductible under section 8-1 of the ITAA 1997

Question 2

If the legal fees are not deductible under section 8-1 of the ITAA 1997, are they included in the cost base of the loan under section 110-25 of the ITAA 1997?

Answer

No. The legal fees do not form part of the cost base of the asset under section 110-25 of the ITAA 1997.

Question 3

If the legal fees are not deductible under section 8-1 of the ITAA 1997 and are not added to the cost base under section 110-25 of the ITAA 1997, are they deductible under section 40-880 of the ITAA 1997?

Answer

No. The legal fees are not deductible under section 40-880 of the ITAA 1997.

Question 4

Are the legal fees incurred related to the preparation and administration of an employment agreement and therefore deductible under section 8-1 of the ITAA 1997?

Answer

No. The legal fees are unrelated to the employee's employment contract and are therefore not deductible under section 8-1 of the ITAA 1997.

This ruling applies for the following period:

1 July 2013 to 30 June 2014.

Relevant facts and circumstances

A loan was made from a company to an individual (who was an employee at the time the loan was made) in order to pay for legal fees incurred by the individual for a private matter. The individual is now a former employee of the company.

The individual is not an associate of the company.

But for the individual being an employee, the loan would not have been made. In other words, the loan arose out of the employment relationship. The loan to the individual has not been recovered and as a result substantial legal fees have been incurred by the company to recover the outstanding loan.

Relevant legislative provisions

Income Tax Assessment Act 1997

Section 8-1

Section 40-880

Section 108-5

Section 110-25

Section 110-35

Reasons for decision

Question 1

Deductibility under section 8-1 of the ITAA 1997 - general principles

Subsection 8-1(1) of the ITAA 1997 provides that:

'You can deduct from your assessable income any loss or outgoing to the extent that:

a) it is incurred in gaining or producing your assessable income; or

b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.'

Subsection 8-1(2) of the ITAA 1997 provides that:

'However, you cannot deduct a loss or outgoing under this section to the extent that:

a) it is a loss or outgoing of capital, or of a capital nature; or

b) it is a loss or outgoing of a private or domestic nature; or

c) it is incurred in relation to gaining or producing your exempt income or your non-assessable non-exempt income; or

d) a provision of this Act prevents you from deducting it'.

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 & Tong Kah Compound NL v Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 4 AITR236; (1949) 8 ATD 431). With regards to the second limb, the High Court in John Fairfax & Sons Pty Ltd v Federal Commissioner of Taxation (1959) 101 CLR 30; (1959) 11 ATD 510 said that an outlay must be part of the cost of trading operations to produce income, that is, it must have the character of a working expense.

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). The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses.

The broad principles that have arisen from cases on the deductibility of expenses is that they must be 'incidental and relevant to' the gaining or producing assessable income, the expenditure must have the 'essential character' of a business expense and there must be a 'perceived connection' with the gaining or producing of income.

The interaction between the above principles was described by Hill J in FC of T v Firth 2002 ATC 4346 at p 4348 when he said:

"The positive tests require that there be a connection between the loss or outgoing on the one hand and the assessable income or business on the other. The nature of that connection has been expressed in different ways in the cases. It is sometimes said that there must be a 'perceived connection' between the loss or outgoing and the assessable income or business: FC of T v Hatchett 71 ATC 4184 at 4187 ... In other cases it has been said that the expenditure must be 'incidental and relevant' to the operations or activities regularly carried on by the taxpayer for the production of income: Ronpibon Tin NL & Tongkah Compound NL v FC of T (1949) 8 ATD 431 at 435; (1949) 78 CLR 47 at 56, FC of T v Smith 81 ATC 4114 at 4117. These ways of describing the connection that is a necessary prerequisite to deductibility are but part of the process of identifying the essential character of the expenditure in order to determine whether a particular loss or outgoing is in fact incurred in gaining or producing the assessable income or in carrying on a business which more directly contributes to the gaining or production of the assessable income: Lunney v FC of T (1958) 11 ATD 404; (1957-1958) 100 CLR 478 at 413 and 499 respectively." [emphasis added]

Legal 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) and the legal action has more than a peripheral connection to the taxpayer's income producing activities (Magna Alloys and Research Pty Ltd v FC of T 80 ATC 4542; (1980) 11 ATR 276).

For example, the recovery of trade debts is ordinarily a matter of revenue and legal costs incurred for this purpose are generally deductible under section 8-1 of the ITAA 1997.

However legal expenses incurred in the recovery of trade debts should be distinguished from recovery of exempt income or capital. In Case C10, 71 ATC 35 legal expenses incurred in realising a real property mortgage, given as security for a loan transaction outside the ordinary course of a money lending business, were disallowed as capital expenditure.

Conclusion

The legal expenses were incurred in recovering a loan to an employee and are unrelated to the taxpayer's management consultancy business. The expenses were incurred outside of the taxpayer's normal course of business.

The legal expenses that were incurred do not have the necessary connection with the taxpayer's income producing activities and cannot be said to have been incurred in the course of the taxpayer's business for the purpose of gaining or producing the assessable income of the taxpayer.

Question 2

Is the debt owed to the taxpayer a CGT asset?

A CGT asset is defined in subsection 108-5(1) of the ITAA 1997 as:

a) any kind of property; or

b) a legal or equitable right that is not property

Note 1 in subsection 108-5(2) of the ITAA 1997 gives the following examples of CGT assets:

• land and buildings

• shares in a company and units in a unit trust

• options

• debts owed to you

• a right to enforce a contractual obligation

• foreign currency

Rights in relation to a debt are recognised by the law and in equity and can be enforced by legal or equitable proceedings. Accordingly, a debt meets the definition of CGT asset.

Cost base of a CGT asset

Section 110-25 of the ITAA 1997 sets out the 5 elements of the cost base of a CGT asset. These elements are:

1. (a) the money you paid, or are required to pay, in respect of acquiring the asset; and

(b) the market value of any other property you gave, or are required to give, in respect of acquiring the asset (worked out as at the time of the acquisition).

2. The second element is the incidental costs you incurred. These costs can include the giving of property. Section 110-35 of the ITAA 1997 lists the types of incidental costs that may be incurred to acquire a CGT asset or that relate to a CGT event.

3. The third element is the costs of owning the CGT asset you incurred. These costs include:

(a) Interest on money you borrowed to acquire the asset; and

(b) Costs of maintaining, repairing or insuring it; and

(c) Rates or land tax, if the asset is land; and

(d) Interest on money you borrowed to refinance the money you borrowed to acquire the asset; and

(e) Interest on money you borrowed to finance the capital expenditure you incurred to increase the asset's value. These costs can include the giving of property.

1. The fourth element is capital expenditure you incurred:

(a) The purpose or expected effect of which is to increase or preserve the asset's value; or

(b) That relates to installing or moving the asset. The expenditure can include the giving of property.

1. The fifth element is the capital expenditure that you incurred to establish, preserve or defend your title to the asset, or a right over an asset. The expenditure can include the giving of property (see section 103-5 of the ITAA 1997).

The legal fees incurred in recovery of the loan cannot form part of the second element of the cost base as they were not part of the incidental costs in acquiring the asset nor do they relate to a CGT event in relation to the asset.

From the information provided, it cannot be concluded that the taxpayer's right over the asset (i.e. the debt) was under any threat or at risk and the title was not in need of establishment, preservation or defence. Therefore the legal expenses incurred in recovering the debt cannot form part of the fifth element of the asset's cost base.

Furthermore, legal fees do not form part of the first, third and fourth elements of the cost base of a CGT asset.

Conclusion

The legal expenses incurred in the recovery of the debt owing do not form part of any of the elements of the cost base of the debt.

Question 3

Deductions for certain business expenses

Section 40-880 of the ITAA 1997 provides a deduction for specified categories of capital expenditure, called 'business related costs' that would otherwise be non-deductible under the general deduction provisions in section 8-1 of the ITAA 1997 and other deduction provisions.

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.

As the business was being carried on, it is not necessary to consider the factors relation to paragraphs (b), (c) or (d) in subsection 40-880 of the ITAA 1997.

In order to establish if an amount of expenditure is deductible under paragraph 40-880(a) of the ITAA 1997 following conditions must be met:

a) the expenditure must be of a capital nature;

b) the expenditure must be 'incurred'; and

c) the expenditure must be in relation to your business.

Paragraph 10 of Taxation Ruling TR 2011/6 points out that the expenditure must be capital expenditure which is business related. This excludes revenue expenditure and non-business expenditure such as expenditure relating to occupation as an employee or to passive investment.

Capital expenditure

In discussing the types of business capital expenditure to which subsection 40-880(2) of the ITAA 1997 applies, paragraphs 2.19 and 2.20 of the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No. 1) Bill 2006 state:

2.19 Expenditure on the structure by which an entity carries on (or used to or proposes to carry on) their business and on the profit yielding structure of the business would ordinarily be expected to be of a capital nature. Capital expenditure can also relate to a business's trading operations or the entity that will carry on the business.

2.20 The structure covers the legal entity (such as a company) or the legal relationship (such as a partnership or trust) that is the entity that carries on the business for a taxable purpose and that holds the business assets.

These paragraphs indicate that capital expenditure incurred on the structure by which an entity carries on (or used to or proposes to carry on) their business, on the profit yielding structure of the business, or relating to the business's trading operations, are capable of being described as capital expenditure incurred 'in relation to' that business for the purposes of subsection 40-80(2) of the ITAA 1997. Whether such capital expenditure is incurred 'in relation to' the particular business will depend on the facts of the particular case as to whether there is a sufficient and relevant connection between the incurring of the expenditure and that business.

Incurred

There is no statutory definition of the term 'incurred' however the principles established by case law regarding the meaning of the word 'incurred' in section 8-1 of the ITAA 1997 also apply to section 40-880 of the ITAA 1997.

In general terms, an outgoing is incurred at the time a taxpayer owes a present money debt that the taxpayer cannot avoid paying. The courts have been reluctant to attempt an exhaustive definition of 'incurred', but have developed a series of guidelines that can be used in assisting to determine whether an item has been incurred in a current year. Paragraph 6 of Taxation Ruling TR 97/7 sets out the general rules that have been settled by case law:

(a)  a taxpayer need not actually have paid any money to have incurred an outgoing provided the taxpayer is definitively committed in the year of income. Accordingly, a loss or outgoing may be incurred within section 8-1 even though it remains unpaid, provided the taxpayer is 'completely subjected' to the loss or outgoing. That is, subject to the principles set out below, it is not sufficient if the liability is merely contingent or no more than pending, threatened or expected, no matter how certain it is in the year of income that the loss or outgoing will be incurred in the future. It must be a presently existing liability to pay a pecuniary sum;

(b)  a taxpayer may have a presently existing liability, even though the liability may be defeasible by others;

(c)  a taxpayer may have a presently existing liability, even though the amount of the liability cannot be precisely ascertained, provided it is capable of reasonable estimation (based on probabilities);

(d)  whether there is a presently existing liability is a legal question in each case, having regard to the circumstances under which the liability is claimed to arise;

(e)  in the case of a payment made in the absence of a presently existing liability (where the money ceases to be the taxpayer's funds) the expense is incurred when the money is paid.

Whether there is a presently existing pecuniary liability is a question which must be determined in light of the particular facts of each case, and especially by reference to the terms of the contract or arrangement under which the liability is said to arise:

(Nilsen Development Laboratories (1981)144 CLR 616; James Flood (1953) 88 CLR 492; Ogilvy and Mather Pty Ltd v. FC of T 90 ATC 4836; and FC of T v. Woolcombers (WA) Pty Ltd 93 ATC 5170).

In relation to

The legislation does not define the expression 'in relation to' and therefore it takes its ordinary meaning. The Macquarie Dictionary Online defines 'related' as 'associated; connected'. Accordingly, the expenditure and the business need to be associated or connected for the expenditure to be described as being 'in relation to' the business.

The legislative context of section 40-880 of the ITAA 1997 indicates that the closeness of the association or connection must objectively support the conclusion that the expenditure is a business expense of the particular business.

Determining whether the expenditure has the character of a business expense can be approached by asking what the expenditure is for, in the sense of identifying the need or object that the expenditure serves. If the facts show that the expenditure satisfies the ends of the relevant business then it will have the character of a business expense.

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 states:

2.25 The provision is concerned with expenditure that has the character of a business expense because it is relevantly connected to the business. The concept used to establish this character or requisite relationship between the expenditure incurred by the taxpayer and the business carried (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 before the business commences or after it has ceased.

Conclusion

The legal expenses that have been incurred by the taxpayer have been determined under question one to be not deductible on the basis that it does not meet the positive limbs of the general deduction provisions of section 8-1 of the ITAA 1997.

Similarly, section 40-880 of the ITAA 1997 does not have application as the legal expenses that have been incurred are not related to the taxpayer's business structure. The legal expenses relate to actions undertaken by the taxpayer that have no relationship to its business activities.

Based on the above, the legal expenses are not deductible under section 40-880 of the ITAA 1997.

Question 4

Paragraph 4 of Taxation Ruling TR 2000/5 states that the following costs incurred by an employer in preparing and administering an employment agreement will be deductible:

• costs of drawing up employment agreements for existing employees and new employees of an existing business; and

• costs incurred in the settling of disputes arising out of existing employment agreements.

Employment agreements are a written, legal and binding confirmation of the employer/employee relationship. The agreements cover rates of pay, working conditions, leave entitlements and other provisions. Costs incurred in the preparation and administration of an employment agreement would typically include:

• representation (which could be a union, an employer organisation, an accountant, a lawyer or any other representative employed during the negotiation process);

• costs associated with drawing up the agreement;

• lodgement fees; and

• costs associated with settlement of disputes.

Conclusion

The legal expenses were incurred in order to recover the outstanding loan amount. The expenditure does not have any connection to the cost of drawing up an employment agreement or any disputation arising from the employee's conditions of employment.