Edited version of private advice

Authorisation Number: 1052091114551

Date of advice: 14 March 2023

Ruling

Subject: Deductions - settlement amount

Question

Are you entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) in respect to the amount of the settlement sum?

Answer

No.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

You were the sole director of Company A.

You were a direct shareholder of the Company A.

Prior to the restructure, you received fully franked dividends and reportable employer superannuation contributions from Company A.

In October 20XX, you transferred Company A shares held by you to Trust X.

Trust X is a discretionary trust, the trustee is Company B.

You then received distributions from Trust X, which received fully franked dividends from Company A.

In September 20YY, Joint and Several Administrators of the Company were appointed and subsequently as Joint and Several Liquidators in following month.

The Liquidators issued letters of demand to you state that Company B and you had engaged in insolvent trading and an uncommercial transaction.

The letter states that investigations into Company A's affairs have confirmed that Company A encountered financial difficulties from 1 July 20ZZ (the Insolvency Date) and possibly earlier.

The proceedings were commenced by the Liquidators against Company B and you to recover the money due to Company A with respect to the insolvent trading claim and the uncommercial transaction claim.

Company B and you disputed the insolvent trading claim and the uncommercial transaction claim (dispute).

Company B and you entered a Deed of Settlement and Release with the Liquidators and Company C to settle the dispute (Deed).

You agreed to pay the settlement amount.

You did not supply a detailed breakup of the settlement amount; you state that the settlement amount was negotiated between the parties of the Deed.

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 your assessable income or are necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income, except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.

Taxation Ruling TR 95/33 Income tax: subsection 51(1) - relevance of subjective purpose, motive or intention in determining the deductibility of losses and outgoings considers factors relevant in determining the deductibility of losses and outgoings.

TR 95/33 states that if an outgoing produces an amount of assessable income greater than the amount of the outgoing, there would normally be no need to examine the taxpayer's motives and intentions when determining the deductibility of the expenditure. If the outgoing produces no assessable income, or the amount of assessable income is less than the amount of the outgoing, it may be necessary to examine all the circumstances surrounding the expenditure to determine whether the outgoing is deductible.

Taxation Determination TD 2018/9 Income tax: deductibility of interest expenses incurred by a beneficiary of a discretionary trust on borrowings on-lent interest-free to the trustee provides that a beneficiary of a discretionary trust who borrows money, and on-lends all or part of that money to the trustee of the discretionary trust interest-free, is usually not entitled to a deduction for any interest expenditure incurred by the beneficiary in relation to the

borrowed money on-lent to the trustee under section 8-1 of the ITAA 1997.

The principles described above would also apply to other expenses incurred by a beneficiary of a discretionary trust to the extent that the beneficiary asserts the expense is deductible by reason of its connection to an expected receipt of a trust distribution.

In Magna Alloys and Research Pty Ltd v. FC of T 80 ATC 4542; 11 ATR 276 (Magna Alloys), the issue was related to whether the taxpayer company could claim a deduction for legal expenses incurred by the defence of criminal charges brought against its director for inappropriate business practices. The Full Federal Court held a deduction was available for the expenses as they were not only incurred in the interests of the director but were also 'desirable and appropriate'' from the point of view of the taxpayer's business.

Company expenses met by director or shareholder

Paragraph 217 of Taxation Ruling TR 1999/10 Income tax and fringe benefits tax: Members of Parliament - allowances, reimbursements, donations and gifts, benefits, deductions and recoupmentsrefers to Case N9 81 ATC 56; 24 CTBR (NS) Case 81 where the Board of Review disallowed a claim for legal expenses by a director of a number of companies. He was defending himself on charges under the Companies Act that would affect his future appointment as a director. The deduction was disallowed as it was of a private and capital nature. The action did not occur as a matter of course in the gaining or producing of his assessable income.

Another court case, referred to in paragraph 218 of TR 1999/10, was Case W101 89 ATC 821; AAT Case 5,009 (1989) 20 ATR 3421 where an employee, at the request of the company, got a corporate credit card. This credit card was used to pay for overseas air travel for three other executives. The company did not reimburse the employee and the credit card company sued the employee, so he paid the debt. The legal expenses and the debt were held not to be deductible as they were not incurred in earning his assessable income.

The fundamental requirement that there must be a sufficient nexus between a particular expense and the assessable income such that the expense is incidental and relevant to the gaining of assessable income was also recognised in Case U134 87 ATC 780; (1987) 18 ATR 3646. That case involved a taxpayer who was a director of and a shareholder in a family company. The taxpayer did not receive any payments from the company for his services as a director of the company. However, the taxpayer did receive a dividend from the company. In disallowing the claim for the expense, the Tribunal at paragraph 14 held that:

... the outgoings were incurred in his capacity as a director and are consequently not sufficiently related to the carrying on the business of being a shareholder. Additionally, as no allowance was paid to him in his capacity as a director, it cannot be said that the expenses were incurred in gaining or producing assessable income in that capacity.

The courts have consistently held that a deduction is not allowable by a director where they pay company expenses, as the expenses are not incurred in gaining or producing their assessable income in their capacity as a director. Such expenses are incurred by the taxpayer in earning assessable income of the company, rather than assessable income of the taxpayer (Federal Commissioner of Taxation v. Munro [1926] HCA 28; (1926) 38 CLR 153) (Munro).

In circumstances where the company is having financial difficulty, deductions for costs incurred by a director personally to assist the company to reach a profitable position have also been disallowed. In Case 26/94 94 ATC 258; (1994) 28 ATR 1133, the taxpayer, who was a shareholder and director of a family company, borrowed money which he on-lent to the family company as the family company was unable to borrow in its own capacity. The taxpayer did this to ensure the company's profitability so as to derive dividends from the company in the future. The Tribunal held that the taxpayer was unable to deduct interest and other costs associated with the loan as the connection between the costs incurred and future income was too remote.

Application to your circumstances

You received franked dividends and reportable employer superannuation contributions from Company A prior to the restructure

After the restructure, you received distributions from Trust X, which received fully franked dividends from Company A.

In September 20YY, Joint and Several Administrators of the Company were appointed and subsequently as Joint and Several Liquidators in following month.

The proceedings were commenced by the Liquidators against Company B and you to recover the money due to Company A with respect to the insolvent trading claim and the uncommercial transaction claim.

Company B and you disputed the insolvent trading claim and the uncommercial transaction claim (dispute). Company B and you entered a Deed of Settlement and Release (Deed).

You agreed to pay the settlement amount. You did not supply a detailed breakup of the settlement amount; you state that the settlement amount was negotiated between the parties of the Deed.

The suspect actions happened in the income year which was after you had transferred your shares to Trust X. At that time, you were not receiving director's fees and you were not receiving dividends directly from the Company.

It is not accepted that the outgoings are linked to the trust distribution you received for the reasons expressed in TD 2018/9 and you have not identified any other relevant assessable income.

The settlement amount and the costs of the proceeding were not incurred in gaining or producing your assessable income or were not necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

Your circumstances failed to establish a sufficient nexus and the occasion of the outgoing was found outside your business operations. The advantage you sought was non-commercial in nature and considered not incurred to gain or produce your assessable income or necessarily incurred in a business for the purpose of producing your assessable income.

You are not entitled to a deduction under section 8-1 of the ITAA 1997 in respect to the amount of the settlement sum.