Edited version of private advice

Authorisation Number: 1051610946587

Date of advice: 26 November 2019

Ruling

Subject: CGT Event C2 triggered when Company A's right to seek compensation expired.

Question 1

Are the legal fees incurred by Company A deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Are the legal fees incurred by Company A deductible under section 25-5 of the ITAA 1997?

Answer

No.

Question 3 (a)

Did Event C2 occur when Company A's right to seek compensation expired?

Answer

Yes.

Question 3 (b)

If the answer to question 3(a) was yes, did a capital loss arise under s 104-25(3) and in which year did it arise?

Answer

A capital loss arose in the financial year ending 30 June 2019.

Question 4

Are the legal fees incurred by Company A deductible under section 40-880 of the ITAA 1997?

Answer

No, as the legal fees are not deductible as they were already applied as a capital loss in response to question 3 (b).

This ruling applies for the following period:

Year ending 30 June 2019.

The scheme commences on:

1 July 2018.

Relevant facts and circumstances

General Facts:

Individual X founded Company B, a company listed on the Australian Securities Exchange (ASX).

Company A held more than half of the issued shares in Company B prior to the put/call option agreement outlined below.

Company A received a portion of the profits of Company B each year in the form of dividends.

At the time, Individual X was beneficially the sole shareholder and director of Company A.

Company A is now owned by a discretionary trust in which Individual X is a named beneficiary.

The Arrangement:

Company B employed a number of portfolio managers who were responsible for attracting and investing funds to be managed by Company B. As a way of incentivising them, Company B proposed to offer share options to the portfolio managers when performance targets were met. To avoid dilution of capital of other investors in Company B, Individual X wanted to explore the arrangement when Company A granted options to the managers out of its shareholding in Company B.

Company B engaged Accountant 1 to advise on the option scheme. One of the key requirements of Individual X for the option scheme was that it should not have adverse CGT consequences for Company A. Accountant 1 stated in their advice that the advice was intended for Company B only and other stakeholders should seek separate advice.

After Company B engaged Accountant 1, Individual X as a Director of Company A engaged Accountant 2 to confirm there would be no adverse tax consequences for Company A from the option scheme proposed by Accountant 1.

Accountant 1's advice was provided which recommended that the arrangement be done by an agreement known as a "Put and Call Option Deed". Accountant 1 noted that "the capital gain of Company B arising from granting a put option to Company A should be [minimal]" and that a CGT Event would arise for Company A in the year that Company B exercised its call option. Accountant 1 went on to say that the market value substitution rules would not apply to the buyback transaction.

Accountant 2 reviewed Accountant 1's advice and also concluded that the Put and Call option would be the best course of action and confirmed that a CGT event will only arise when options are exercised. Accountant 2 had previously advised Individual X that when the options were exercised [minimal] tax would be payable from the CGT Event.

Both Accountant 1 and Accountant 2 overlooked the application of subsection 159GZZZQ(2) of the Income Tax Assessment Act 1936 (ITAA 1936) which applies to off-market buybacks of listed shares. Subsection (2) provides that if the buyback price is less than the market value at the time of the buyback on certain assumptions, CGT is to be assessed on the basis that the consideration for the buyback is that market value.

At the time the advice was given, the market price of Company B shares was significantly higher than the exercise price of the options. This meant that subsection 159GZZZQ(2) of the ITAA 1936 was likely to have a significant impact on Company A's estimated CGT liability.

Company A entered into the 'Put and Call Option Deed' based on the advice that had been provided.

The put/call options were exercised resulting in a CGT Event being triggered in Company A.

Company A's Background Facts:

Accountant 2 lodged Company A's income tax returns disclosing the CGT events that arose from the put/call options being exercised but did not consider the application of subsection 159GZZZQ(2) of the ITAA 1936 on the capital proceeds received.

The ATO audited the income tax returns of Company A and issued amended Notices of Assessment.

Following the ATO audit, the net capital gain reported by Company A for the relevant financial years was adjusted upwards resulting in an additional tax liability.

Company A acknowledged the existence of the liability assessed by the ATO and paid the amount due.

Company A engaged legal advisers who were instructed to examine and pursue legal avenues against its advisers (Accountant 1 and Accountant 2) with a view to receiving compensation. Proceedings were subsequently commenced in the Supreme Court against Accountant 2, with Company A claiming that the advice provided was misleading and deceptive and that it relied on this advice when entering into the 'Put and Call Option Deed'. Company A sought damages for additional CGT payable, Shortfall Interest Charge (SIC), audit costs and other losses. Judgement was delivered in favour of Accountant 2. No appeal was filed by Company A.

Company A incurred legal costs and also paid additional legal costs for the defendant's legal costs as a result of losing the court case.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 subsection 8-1(2)

Income Tax Assessment Act 1997 section 25-5

Income Tax Assessment Act 1997 subsection 25-5(1)

Income Tax Assessment Act 1997 subsection 25-5(2)

Income Tax Assessment Act 1997 subsection 25-5(4)

Income Tax Assessment Act 1997 section 40-880

Income Tax Assessment Act 1997 subsection 40-880(2)

Income Tax Assessment Act 1997 subsection 40-880(3)

Income Tax Assessment Act 1997 subsection 40-880(4)

Income Tax Assessment Act 1997 subsection 40-880(5)

Income Tax Assessment Act 1997 subsection 104-25(1)

Income Tax Assessment Act 1997 subsection 104-25(2)

Income Tax Assessment Act 1997 subsection 104-25(3)

Income Tax Assessment Act 1997 section 110-25

Income Tax Assessment Act 1997 subsection 110-25(1)

Income Tax Assessment Act 1997 subsection 110-25(2)

Income Tax Assessment Act 1997 subsection 110-25(3)

Income Tax Assessment Act 1997 subsection 110-35(2)

Reasons for decision

Summary Question 1

The legal costs incurred by Company A in relation to the court proceedings are not deductible under section 8-1 of the ITAA 1997.

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 assessable income except where the outgoings are of a capital, private or domestic nature.

Where an outgoing is of a capital nature in relation to the acquisition of a CGT asset, it will be accounted for under section 110-25 of the ITAA 1997, which includes subsection 110-25(2) for capital expenditure incurred in respect of acquiring the asset.

In determining whether a deduction 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; 8 ATD 190; 3 AITR 436 per Dixon J). The nature or character of the legal expenses follows the advantage which is sought to be gained by incurring the expenses.

Where legal expenses arise as a consequence of the day to day activities of a business or income earning activity, the object of the expenditure is devoted towards a revenue end and the legal expenses are deductible (Herald & Weekly Times v. Federal Commissioner of Taxation (1932) 48 CLR 113; 2 ATD 169).

However, where the expenditure is devoted towards a personal asset rather than an operational purpose, the expenditure is of a capital nature and the expenses are not deductible (Sun Newspapers Ltd v. FC of T (1938) 61 CLR 337; 5 ATD 87; (1938) 1 AITR 403).

Based on the guidance in Taxation Ruling TR 95/35 "Income Tax: capital gains: treatment of compensation receipts", Company A had a right to seek compensation from the defendants which is an asset for the purposes of the CGT provisions. When the right to seek compensation expires for Company A, a capital gain or loss may arise on the expiration of that right.

Accordingly, any proceeds received from the legal proceedings against the defendants would be treated as capital proceeds in the hands of Company A for the settlement of the company's right to seek compensation. As the legal costs were in relation to the company's right to seek compensation, the fees incurred form part of the asset's cost base as incidental costs under subsection 110-35(2) of the ITAA 1997.

On this basis, the legal costs incurred are disallowed as a deduction under subsection 8-1(2)(a) of the ITAA 1997 as these expenses are an outgoing of a capital nature.

Summary Question 2

The legal costs incurred by Company A in relation to the court proceedings are not deductible under section 25-5 of the ITAA 1997 because they relate to "expenditure for a matter relating to the commission (or possible commission) of an offence against an Australian law" as per subsection 25-5(2)(d) of the ITAA 1997.

Detailed reasoning

Subsection 25-5(1) of the ITAA 1997 allows taxpayers to deduct costs incurred relating to the management of their income tax affairs.

Subsection 25-5(1) of the ITAA 1997 states:

(1)   You can deduct expenditure you incur to the extent that it is for:

(a)   managing your *tax affairs; or

(b)   complying with an obligation imposed on you by a *Commonwealth law, insofar as that obligation relates to the *tax affairs of an entity; or

(c)   the *general interest charge or the *shortfall interest charge; or

ca) a penalty under Subdivision 162-D of the *GST Act; or

cb) levy under the Major Bank Levy Act 2017; or

(d)   obtaining a valuation in accordance with section 30-212 or 31-15.

Company A's legal case was concerned with misleading or deceptive conduct under the Trade Practices Act 1974 (Cth) (section 52) in relation to advice provided by the defendants on the operation of the Income Tax Assessment Acts, which impacted Company A's income tax returns. It can be argued that the legal fees incurred are linked with the management of Company A's tax affairs and therefore fall within the definition of section 25-5(1)(a) of the ITAA 1997.

However, subsection 25-5(2) of the ITAA 1997 disallows deductions for amounts which relate to subsection (1) which are:

(a)   *tax; or

(b)   an amount withheld or payable under Part 2-5 or Part 2-10 in Schedule 1 to the Taxation Administration Act 1953; or

(c)   expenditure for *borrowing money (including payments of interest) to pay an amount covered by paragraph (a) or (b); or

(d)   expenditure for a matter relating to the commission (or possible commission) of an offence against an *Australian law or a *foreign law; or

(e)   a fee or commission for advice about the operation of a *Commonwealth law relating to taxation, unless that advice is provided by a *recognised tax adviser.

Subsection 25-5(4) of the ITAA 1997 states you cannot deduct capital expenditure under subsection 25-5(1). As the legal costs were in relation to the company's right to seek compensation, the fees incurred would form part of the asset's cost base as incidental costs under subsection 110-35(2) of the ITAA 1997.

Further, as the legal fees incurred by Company A were in relation to the possible commission of an offence against an Australian law, being the Trade Practices Act 1974 (Cth), a deduction under section 25-5 of the ITAA 1997 is disallowed because of subsection 25-5(2)(d).

Therefore, the legal costs will be disallowed as a deduction under either subsection 25-5(2)(d) or subsection 25-5(4).

Summary Question 3 (a)

Company A triggered a CGT event C2 in relation to the expiry of its right to seek compensation in the year ended 30 June 2019.

Detailed reasoning

Section 104-25(1) states:

CGT event C2 happens if your ownership of an intangible *CGT asset ends by the asset:

(a)   being redeemed or cancelled; or

(b)   being released, discharged or satisfied; or

(c)   expiring; or

(d)   being abandoned, surrendered or forfeited; or

(e)   if the asset is an option - being exercised; or

(f)     if the asset is a *convertible interest - being converted.

Company A's right to seek compensation against its former tax advisers is an intangible asset that expired when judgement was delivered in favour of Company A's former tax advisers.

Summary Question 3 (b)

A capital loss arose comprising of legal costs incurred.

Detailed reasoning

The cost base of an asset is determined in accordance with subdivision 110-A of the ITAA 1997.

Section 110-25(1) of the ITAA 1997 states:

The cost base of a *CGT asset consists of 5 elements.

The 5 elements of the cost base are described in 110-25(2) to 110-25(6) of the ITAA 1997 as follows:

110-25(2)

The first element is the total of:

(a)   the money you paid, or are required to pay, in respect of *acquiring it; and

(b)   the *market value of any other property you gave, or are required to give, in respect of acquiring it (worked out as at the time of the acquisition)

110-25(3)

The second element is the *incidental costs you incurred. These costs can include giving property: see section 103-5.

110-25(4)

The third element is the costs of owning the *CGT asset you incurred (but only if you *acquired the asset after 20 August 1991). These costs include:

(a)   interest on money you borrowed to acquire the asset; and

(b)   costs of maintaining, repairing or insuring it; and

(c)   rates or land tax, if the asset is land; and

(d)   interest on money you borrowed to refinance the money you borrowed to acquire the asset; and

(e)   interest on money you borrowed to finance the capital expenditure you incurred to increase the asset's value.

110-25(5)

The fourth element is capital expenditure you incurred:

(a)   the purpose or the expected effect of which is to increase or preserve the asset's value; or

(b)   that relates to installing or moving the asset.

110-25(6)

The fifth element is capital expenditure that you incurred to establish, preserve or defend your title to the asset, or a right over the asset.

Example 9 of the Taxation Ruling TR 95/35 should be referred to when determining the cost base of the right to seek compensation.

Example 9 of TR 95/35, paragraphs 286 and 287 states the following:

286. The Newco Superannuation Fund, relying on advice from its legal advisers, B Co, has been lodging taxation returns on the basis that it is a complying fund. Due to certain irregularities in its accounting and taxation records, amended assessments are raised against the super fund which it pays in February 1994. In April 1994, the fund commences legal action against its advisers, seeking to recover the additional tax liability and penalties, being $60,000. In June 1994, the fund receives $60,000 plus an amount to cover the legal costs of the fund from B Co.

287.

In considering the cost base of Company A's right, the legal fees paid by Company A will be included in the second element of the cost base as they relate to the remuneration for the services of the legal advisor. The second element of the cost base is defined in subsection 110-25(3) of the ITAA 1997 as the incidental costs a taxpayer incurs. Incidental costs are described in section 110-35(2) of the ITAA 1997, as:

remuneration for the services of a surveyor, valuer, auctioneer, accountant, broker, *agent, consultant or legal adviser.

The additional tax Company A paid due to amendment of its income tax returns by the Commissioner does not relate to a particular element of the cost base as this amount relates to the amount of tax that has to be paid by the entity. There are legal consequences (being sued for debt, garnishment, bankruptcy or possible imprisonment) for not paying it. Any tax is imposed because the Parliament of a jurisdiction (the Commonwealth or a State or Territory) has enacted a law imposing it, or creating a system for imposing it, as part of that Parliament's sovereignty over that jurisdiction. The additional tax cannot be in Company A's cost base.

A capital loss was incurred by Company A in the relevant year due to legal costs it incurred for the court proceeding.

Summary Question 4

The legal costs are not deductible under section 40-880 of the ITAA 1997 as they have already been taken into account as a capital loss from CGT Event C2 (refer to Question 3). A deduction for amounts used to calculate a capital gain or loss is disallowed under section 40-880(5)(f) of the ITAA 1997.

Detailed reasoning

Section 40-880 of the ITAA 1997 states:

40-880(1)

The object of this section is to make certain *business capital expenditure deductible over 5 years, or immediately in the case of some start-up expenses for small businesses, if:

(a)   the expenditure is not otherwise taken into account; and

(b)   a deduction is not denied by some other provision; and

(c)   the business is, was or is proposed to be carried on for a *taxable purpose.

Company A incurred capital expenditure in the form of legal fees, as part of proceedings concerning whether their advisers had been involved in misleading or deceptive conduct in relation to tax advice provided on a put/call option that allowed Company B to undertake an off-market share buy back from Company A.

Section 40-880(2) of the ITAA 1997 states:

You can deduct, in equal proportions over a period of 5 income years starting in the year in which you incur it, capital expenditure you incur:

(a)   in relation to your *business; or

(b)   in relation to a business that used to be carried on; or

(c)   in relation to a business proposed to be carried on; or

(d)   to liquidate or deregister a company of which you were a *member, to wind up a partnership of which you were a partner or to wind up a trust of which you were a beneficiary, that carried on a business.

Company A carried on a business for the purposes of this test. The expenditure incurred was 'in relation to' that business.

The term 'business' is broadly defined in subsection 995-1(1) of the ITAA 1997 as:

any profession, trade, employment, vocation or calling, but does not include occupation as an employee

Example 21 in Taxation Ruling TR 2011/6 "Income tax: business related capital expenditure - section 40-880 of the Income Tax Assessment Act 1997 core issues" (TR 2011/6) at paragraphs 189 and 190 outlines that a company can carry on a business of being a holding company:

189. Company A incurred capital expenditure to establish a holding company, which holds 100% of the shares in the taxpayer. The shares in the holding company are held by Company A's former shareholders. The holding company carries on the business of being a holding company.

190. Company A is not a shareholder in the holding company therefore it is not in a position to derive assessable income, being an entitlement to a share in the profits (derived either directly or indirectly) from the holding company's business. It is Company A's former shareholders who are in such a position. Therefore, subparagraph 40-880(4)(b)(i) is not satisfied.

Company A was in the business of being a holding company in relation to the shares held in Company B. While carrying on the business of being a holding company, Company A held majority share in Company B before the put/call options were granted.

Company A ceased carrying on a business of being a holding company when it sold its remaining shareholding in Company B to an unrelated third party.

Subsections 40-880(3) and 40-880(4) both contain a 'taxable purpose test' which applies to the expenditure identified in subsection 40-880(2) by reference to the extent to which it relates to carrying on the business for a taxable purpose. Therefore, the expenditure identified in subsection 40-880(2) is deductible only to the extent that it relates to so much of the business (that was) carried on for a taxable purpose.

Subsection 40-880(5) contains a list of circumstances which would disallow a deduction for expenditure incurred. Subsection 40-880(5) of the ITAA 1997 states:

You cannot deduct anything under this section for an amount of expenditure you incur to the extent that:

(a)   it forms part of the *cost of a *depreciating asset that you *hold, used to hold or will hold; or

(b)   you can deduct an amount for it under a provision of this Act other than this section; or

(c)   it forms part of the cost of land; or

(d)   it is in relation to a lease or other legal equitable right; or

(e)   it would, apart from this section, be taken into account in working out:

                                     i.          a profit that is included in your assessable income (for example, under section 6-5 or 15-15); or

                                    ii.          a loss that you can deduct (for example, under section 8-1 or 25-40); or

(f)     it could, apart from this section, be taken into account in working out the amount of a *capital gain or *capital loss from a *CGT event; or

(g)   a provision of this Act other than this section would expressly make the expenditure non-deductible if it were not of a capital nature; or

(h)   a provision of this Act other than this section expressly prevents the expenditure being taken into account as described in paragraphs (a) to (f) for a reason other than the expenditure being of a capital nature; or

(i)     it is expenditure of a private or domestic nature; or

(j)     it is incurred in relation to gaining or producing *exempt income or *non-assessable non-exempt income.

The limitations listed at subsection 40-880(5)(f) disallow an amount of expenditure a taxpayer incurs to the extent that it could, apart from section 40-880, be taken into account in working out the amount of a capital gain or capital loss from a CGT event.

The legal costs incurred by Company A's right to seek compensation form part of the cost base of the asset. The legal fees paid would be disallowed as a deduction under subsection 40-880(5) of the ITAA 1997 as they are taken into account when calculating the capital loss from the CGT event.