Edited version of your written advice

Authorisation Number: 1012853869326

Date of advice: 6 August 2015

Ruling

Subject: Deductions - legal expenses and proceeds of settlement

Questions and answers

1. Are the rulees entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for the cost of legal expenses and court costs incurred in defending legal proceedings brought against them?

Yes.

2. Are the proceeds of settlement between the rulees and an insurance company assessable under section 6-5 of the ITAA 1997?

No.

3. Are the proceeds of settlement between the rulees and an insurance company assessable under subdivision 20-A of the ITAA 1997?

Yes.

4. Are the rulees entitled to a deduction under section 8-1 of the ITAA 1997 for the legal expenses incurred in taking legal action against an insurance company in which the insurance company paid a settlement sum?

Yes.

This ruling applies for the following period

1 July 2010 to 30 June 2011

1 July 2011 to 30 June 2012

1 July 2012 to 30 June 2013

1 July 2013 to 30 June 2014

1 July 2014 to 30 June 2015

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

The rulees are officers of the company.

The rulees derive income from the company.

Legal action was taken against the rulees.

It was alleged that the rulees breached their duty.

The rulees have incurred legal expenses in defending the legal action.

The rulees had an insurance policy to cover work related liability; however, their claim was disputed by the insurers.

The rulees commenced legal action in relation to the claim but eventually agreed to settle the matter with the insurer for a settlement payment.

A deed of release and discharge (the settlement) between the rulees and the insurance companies was signed.

The rulees incurred legal costs in bringing the proceedings in the Federal Court against the insurers.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 20-20

Reasons for decision

Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of a resident taxpayer includes ordinary income derived directly or indirectly from all sources during the income year.

Section 8-1 of the ITAA 1997 allows a deduction for all losses or outgoings to the extent to which they are incurred in gaining or producing assessable income, or are necessarily incurred in carrying on a business for that purpose. However, where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income they will not be deductible (subsection 8-1(2) of the ITAA 1997).

In determining whether a deduction for legal expenses is allowed 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.

Under subdivision 20-A, certain amounts received by way of insurance, indemnity or other recoupment are assessable income if the amounts are not income under ordinary concepts or otherwise assessable.

Subsection 20-20(2) of the ITAA 1997 provides that an amount received as a recoupment of a loss or outgoing will be an 'assessable recoupment' if the amount is received by way of insurance or indemnity, and the loss or outgoing is deductible either in the current income year, or in an earlier income year.

In order to be an assessable recoupment, both paragraphs of subsection 20-20(2) of ITAA 1997 must be satisfied.

In the Federal Court decision Sommer v Federal Commissioner of Taxation [2002] FCA 1205 to characterise the proceeds under the settlement the surrounding circumstances could be considered because the terms of the agreement expressly allowed it.

Application to your circumstances

The legal expenses and court costs, in relation to legal proceedings brought against the rulees incurred in defending charges that arose from the rulees day-to-day work role (for which the rulees were paid assessable income), and directly related to producing their assessable income.

Accordingly, the rulees are entitled to claim a deduction for legal expenses and court costs under section 8-1 of the ITAA 1997.

The insurance settlement is not income under ordinary concepts as the rulees did not make a gain or profit from the transaction. Therefore section 6-5 of the ITAA 1997 does not apply.

To characterise the proceeds under the settlement we must consider the operative provisions. The operative provisions of the settlement deed expressly refer to the 'Proceeding'. The Proceeding is a defined term in the background/recitals of the agreement. Accordingly the contents of the documents that are included in the definition of the Proceeding can therefore be taken into account in characterising the payment (Sommer v Federal Commissioner of Taxation [2002] FCA 1205).

The settlement proceeds were received by way of insurance in respect of deductible expenditure in defending the legal action and there is a nexus between the amount received at settlement and the amount being received by way of insurance or indemnity.

Therefore, under section 20-20(2) of the ITAA 1997 the settlement proceeds are treated as an assessable recoupment in the year in which it was received. The payment will be assessable in that year to the extent to which you incurred deductible legal costs relevant to the insurance claim you made (that is, legal costs defending your actions as directors of a company) both in that year and in earlier years. Any balance of the settlement sum will be assessable in subsequent years to the extent that relevant deductible legal costs are incurred in those years.

The legal fees incurred, in relation to the insurance claim by the rulees were for the purpose of obtaining a payment from the insurer under the insurance policy. The settlement proceeds received from the insurer are included in assessable income under subdivision 20-A of the ITAA 1997 as an assessable recoupment; therefore the legal fees are incurred in gaining or producing assessable income.

Accordingly, the rulees are entitled to claim a deduction for the legal fees, in relation to the insurance claim, under section 8-1 of the ITAA 1997.