Edited version of private advice

Authorisation Number: 1051950679747

Date of advice: 25 March 2022

Ruling

Subject: Deduction for legal expenses for enforcing a deed of covenant

Question 1

Can Entity A deduct legal fees to enforce a water agreement under section 8-1 of Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Can Entity A deduct legal fees incurred to enforce a water agreement under the Primary Producer Water Facility depreciation provisions under section 40-515 of the ITAA 1997?

Answer

No.

Question 3

Can Entity A deduct legal fees incurred to enforce a water agreement under section 25-20 of the ITAA 1997?

Answer

No

Question 4

Can A deduct legal fees incurred to enforce a water agreement under section 40-880 of the ITAA 1997?

Answer

No

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Entity A operates a primary production business.

There is a Deed of Covenant entered into for years which has allowed Entity A to access water from a water bore located on Entity B's property for its primary production activity.

Entity B in or about 20XX prevented Entity A from using water from this bore.

Entity A has commenced legal proceedings to enforce the Deed of Covenant, to allow access to the water from the bore for its primary production activity.

The legal proceedings became very protracted and, in the process, Entity A incurred $X of legal expenses which were paid in the year ended 30 June 20XX.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 40-515

Income Tax Assessment Act 1997 subsection 40-525(1)

Income Tax Assessment Act 1997 section 25-20

Income Tax Assessment Act 1997 section 40-880

Reasons for decision

Question 1

Section 8-1 of the ITAA 1997 allows a deduction for all losses or outgoings to the extent to which they are incurred in gaining or producing assessable income. However, where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income they will not be deductible.

A number of significant court decisions have determined that for an expense to be an allowable deduction:

•         it must have the essential character of an outgoing incurred in gaining assessable income or, in other words, of an income-producing expense (Lunney v. Federal Commissioner of Taxation; (1958) 100 CLR 478) (Lunney's case),

•         there must be a nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income (Ronpibon Tin NL v. Federal Commissioner of Taxation, (1949) 78 CLR 47), and

•         it is necessary to determine the connection between the particular outgoing and the operations or activities by which the taxpayer most directly gains or produces his or her assessable income (Charles Moore Co (WA) Pty Ltd v. Federal Commissioner of Taxation, (1956) 95 CLR 344; Federal Commissioner of Taxation v. Hatchett, 71 ATC 4184).

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. 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.

The following guidelines for determining whether a loss or outgoing is of a capital nature have been set down by the High Court in Sun Newspapers Ltd. and Associated Newspapers Ltd. v. Federal Commissioner of Taxation (1938) 5 ATD 23; 5 ATD 87; 61 CLR 337:

•         the expenditure is related to the business structure itself, that is, the establishment, replacement or enlargement of the profit yielding structure rather than the money earning process, or

•         the nature of the advantage has lasting and enduring benefit, or

•         the payment is 'once and for all' for the future use of the asset or advantage rather than being recurrent and ongoing.

That is, 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.

Outgoings incurred in the preservation of an existing capital asset have been held to be capital in nature (John Fairfax & Sons Pty Limited v. Federal Commissioner of Taxation (1959) 101 CLR 30; (1959) 7 AITR 346; (1959) 11 ATD 510).

Entity A incurred legal expenses to enforce the Deed of Covenant that allows Entity A the right to access water from the bore, which is considered as an enduring benefit.

As the legal expenses incurred were for the purpose of securing an enduring benefit, the expenses are capital in nature and are not deductible under section 8-1.

Question 2

Subdivision 40-F of the ITAA 1997 allows immediate deductions for capital expenditure incurred on certain depreciating assets used in primary production. One of these depreciating assets is a 'water facility' (paragraph 40-515(1)(a) of the ITAA 1997). If the expenditure was incurred prior to 12 May 2015, but after 1 July 2004, it would have qualified for deduction spread over three years.

Subsection 40-520(1) of the ITAA 1997 relevantly defines 'water facility' as:

(a)  plant or a structural improvement,...that is primarily and principally for the purpose of conserving or conveying water; or

(b)  a structural improvement,...or an alteration, addition or extension, to a structural improvement, that is reasonably incidental to conserving or conveying water.

The legislation provides examples of a water facility which include a dam, tank, tank stand, bore, well, irrigation, pipe, pump, water tower and windmill. Examples of things reasonably incidental to conserving or conveying water include a culvert, a fence to prevent livestock entering an irrigation channel and a bridge over an irrigation channel.

In order to claim a deduction for the decline in value of a water facility, all of the following conditions in subsection 40-525(1) of the ITAA 1997 must be satisfied:

•         capital expenditure was incurred by the taxpayer on the construction, manufacture, installation or acquisition of the water facility

•         primarily and principally for the purpose of conserving or conveying water for use in a primary production business that the taxpayer conducts on land in Australia.

To be entitled to a deduction under subsection 40-515) of the ITAA 1997, Entity A needs to meet all the conditions under subsection 40-525(1).

In this instance the legal expenditure incurred was not for the construction, manufacture, installation or acquisition of a water facility. It did not relate to primarily and principally conserving or conveying water in a primary production business as it related to restoring access to the water facility, being the bore.

As the requirements under subsection 40-525(1) of the ITAA 1997 are not met, a deduction is not allowed under section 40-515 of the ITAA 1997.

Question 3

Section 25-20 of the ITAA 1997 discusses lease document expenses. Section 25-20 allows a deduction for expenditure incurred in preparing, registering, stamping, assigning or surrendering a lease of property which the taxpayer used or will use for the purpose of producing assessable income.

In this instance legal expenses were incurred to enforce a previously agreed upon Deed of Covenant. Entity A did not incur expenditure for preparing, registering or stamping a lease of property or an assignment or surrender of a lease of property. Entity A deduction is therefore not allowed under section 25-20.

Question 4

Section 40-880 of the ITAA 1997 allows certain business capital expenditure to be written off in equal proportions over five income years provided the requirements of the provision are met. However, subsection 40-880(5) contains exceptions to the types of expenditure to which section 40-880 applies.

In particular, paragraph 40-880(5)(d) of the ITAA 1997 states:

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

...

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

The legal expenses were incurred by A to enforce the right granted under the Deed of Covenant which would allow A to use the bore and access water from the bore for their primary production business. The Commissioner considers that the legal expenses incurred falls under the exception in paragraph 40-880(5)(d), as it is in relation to a legal or equitable right.

Therefore, a deduction is also not allowed under section 40-880 of the ITAA 1997 in relation to the legal expenses incurred by Entity A to enforce the Deed of Covenant.