Edited version of your written advice

Authorisation Number: 1012918855893

Date of advice: 1 December 2015

Ruling

Subject: Settlement payment

Question

Is the settlement sum paid an allowable deduction?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 20YY

The scheme commenced on:

1 July 20XX

Relevant facts

Entity A operates a business.

A dispute arose from a client. Entity A provided services to the client.

Approximately nine months after the work undertaken by entity A was done, entity A received a call to notify of a problem.

There was no culpability for entity A.

The client sought settlement from entity A.

Entity A had spent money in legal fees and could reasonably estimate this ballooning which was a factor in settling.

Without admission of liability, entity A agreed to resolve the dispute as per the deed of settlement in which entity A would pay an amount to the client.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

Legal expenses

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 or are necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature.

A number of significant court decisions have determined that for an expense to be an allowable deduction:

• it must have the essential character of an outgoing incurred in gaining assessable income or, in other words, of an income-producing expense (Lunney v. FC of T; (1958) 100 CLR 478), 

• there must be a nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income (Ronpibon Tin NL v. FC of T, (1949) 78 CLR 47), and

• it is necessary to determine the connection between the particular outgoing and the operations or activities by which the taxpayer most directly gains or produces his or her assessable income (Charles Moore Co (WA) Pty Ltd v. FC of T, (1956) 95 CLR 344; FC of T v. Hatchett, 71 ATC 4184).

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 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 (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).

However, where the expenditure is incurred for the purpose of securing an enduring benefit, rather than a revenue purpose, the expenditure is capital in nature and is not deductible (Sun Newspapers Ltd v. FC of T (1938) 61CLR 337; 5 ATD 87; (1938) 1 AITR 403).

Although the above cases relate more to legal expenses, the principles are relevant in the treatment of your settlement sum payment.

In this case, the dispute followed the provision of services to a client. Similar to what was found in the Herald and Weekly Times case, it is considered that the liability arose from the income-producing activities of entity A.

The nature of the advantage sought by paying the settlement sum is not one that provides a lasting or enduring benefit. The primary purpose for incurring the expense is to respond to the dispute from the client. Whilst it is recognised that the expenditure to settle the dispute may be associated with long term benefits to the reputation and goodwill of the business, it was noted in Magna Alloys that whilst expenditure on legal expenses may serve to protect the reputation and goodwill of a business, this will not make the expenditure one of capital if the taxpayer is defending the way in which it operated its commercial activities in the course of carrying on its business.

As the settlement payment arises out of the day-to-day activities of entity A's business, it is considered that there is a sufficient connection between the expense and the assessable income of the business. Furthermore the expense is not of a capital nature and therefore a deduction is allowed under section 8-1 of the ITAA 1997.