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Edited version of your written advice
Authorisation Number: 1051387661379
Date of advice: 21 June 2018
Ruling
Subject: Deductibility of settlement sum paid to enter deed of release
Question
Is the settlement sum paid to the landlord to enter the deed of release deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?
Answer
Yes
This ruling applies for the following period:
Year ending 30 June 20XX
The scheme commences on:
1 July 20XX
Relevant facts and circumstances
The Partnership structure is a partnership of trusts, Company No.1, as trustee for Trust No.1, and Company No.2, as trustee for Trust No.2.
The Partnership conducted a business out of leased premises.
Company X entered into a lease over the premises with the landlord, the owner of the building, several years ago.
During the period of the lease, the business suffered significant loss of trade because the landlord breached promises to:
a. maintain the property in watertight condition
b. maintain the air conditioning systems
c. keep plumbing in good repair
d. reasonably consent to alter the premises.
Expert consultants were engaged and it was their opinion that there were defects in the building and responsibility for the rectification should lie with the landlord.
The landlord refused to accept responsibility for the building defects.
The terms of the lease provided that the landlord could not unreasonably refuse consent for the Lessee to make alterations to the demised premises.
As a result of the loss of profits and damages caused by the landlord’s conduct in not rectifying the building defects and the other matters listed above, Company X commenced legal action against the landlord.
Company X sought relief via the court action to have the defects in the premises rectified and for consent to be given for expansion of the area with consequent claim for damages for loss of profits.
The legal proceedings were conducted by Company X as plaintiff (in its capacity as agent for The Partnership), and the landlord the defendant.
Significant costs were incurred on legal fees, expert consultant’s reports and forensic accountant’s reports for assessment of loss of profits.
Evidence was presented to the court to show the extent of the building defects and to show that the business trading profit was severely affected by the landlord’s refusal to remedy them.
Forensic accountant’s reports were presented to detail the effects on the business and loss of profits caused by the building defects and landlord’s failure to consent to the expansion of the area.
Altering the existing area of the premises for the designated use did not involve the addition or enlargement of the profit yielding structure of the business as there was no proposal to acquire a new or enlarged asset. The proposed area for expansion was within the leased premises.
During the court proceedings legal counsel representing the landlord argued that Company X, as Lessee under the lease, in its capacity as agent for The Partnership, did not have a right to be compensated for damages as it was acting only in its capacity as agent and had not suffered any loss in its own right. Further, it was argued that The Partnership did not have a right to take action against the landlord as it was not a known party under the lease.
During the court proceedings, due to the complex nature of the arguments, the judge made a recommendation that the matter be settled by way of mediation.
In view of the legal advice the decision was made to stem any potential loss and try to settle the matter.
A mediator was appointed and as a result of negotiations the parties to the proceeding entered into a settlement agreement.
As part of the settlement agreement, Company X and The Partnership agreed to pay the landlord an amount to enter into a Deed of Release.
A Deed of Release between the landlord, Company X, Company No.1 and Company No.2 was made. The parties to the deed agreed to resolve all disputes, claims and the legal proceedings on the terms set out in the deed.
Under clause Y of the deed, subject to completion of particular actions, the landlord was ordered to consent to the development approval application. Agreements and undertakings regarding building works and the lease were specified under various other clauses of the deed.
Clause Z of the deed directed Company X, Company No.1 and Company No.2 to pay the landlord a specified settlement amount.
The Partnership paid the landlord the full settlement amount in satisfaction of the direction to pay.
Relevant legislative provisions
Income Tax Assessment Act 1997 section 8-1
Reasons for decision
General deductions
Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) sets out the general rules for deductibility under the Act.
The two positive limbs of the provision are contained in subsection 8-1(1) of the ITAA 1997 which states that 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.
The four negative limbs of the provision are contained in subsection 8-1(2) of the ITAA 1997 which qualifies the application of the positive limbs by stating that you cannot deduct any loss or outgoing under section 8-1 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 the Act prevents you from deducting it.
Legal expenses
For legal expenses to be an allowable deduction, it must be shown that they are incidental or relevant to the taxpayer's business operations. The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses.
Advantage sought by incurring the expenses
The lease
A contract for lease is in essence a promise by the tenant to pay rent in consideration of the promise by the landlord to, among other things, afford exclusive possession of the real property.
Rent is a revenue expense deductible under section 8-1 of the ITAA 1997.
The Partnership, as tenant, paid rent in consideration of all the promises made by the landlord, under the contract of the lease.
The proceeding
The dispute was founded on a claim that the landlord breached a number of promises to:
a. maintain the property in watertight condition
b. maintain the air conditioning systems
c. keep plumbing in good repair
d. reasonably consent to altering the premises.
The character of the advantage sought in paying the rent is the very same thing which The Partnership sought in incurring the legal costs.
The landlord was contractually obligated to undertake what was claimed. The Partnership was only seeking conformance with what they believed to be the contractual terms. They were not seeking anything beyond those contractual terms. Their litigation was not to seek to enlarge the profit yielding structure or to gain an enduring advantage.
The issue of whether The Partnership had standing in the proceedings makes no difference in our view as the advantage sought is still exactly the same. Similarly, the outcome of the proceedings does not have anything to do with why The Partnership sought to commence the proceedings in the first place. In other words, whatever the outcome, the advantage sought was still redress in respect of the alleged failings of the landlord.
The settlement amount
It is reasonable to view that the deed of release was executed to satisfy expectancy as to costs. The prospect of costs being awarded against The Partnership, and therefore the character of the advantage sought in becoming exposed to costs, is exactly the same as the character of the advantage sought in commencing the proceedings.
The legal costs of running the proceedings have the same character as rent payments and the character of the settlement paid assumes the same character as the legal costs of running the proceedings.
Accordingly, there is a clear and direct link between the lease, the outgoings and the process of operating the business.
Conclusion
The outgoings that The Partnership incurred as tenant seeking to enforce contractual terms of the lease satisfy the 2nd positive limb of section 8-1 of the ITAA 1997 in that they have been incurred in carrying on a business for the purposes of gaining or producing assessable income.
The outgoings are not excluded by a negative limb in subsection 8-1(2) of the ITAA 1997.
The settlement sum is therefore deductible under section 8-1 of the ITAA 1997.