Edited version of private advice

Authorisation Number: 1051618665507

Date of advice: 11 December 2019

Ruling

Subject: Legal expenses

Question

Is the expenditure incurred by the taxpayer for legal fees in respect of a claim commenced by the taxpayer as plaintiff in Court an allowable deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

This ruling applies for the following periods

Income years ended 30 June 20XX and 20XX

The scheme commences on

1 July 20XX

Relevant facts and circumstances

The business of the taxpayer involves the development, manufacture and the wholesale distribution of certain products, with more than 50% of its sales income derived from the sale of one particular product.

The taxpayer's product is contract manufactured in a facility located overseas and imported into Australia. It is sold to various distributors for resale to consumers.

Legal fees are being incurred by the taxpayer as a result of litigation commenced against a competitor in Court.

The competitor also sells a similar product to the taxpayer, in many of the same retail outlets as those in which the taxpayer's product is sold. The packaging of the competitor's product is almost identical to that of the taxpayer's product. It is also marketed directly to distributors of the taxpayer's product.

The basis of the complaint is that the packaging of the competitor's product is misleading and deceptive in contravention of the provisions of the Australian Consumer Law and in the common law cause of action known as "passing off" (where a supplier passes off its own goods as being the goods of a competitor).

The assertion is that the competitor's product has been designed in order to mislead and deceive consumers that they are buying the taxpayer's product, and/or that the taxpayer is the manufacturer of the competitor's product.

The taxpayer is also seeking compensation for profits lost as a result of the competitor's product being sold in almost identical packaging, as if it were the taxpayer's product.

It is noted that there are other products available in the marketplace of other brands, which compete with the taxpayer's product. These brands use substantially different and distinct packaging, and cannot be confused with the taxpayer's product.

Relevant legislative provisions

Section 8-1 of the Income Tax Assessment Act 1997

Reasons for decision

Summary

The legal expenses incurred in respect of a claim commenced by the taxpayer as plaintiff are deductible under section 8-1 of the ITAA 1997.

Detailed reasoning

You are entitled to a deduction under section 8-1 for your legal expenses to the extent your legal expenses are incurred in gaining or producing your assessable income, or necessarily incurred in carrying on your business for the purpose of gaining or producing assessable income. However, you cannot claim your legal expenses if they are:

·         of a capital, private or domestic nature;

·         are incurred in relation to gaining or producing your exempt income or your non-assessable non-exempt income; or

·         a provision of the Act prevents you from deducting them.

The following general principles derived from case law are relevant in determining whether legal expenses are deductible under section 8-1:

a)    The legal expenses must have a sufficient connection with the operations or activities by which you gain or produce your assessable income or the carrying on of your business for the purpose of gaining or producing assessable income.

b)    Whether there is the necessary nexus between your legal expenses and your income producing activities or carrying on your business is a question of fact to be determined by reference to the facts and circumstances of each case, including if they arise out of the day to day activities of your business or dealing with a normal incident to which you had been exposed in the day to day conduct of your business, or they have a more than a peripheral connection to your income producing activities.

c)    The essential character of the legal expenses must be of an income nature and not be of a capital, private or domestic nature. These elements are not mutually exclusive. The essential character of legal expenses is a question of fact and degree, to be decided on the facts and circumstances of each case. Legal expenses take their character from the cause or purpose of incurring the expenditure.

Legal expenses are of an income nature when incurred for purposes that:

·         relate to the process by which assessable income that is ordinary income or statutory income of a non-capital nature is derived, such as:

-        producing assessable income;

-        collecting assessable income;

-        managing property or structures held for the production of income; or

-        the manner in which the taxpayer carries out their employment duties or conducts their business; or

·         relate to replacing lost income that is assessable ordinary income or statutory income of a non-capital nature.

Legal expenses are of a capital nature when incurred for purposes that:

·         relate to the profit yielding or income earning structure, such as:

-        acquiring property or rights over an asset that will provide an enduring benefit;

-        establishing, preserving, perfecting or defending title to property or a right over an asset;

-        disposing of property or enduring benefit assets; or

-        the formation of income producing structures.

·         relate to the loss or impairment of the profit yielding or income earning capacity from the profit yielding or income earning structure; or

·         relate to the process by which amounts that are capital in nature, but rendered assessable under specific provisions are derived, such as:

-        producing or collecting such income; or

-        managing property or structures held for the production of income.

The determination must not be based on irrelevant considerations, for example, it is irrelevant whether the legal action or litigation succeeds or fails; or whether amounts (if any) received as a consequence of the legal action, are assessable or otherwise.

Dixon J in Sun Newspapers Limited & Associated Newspapers Limited v FC of T (1938) 5 ATD 87; 61 CLR 337 referred (at ATD 94; CLR 360) to the distinction between income and capital as dependent upon the distinction between the profit yielding subject on the one hand and the process of operating it on the other.

Relevant to the distinction is a difference between an outlay which is recurrent, repeated or continual on the one hand, and an outlay which is final or made 'once and for all' on the other. Expenditure made to bring into existence or procure an asset or advantage of a lasting nature for the benefit of the profit-earning subject would ordinarily be on capital account as distinct from expenditure which falls 'within the very wide class of things which in the aggregate form the constant demand which must be answered out of the returns of a trade or its circulating capital...'.

In Federal Commissioner of Taxation v Duro Travel Goods Pty Ltd (1953) 87 CLR 524, the High Court held that expenditure to protect the taxpayer's interest in a trademark was on revenue account. Taylor J reasoned that the expenses were operating costs incurred in the process of exploiting the taxpayer's rights in its capital asset (i.e.: they arose out of the taxpayer's day to day business activities).

In AAT Case Re Pech and Anor and Federal Commissioner of Taxation (2001) 47 ATR 1215; [2001] AATA 573, a deduction was allowed for legal expenses incurred in defending a right to have used a trademark in the past, with the Tribunal treating the expenses as relating to the way in which the taxpayer conducted its business

The Commissioner considers the principles from the cases mentioned above can be applied in this case.

The taxpayer is undertaking legal action because a competitor's product is allegedly being "passed off" as its own product, by way of almost identical packaging. The packaging itself is not a capital asset of a lasting nature, but is used essentially to contain and identify the trading stock of the business for sale.

The taxpayer is undertaking the legal action in order to stop the competitor using the packaging that looks like its own. It is not trying to stop or restrict the sale of their competitor's products. The taxpayer is not seeking to establish or defend a right over an asset.

The taxpayer's claims also seek compensation for income lost as a result of customers buying the competitor's product whilst possibly thinking it was the taxpayer's product. This lost income would have been ordinary assessable business income to the taxpayer.

It is clear that the legal expenses incurred are connected with the day to day operating of the business activities of the taxpayer, and are therefore deductible under section 8-1 of the ITAA 1997.