Edited version of your written advice

Authorisation Number: 1051213141540

Ruling

Subject: Deductibility of legal expenses

Date of Advice: 11 April 2017

Question 1

Are the legal expenses incurred by the taxpayer, in order to defend the criminal proceedings brought against the taxpayer's director, deductible expenses to the taxpayer under section 8-1 of the Income Tax Assessment Act 1997 (Cth)?

Answer

Yes.

This ruling applies for the following periods:

01/07/2015 to 30/06/2018

The scheme commences on:

This scheme has commenced.

Relevant facts and circumstances

Investment Activities

The taxpayer is an Australian proprietary company that has carried on the business of investing since its establishment in 200X.

Mr X is the sole director, the secretary and the sole shareholder of the taxpayer.

Mr X has been, from the establishment of the taxpayer, solely responsible for identifying and attracting investment opportunities for the taxpayer through his professional network, and exercising commercial judgement as to whether the taxpayer should pursue an investment opportunity, as well as managing the taxpayer's portfolio of investments. This has resulted in the taxpayer being highly successful in its investment activities and has grown in wealth.

The investment activities of the taxpayer during this period were not limited to any particular type of investment, but rather depended on an assessment by Mr X of the investment opportunities available to the taxpayer at any point in time. The types of taxpayer's investments have included, without limitation, investments in listed shares, investments in private equity, purchase and leasing of commercial property, provision of financial accommodation secured by mortgages, and investments in interest bearing securities. The types of investment activities have been diverse with varying degrees of risk.

Investment Opportunity

In 200Y, Mr X was introduced to an investment opportunity for the taxpayer in a foreign jurisdiction, whereby an amount would be advanced to the Company, in exchange for a sum twice the amount advanced, payable upon the occurrence of a trigger event at an unspecified time in the future (the Investment).

In 200Y, the taxpayer entered into the Investment, advancing an amount to the company.

In 200Z, the trigger event took place, and a payment of twice the amount advanced was made to the taxpayer.

Criminal Proceedings and Legal Expenses

In 201X, criminal proceedings were commenced in the foreign jurisdiction against Mr X, as the legal representative of the taxpayer, in relation to the terms of the investment (Criminal Proceedings).

In 201X, the taxpayer engaged the services of a legal firm (the Firm) to defend the criminal proceedings against Mr X. The Firm has expertise in international business transactions, criminal law and litigation and dispute resolution.

The taxpayer incurred legal expenses in defending the Criminal Proceedings and additional expenses are expected to be incurred as the Criminal Proceedings are ongoing (legal expenses).

Relevant legislative provisions

Income Tax Assessment Act 1997 (ITAA 1997) section 8-1

Reasons for decision

Applicable Law

Claims for deduction of legal expenses are considered under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997).

Section 8-1 of the ITAA 1997 states:

General deductions

(1) You can deduct from your assessable income any loss or outgoing to the extent that:

(a) It is incurred in gaining or producing your assessable income; or

(b) It is necessarily incurred in carrying on a * business for the purpose of gaining or producing your assessable income.

Note: Division 35 prevents losses from non-commercial business activities that may contribute to a tax loss being offset against other assessable income.

(2) However, you cannot deduct a loss or outgoing under this section to the extent that:

(a) It is a loss or outgoing of capital, or of a capital nature; or

(b) It is a loss or outgoing of a private or domestic nature; or

(c) It is incurred in relation to gaining or producing your exempt income or your non-assessable non-exempt income; or

(d) A provision of this Act prevents you from deducting it.

For a summary list of provisions about deductions, see section 12-5.

(3) A loss or outgoing that you can deduct under this section is called a general deduction.

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 (Ronpibon Tin NL and Tong Kah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 4 AITR 236; (1949) 8 ATD 431).

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) 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) 33 ALR 213) (Magna Alloys).

The main case on the deductibility of legal costs incurred in defending prosecution proceedings is the decision of the Full Federal Court in Magna Alloys.

In Magna Alloys, the taxpayer company claimed a deduction for legal expenses incurred by the company in defending several of its directors against criminal prosecution for conspiracy. The Federal Court upheld an appeal by the taxpayer, allowing the deduction. It was found that the expense satisfied the positive limb of what was then subsection 51(1) of the Income Tax Assessment Act 1936 (now section 8-1 of the ITAA 1997) as it was necessarily incurred in carrying on the business. It was found it was reasonably appropriate for the interests of the taxpayer company to defend the directors and protect the reputation of the business against charges.

In Magna Alloys, Deane and Fisher JJ stated at 237:

“The interests of the taxpayer were inextricably involved with those of its directors and agents, and it is plainly in the taxpayer's own interests that the directors and agents be properly represented. In these circumstances, the incurring of expenditure in providing adequate representation for the directors and agents was reasonably capable of being regarded as desirable and appropriate from the point of view of the pursuit of the business ends of the taxpayer's business”.

Deane and Fisher JJ continue at 238:

“In these circumstances, the fact that the directors may have been motivated by consideration of their own position neither negatives the conclusion that the outgoings were reasonably capable of being seen as desirable and appropriate from the point of view of the pursuit of the business ends of the taxpayer's business nor prevents the conclusion that they were incurred by the directors on behalf of the taxpayer for the purpose of gaining advantages which they saw as being desirable and appropriate in that sense.”

In Magna Alloys, the expense was also not found to be private and domestic or capital, as per the negative limb of section 8-1 of the ITAA 1997, on the basis that the criminal charges being defended arose out of conduct in the ordinary course of the business and the expense secured for the taxpayer no enduring or tangible asset.

Brennan J stated the following at 228:

The respondent further relied upon the exceptions to s 51(1) submitting that the expenditure was of a private or of a capital nature. As Menzies J said in FC of T v Hatchett (1971) 125 CLR 494 at 498; ATR 557 at 560 : “It must be a rare case where an outgoing incurred in gaining assessable income is also an outgoing of a private nature. In most cases the categories would seem to be exclusive.” What his Honour said with respect to outgoings incurred in gaining assessable income may be said of outgoings necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. Expenditure falling under the second limb of s 51(1) is incidental to the carrying on of a business and it must be a rare case where the same expenditure can at once possess that character and be an outgoing of a private nature. This is not such a case.

Nor was the expenditure an outgoing of a capital nature. The capital of the business was in no way increased by the expenditure incurred.

True it is that the expenditure protected the reputation and goodwill of Magna's business, but the attack which was made arose out of the day to day selling activities of that business and it was the business purpose of vindicating the methods by which it was conducted that brings the expenditure within s 51(1). Though goodwill is a capital asset of a business it is frequently earned and maintained by the daily activities of those engaged in the business. The valuable if intangible asset of goodwill frequently grows out of activities the cost of which is a charge on revenue account: see Sun Newspapers, supra, ; 61 CLR at 360-1 ; AITR at 411. Expenditure incurred in attempting to vindicate the business methods of the taxpayer, overcoming the obstacle to its trading which had been raised by the prosecutions is properly to be regarded as a cost on revenue account.

Further guidance whether such legal expenses are revenue or capital in nature was discussed in Putnin v FCT (1991) 98 ALR 13 (Putnin). In that case, an accountant incurred legal expenses in defending criminal charges that arose out of the administration of an insolvent estate as part of his business. The outgoings were not found to be capital merely because he was protecting his reputation and accreditation. Burchett, French and Lee JJ stated at 19:

However, it was submitted for the Commissioner that the outgoings were of a capital nature. A similar argument was tersely rejected in Magna Alloys and Research, by Brennan J (FLR at 201), and by Deane and Fisher JJ (FLR at 213; ALR at 239). Deane and Fisher JJ said:

Except in the most indirect way, the criminal proceedings imperilled neither the business nor the capital assets of the taxpayer…. The criminal proceedings in respect of which the outgoings were incurred arose out of the day to day business activities of the taxpayer. The outgoings did not involve the acquisition of any enduring or tangible assets. They represented expenditure incurred in carrying on the taxpayer's business which should properly be seen as being of a revenue character.

In the argument presented to this court, great emphasis was laid on the possibility that the taxpayer might, if he had been convicted, have incurred professional censure and cancellation of his registration as a trustee in bankruptcy or as an official liquidator. As a result, his partnership might have been dissolved. But these were all indirect consequences that might or might not have happened. They were neither the object of the prosecution, nor could it be said they would inevitably have followed upon its success. As in Magna Alloys and Research, the criminal proceedings arose from the activities by which the taxpayer earned his income, the mode of his performance of a particular task carried out in the course of business operations. Something of that kind is quite remote from capital, and the outgoings secured for the applicant no enduring or tangible asset. The last matter, though not conclusive, may be of significance as an indication that an expense is chargeable to revenue and not to capital: Australian National Hotels Ltd v FCT (1988) 19 FCR 234 at 241 ; 81 ALR 667 ; FCT v Ampol Exploration Ltd (1986) 13 FCR 545 at 575-7 ; 69 ALR 289 . The true view is that it is not a determinative factor, but it is a pointer to the conclusion that expenditure is not on capital account. In Consolidated Fertilisers Ltd v FCT (1990) 21 ATR 1056 at 1064 , Pincus J said: “ Snowden and Willson, and even more strongly the Magna Alloys case , support the deductibility of expenditures, even if of an unique kind, to protect commercial reputation.” If that is generally so, there is no sound basis for treating the costs paid in this case as of a capital nature merely because, in incurring them, the applicant may have been protecting his professional reputation. Under the circumstances, it was not open to the tribunal to regard the outgoings as outgoings of capital or of a capital nature.

Application to Facts

The taxpayer's case is similar and can be compared to the Magna Alloys case.

The taxpayer engaged in the business of investment, from the time of its incorporation in 200X, including in the years of 200Y to 200Z. As part of this business, a variety of different types of investments were entered into.

Mr X is the sole director and shareholder of the taxpayer, and is solely responsible for identifying and attracting investment opportunities for the taxpayer. The business reputation and success of the taxpayer relies on the expertise and reputation of Mr X.

Mr X directed the taxpayer to enter into the Investment in 200Y, as one of the many investment activities that were entered into in 200Y.

As such, the investment was entered into in the ordinary course of the investment business of the taxpayer.

The Investment, and the terms under which it was entered into and carried out, led to criminal charges being levied against Mr X in his capacity as the legal representative of the taxpayer. Further, due to the reliance of the taxpayer on the skill and reputation of Mr X, which would be affected by any conviction, the interests of Mr X and the taxpayer are, in regards to the criminal charges, inseparable and inextricably linked.

Due to all these factors, applying the Magna Alloys case, it was reasonably appropriate for the taxpayer to incur the legal expenses to defend Mr X against the criminal charges. The charges arose out of the ordinary, day to day conduct business of the taxpayer and defence of the charges is a defence of the business of the taxpayer as much as it is a defence of Mr X.

As such, the legal expenses were necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income of the taxpayer, satisfying paragraph 8-1(1)(b).

Even though the positive limb of section 8-1 of the ITAA 1997 is satisfied, it is still necessary to determine whether the legal expenses are capital, private or domestic in nature and so deny the deduction.

Applying the Magna Alloys' case, the legal expenses incurred by the taxpayer secured for the taxpayer no enduring or tangible benefits. The legal expenses incurred by the taxpayer to defend the charges against Mr X in his capacity as the legal representative of the taxpayer were incurred in the day to day activities in carrying on the taxpayer's business. This should be seen as being of a revenue character. As such, the outgoings are not of a capital nature, satisfying paragraph 8-1(2)(a).

Similarly, the legal expenses in defending the charges arose from the ordinary course of the business of the taxpayer, the expenses are not private or domestic, as per Magna Alloys, satisfying paragraph 8-1(2)(b) of the ITAA 1997.

The legal expenses further were not incurred in relation to gaining or producing exempt income or non-assessable non-exempt income of the taxpayer, and a provision of this Act does not prevent the taxpayer from deducting the expenses.

Accordingly, based on the facts provided, the legal expenses are deductible to the taxpayer under section 8-1 of the ITAA 1997.