Edited version of private advice

Authorisation Number: 1051949482261

Date of advice: 11 February 2022

Ruling

Subject: Legal expenses

Question

Are you entitled to a deduction for a portion of the legal expenses you incurred in relation to the dispute under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ended 30 June 20XX

The scheme commences on:

XX Month 19XX

Relevant facts and circumstances

You were one of a number of defendants to legal proceedings which recently commenced.

The dispute arose in many years ago between you, and other parties related to the repayment of an amount under a Deed.

The Court action was pursued by a Plaintiff.

The Plaintiff claimed that by a Deed dated on a specific date, you and other parties were jointly and severally indebted to the Plaintiff for the following as a result of a loan:

• Principal of specified amount; and
• Interest to of specified amount to a specific date.

The Plaintiff claimed that you and other parties (one of which has since deceased) agreed to pay the balance together with compound interest at X% upon X months' notice.

The Plaintiff claimed that as at a later specified date, a sum (principal and interest of) remained unpaid and no payments had been made since specified date.

The Plaintiff asserted that as at a more recent date, the total amount owing was a specified amount, taking into account the particular sum with compound interest at the rate of X%.

The Plaintiff made a claim for the sum, with interest thereon at a daily rate of, plus costs.

You responded in your defence, that the balance claimed by the Plaintiff was repaid in full by you and the other parties many years ago and that the Plaintiff acknowledged this later that same year.

You contended that you had not received any demand in relation to this loan suggesting that it had not been repaid except for a letter from the Plaintiff's solicitor in recent times.

You denied that you were indebted, and that the action was barred by the Limitations Laws.

The proceedings have been finalised and the judgment of the court ordered:

1. There be judgment for the Plaintiff against the Defendants for a specified sum.
2. The Defendants pay interest on the judgment sums at a specified rate per day until paid.
3. The Defendants pay a percentage of the Plaintiff's costs of the action to be taxed if not agreed.

You have provided a letter from your solicitors which provides a break down of the total judgment amounts.

This letter provided details of your likely share of costs.

You do not have applicable professional indemnity insurance.

You have not received and will not seek any reimbursement.

You have not sought and will not seek to recover your costs from another party.

A statement from your solicitors provides details of the costs you incurred that you incurred.

You have provided details of your proposed claims of legal expenses.

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).

Consequently, it is necessary to consider the reason for which your legal expenses were incurred, that is, the object in view when the legal proceedings were undertaken.

You incurred legal expenses in an attempt to defend both the principal amount of a loan and interest. The principal amount of the loan is considered to be capital. Therefore, it follows that the legal expenses incurred to defend the principal aspect of the loan is capital in nature. However, the interest on the loan is considered to be revenue in nature.

The apportionment of legal expenses is dealt with in Taxation Determination TD 93/29 Income tax: if an employee incurs legal expenses recovering wages paid by a dishonoured cheque, are these legal expenses an allowable deduction under section 8-1 of the Income Tax Assessment Act 1997?. This determination states that where legal expenses are incurred in relation to proceedings that relate both to amounts that are revenue in nature as well as amounts which are capital in nature; there must be some fair and reasonable assessment of the extent of the relation of the outlay to assessable income.

Taxation Determination TD 93/29 states:

Where the solicitors account is itemised, one reasonable basis for apportionment would be the time spent involving the revenue claim, relative to the time spent on the capital claim. If the solicitors account is not itemised, a possible basis for apportionment would be either a reasonable costing of the work undertaken by the solicitor in relation to the revenue claim, or, where this is not possible, an apportionment on the basis of the monetary value of the revenue claim relative to the capital claim.

Therefore, the proportion of legal expenses incurred in defending amounts of principal would not be an allowable deduction but considered a capital expense. However, the proportion of the legal expenses incurred in defending amounts of interest (and defending a revenue claim), are considered an allowable deduction.