Edited version of private advice

Authorisation Number: 1051526447311

Date of advice: 04 June 2019

Ruling

Subject: Legal and travel expenses

Question 1

Are you entitled to the legal expenses and expert evidence costs you incurred in relation to a home building dispute under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer 1

No

Question 2

Are you entitled to claim the travel expenses you incurred under section 8-1 of the ITAA 1997?

Answer 2

No

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You entered into a residential building contract with a builder for the construction of a new residential property. You agreed that this building will serve as a display home for the builder who will pay you rent in return.

The builder abandoned the project without completion. You contacted the builder to complete the contract but failed. You did not pay the balance owing to the builder.

You lodged an application with a tribunal to have the complaint heard and determined. You were not legally represented at the time of application.

You engaged the services of an expert witness to report the extent of defective or incomplete works. The expert's total estimated costings to repair defects and incomplete items amount to more than $100,000. A general overview of the expert report indicated the following:

·         that the dwelling was not habitable as fixtures and fittings to the kitchen have not been provided and/or installed;

·         hot water service was not connected;

·         numerous items have not been provided in accordance with the approved plans and specifications;

·         the standard of some finished works was below what is required by the Building Code of Australia.

Later, you sought legal representation. The solicitors submitted the following heads of claim against the builder:

·         misleading and deceptive conduct;

·         failure to complete work in accordance with the plans and specifications of the contract;

·         builder repudiation of the contract;

·         the residential building work was incomplete or defective breaching the warranties in the Home Building Act 1989 (NSW);

·         damages for incomplete works and rectification of defects and breaches of statutory warranty;

·         work done without due diligence and out of time;

·         work conducted in the dwelling has not resulted to the extent of making it reasonably fit for occupation.

You sought damages for the cost of rectification of defective and incomplete residential building work, plus interest paid on borrowings, plus out of pocket expenses, plus loss of rental income.

The tribunal dismissed the proceedings because the builder was in liquidation.

You received a letter from the Liquidator that you will unlikely to be paid of any debt owing by the builder.

You applied for an insurance claim but this was denied by the insurer.

You incurred expenses for legal representation and expert report costs in relation to this claim.

You incurred travel expenses. You travelled to the tribunal and to the solicitors, and to the construction site to supervise and to help finish the construction works.

While the proceedings were ongoing, you completed the construction works.

The property started to earn rental income a few months before the proceedings ceased.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 25-10

Income Tax Assessment Act 1997 section 26-31

Income Tax Assessment Act 1997 section 110-25

Income Tax Assessment Act 1997 section 110-35

Reasons for decision

Summary

Whilst we acknowledge your circumstances, the legal expenses and expert evidence costs you incurred in relation to a home building dispute are considered to be capital expenses and are not deductible under section 8-1 of the ITAA 1997. Similarly, the travel expenses you incurred in travelling to and from the solicitors, the tribunal and the construction site are not deductible under section 8-1 of the ITAA 1997. These travel expenses were not incurred in gaining or producing your assessable income or were necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

Detailed reasoning

Legal Expenses and associated costs

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.

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. Expenditure is capital in nature where it is made with a view to bring into existence an asset or advantage that is of enduring benefit. Capital expenditure is characterised by the fact that it is usually a one-off payment and establishes, replaces or enlarges the income producing asset.

Taxation Ruling 97/23 Income Tax: deductions for repairs, explains the circumstances in which expenditure incurred by a taxpayer for repairs is an allowable deduction under section 25-10 of the ITAA 1997. The expression 'initial repair' refers to a repair by a taxpayer that remedies some defect in property or makes good damage to, or deterioration of, property being a defect, damage or deterioration: existing when the property was acquired from another person and not arising from the operations of the taxpayer who incurs the repair expenditure (see paragraph 4 TR 97/23).

An initial repair expense is not the type of repair expenditure ordinarily incurred as a working or operating expense in producing assessable income or in carrying on a business. This is because it lacks a connection with the conduct or operations of the taxpayer that produce the taxpayer's assessable income. It is essentially an additional cost of acquiring the property or an improvement in the quality of the property acquired. Initial repair expenditure relates to the establishment of the profit - yielding structure. Initial repairs are of a capital nature and not deductible (see paragraph 61 TR 97/23).

In your case, your builder abandoned the job and left the dwelling with structural defects. At that stage, the dwelling required initial repairs that will align with the approved plans, specifications and building standards. You needed to undertake initial repairs to make the new home habitable and available for rent. Hence, you sought a compensation amount that will cover losses and the expenses to rectify the structural damages and to bring the project to completion. It is considered that the legal fees and experts' costs you incurred were required to finish the construction of your new residential rental property- the profit yielding structure.

Therefore, the legal and expert evidence fees incurred in the course of action taken to receive compensation for the cost of rectification of defective and incomplete residential building work to your future residential rental property are an outgoing of a capital nature. These expenses are not deductible under section 8-1 or 25-10 of the ITAA 1997.

As the expenditure is a capital expense, which is not deductible, you need to consider whether the expenditure can form part of the cost base of your residential rental property.

Section 110-25 of the ITAA 1997 provides the general rules regarding cost base. The cost base consists of five elements:

·         Acquisition costs

·         Incidental costs

·         Non-capital ownership costs which are not deductible elsewhere

·         Amounts which increase or preserve the value of the asset

·         Amounts incurred in establishing, preserving or defending your title to the asset, or right over the asset

The legal fees and expert evidence fees connected with the proceedings may be included in the cost base of the asset as incidental costs in terms of subsection 110-25(3) and section 110-35 of ITAA 1997.

Travel expenses

Section 8-1 of the ITAA 1997 allows a deduction for employment or business related travel expenses 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.

You drove to your solicitors and to the tribunal in the course of resolving your building claims. You also drove to the construction site to supervise and to work on the construction yourself. We acknowledge that the circumstances surrounding your travel expenses were in relation to finishing the construction of your future residential rental property. However, when you incurred the travel expenses, the dwelling was not at the stage where it is capable of returning rental income, and therefore the costs were not incurred in gaining or producing your assessable income.

The travel expenses are not deductible under section 8-1 of the ITAA 1997.