Edited version of private advice

Authorisation Number: 1051568771496

Date of advice: 12 September 2019

Ruling

Subject: Legal expenses - loan instrument

Question

Are you entitled to a full deduction on legal expenses you incurred under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No, however you are entitled a deduction of a proportionate amount relating to the expense incurred in relation to the outstanding interest.

This ruling applies for the following periods:

Year ended 30 June 20xx

Year ended 30 June 20xx

Year ended 30 June 20xx

The scheme commences on:

1 July 20xx

Relevant facts and circumstances

Entity A does not carry on a business in trading shares or in money lending.

Entity A loaned funds to Entity B. Interest was also payable and was declared by Entity A.

The loan matured with Entity B defaulting on all the required repayments.

Entity A commenced legal proceedings against Entity B.

Entity A claimed to recover the amount including interest in breach of the agreement.

Entity A has incurred legal expenses in relation to the matter, however, the litigation remains on going.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Summary

The legal expenses were incurred to recover an outstanding debt. The loan provided is an investment and is capital in nature. However, Entity A is entitled a deduction of a proportionate amount relating to the expense incurred in relation to the outstanding interest.

Detailed reasoning

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 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).

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.

The courts, on a number of occasions, have determined legal expenses to be an allowable deduction if the expenses arise out of the day to day income producing activities of the taxpayer (The Herald and Weekly Times Ltd v. FC of T (1932) 48 CLR 113). In this case, 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 John Fairfax & Sons Pty Ltd v. FC of T (1958-9) 101 CLR 30 Menzies J stated at page 49:

...there must, if an outgoing is going to fall within its terms, be found (i) that it was necessarily incurred in carrying on a business; and (ii) that the carrying on of the business was for the purpose of gaining assessable income. The element that I think is necessary to emphasise here is that the outlay must have been incurred in the carrying on of a business, that is, it must be part of the cost of trading operations.

Application

Entity A is not the business of trading shares nor in the business of money lending. The loan provided by Entity A could not be regarded as a trade debt that arose out of a transaction in the ordinary course of Entity A's business.

Entity A incurred legal expenses in an attempt to recover the capital amount invested plus interest. The interest had already been earned and was therefore considered revenue in nature.

The apportionment of legal expenses is dealt with in Taxation Determination TD 93/29. This determination states that where legal expenses are incurred in relation to proceedings that relate both to amounts that are revenue in nature as well as amounts which are capital in nature, there must be some fair and reasonable assessment of the extent of the relation of the outlay to assessable income.

Taxation Determination TD 93/29 states:

Where the solicitors account is itemised, one reasonable basis for apportionment would be the time spent involving the revenue claim, relative to the time spent on the capital claim. If the solicitors account is not itemised, a possible basis for apportionment would be either a reasonable costing of the work undertaken by the solicitor in relation to the revenue claim, or, where this is not possible, an apportionment on the basis of the monetary value of the revenue claim relative to the capital claim.

Therefore, the proportion of legal expenses incurred in pursuing interest is deductible. However, the proportion of the legal expenses relating to pursuing the capital amount is not deductible under section 8-1 of the ITAA 1997.