Edited version of your written advice

Authorisation Number: 1051223472869

Date of advice: 15 May 2017

Ruling

Subject: Legal Expenses

Question 1

Are you entitled to claim a deduction for legal expenses?

Answer

No

This ruling applies for the following periods:

For the year ended 30 June 2014

For the year ended 30 June 2015

The scheme commences on:

1 July 2013

Relevant facts and circumstances

You were an employee who took out a “business loan” amount to invest in a partnership.

You gave the partnership a cheque.

The loan amount was not applied to the partnership.

The funds were applied to a personal debt owed by the director of the partnership.

You did not receive a share of the business of the partnership.

You were not made a partner in the partnership.

You filed a claim against the bank for failing their fiduciary duty.

You accepted a settlement amount from the bank.

You incurred legal fees as a result of this claim and subsequent settlement.

You were not in business at the time of incurring the legal fees.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1.

Reasons for decision

Summary

The legal expenses you have incurred are not an allowable deduction. They were not incidental or relevant to the production of your assessable income; they are therefore not incurred in gaining or producing your assessable income. They were also not incidental or relevant to a business operation as you never received a share of the business; they are therefore not necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. Further, the legal expenses take on the capital nature of the advantage being sought from the legal action. As the legal expenses are capital in nature, a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) is not allowable.

Detailed reasoning

Section 8-1 of the 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 necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income, except where the outgoings are of a capital or personal nature.

This means that for legal expenses to constitute an allowable deduction, it must be shown that they are incidental or relevant to the production of your 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). If the expenses do not relate to your normal activities through which you earn assessable income or do not relate to an actual business operation then you cannot claim a deduction.

Also, 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. FC 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 your 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 your income producing activities (Magna Alloys and Research Pty Ltd v. FC of T 80 ATC 4542; (1980) 11 ATR 276).

The question of whether legal fees are capital in nature has been the subject of much judicial consideration. The classic exposition of the test was by Dixon J in Sun Newspapers Ltd and Associated Newspapers Ltd v. FC of T (1938) 61 CLR 337; (1938) 5 ATD 87; (1938) 1 AITR 403. In his judgment he referred to three tests:

There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it, that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment.

In Hallstroms, Dixon J said that legal expenses:

… take the quality of an outgoing of a capital nature or of an outgoing on account of revenue from the cause or purpose of incurring the expenditure. We are, therefore, remitted to a consideration of the object in view when the legal proceedings were undertaken, or of the situation which impelled the taxpayer to undertake them.

In your case, your legal expenses were not incidental or relevant to the production of your assessable income or a business operation. The legal expenses were not incidental or relevant to the production of your assessable income as they did not relate to your normal day to day activities to which you earn assessable income. A capital investment or the recovery of a capital investment is not a normal day to day activity to which you earn income. The legal expenses were also not incidental or relevant to a business operation as you did not receive a share of the business and were not in business at the time you incurred the legal expenses, despite the bank classifying the loan as a business loan.

Your purpose in incurring this expense and the nature of the advantage being sought is also relevant. You took out a loan with a bank to invest in a business. This money was not applied to the business and you did not receive a share in this business. You filed a claim against the bank for failing in their fiduciary duty. The object of this claim was to recover the capital investment that was intended to be applied to the business. A capital investment is capital in nature, so as the advantage being sought is capital; the legal expenses will also be capital.

As the legal expenses are not incidental and relevant to the production of your assessable income or a business operation, and the nature of the legal expenses has taken on the capital nature of the advantage being sought, the legal expenses are not deductible under section 8-1 of the ITAA 1997. The legal expenses are also not deductible under any other provision.