Edited version of your written advice

Authorisation Number: 1051478167180

Date of advice: 16 May 2019

Ruling

Subject: The deductibility of settlement money and legal expenses

Question 1

Are you entitled to claim a deduction on settlement money you paid under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Question 2

Are you entitled to claim a deduction on legal expenses you incurred under section 8-1 of the ITAA 1997?

Answer

No

This ruling applies for the following period:

Year ended 30 June 2015

The scheme commences on:

1 July 2014

Relevant facts and circumstances

You were an employee of Company Y prior to being with Company X.

You were the sole director and shareholder of Company X. One of Company X’s clients was Plaintiff Company. Company X had a profit-split arrangement with Company Y. Company Y also serviced Plaintiff Company.

Company X did not gain any profits and did not return any taxable income. There were no dividends distributed to its sole shareholder.

You received remuneration for your efforts earning money for Company X. You did not receive other forms of distribution from Company X.

Company X ceased its trading activities.

Plaintiff Company filed a claim for compensation for loss. Plaintiff Company claimed that it suffered loss and damage as a result of a scheme operated by the defendants.

You were a named defendant in this matter as an associate of another defendant and as an employee of Company Y.

You denied the allegations made against you by Plaintiff Company.

The parties engaged in mediation.

Without any admission of liability, you entered into a settlement agreement to settle the claim with Plaintiff Company for the sole purpose of avoiding the costs and uncertainty associated with litigation, Plaintiff Company.

You paid a sum of money to the Plaintiff Company.

You paid your solicitors legal fees and costs relevant to the proceedings.

You claim that you have not previously deducted these legal expenses in any tax return.

In the same financial year of incurring the expenses, you gained assessable income from employers who are not parties to the proceedings.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Summary

The settlement money and legal expenses incurred are not deductible under section 8-1 of the ITAA 1997. The outgoing was incurred for the sole purpose of avoiding litigation. The outgoing was not incurred in gaining or producing your assessable income or was not necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

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 your assessable income or are necessarily incurred in carrying on a business for the purpose of gaining or producing your 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.

In FC of T v. Rowe (1995) 31 ATR 392; 95 ATC 4691 (Rowe) the taxpayer, an employee, was suspended from normal duties and was required to show cause why he should not be dismissed after several complaints were made against him. A statutory inquiry subsequently cleared him of any charges of misconduct or neglect. The court accepted that the legal expenses incurred by the taxpayer in defending the manner in which he performed his duties, in order to defend the threat of dismissal, were allowable. Since the inquiry was concerned with the day to day aspects of the taxpayer's employment, it was concluded that his costs of representation before the inquiry were incurred by him in gaining assessable income.

In Herald & Weekly Times Ltd v. FC of T (1932) 48 CLR 113 the taxpayer, the proprietor and publisher of an evening newspaper, claimed outgoings (for legal advice, defence costs and damages awarded) in connection with libels the newspaper had published. The Full High Court allowed the deduction since, firstly, publishing the newspaper was both the source of income and the cause of liability and, secondly, the risk of libel was a regular and almost unavoidable incident or inherent risk of publishing.

In Magna Alloys & Research Pty Ltd v. FC of T 80 ATC 4542, the issue was related to whether the taxpayer company could claim a deduction for legal expenses incurred by the defence of criminal charges brought against its director for inappropriate business practices. The Full Federal Court held a deduction was available for the expenses as they were not only incurred in the interests of the director, but were also ‘desirable and appropriate’' from the point of view of the taxpayer's business.

The cases do not make clear what the ‘occasion’ of an outgoing is. The cases do, however, provide examples of ‘occasions’. In AGC (Advances) Ltd v. FC of T 75 ATC 4057; (1975) 5 ATR 243 the occasion of a debt that turned bad after the cessation of business activities was found to be in the ‘agreement by which the debt was created’ (per Mason J at ATC 4072; ATR 260). In Placer Pacific Management Pty Limited v. FC of T (1995) 95 ATC 4459; (1995) 31 ATR 253A the occasion of an outgoing to remedy a defective conveyor system was found to be in the agreement for the supply of the conveyor belt which was alleged to be defective.

Taxation Ruling TR 95/33 also considers factors relevant in determining the deductibility of losses and outgoings. TR 95/33 states that if an outgoing produces an amount of assessable income greater than the amount of the outgoing, there would normally be no need to examine the taxpayer's motives and intentions when determining the deductibility of the expenditure. If the outgoing produces no assessable income, or the amount of assessable income is less than the amount of the outgoing, it may be necessary to examine all the circumstances surrounding the expenditure to determine whether the outgoing is deductible.

Company expenses met by director or shareholder

Taxation Ruling TR 1999/10 is a ruling regarding income tax deductions that are available for Members of Parliament. Paragraph 217 of TR 1999/10 refers to Case N9 81 ATC 56; 24 CTBR (NS) Case 81 where the Board of Review disallowed a claim for legal expenses by a director of a number of companies. He was defending himself on charges under the Companies Act that would affect his future appointment as a director. The deduction was disallowed as it was of a private and capital nature. The action did not occur as a matter of course in the gaining or producing of his assessable income.

Another court case, referred to in paragraph 218 of TR 1999/10, was Case W101 89 ATC 821; AAT Case 5,009 (1989) 20 ATR 3421 where an employee, at the request of the company, got a corporate credit card. This credit card was used to pay for overseas air travel for three other executives. The company did not reimburse the employee and the credit card company sued the employee, so he paid the debt. The legal expenses and the debt were held not to be deductible as they were not incurred in earning his assessable income.

The fundamental requirement that there must be a sufficient nexus between a particular expense and the assessable income such that the expense is incidental and relevant to the gaining of assessable income was also recognised in Case U134 87 ATC 780; (1987) 18 ATR 3646. That case involved a taxpayer who was a director of and a shareholder in a family company. The taxpayer did not receive any payments from the company for his services as a director of the company. However, the taxpayer did receive a dividend from the company. In disallowing the claim for the expense, the Tribunal at paragraph 14 held that:

...the outgoings were incurred in his capacity as a director and are consequently not sufficiently related to the carrying on the business of being a shareholder. Additionally, as no allowance was paid to him in his capacity as a director, it cannot be said that the expenses were incurred in gaining or producing assessable income in that capacity.

The courts have consistently held that a deduction is not allowable by a director where they pay company expenses, as the expenses are not incurred in gaining or producing their assessable income in their capacity as a director. Such expenses are incurred by the taxpayer in earning assessable income of the company, rather than assessable income of the taxpayer (Federal Commissioner of Taxation v. Munro [1926] HCA 28; (1926) 38 CLR 153) (Munro).

In circumstances where the company is having financial difficulty, deductions for costs incurred by a director personally to assist the company to reach a profitable position have also been disallowed. In Case 26/94 94 ATC 258; (1994) 28 ATR 1133, the taxpayer, who was a shareholder and director of a family company, borrowed money which he on-lent to the family company as the family company was unable to borrow in its own capacity. The taxpayer did this to ensure the company’s profitability so as to derive dividends from the company in the future. The Tribunal held that the taxpayer was unable to deduct interest and other costs associated with the loan as the connection between the costs incurred and future income was too remote.

Losses or outgoings where business has ceased

Expenditure incurred in relation to income derived in an earlier year may be deductible under section 8-1 for recurrent and non-recurrent items where the business operations have ceased. The Full Federal Court in Placer said that a loss or outgoing will be deductible provided the occasion for the loss or outgoing is to be found in the business operations directed to gaining or producing assessable income unless it is capital or capital in nature.

In FCT v EA Marr & Sons (Sales) Ltd (1984) 2 FCR 326; 15 ATR 879; 84 ATC 4580 the Full Federal Court allowed the taxpayer a deduction in respect of payments made by its liquidators to unsecured creditors in respect of debts due on leased plant. The debts were made when the taxpayer was solvent. They were made in discharge of the taxpayer's liabilities incurred in the course of carrying on its business which included its leasing activities.

In Associated Minerals Consolidated Ltd v FCT (1994) 27 ATR 542; 94 ATC 4008; 29 ATR 147; 94 ATC 4499, a mining company was entitled to a deduction for certain clean-up costs relating to the mining activities of a subsidiary which had ceased operations. The company agreed to contribute towards the cost of removing radioactive tailings from various contaminated sites. The Full Federal Court allowed a deduction because clean-up work was a necessary ongoing cost of the company's mining business. The payments were an almost unavoidable incidence of the business.

In FCT v Brown (1999) 43 ATR 1; 99 ATC 4600, the taxpayer and his wife obtained a loan to purchase a delicatessen and when the business was sold some 3 years later, the proceeds did not completely pay out the loan so the interest continued to accrue. The Full Federal Court concluded that the occasion for the recurring liability for interest on the bank loan was the bank loan agreement which arose while carrying on the delicatessen business.

Taxation Ruling TR 2004/4 considers the deductibility of interest expenses incurred prior to the commencement of income earning activities, or after income earning activities have ceased. In some circumstances related to a liability, a taxpayer must be completely subjected or definitively committed to an outgoing for this to be deductible, even though it may not be payable until a future income year (paragraph 10 of TR 2004/4).

Application to your circumstances

Action was taken against you when you were named as a defendant in a matter as an associate of another defendant and as an employee of Company Y.

In your case, Company X paid you $x in remunerations but did not distribute dividends to you as a shareholder. Company X ceased its trading activities a few years later.

A number of years after Company X closed, you paid the Plaintiff Company settlement money to dismiss the claim and discharge the freezing order. You incurred legal expenses for the relevant proceedings in the same year.

At the financial year you incurred the expenses, you were an employee of other companies. The settlement money and legal expenses were not incurred in earning your assessable income from either of these employers or your previous employer.

You submitted that the ‘occasion of’ you paying the settlement sum to the Plaintiff Company was to be found in the trading conditions of your company, conduited through to you, as an assessable salary or expected dividends.

1. Incurred in gaining or producing your assessable income in your capacity as the company director of Company X

Outgoings can be characterised by reference to the legal rights the taxpayer obtains from incurring them. In the ordinary case of a payment under a contract, the legal and substantial nature of the outgoing will commonly be determined by what was gained in return. In your case, you paid the settlement sum which effectively dismissed the proceeding against you, discharged the Freezing Order and avoided costs order between the parties. You entered into the settlement agreement with the dominant purpose of being freed from an imminent and expensive court proceeding. The advantage you sought was non-commercial in nature. We consider that the expenses cannot be objectively viewed as income producing.

To be deductible under the first positive limb, there must be a sufficient nexus between the loss or outgoing and the production of assessable income. The link between the outgoing and your income producing activities is not sufficient to establish that the outgoing was direct, relevant and incidental to gaining or producing your assessable income. The circumstances leading to settling the claim were not inherent in your day to day role as a director managing the business activities of Company X. The expenses did not arise directly from your office. The alleged wrongful actions that you had to settle do not represent the kind of casualty, mischance or misfortune which are natural consequence or recognised incident of your income earning activities as the company director of Company X.

Your case can be distinguished from Rowe where the nature of the taxpayer’s employment exposed him to allegations of negligence and misconduct. The outgoings he incurred in defending the manner in which he performed his duties were allowed as deductions.

On the other hand, you submitted that the claims revolve around the trading stock of Company X and were on revenue account. You stated that in essence, Plaintiff Company claimed that Company X was not entitled to its sales proceeds. The ‘occasion of’ you incurring this outgoing was with Company X making sales, during the prolonged period over which the fraud was being perpetrated (albeit by others). The effect of the settlement sum was to return relevant sales proceeds.

To be deductible under the first positive limb, the outgoing must be incurred in gaining or producing the assessable income of the person who incurs it. Looking at the total circumstances, you incurred the expenses. You did not incur the settlement money and legal costs in gaining or producing your income as the company director of Company X.

2. Necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income as the sole shareholder of Company X

You submitted that the basis of the settlement money you paid was from an alleged fraudulent invoice that Company X issued to Plaintiff Company. You stated that the claims revolved around the products, which were the trading stock of Company X and you were only returning to Plaintiff Company the money it spent buying the misappropriated products. You also submitted that Company X ‘salary policy’ resulted in the absence of dividend distributions to you as a shareholder.

While the trading conditions may have been exposed to alleged fraudulent activities, the outgoing is not a normal incident of Company X’s business. The different heads of claims did not flow directly from the scope of trading operations of Company X carried on for the purpose of earning your assessable income. The outgoing was not the ‘kind of casualty, mischance or misfortune which is a natural or recognised incident of a particular trade or business the profits of which are in question’ (C of T (NSW) v. Ash (1938) 61 CLR 263, per Rich J at page 277). Your case is in contrast with Herald & Weekly Times and Magna Alloys where damages and legal expenses allowed as deductions were relevant to the taxpayers’ revenue earning activities for the business.

You claimed that your case is on ‘all fours’ with Placer. You incurred settlement payments and legal expenses to settle a claim after a business has ceased. The taxpayer in Placer is the company which carried on the business. There was a contractual agreement in relation to the supply of conveyor belts. The business agreements generated warranties and liabilities. The company taxpayer was obliged to discharge a liability by settling a claim and incurring settlement payment and legal expenses after the business had been sold to another entity. The outgoings can be linked directly to the specific contract that arose during the income producing activities.

You submitted that the occasion of the outgoing is to be found in the trading conditions of Company X. You stated in general terms that Company X’s trading conditions provided the necessary link between the outgoing and the income earning activities. However, there is no specific business transaction that would have imposed an obligation to pay the settlement money to the Plaintiff Company a few years after Company X ceased its business. When Company X was trading, there was no obligation or liability created that would have required the payment of settlement money or legal expenses in the considerable future. It is therefore considered that the outgoings are not part of the cost of Company X’s trading operations.

To be deductible under the second positive limb, the outgoing must be necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income. The expenditure that you incurred was neither required to establish or to terminate the business. The outgoing was outside the mainstream of Company X business operations and cannot be characterised as a working expense. The settlement money was incurred not for the purpose of gaining or producing income, rather, for the purpose of terminating a claim.

Conclusion

The settlement money and legal expenses were not incurred in gaining or producing your assessable income or were not necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income. Your circumstances failed to establish a sufficient nexus and the occasion of the outgoing was found outside your employment conditions and business operations. The advantage you sought was non-commercial in nature and considered not incurred to gain or produce your assessable income or necessarily incurred in a business for the purpose of producing your assessable income.