Edited version of your written advice

Authorisation Number: 1051354977260

Date of advice: 15 October 2018

Ruling

Subject: Deductions

Question

Are you entitled to a deduction for payments totalling $Z incurred in relation to a dispute about your administration of the affairs of the deceased person?

Answer

No.

This ruling applies for the following period

Year ended 30 June 20XX

The scheme commenced on

1 July 20XX

Relevant facts and circumstances

Background

You are a Partner in the Firm which operates through a number of entities including a practice company and service trust:

● You are a partner and derive income from this partnership.

● You are a director and shareholder of the practice company and benefit from dividends paid by the Firm.

● Your family trust, of which you are a beneficiary, is a unit holder in the service trust. You benefit from trust distributions paid by the Trust by way of distributions to your family trust.

You were appointed to act as the financial manager for a person when that person was judged to be incapable of making financial decisions. You were appointed because of your family relationship to the person.

In the position of financial manager for the person you were not permitted to charge fees.

After your appointment, you discovered that the person’s records had not been maintained and that a substantial amount of work was required to bring the records up to date. Accordingly, you appointed the Firm to undertake the work which included accounting services and taxation compliance services undertaken by yourself and other professional staff of the Firm.

Fees were subsequently raised by the Firm in respect of this work. The Firm also provided investment advice in relation to the person’s investments.

You stood to share in the profits arising from these services and fees via the practice company (the Firm) and the service trust (the Trust).

The deceased person died in 200X at the age of XX.

A second person was the sole beneficiary of the deceased person’s Estate.

The legal and associated actions

The beneficiary brought an action against you in respect of the fees charged by the Firm to the deceased. The beneficiary, the Plaintiff, sought relief from you personally as they believed you acted in breach of your fiduciary duty and duty of care as a financial manager in procuring the payment to the Firm of professional fees for the management of the estate of the deceased in excess of $X; as per the Statement of Claim. You have supplied a copy of the Statement of Claim.

The Plaintiff took action against you personally. The Firm was not subject to a claim by the Plaintiff. Nevertheless, the Firm believed it was in its best interests to ensure that you defended the claim because the claim related to fees charged by the Firm to the Estate. However, an agreement was reached between you and the Firm whereby you would be required to contribute to the legal costs incurred.

There were also legal costs associated with a disciplinary hearing conducted by the relevant professional body.

The Firm engaged lawyers to defend its interest in the claim that related to fees charged by the Firm. The law firm engaged was the Solicitors.

The Firm incurred legal fees and other costs. In total, the firm made payments for the following:

● Legal fees associated with the Plaintiff’s claim $X

● Pre-settlement concessions paid to the Plaintiff $X

● Settlement amount per Deed of Settlement and Release $X

● Legal fees associated with disciplinary proceedings $X

TOTAL $XX

The settlement and associated outcomes

In the Deed of Settlement and Release, dated 201X, you agreed to pay a Settlement Sum of $X to the Plaintiff. The Firm subsequently paid this amount to the Plaintiff on your behalf.

Following the settlement you were required to make a payment to the Firm towards the settlement and costs incurred. This amount was paid by you in two instalments:

● $X1 was paid on 201X; and,

● $X2 was paid on 201X.

These amounts totalled $Z. Both payments were paid out of a cheque account held jointly in your and your spouse’s names. Both the cheques were made out to the Firm. They fulfilled a requirement placed on you by the Firm as part of the arrangements to help settle the action. You have supplied copies of documents to substantiate these payments.

The Firm paid the settlement agreement on the basis that you would reimburse the Firm. The payments were made by you were in accordance with an agreement reached with the Managing Director of the Firm. The amount paid represented a contribution to the total costs of the Firm disputing the claim for recovery of fees and then settling the claim.

The payment of the legal expenses reduced the profitability of the Firm’s entities (of which you receive a share by way of dividends, trust distributions and partnership distributions) but as you were required to make a contribution, the profitability of the Firm’s entities (and hence distributions and dividends received by all Partners and Directors including you) was increased.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

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 except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.

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. 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 High Court in Federal Commissioner of Taxation v. Day (2008) 236 CLR 163; 2008 ATC 20- 064; (2008) 70 ATR 14 held that for an employee’s legal expenses to be deductible, the occasion for the expenses must be found in their employment. It also held that the scope of a particular taxpayer's employment is not confined to the day-to-day activities performed by the employee. In the circumstances of Day the High Court had regard to the nature of the employment and the fact that the taxpayer was exposed to the action by reason of his employment.

Application to your circumstances

In your case, the payment of $X you made to the Firm was as reimbursement for a payment the Firm had made on your behalf pursuant to the Deed of Settlement. The payment had been agreed to by you and was made to settle a matter in relation to a position to which you had been appointed in your private capacity. In this position you were not permitted to charge for your time. Accordingly, the $X outgoing was of a private nature and not incurred in earning your assessable income. The fact the Firm made the payment to the Plaintiff on your behalf, and you reimbursed the Firm, does not change the nature of the payment.

The occasion for the further outgoing of $X which you paid to the Firm is also to be found in your position as manager of deceased person’s estate. As noted above, you were appointed to this position in your private capacity and you were not permitted to charge fees. As such, this payment was also of a private nature and not incurred in earning your assessable income.

We recognise that you and the Firm’s professional staff provided accounting and taxation compliance services to the deceased person, that the Firm invoiced the deceased person in respect of the services undertaken, and that, as the financial manager, you paid the fees from the estate on behalf of the deceased. You and others provided services to the Firm that were invoiced to the deceased. You stood to share in the profits arising from these services and fees from the Firm and the Trust.

However, the Plaintiff took legal action against you personally in respect of the fees paid to the Firm on behalf of the deceased. While the Firm incurred legal expenses in protecting its right to retain the fees, it was the Firm’s decision to incur those expenses. There were also legal costs incurred by the Firm associated with a disciplinary hearing conducted by the professional body.

The Firm’s decision to incur these legal expenses was to protect its reputation and to avoid having to refund some or all of the fees it had charged (although it would have had recourse against you for any losses sustained). Legal expenses incurred in such circumstances would be deductible under section 8-1 to the Firm.

However, the making of a contribution by you to the Firm’s expenses needs to be considered in relation to your situation to determine its deductibility. The requirement for you to make a contribution to the Firm’s legal expenses arose both from your position as financial manager of the deceased’s estate and from your position as a Partner in the Firm.

To the extent that the requirement relates to your position as financial manager of the deceased’s estate, your contribution to the Firm’s expenses had an insufficient connection to the earning of your assessable income because you were not permitted to earn income in that capacity. To the extent that it relates to your position as a Partner in the Firm, the expenses were incurred to protect a capital asset, being your position as a Partner in the Firm. As such, the expenses were of a ‘once and for all’ capital nature and not deductible under section 8-1.