Edited version of private advice

Authorisation Number: 1051959432082

Date of advice: 11 March 2022

Ruling

Subject: Deductibility of legal expenses

Question 1

Are the legal expenses you incurred in defending the attempt to terminate the franchise agreement deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

If the answer to question 1 is no, are the legal expenses you incurred in defending the attempt to terminate the franchise agreement deductible under section 40-880 of the ITAA 1997?

Answer

Yes.

Question 3

Are the legal expenses you incurred in relation to your claim relating to loss and damage suffered as a result of the franchisor breaching its representations and warranties deductible under section 8-1 of the ITAA 1997?

Answer

Yes.

Question 4

If the answer to question 3 is no, are the legal expenses you incurred in relation to your claim relating to loss and damage suffered as a result of the franchisor breaching its representations and warranties deductible under section 40-880 of the ITAA 1997?

Answer

Not applicable

This ruling applies for the following periods:

For a number of income years commencing in the year ended 30 June 20XX

The scheme commences on:

In the year ended 30 June 20XX

Relevant facts and circumstances

In the relevant income year, you became a franchisee of the franchisor.

At different times certain representations and warranties were made to you about the pricing and fees that you would pay to the franchisor.

After a number of years, the Franchisor sought to terminate the franchise agreement and you defended this action.

You incurred legal expenses in defending this action.

The franchise arrangement has since been terminated.

You have lodged legal claims in Court relating to loss and damages suffered as a result of the franchisors alleged wrongful conduct in in breaching representations and warranties made to you.

You have incurred legal expenses relating to this claim and this dispute is still ongoing.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 40-880

Reasons for decision

Issue 1

Question 1

Summary

The legal expenses you incurred in defending the attempt to terminate the franchise agreement are capital in nature and therefore not deductible under section 8-1 of the ITAA 1997.

Detailed reasoning

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, except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.

Section 8-1 explicitly states:

(1)   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 purposes of gaining or producing your assessable income.

(2)   However, you cannot deduct a loss or outgoing under this section 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.

(3)   A loss or outgoing that you can deduct under this section is called a general deduction.

ATO ID 2007/136 Income Tax Legal expenses: shareholder resisting further share issue (ATOID 2007/136) provides the following guidance around the deductibility of legal expenses under section 8-1 of the ITAA 1997:

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 may be of a revenue nature and therefore deductible if they arise out of the day to day activities of the taxpayer's business or income producing activity (Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 2 ATD 169). Where however, expenditure is devoted towards a structural rather than an operational purpose, the expenditure is of a capital nature and the expenses are not deductible (Sun Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 87; (1938) 1 AITR 403).

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).

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? (TD 93/29) in discussing the deductibility of legal expenses under section 8-1 of the ITAA 1997 states:

1.    ... in deciding '... whether expenditure has the character of a capital or of a revenue payment... the advantage for which the expenditure was incurred must be identified and the manner in which it "is to be relied upon or enjoyed" must be considered...'. (Magna Alloys & Research Pty. Ltd. v. FC of T 80 ATC 4542 at 4548; 11 ATR 276 at 283).

TD 93/29 goes on to discuss, in the context of legal expenses recovering wages paid by a dishonoured cheque, that if in that context a legal action goes beyond a claim for a revenue item such as wages and constitutes an action for breach of the contract of employment where the essential character of the advantage sought relates to an enduring advantage, that is of a capital nature and the legal costs would not be deductible.

The advantage that you were attempting to gain when you incurred the legal expenses to defend the franchisor's attempt at terminating the franchise agreement was the protection and continuation of the franchise agreement, that is, the protection of a capital asset. Preserving the franchise agreement is considered to provide an enduring advantage and is therefore capital in nature. As discussed in ATO ID 2007/136, Court decisions have confirmed that when considering whether legal expenses have the character of revenue or capital, the character follows the advantage that is sought to be gained by incurring the expenses. Specifically, John Fairfax & Sons Pty Limited v. Federal Commissioner of Taxation (1959) 101 CLR 30; (1959) 7 AITR 346; (1959) 11 ATD 510 provides that outgoings incurred in the preservation of an existing capital asset are capital in nature. Further, as discussed above, TD 93/29 provides that where the essential character of the advantage sought relates to an enduring advantage the legal costs would not be deductible. As such, the legal expenses you incurred in defending the attempt to terminate the franchise agreement are considered to be capital in nature and therefore not deductible under section 8-1 of the ITAA 1997.

Question 2

Summary

The legal expenses you incurred in defending the attempt to terminate the franchise agreement are capital expenses and are deductible under subsection 40-880(2) of the ITAA 1997.

Detailed Reasoning

As concluded in question 1 above, the legal expenses you incurred in defending the franchisor's attempt to terminate the franchise agreement are capital in nature and as such, are not deductible under section 8-1 of the ITAA 1997.

Section 40-880 of the ITAA 1997 provides scope for certain types of business related capital expenditure to be allowed as a deduction if no other provision allows or denies a deduction or otherwise takes the expenditure into account. Section 40-880 states:

Business related costs

Object

(1)  The object of this section is to make certain business capital expenditure deductible over 5 years, or immediately in the case of some start-up expenses for small businesses, if:

(a)  the expenditure is not otherwise taken into account; and

(b)  a deduction is not denied by some other provision; and

(c)   the business is, was or is proposed to be carried on for a taxable purpose.

...

Deduction

(2)  You can deduct, in equal proportions over a period of 5 income years starting in the year in which you incur it, capital expenditure you incur:

(a)  in relation to your *business; or

(b)          in relation to a business that used to be carried on; or

(c)          in relation to business proposed to be carried on; or

(d)          to liquidate or deregister a company of which you were a member, to wind up a partnership of which you were a partner or to wind up a trust of which you were a beneficiary, that carried on a business.

...

Limitations and exceptions

(3)  ...

...

(9)  ...

ATO Interpretative Decision ATO ID 2007/109 Income Tax Capital Allowances: business related costs - in relation to your business (ATO ID 2007/109) and Taxation Ruling TR 2011/6 Income tax: business related capital expenditure - section 40-880 of the Income Tax Assessment Act 1997 core issues (TR 2011/6), provide guidance on determining the deductibility of capital expenses under section 40-880 of the ITAA 1997. In relation to the proximity required by the phrase 'in relation to' as used in section 40-880 TR 2011/6 states:

15. The expression 'in relation to' denotes the proximity required between the expenditure on the one hand and the former, current or proposed business on the other. For capital expenditure to be 'in relation to' a business, there must be a sufficient and relevant connection between the expenditure and the business.

16. The closeness of the association or connection must objectively support the conclusion that the capital expenditure is a business expense of the particular business.

17. Whether capital expenditure is truly business expenditure is determined by the facts. If the facts show that the expenditure satisfies the ends of the relevant business, it will have the character of business expenditure.

We are satisfied that the capital expenditure of the legal expenses incurred in defending the franchisor's attempt at terminating the franchise agreement are incurred in relation to your business. Based on the information provided to the ATO none of the limitations and exceptions set out in subsections 40-880(3) to 40-880(9) apply to disallow the deduction. As such, the legal expenses you incurred in defending the franchisor's attempt to terminate the franchise agreement are deductible under subsection 40-880(2) of the ITAA 1997.

For your information, please note that if there is an undivided amount of capital expenditure incurred by a taxpayer on legal fees where there are several discrete matters the fees are attributable towards, ATO Interpretative Decision ATO ID 2009/83 Income Tax Capital Allowances: business related costs - undivided amount of capital expenditure - several discrete matters - dissection of amount (ATO ID 2009/83), states that the undivided amount of capital expenditure should be dissected as between each discrete legal matter for the purposes of considering deductibility under section 40-880 of the ITAA 1997 because only part of the undivided expenditure is attributable to each distinct and severable matter. Dissecting the amounts ensures that the limitations and exclusions contained in subsection 40-880(3) to subsection 40-880(9) can be applied to each amount separately.

Question 3

Summary

The expenses incurred in relation to your claim relating to loss and damage suffered as a result of the franchisor breaching its representations and warranties are deductible under section 8-1 of the ITAA 1997.

Detailed reasoning

As discussed in question 1 above, section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income, except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.

ATOID 2007/136, also discussed in question 1 above, states that the nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses and specifically states that legal expenses may be of a revenue nature and therefore deductible if they arise out of the day to day activities of the taxpayer's business or income producing activity.

ATO Interpretative Decision ATO ID 2010/131 Income Tax Legal Expenses: payment in lieu of notice under an employment contract (ATO ID 2010/131) confirms that a deduction will be allowed for legal expenses incurred in seeking certain entitlements under an employment contract and provides the following useful guidance:

In determining whether a deduction for legal expenses is allowed 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 revenue nature, then the expenses incurred in gaining the advantage will also be of a revenue nature.

It follows also that the character of legal expenses is not determined by the success or failure of the legal action.

The question of deductibility of legal expenses under section 8-1 of the ITAA 1997 to enforce a contractual entitlement to a lump sum payment in lieu of notice was considered in Romanin v. Commissioner of Taxation [2008] FCA 1532; 2008 ATC 20-055; (2008) 73 ATR 760.

In that case, McKerracher J held, at FCA paragraph 52, in terms of positive limb nexus:

In my view, the requisite connection exists between the outgoing claimed (legal expenses) and the incurrence of assessable income. On this point, I accept Mr Romanin's submission that he pursued proceedings in the Commission to obtain income that was contractually owed to him and that the costs incurred in doing so are deductible under s8-1(1) of the ITAA.

In terms of the negative limbs, McKerracher J held, at FCA paragraph 56, that:

It is true that payment was for a lump sum in lieu of 12 months income (less other income received) but the amount was described in the orders pursuant to the Commission's judgment as remuneration, was computed by reference to his entitlement to income, was set off against other income actually earned and is a financial reward for exertion that would have been carried out had his employment not been (invalidly) terminated. Income is of course received by people and entities in a variety of ways. The payment in a lump sum of the sum which would otherwise be income by way of regular payments, does not of itself, in my view change the character of the payment. [Emphasis added.]

That is, the character of the advantage sought was held to be on revenue rather than capital account.

Therefore, in the circumstances here, the same conclusion follows. That is, the taxpayer's legal expenses in enforcing payment of their contractual entitlement to payment in lieu of notice are outgoings with nexus to assessable income and where the character of the advantage sought is on revenue account. The legal expenses are therefore deductible under section 8-1 of the ITAA 1997

You have provided that the object of the legal expenditure was to take action against the franchisor for breaching its representations and warranties. Through the legal expenditure you have sought to claim damages for loss of revenue and compensation in order to recoup the losses incurred in the previous years caused by the franchisor's actions. We consider that the character of the advantage sought by these legal claims is on revenue account and as such not excluded from being deducible under paragraph 8-1(2)(a) of the ITAA 1997. The relevant nexus with your assessable income required by subsection 8-1(1) of the ITAA 1997 is satisfied and none of the other limitations listed in paragraph 8-1(2)(b) - 8-1(2)(d) apply to deny the deduction and therefore the expenses can be deducted under section 8-1 of the ITAA 1997.

For your information, TD 93/29 discusses how legal fees that are incurred partly for revenue and partly for capital claims can be apportioned and states:

6. There will often be occasions where the 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. For example, many proceedings in relation to wrongful dismissal will also involve the recovery of unpaid salary or wages. In these circumstances '... there must be some fair and reasonable assessment of the extent of the relation of the outlay to assessable income' (Ronpibon Tin N.L. v. FC of T (1949) 78 CLR 47 at 59).

6A. A deduction for legal expenses by an employee depends on the particular facts of any case. To be deductible the occasion of the expenditure must be found in what is productive in the gaining of assessable income by the employee. If expenses are incurred to dispute the receipt of income contractually owed under an employment contract, then the expenses are on revenue account and allowable as a deduction.

7. Where the solicitor's 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 solicitor's 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.

Example:

Andrew B is dismissed by his employer. He consults a solicitor who advises that he is entitled to wages, severance pay and damages for wrongful dismissal. The solicitor sends a letter of demand for payment of $5,000 (wages and severance pay) and institutes legal proceedings in respect of the wrongful dismissal. Upon receipt of the letter of demand, the employer pays the amount of $5,000, but he decides to defend the action for wrongful dismissal. After 15 months of negotiations, Andrew receives a further $5,000 for wrongful dismissal in an out-of-court settlement. He also receives an account from his solicitor for $3,000, which he pays. The account is not itemised.

Andrew includes a deduction of $100 for legal expenses in his return. This amount is acceptable because only one letter was written by the solicitor to recover the wages and severance pay. The balance of $2,900 is not deductible.

If the letter of demand had not resulted in payment, and legal proceedings had been instituted which led to a settlement of $5,000 for wages and severance pay, as well as $5,000 for wrongful dismissal, a deduction of $1,500 would be reasonable, the apportionment being based on the size of the revenue amount relative to the capital amount.

Question 4

Detailed reasoning

As the answer to question 3 above is yes, this question is not applicable and does not need to be considered.