Edited version of private advice

Authorisation Number: 1051792884220

Date of advice: 22 December 2020

Ruling

Subject: Deductibility of settlement payment

Question 1

Is Company A entitled to an allowable deduction pursuant to section 8-1 of the Income Tax Assessment Act 1997 ("ITAA97") for Settlement Payment paid to Company B in the year ended 30 June 20XX?

Answer

Yes

Question 2

If the answer to Question 1 is "no", is Company A entitled to claim a deduction for the Settlement Payment in equal proportions over a period of five years commencing in the year ended 30 June 20XX pursuant to section 40-880 of the ITAA97?

Answer

Not applicable

This ruling applies for the following period:

30 June 20XX

Relevant facts and circumstances

Company A is an Australian proprietary company limited by shares.

Company A is the head entity of a tax consolidated group.

Company A's objectives as the head entity are as follows:

•         to maximise profits from the Business and other activities

•         to develop and enhance the products and services of the Business

•         to engage in such other business or Businesses whether or not of a like kind

•         to buy sell develop and manage real estate

•         to market products and services of the Business to their best advantage and to achieve their maximum value, and

•         to generate the best possible future return to the shareholders.

Company B subscribed to convertible notes ("Notes") in Company A, which were later converted into preference shares.

Company B used its shareholding to vote against various business operation decisions when presented to the shareholders disrupting and restrict Company A's business operations and management.

There were two legal disputes between Company A and Company B. One with regards to the amount of the preference shares allocated to Company B and the other with regards to an interim dividend paid by Company A to its ordinary shareholders.

Company B commenced legal proceedings against Company A in relation to the two legal disputes. In the legal proceedings, Company B alleged that the Director of Company A breached their duties as a Director under the Corporation Act 2001.

Company B had been on an active campaign against the Director of Company A and their fitness to run the business. None of the allegations against the Director were discussed at the Court hearings and no evidence was presented with regards to the alleged breach of the Director's duties.

While the Court made a decision, Company A was concerned that the allegations against the Director were not discussed at the Court hearings and Company B could still raise those in future litigation.

According to section 232 of the Corporations Act 2001, shareholders can make an order in the Court if the company's actions are discriminatory or against their interests. Section 234 and section 247E of the Corporations Act 2001 also allow past members of a company to sue for damages and compensation regarding matters that related to them when they were shareholders of the company

Senior staff of Company A felt the normal strains of running a business with the ongoing disputes.

In order to reach a resolution to the disputes, the parties agreed to settle all claims made by Company B against Company A and the Director. The agreement was set out in a Settlement and Release Deed (Release Deed).

As part of the settlement of the dispute, Company A must pay Company B a Settlement Payment.

The purpose of the Settlement Payment was to put to rest the allegations raised against Company A and the Director and any potential future legal disputes.

Company A presented to the remaining shareholders the following advantages from entering into the Release Deed:

•         Resolution of the various actual and potential claims and disputes between Company A and its Director and Company B

•         Allowing Company A's management to focus on the normal business operations and the possibility of pursuing an exit opportunity for its shareholders, and

Remove ongoing risks and uncertainties in relation to the current and possible future claims and litigation.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Detailed Reasoning

Subsection 8-1(1) of the ITAA 1997 provides that you can deduct from your assessable income any loss or outgoing to the extent that:

(a)  it is incurred in gaining or producing your assessable income; or

(b)  it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

(collectively referred to as "the positive limbs")

However, subsection 8-1(2) of the ITAA 1997 prevents deductions for losses or outgoings to the extent that:

(a)  it is a loss or outgoing of capital, or of a capital nature; or

(b)  it is a loss or outgoing of a private or domestic nature; or

(c)   it is incurred in relation to gaining or producing your exempt income or your non-assessable non-exempt income; or

(d)  a provision of this Act prevents you from deducting it.

(collectively referred to as "the negative limbs")

The Settlement Payment will be deductible under section 8-1 of the ITAA 1997 if either of the positive limbs in subsection 8-1(1) of the ITAA 1997 are satisfied and it does not fall within the negative limbs in subsection 8-1(2) of the ITAA 1997.

Positive limbs

Company A incurred an outgoing by paying the Settlement Payment to Company B according to the terms of the Release Deed. The Settlement Payment was consideration for:

(a)  the termination, release and withdrawal of all claims, allegations and assertions by Company B against Company A and

(b)  the termination and release of all claims, allegations and assertions by Company B regarding the Director's alleged misconduct, breach of statutory or fiduciary duties.

There must be a connection between the Settlement Payment and the business operations of producing assessable income in order to satisfy the requirement that the outgoing is necessarily incurred in carrying on a business (Ronpibon Tin NL v. Federal Commissioner of Taxation (1949) 78 CLR 47 (Ronpibon Tin).

Magna Alloys & Research Pty Ltd v FC of T (1980) 11 ATR 276 ("Magna Alloys") is the leading authority with regards to the second positive limb of section 8-1 of the ITAA 1997. In this case, the taxpayer's company claimed a deduction for legal expenses incurred by the company in defending several of its directors against criminal prosecution for conspiracy. The Federal Court upheld an appeal by the taxpayer, allowing the deduction. It was found that the expense satisfied the positive limb of what was then subsection 51(1) of the Income Tax Assessment Act 1936 (now section 8-1 of the ITAA 1997) as it was necessarily incurred in carrying on the business. It was found it was reasonably appropriate for the interests of the taxpayer company to defend the directors and protect the reputation of the business against charges.Deane and Fisher JJ stated:

"Interests of the taxpayer were inextricably involved with those of its directors and agents, and it is plainly in the taxpayer's own interests that the directors and agents be properly represented. In these circumstances, the incurring of expenditure in providing adequate representation for the directors and agents was reasonably capable of being regarded as desirable and appropriate from the point of view of the pursuit of the business ends of the taxpayer's business".

Deane and Fisher JJ continue:

"In these circumstances, the fact that the directors may have been motivated by consideration of their own position neither negates the conclusion that the outgoings were reasonably capable of being seen as desirable and appropriate from the point of view of the pursuit of the business ends of the taxpayer's business nor prevents the conclusion that they were incurred by the directors on behalf of the taxpayer for the purpose of gaining advantages which they saw as being desirable and appropriate in that sense."

In the current case, company B's actions and allegations substantially impacted Company A's operations and disrupted the day-to-day running of the business. Company B used its shareholding to restrict Company A's business activities and in particular it voted against business propositions to expand the business even though it was in the interest of the shareholders to increase potential profitability of Company A.

Company B also made allegations against Company A Director's fitness for business and alleged breach of Director's duties. Those allegations remained open since no evidence was presented at the Court hearings, which meant that they could still be the subject of future litigation. The advantage sought with the Settlement Payment was to stop all current and future litigation, the cessation of the disruptive actions of Company B against both Company A and the Director. The main purpose of the Settlement Payment appears to put to rest the allegations for the purported breach of the Director's duties in running Company A and their obligations under the Corporations Act 2001.

According to section 232 of the Corporations Act 2001, shareholders can make an order in the Court if the company's actions are discriminatory or against their interests. Section 234 and section 247E of the Corporations Act 2001 further confirm that past members can still sue for damages and compensation against the company regarding matters that related to them during the time they were shareholders of the company.

None of the specific allegations and accusations, which Company B made against the Director were addressed in the Court hearings. There was no evidence ever presented in support of the allegation and accusations. Therefore, without the Release Deed, Company B could pursue future claims for damages or compensations even after they ceased being a shareholder.

Therefore, the Settlement Payment allowed Company A to resume normal business operations.

In Nevill v FCT (1936) 56 CLR 290, the taxpayer paid a significant sum to terminate the contract of one of its managing directors (which was received by the director as capital). The Commissioner argued that the payment was not deductible because it was not incurred exclusively in the production of income. The High Court held the payment to be deductible saying at 300:

"The payments in question were actually made bona fide in the course of business in the interests of the efficiency of the business... The expenditure was made for the purpose of increasing the efficiency of the company and therefore increasing its income producing capacity."

Company B voted against various business proposals made by Company A at shareholders meetings preventing Company A from running normal business operations.

Therefore, the actions taken by Company B impacted the efficiency of the company and its income producing ability.

The purpose of the Settlement Payment was allowing Management to focus on business operations and therefore increase the efficiency of the business, which would result in an increased income producing capacity. Therefore, it is considered that the Settlement Payment incurred by Company A is an outgoing necessarily incurred in carrying on a business for the purpose of producing its assessable income, satisfying the positive limb of section 8-1 of the ITAA 1997.

Negative limb - Whether an outgoing or loss is capital or of a capital nature?

In determining whether the Settlement Payment is capital or revenue in nature, the test formulated by Dixon J. in Sun Newspapers Ltd & Associated Newspapers Ltd v. FC of T (1938) 5 ATD 87; (1938) 61 CLR 337 must be considered. His Honour stated, at 363:

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 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.

Character of the advantage sought

The legal actions by Company B had been disruptive for Company A's business since questioning the Director's abilities would have had negative impact with the normal business operations and how the business would be perceived by other parties. Putting an end to this damaging campaign would benefit not only the Director but the normal operations of the business. Those considerations were presented to the shareholders. In summary, those are:

•         Resolution of the various actual and potential claims and disputes between Company A and its Director and Company B

•         Allowing the Company's management to focus on the normal business operations and the possibility of pursuing an exit opportunity for shareholders, and

•         Remove ongoing risks and uncertainties in relation to the current and possible future claims and litigation.

The decision to pay the Settlement Payment to Company B was a commercial decision of reducing the risk of future litigation and improving the efficiency of the business by allowing Company A to focus and make the most advantageous decisions for the business without the disruptive actions of Company B.

Whilst it is recognised that the expenditure to defend and settle the allegations raised by Company B may be associated with long term benefits to the reputation and goodwill of Company A and the Director, it was noted in Magna Alloys that whilst expenditure on legal expenses may serve to protect the reputation and goodwill of a business, this will not make the expenditure one of capital if the taxpayer is defending the way in which it operated its commercial activities in the course of carrying on its business.

Company A did not seek to obtain an asset, nor did it seek to obtain enduring or lasting qualities or privileges. The payment sought to achieve the settlement of the disputes made by Company B against Company A and its Director and allegations for breach of Director's duties. Therefore, it cannot be said to be capital as it did not add to the profit yielding capacity of Company A.

The other advantage that was sought by making the Settlement Payment was to improve the chances of a better exit strategy in securing a higher price for the shareholders interested in disposing of their shares and/or moving forward with a plan to list the company on Australian Securities Exchange ("ASX").

In the case of Foley Bros Pty Ltd v FC of T (1965) 13 ATD 474 at 563, the taxpayer company entered into a 20-year agreement containing an undertaking not to reduce the scope or extent of its trading activities. It breached this undertaking when financial difficulties forced it to undergo a major rationalisation and reorganisation of its activities. The other party to the agreement commenced legal proceedings. The proceedings were settled on the basis that the taxpayer pay a certain sum in return for the agreement being rescinded, thereby leaving the taxpayer free to carry out its reorganisation. In the end, six of its seven branches and almost all the capital assets were disposed of, the taxpayer had withdrawn from one of its major businesses and its turnover had fallen by 80%.

Deductions for the settlement sum and associated legal expenses were disallowed as capital expenditure. The Full High Court took the view that the freedom acquired to carry out the reorganisation was an enduring advantage and not merely a freedom to make day-to-day decisions in the course of carrying on income-producing activities.

In contrast to Foley Bros, Company A and its Director were not restricted from exiting the business at any time even when involved in the legal proceedings with Company B. While settling the disputes with Company B had an added benefit of improving the chances of an exit strategy, the Settlement Payment also allowed Company A to continue to operate its business without the distraction of a court action over an extended period. Hence, there was an income producing nature to the expenditure and the character of the Settlement Payment was not capital.

The manner the expenditure was used

Company A made the commercial decision to make the Settlement Payment to put an end to the legal disputes with Company B and prevent future litigation. Therefore, improving the business expediency to free the business from any commercial distraction so that existing efficiencies could be maintained. Therefore, the Settlement Payment arose out of the day-to-day activities of Company A's business and had more than a peripheral connection to the taxpayer's income producing activities. As a result, the Settlement Payment was incurred in gaining or producing assessable income for the purpose of section 8-1 of the ITAA 1997.

The Settlement Payments was not of a capital nature because it did not relate to the establishment, replacement or enlargement of Company A's profit yielding structure. The primary purpose for incurring the expense was to stop allegations made against Company A and its Director.

The means of payment - recurrent v. one-off lump sum payment

Finally, we need to consider the manner in which the Settlement Payment was made, and the criteria listed by Dixon J in Sun Newspapers, being recurrent and periodical as opposed to one-off lump sum.

Although the Settlement Payment was a one-off lump sum payment and will not re-occur in the future, this does not mean that it is capital in nature. Dixon J. explained in Sun Newspapers (at 362) that the actual recurrence of expenditure need not take place nor be expected as likely for such expenditure to be in the nature of revenue. It is enough that there be a potential for such an outgoing to be met by the business (Commissioner of Taxation v. Consolidated Fertilizers Ltd (1991) 22 ATR 281 at 293).

In conclusion, the advantages sought by making the Settlement Payment were to put a stop on current legal proceedings, prevent future litigation and disruption to the business operations. The payment was not incurred to develop, replace or protect the profit-yielding structure of Company A and did not bring into existence an asset or an advantage (tangible or intangible) to the enduring benefit of Company A's business. Therefore, the Settlement Payment is not capital or in the nature of capital.

Considering the remaining criteria in subsection 8-1(2) of the ITAA 1997, the Settlement Payment is also not:

•         of a private or domestic nature; or

•         incurred in relation to producing exempt or non-assessable non-exempt income; or

•         subject to another provision in ITAA the 1997 that would prevent the deduction.

Accordingly, the Settlement Payment meets the requirements to be an allowable deduction under subsection 8-1(1) of the ITAA 1997 and is not excluded by subsection 8-1(2) of the ITAA 1997.

Question 2

If the answer to Question 1 is "no", is Company A entitled to claim a deduction for the Settlement Payment in equal proportions over a period of five years commencing in the year ended 30 June 20XX pursuant to section 40-880 of the ITAA97?

Answer

Since the answer to question 1 is 'yes', there is no need to rule on question 2.