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Edited version of your written advice
Authorisation Number: 1012785851023
Ruling
Subject: Associated costs of legal action
Question
Are the legal fees and payment under the Deeds of Release and Indemnity deductible as a business expense?
Answer
Yes.
This ruling applies for the following periods:
Year ended 30 June 2014
Year ended 30 June 2015
The scheme commenced on:
1 July 2013
Relevant facts and circumstances
You are a sole trader operating a business.
You hired a contractor.
This worker injured themselves whilst under contract to you.
The worker did not have income protection insurance.
You did not have workers compensation insurance.
The worker took legal action resulting in Deeds of Release and Indemnity in which you agreed to pay an amount to the worker, covering settlement and legal fees.
You also incurred an amount in your own legal fees in this matter.
Relevant legislative provisions
Income Tax Assessment Act 1997 Section 8-1
Reasons for decision
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 except where the outgoings are of a capital, private or domestic nature.
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.
Legal expenses are generally deductible if they arise out of the day to day income earning activities (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 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).
In order to determine whether your legal fees and the payout you agreed to make are deductible under section 8-1 of the ITAA 1997, we need to look at the reason for the expenses and why they were incurred.
The expenses relate to your obligations in respect of your business and the contractor you engaged to work in your business. The expenses arose as a consequence of your day to day activities as a sole trader and therefore sufficiently relate to your assessable business income and are not capital in nature.
As such, both the payment to the contractor and the legal expenses you incurred in the process of defending your business are deductible under section 8-1 of the ITAA 1997.