Edited version of private advice

Authorisation Number: 1051762731667

Date of advice: 13 October 2020

Ruling

Subject: Legal expenses

Question

Is a deduction allowed under section 8-1 of the Income Tax Assessment Act 1997 for the legal expenses incurred?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ending 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts

Over many years you purchased several businesses and sometimes the properties on which the businesses were operated.

You entered into management agreements in relation to some of the businesses and properties.

Under each management agreement:

·         the other party would pay you a weekly fee for the right to operate the business and to lease the business premises;

·         the other party would be entitled to the profits from the business; and

·         you would open an account with the principal supplier in your name as the other party did not have the necessary security required by the supplier, but the other party would be responsible for paying the account.

The management agreements were unwritten.

Some of the other parties commenced proceedings against you alleging that under the oral contracts, you would purchase the business and premises for the other party to run the business and you would subsequently transfer the business and premises to the other party after the weekly amounts paid to you had totalled a certain sum. They sought specific performance of the alleged terms of the oral contracts.

You incurred legal expenses in disputing their claims.

You also made a cross claim seeking reimbursement of large sums paid by you for the amounts owed on the supplier accounts because of the other parties' failure to pay them.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

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 or are 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. 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). 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.

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).

However, where the expenditure is incurred for the purpose of securing an enduring benefit, rather than a revenue purpose, the expenditure is capital in nature and is not deductible (Sun Newspapers Ltd v. FC of T (1938) 61CLR 337; 5 ATD 87; (1938) 1 AITR 403).

Defending ownership of the businesses and properties

In the present case, the legal proceedings primarily relate to you defending your title and ownership in the various businesses and properties. The legal expenses incurred that relate to defending the possible transfer of the businesses and the underlying land are capital in nature. Although these assets produced rental income for you, the legal expenses do not relate to a dispute about the rental income or your day to day income earning activities.

Legal expenses incurred in preserving an asset or defending ownership rights are not deductible under section 8-1 of the ITAA 1997 as they are considered to provide an enduring advantage and are therefore capital in nature.

Supplier accounts

Although the legal proceedings mainly relate to the ownership of the businesses and properties, part of the proceedings relate to cross claims made that were essentially for reimbursement of the amounts paid by you that were owing on the supplier accounts that should have been paid by the plaintiffs.

The supplier accounts were used by the plaintiffs to purchase their stock and they were responsible for the payment of the accounts. The accounts were in your name as the plaintiffs did not have sufficient security to open the accounts in their own names. This arrangement meant that you essentially became a guarantor for the plaintiffs in relation to the accounts as you were liable for the amounts owed if they were not paid by the plaintiffs.

In Case Q39 83 ATC 171; (1983) 26 CTBR (NS) Case 103 the issue was whether an amount paid by an accountant to honour a guarantee provided by him to a bank for a client's loan was deductible. He claimed that providing such a service to clients promoted his practice. The Board of Review held that liabilities arising from guarantees will not be deductible if the provision of guarantees was not a regular and normal incident of the taxpayer's income earning activities. As the taxpayer had provided guarantees to clients on on only four occasions, the Board concluded that the provision of guarantees was not incidental to the carrying on of his income earning activities.

The Board also considered the expenditure was capital in nature as:

The purpose of furnishing guarantees was to establish a clientele and from such to secure a source of income. Any payment made under the guarantee would be associated with the acquisition of a position from which income is to be yielded rather than with the day to day revenue costs of deriving income.

In Case 38/96 96 ATC 401; AAT Case 10,991 33 ATR 1028 the taxpayer was a landlord who paid an amount to honour a guarantee the taxpayer provided to a bank for a loan taken out by their tenant to further the tenant's business. The taxpayer claimed that provision of the guarantee would result in an increase in rental income received from the tenant. The Administrative Appeals Tribunal (AAT) held that the amount was not deductible as there was an insufficient nexus with the taxpayer's income earning activities. The AAT also concluded that the amount was capital in nature.

As discussed further above, under the arrangement that was entered into in the present case, you in effect became guarantor for the debts of the plaintiffs in relation to the stock ordered by the plaintiffs. You entered into the arrangement to help secure the management agreements under which you would earn income. That is, agreeing to have the accounts in your name was associated 'with the acquisition of a position from which income is to be yielded rather than with the day to day revenue costs of deriving income'.

Therefore, the legal expenses incurred as a consequence of agreeing to have the accounts in your name are considered to be capital in nature.

Summary

The legal expenses in this case relate mainly to defending ownership of the businesses and properties but a portion relate to seeking reimbursement of the amounts paid on the supplier accounts. The legal expenses relating to both purposes are considered to be capital in nature and therefore not deductible under section 8-1 of the ITAA 1997.