Edited version of your written advice

Authorisation Number: 1051177536732

Date of advice: 4 January 2016

Ruling

Subject: Equity agreement expenses

Question 1

Is a deduction allowed for the legal expenses incurred?

Answer

No.

Question 2

Is a deduction allowed for the settlement payment?

Answer

No.

Question 3

Is a deduction allowed for the marketing collateral expenses incurred?

Answer

Yes.

This ruling applies for the following periods

Year ended 30 June 2015

The scheme commenced on

1 July 2014

Relevant facts

Entity A entered into an equity agreement with entity B for them to be involved in a new division of the business.

Under the Agreement between entity A and entity B, entity B paid entity A an amount to become an equity partner.

Sometime after entity B reneged on their obligations and decided not to proceed.

Entity B, without discussion with entity A, submitted a claim demanding a full refund of the money they paid as consideration for their inclusion in the contract.

After many months of litigation, entity B finally agreed to an out of court settlement where entity A agreed to pay them a one off termination payment and for both parties to pay their own legal costs.

Entity A also incurred marketing collateral expenses in relation to the above.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

Allowable deductions - 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, or relate to the earning of exempt income, or a provision of the ITAA 1997 prevents it.

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, (Lunney's case)), 

● 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 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).

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 and Helsby Cables Ltd v. Atherton (1926) AC 205) The nature of the advantage sought by the taxpayer is therefore relevant.

The enduring benefit test was adopted and expanded by Dixon J in Sun Newspapers Limited v. FC of T (1938) 61 CLR 337 when expenditure is made once, with a view to bringing into existence an asset or advantage for the enduring benefit of the business, and absent of special circumstances leading to the opposite conclusion, this expenditure would be properly classified as capital.

It is a long standing principle that a taxpayer does not satisfy section 8-1 of the ITAA 1997 merely by demonstrating some casual connection between the expenditure and the derivation of income. What must be shown is a closer and more immediate connection. The expenditure must be incurred in gaining or producing assessable income (Lunney's case). These principles have been affirmed by the High Court in Commissioner of Taxation v Payne [2001] HCA 3.

Taxation Ruling TR 95/33 considers the decision of the Full High Court of Australia in Fletcher and Ors v. FC of T 91 ATC 4950; (1991) 22 ATR 613 and in particular, considers situations in which a taxpayer's subjective purpose, intention or motive is relevant in determining the availability of an income tax deduction.

In order to determine whether the legal fees are deductible under section 8-1 of the ITAA 1997, we first need to look at the reason for the legal fees and why they were incurred.

Entity A's legal expenses relate to the termination of the equity agreement. Entering into the equity agreement with another entity relates to the setting up of a new business structure for its future operations. Setting up a new division of the business provides an enduring benefit and is capital in nature.

It is acknowledged that the new arrangement was to earn additional business income and that the other business income streams suffered while setting up the new arrangement, however, legal expenses incurred in relation to a new business structure are not deductible as they are considered to provide a lasting benefit and advantages and are therefore capital in nature. Furthermore, the legal expenses are not sufficiently connected to the day to day business operations and assessable income of entity A.

As such, the legal expenses are not deductible under section 8-1 of the ITAA 1997.

Similarly the one off termination payment of part of the equity amount is capital in nature and relates to the ending of the equity agreement.

The marketing collateral expenses incurred are sufficiently connected to entity A's income earning activities and are not capital or private in nature. Therefore, the associated expenses incurred are an allowable deduction under section 8-1 of the ITAA 1997.