Edited version of private advice

Authorisation Number: 1052172853797

Date of advice: 6 October 2023

Ruling

Subject: Deductions - legal expenses

Question

Are you entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 in respect to the legal and settlement expenses?

Answer

No.

This ruling applies for the following periods:

Year ended XX June 20XX

Year ended XX June 20XX

The scheme commenced on:

XX July 20XX

Relevant facts and circumstances

You are a Director and shareholder of Company X and are paid a salary.

You and Company X were sued.

Due to the costs with defending the matter, the dispute was settled outside of court.

You acted as an indemnifier for Company X.

You provided several invoices that relate to the legal and settlement costs of the dispute.

You used non-company funds to pay the invoices.

You and Company X do not have the ability to use indemnity insurance or recover payments from each other.

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.

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. FC of T; (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. FC of T, (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. FC of T, (1956) 95 CLR 344).

Legal expenses are generally deductible if the expenses 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), 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 (1980) 49 FLR 183).

Do the legal and settlement expenses in respect of the patent and trademark dispute satisfy the elements of a deduction?

Expenditure incurred to repel attacks upon a taxpayer's methods of carrying on its business is deductible under section 8-1.

Application to your situation

Legal and settlement fees have been incurred in defending and settling the dispute, and the dispute is connected to the day-to-day operations of Company X. It follows that these expenses would satisfy the elements of a deduction. The question of if you are the proper taxpayer to deduct these expenses is discussed below.

Expenses incurred by an indemnifier on behalf of a company of which the taxpayer was a director

The Full Federal Court in FC of T v. Email Ltd (1999) 42 ATR 698 indicated that the provider of a guarantee/indemnity will be able to claim a deduction where the guarantee/indemnity is given in a context which has a sufficient nexus with the income producing activities of the provider. It was considered that the Court in Morley v. Lawford and Company (1928) 14 TC 229 (Morley) was correct in holding that moneys paid under a guarantee by a firm of contractors to ensure preference in the allotment of contracts for work at an exhibition was deductible because it was wholly and exclusively laid out for the purposes of the taxpayer's trade. In particular, the Full Federal Court stated the following in relation to the Morley case:

No doubt that case was correctly decided and would probably be decided in the same way in Australia under subsection 51(1). The guarantee was so much a part of the taxpayer's trading operations that it was properly to be regarded as a revenue outgoing.

It follows that payments made under guarantees or indemnities by shareholders or directors are generally not deductible under section 8-1 of the ITAA 1997 unless the guarantees or indemnities are a regular and normal incident of the taxpayer's earning activities. This is because directors of a company would not ordinarily be expected to guarantee or act as an indemnifier for a business's debts and therefore the nexus between income earned by the company and the expenses incurred by a taxpayer, as director/shareholder of the company, is too remote. Debts are normally incurred by a business in relation to their operations and, thus, the earning of the business's assessable income. Acting as an indemnifier is seen as more of a one-off action peripheral to the general running of the company and therefore the expense is either personal in nature or an expense which is capital unless you are in the business of providing indemnities/guarantees.

Application to your situation

You, as an indemnifier, incurred expenses in paying legal fees and settlements costs in relation to the proceeding. It is viewed that the purpose of your action was not to directly produce any assessable income for yourself, but to fulfil your contractual commitment as an indemnifier. You are not in the business of providing indemnities to other parties and therefore it is not considered that the provision of indemnifications was undertaken by you as a regular and normal incident of your income earning activities. As a result of this, a deduction for paying Company X's legal expenses and settlement fees as an indemnifier is not allowable under section 8-1 as there is an insufficient connection between acting as an indemnifier and producing your assessable income as a Director.

Expenses incurred by an individual taxpayer on behalf of a company of which the taxpayer was a director

Disregarding the indemnification issue, generally a loss or outgoing is not deductible under section 8-1 unless it is incurred in gaining or producing the assessable income of the person who incurs it (Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153).

The Courts and Tribunals have consistently held that a deduction is not allowable for expenses incurred by an individual taxpayer on behalf of a company of which the taxpayer was a shareholder and/or director. These expenses have not been incurred in gaining or producing assessable income in the taxpayer's capacity as a shareholder/director and consequently there is not a sufficient connection between the expenses and director salary received by an individual taxpayer

For example, in Case U134 87 ATC 780 (Case U134) the taxpayer was a shareholder and director of a family company who paid some of the company's expenses but was not reimbursed by the company for these expenses. The taxpayer did not receive any directors' fees from the company in the relevant income year. The Administrative Appeals Tribunal held that the expenses were not deductible as the taxpayer incurred the expenses in his capacity as a director but did not derive any assessable income in that capacity. The Tribunal said:

There is a long established line of Board of Review decisions in relation to claims to deduct travelling expenses voluntarily incurred by persons who were shareholders in, and directors of, proprietary companies, all of which in my respectful opinion were correctly decided... As was said by Dixon J. (as he then was) in North Australian Pastoral Co. Ltd. v. F.C. of T. (1946) 71 C.L.R. 623 at p. 635: "For the companies paying the dividends are independent entities taxable as such and no deduction would be allowed in the appellant's assessment for expenses incurred by the appellant for the purpose of the earning of profits for those companies."The need remains for a sufficient nexus to exist between the expenditure and the income. Total Holdings was a case in which, given the existence of a not uncomplicated corporate and business structure, with interlocking company loans, the Court was able to discern the existence of the required nexus. It is not in my view an authority that can be made to apply in this case.

The Tribunal thus finds that the expenses were incurred by the applicant in his capacity as a director for the purpose of gaining or producing assessable income for the family company. As he produced no assessable income for himself in that capacity the required nexus is not established and therefore the expenses are not deductible

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 is further recognised by Case U134, where the Tribunal in disallowing the claim for expense held at paragraph 14 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.

A company is considered a separate legal entity and the nexus between income earned by the company and the expenses incurred by a taxpayer, as director/shareholder of the company is too remote. When considering whether a director/shareholder is entitled to a deduction, it is the income earned by the director/shareholder that provides the relevant connection, not that earned by another entity. Expenses paid by taxpayers to enable the company to earn income that may flow to you via wages as an employee of the company, director's fees and future dividends as shareholder will not normally be a sufficient connection.

Application to your situation

We acknowledge that you derived salary and wages from the company, however it is not considered that the dispute expenses arose from carrying out the day-to-day duties of your employment. Rather they relate to the company. A company is a separate legal entity from its employees and directors (Salomon v. A Salomon & Co Ltd (1897) AC 22) and is taxable in its own right.

It is considered that the expenses you paid in relation to the proceedings are not properly referable to the earning of your salary or wage income as a director. That is, there is an insufficient nexus between the expenses and the derivation of your assessable income.

Even though it could be said that the outgoings will ensure profitability which is said to be 'necessary' or 'essential' to the payment of a director's wages and so the expenditure is incurred for the purpose of earning assessable income, these expenses remain too remote or have only a casual connection to the production of your assessable income because these expenses are incurred by you in earning assessable income of the company, rather than assessable income for yourself.