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Edited version of your written advice
Authorisation Number: 1012872179387
Date of advice: 18 September 2015
Ruling
Subject: Legal expenses
Question 1:
Is the trust entitled to a deduction for the legal expenses it paid for the individual who was a director of its corporate trustee?
Answer:
No
Question 2:
Is the trust entitled to a deduction for legal expenses the trust paid to recover legal costs in relation the director's legal dispute?
Answer:
No
This ruling applies for the following periods:
Year ended 30 June 2012
Year ended 30 June 2013
Year ended 30 June 2014
Year ended 30 June 2015
The scheme commenced on:
1 July 2011
Relevant facts
A director of a corporate trustee entered into a contract of sale to purchase a residential property.
The director did not purchase the property on behalf of the corporate trustee for the trust.
The property was not purchased for income producing purposes.
The property is the director's main residence.
The director had a legal dispute over the title of the property.
The director took legal action to protect the title of the property.
The trust paid the legal expenses in relation to the advice sought to protect the title of the property.
In order to pay the legal expenses the trust re-mortgaged rental properties that it owned.
The trust was not a party to the legal action.
The trust did not receive any income in relation to the legal action.
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, relate to the earning of exempt income or are excluded by another provision of the taxation legislation.
The courts have considered the meaning of 'incurred in gaining or producing assessable income'. In Ronpibon Tin NL & Tong Kah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 56 ALR 785; (1949) 8 ATD 431 the High Court stated that:
For expenditure to form an allowable deduction as an outgoing incurred in gaining or producing the assessable income it must be incidental and relevant to that end. The words "incurred in gaining or producing the assessable income" mean in the course of gaining or producing such income.
The reference to your assessable income in section 8-1 of the ITAA 1997 means that the expenditure must be incurred in producing the assessable income of the person who incurs the expenditure.
Generally, a taxpayer cannot claim a deduction unless it is incurred in gaining or producing their assessable income. Only the person who incurs the expense can claim the deduction, but it has to relate to assessable income that they have derived.
As stated in Case M36 80 ATC 280 (Case M36):
It is a condition of deductibility under section [8-1 of the ITAA 1997] that any loss or outgoing must have a nexus with the gaining or producing of assessable income in the hands of the claimant, or be necessarily incurred in carrying on a business (by the claimant) for the purpose of producing such income.
All losses and outgoings of a taxpayer incurred in gaining or producing assessable income of the same taxpayer are allowable deductions to that taxpayer and only that taxpayer: Marshall Richards Machine Co Ltd v Jewitt (1956) 36 TC 511.
In practice, taxpayers often have to deal with groups of related companies or entities and with payments which are non-arm's length in the sense that payments are made either to or (wholly or partly) for the benefit of an associated person or entity.
Taxpayers must bear in mind that each entity is a separate taxpayer, and that generally a loss or outgoing will not be deductible under 8-1 unless it is incurred in gaining or producing assessable income (or in carrying on a business for the purpose of gaining or producing such income) for the taxpayer who incurred that loss or outgoing: see Federal Commissioner of Taxation v Munro (1926) 38 CLR 153 at 170 per Knox CJ.
Capital expenses
An expense will usually be capital in nature where it is incurred with the intention to create an asset or advantage of a lasting and enduring nature (British Insulated & Helsby Cables Ltd v. Atherton (1926) AC 205; (1926) 10 TC 155).
Legal expenses paid on behalf of the individual and to recover the legal costs
In the trust's case, while the trust may have re-mortgaged rental properties and used the funds to pay the legal expenses in relation to the legal action undertaken by the individual and to recover the legal costs in relation to that action, it cannot be said that the legal expenses were incurred in earning the trust's assessable income as from the information provided at the time of paying the legal expenses the trust was not involved in any legal action nor did the trust receive any assessable income from the outcome of the legal action. Any perceived connection between the trust's assessable income from the renting of the properties and the paying of the legal expenses is too remote. Consequently the trust is not entitled to a deduction for the legal expenses it paid as there is an insufficient nexus between the legal expenses and the earning of the trust's assessable income.