Edited version of your written advice

Authorisation Number: 1051330866166

Date of advice: 22 February 2018

Ruling

Subject: Deductibility of legal expenses and costs

Question

Are the legal fees and costs paid in the income year ended 30 June XXXX (‘XXXX income year’) in the circumstances described deductible under section 8-1 of the Income Tax Assessment Act 1997 in that same income year?

Answer

Yes

Relevant facts and circumstances

The taxpayer is a publisher of a newspaper. The newspaper is owned by a related entity of the taxpayer.

The taxpayer derived income whilst they were an employee and publisher of the newspaper.

Some year ago, the newspaper published material about a person. Subsequently, defamatory proceedings were commenced by that person against the taxpayer personally as publisher of the newspaper.

A few years after the commencement of the defamation proceedings, the taxpayer ceased their involvement in the running of the newspaper, as the ownership of the newspaper was transferred to another entity.

Several years after the taxpayer ceased their involvement in the newspaper, the court judgment was handed down. Damages were awarded against the taxpayer. Further, the court ordered that the taxpayer pay the other party’s costs.

The other party applied to the court for an assessment of costs under the costs order. Subsequently, the taxpayer sought a review of the costs determination. Revised determinations were issued by the court in the YYYY income year.

Shortly after the issue of the revised determinations, the taxpayer initiated proceedings to formally appeal against these determinations.

In the following income year i.e XXXX income year, the taxpayer paid the costs and the associated legal expenses. The taxpayer also discontinued the appeal proceedings.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Summary

The taxpayer’s claim for a deduction of legal expenses and costs incurred in the XXXX income year in relation to the defamation claim are deductible under section 8-1 of the Income Tax Assessment Act 1997. It is considered that there is sufficient nexus between the costs and legal expenses that the taxpayer incurred in connection to the defamation claim and their employment as publisher of the newspaper from which they derived assessable income. This is notwithstanding that the taxpayer no longer derives income as a publisher and there is a significant period of time between the claim for deduction and the performance of those duties that gave rise to the defamation action.

Further, it is considered that the taxpayer ‘incurred’ the outgoing for costs and legal expenses in the XXXX income year as it is at this point of time that the taxpayer became definitively committed to the liability by paying them.

Detailed reasoning

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that a loss or an outgoing is an allowable deduction if it is incurred in producing assessable income or in carrying on a *business for the production of assessable income unless that loss or outgoing is capital or of a private or domestic nature.

For legal expenses to constitute an allowable deduction under the first limb of section 8-1, it must be shown that the expenses were incidental or relevant to the production of the taxpayer’s assessable income (Ronpibon Tin NL & Tongkah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 4 AITR 236; (1949) 8 ATD 431).

Generally, legal expenses have been held to be deductible if the expenses have arisen as a consequence of the taxpayer's income earning activities: see The Herald & 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).

In the Herald and Weekly Times Case, a company which was both the owner and publisher of a newspaper was allowed a deduction for damages paid and legal costs incurred in connection with libels published in the newspaper. A majority of the Full High Court allowed the deduction as publishing the newspaper was firstly both the source of income and cause of the liability and secondly, the risk of libel was a regular and almost unavoidable incident or inherent risk of publishing. Gavan J Duffy C.J. and Dixon J relevantly said:

The liability to damages was incurred, or the claim was encountered, because of the very act of publishing the newspaper. The thing which produced the assessable income was the thing which exposed the taxpayer to the liability or claim discharged by the expenditure.

….. But this expenditure flows as a necessary or a natural consequence from the inclusion of the alleged defamatory matter in the newspaper and its publication. Expenditure in which the taxpayer is repeatedly or recurrently involved in an enterprise or exertion undertaken in order to gain assessable income cannot be excluded by sec. 25(e) simply because the obligation to make it is an unintended consequence which the taxpayer desired to avoid. No point is made of the fact that the publication took place in a former year, and properly so. The continuity of the enterprise requires that the expenditure should be attributed to the year in which it was actually defrayed.”

…..The money was spent to answer the claims, and whether it was expended wholly and exclusively for the production of income, must depend upon the manner in which the claims were incurred. When it appears that the inclusion in the newspaper of matter alleged by claimants to be defamatory is a regular and almost unavoidable incident of publishing it, so that the claims directly flow from the acts done for no other purpose than earning revenue, acts forming the essence of the business, no valid reason remains for denying that the money was wholly and exclusively expended for the production of assessable income.

In Case V116, 88 ATC 737; 19 ATR 3703, a director was allowed a deduction for costs incurred in defending a defamation action brought about by an ex-director against a board of directors of which the taxpayer was a member. The expenses incurred were held to be directly related to the performance of his duties as a director and thereby his income earning activities. There was no foundation for finding the alleged defamation was something private in nature.

In FC of T v. Rowe (1995) 31 ATR 392; 95 ATC 4691, the court considered a taxpayer’s claim for legal expenses which were incurred by the taxpayer in defending the manner in which he performed his employment duties. No significance was placed by the court on the taxpayer's status as an employee (see also FC of T v. Day [2008] HCA 53).

In this instance, the taxpayer derived assessable income from their employment as publisher of the newspaper.

Defamation proceedings for comments published in the newspaper were bought against the taxpayer personally in their capacity as publisher of a newspaper. This is as the Court pointed out in the Herald and Weekly Times Case is an unavoidable incident of publishing a newspaper. As such, the defamation proceedings are considered to be directly related to the taxpayers’ income earning activities as publisher of a newspaper.

Consequently, it is considered that the taxpayer is eligible to claim a deduction under section 8-1 as there is sufficient nexus between the legal expenses that the taxpayer incurred in connection to the defamation claim and their employment as publisher of a newspaper from which they derived assessable income.

However, consideration must be given to the fact that a number of years has now lapsed since the action that gave rise to the defamation proceedings and the cessation of the taxpayer’s employment as publisher of the newspaper.

As a general principle, the courts have accepted that in order to be deductible, a loss or outgoing incurred in one year need not necessarily produce income in that year provided it is incurred to produce assessable income in future or past years – see for example, the Herald and Weekly Times Case where the Court accepted that the claim for the deduction need not be made in the same accounting period in which the cause of the liability arose.

Further, the courts have held that a loss or outgoing incurred after the cessation of income-earning activities will be deductible under section 8-1 in a year later than the year in which the income was earned, notwithstanding the cessation or suspension of business operations in the interim. This is provided that the occasion for the loss or outgoing is found in the business operations directed to gaining or producing assessable income (Placer Pacific Management Pty Ltd v. FC of T (1995) 95 ATC 4459; (1995) 31 ATR 253 and AGC (Advances) Ltd v. FC of T 75 ATC 4057; (1995) 5 ATR 243 (AGC Advances Case)).

In Placer Pacific Management Pty Ltd v FC of T 95 ATC 4459 (Placer’s Case), the taxpayer had previously carried on a business of manufacturing conveyor belts. After this business had ceased, the taxpayer was sued by a company for which it had previously installed an allegedly defective conveyor belt. The Court allowed a deduction for the legal expenses incurred by the taxpayer, stating at 4464:

In our view AGC should be taken as establishing the proposition that provided the occasion of a business outgoing is to be found in the business operations directed towards the gaining or production of assessable income generally, the fact that that outgoing was incurred in a year later than the year in which the income was incurred and the fact that in the meantime business in the ordinary sense may have ceased will not determine the issue of deductibility… Provided the occasion for the loss or outgoing is to be found in the business operations directed to gaining or producing assessable income, that loss or outgoing will be deductible unless it is capital or of a capital nature.

Both Placer’s Case and AGC Advances Case dealt with the deductibility of one-off expenditure. The decision in Riverside Road Lodge Pty Ltd (In Liq) v FC of T (1989) 90 ATC 4031; 21 ATR 508 confirmed that ongoing expenditure may continue to be deductible despite the cessation of the business, provided the relevant connection between the expenditure and the income-producing activity still exists. Moreover, French J observed that the deductibility of expenditure where the income producing activity has ceased would be allowable under either of the limbs of section 8-1 of the ITAA 1997

Therefore, whilst the above court cases involve taxpayers carrying on a business, it is considered that principles established in these cases can apply equally in certain circumstances to taxpayers who are employees.

In accordance with the principles set out in the above cases, it is considered that the legal expenses and costs that the taxpayer incurred in the 2016 income year are deductible as the occasion for payment of these expenses and costs are to be found in the taxpayer’s employment as a publisher from which they derived assessable income.

The fact that the taxpayer is no longer deriving income as a publisher or there is a considerable time gap between the claim for deduction and the performance of those duties that gave rise to the defamation action will not prevent the taxpayer’s claim for deduction as the connection between the expenses and income earning activity still remain.

Finally, the amounts claimed by the taxpayer are neither capital or of a private or domestic nature and therefore not excluded from deduction under section 8-1 of the ITAA 1997.

Accordingly, the taxpayer is entitled to claim a deduction under section 8-1 of the ITAA 1997 for legal expenses and costs that were incurred regarding the defamation claim brought against them as a consequence of their employment as publisher of a newspaper.

Timing of the deduction

The facts of this case also raise an issue regarding the time at which the deduction for costs under the costs order became available. Specifically, whether the outgoing for costs were ‘incurred’ for the purposes of section 8-1 in the 2015 income year when the Review Panel of the Supreme Court issued Certificates of Determination in relation to the costs order or in the 2016 income year when the taxpayer actually paid the costs order and associated legal expenses, after initiating formal appeal proceedings.

Taxation Ruling TR 97/7 Income tax: section 8-1 – meaning of ‘incurred’ – timing of deductions sets out the Commissioner’s views on when an expense is incurred.

There is no statutory definition of the term 'incurred'; however, TR 97/7 outlines general rules, settled by case law, which will assist in most cases in defining when an outgoing is incurred. Broadly, a loss or outgoing is "incurred" if a taxpayer is ‘definitively committed’ or ‘completely subjected’ to paying the liability, even though the liability remains unpaid.

A loss is not incurred if it is merely contingent or is no more than ‘impending, threatened or expected’ – see paragraphs 6 and 20 of TR 97/7. A taxpayer cannot deny liability to pay an alleged debt and at the same time be said to have incurred that debt for the purposes of claiming a deduction. A debt, unpaid and denied by the taxpayer, is merely a loss or outgoing which is impending, threatened or expected, and therefore not "incurred" - Softwood Pulp & Paper Ltd v FC of T 76 ATC 4439.

See also Example 7 in TR 97/7 (paragraph 46) where a taxpayer disputing an amount of union fees is not definitively committed to paying the fees and therefore will not have incurred an outgoing until the fees are actually paid.

A taxpayer can be completely subjected to a liability, notwithstanding it is defeasible by others – Commonwealth Aluminium Corporation Ltd (77 ATC 4151 at 4161; (1977) 7 ATR 376 at 386. However, TR 97/7 at paragraph 20 notes that even though the liability may be defeasible, the taxpayer must be definitively committed to the outgoing.

In the present circumstances, the revised costs determination was issued by the court in the YYYY income year. Subsequently, the taxpayer commenced formal appeal proceedings. In the following income year, these proceedings were discontinued with the taxpayer paying the costs order and associated legal expenses.

Although the taxpayer’s liability for costs pursuant to the costs order was determined in the earlier income year i.e YYYY income year, it is considered that a deduction was not available to the taxpayer at this point of time. At this time, the taxpayer was not definitively committed or completely subject to the discharge of this liability as they disputed the costs by commencing appeal proceedings against the liability.

In the following income year i.e XXXX income year, the taxpayer is taken to have ‘incurred’ the outgoing for costs as they became definitively committed to the liability by paying the costs and associated legal expenses.

Consequently, the outgoings for legal expenses and costs became deductible under section 8-1 in the XXXX income year.