Edited version of private advice

Authorisation Number: 1051607617473

Date of advice: 12 November 2019

Ruling

Subject: Income tax - deductions - legal fees

Question 1

Can you claim legal fees as a deduction?

Answer

No

Question 2

Can the settlement amount reduce your capital gain in the 20XX income year?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You ran a business.

You sold your business to a friend.

There was no written contract in relation to the sale of the business.

The terms were agreed upon verbally.

The business was sold for $XX,000.00.

The terms were agreed that you would work for your friend for a period of X months to assist in the transition period to hand over to existing clients/customers.

You were to be paid a wage this was to train and assist in the transition with existing customers/clients.

You were to negotiate a deal with the lease company for a new leased machine for your friend and then also transfer an existing leased machine to your friend.

Once you had completed contracted unfinished work your friend was to take over the lease payments on this machine (as this machine was still under contract).

This was accepted by the leasing company

The agreement was entered into in XXXX 20XX. Monies were transferred for the sale transaction on X XXX 20XX which was also takeover date.

After 1 week your friend decided that they did not need your assistance.

They notified you that they did not need the second machine which was still under contract to you.

Three of your existing clients decided that they did not want to use the new owner and sought out other businesses in the same industry.

Your friend received legal advice and made a claim that you did not give your friend enough training or introduction to customers/clients.

This ended up in the parties negotiating a deed of settlement and release -

You paid your friend $XX,000 as a settlement.

You incurred $XX,000.00 in legal fees defending yourself.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 subsection 116-50(1)

Reasons for decision

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)

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 assessable income, or necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income, except where the outgoings are of a capital, private or domestic nature.

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 or business operations (Ronpibon Tin NL & Tong Kah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 4 AITR 236; (1949) 8 ATD 431).

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 (Hallstroms)). The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses.

Legal expenses are generally deductible if they arise out of the day to day activities of the taxpayer's business (Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 39 ALR 46; (1932) 2 ATD 169) and the legal action has more than a peripheral connection to the taxpayer's income producing activities (Magna Alloys and Research Pty Ltd v. FC of T 80 ATC 4542; (1980) 11 ATR 276).

The question of whether legal fees are capital in nature has been the subject of much judicial consideration. The classic exposition of the test was by Dixon J in Sun Newspapers Ltd & Associated Newspapers Ltd v. FC of T (1938) 61 CLR 337; (1938) 5 ATD 87; (1938) 1 AITR 403.

In his judgment he referred to three tests:

There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it, that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment.

In Hallstroms, Dixon J said that legal expenses:

take the quality of an outgoing of a capital nature or of an outgoing on account of revenue from the cause or purpose of incurring the expenditure. We are, therefore, remitted to a consideration of the object in view when the legal proceedings were undertaken, or of the situation which impelled the taxpayer to undertake them.

Generally, the treatment of a settlement sum or damages payment will follow the treatment of the other legal costs incurred in relation to a particular matter.

In your case the legal expenses arose out of the sale of your business to a friend.

Your friend purchased the business from you with a verbal agreement in place.

After a period of time your friend took legal action against you claiming that you had not provided enough training to her in relation to the business.

You sought legal advice which cost you $XX,000.00.

The legal expenses were incurred after the sale of the business and therefore are not necessarily incurred in carrying on your business and do not have a connection with the derivation of income.

The legal expenses are not an allowable deduction under section 8-1 of the ITAA 1997 as they are a capital expense.

Settlement amount

Subsection 116-50(1) of the ITAA 1997 provides, however, that the capital proceeds from a CGT event are reduced by any compensation you pay that can reasonably be regarded as a repayment of part of them. This provision provides the following example:

You sell a block of land for $50,000 (the capital proceeds). The purchaser later finds out that you misrepresented a term in the contract.

The purchaser sues you and the court orders you to pay$10,000 in damages to the purchaser.

The capital proceeds are reduced by $10,000.

In your case, your friend sought and received from you a payment of the type that cause a reduction under section 116-50 of the ITAA 1997 in your capital proceeds from the CGT event, being the settlement amount of $XX,000.00.