Edited version of private advice

Authorisation Number: 1052177179003

Date of advice: 17 October 2023

Ruling

Subject: Legal expenses

Issues

This ruling applies for the following periods:

1 July XXXX to 30 June XXXX

Relevant facts and circumstances

The Trust was established to house the assets of Individual A and Individual B, Appointors and Primary Beneficiaries maintained total control over the assets held within the Trust and continue to do so.

The Trustee was joined to a family law matter involving Individual C and Individual D

Individual D sought X% of the income of the Trust with respect to the family law matter. There was no demand on the fixed capital of the Trust.

Individual D was unaware of the Trust until Family Law Court disclosures.

Individual D was not a beneficiary of the Trust.

Question

Is the Trustee entitled to claim a tax deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for total legal expenses incurred in defending a claim against the Trust pursuant to a family law matter?

Answer

No.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Question

Detailed reasoning

The deductibility of legal expenses

You are entitled to a general deduction under section 8-1 for a loss or outgoing where the loss or outgoing satisfies either one of the two positive limbs under subsection 8-1(1) of the ITAA 1997 and is not prevented from claiming a deduction under any one of the four negative limbs in subsection 8-1(2). That is, there is an entitlement to a deduction for 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 to the extent to which they are losses or outgoings of a capital, private or domestic nature, or are incurred in relation to the gaining or production of exempt or non-assessable non-exempt income, or where another provision specially denies a deduction for the loss or outgoing

Relevantly, to be deductible under section 8-1 of the ITAA 1997, the legal expenses must have a sufficient connection with:

• the operations or activities by which you gain or produce your assessable income, or
• the carrying on of your business for the purpose of gaining or producing assessable income.

Whether there is the necessary nexus between your legal expenses and your income producing activities or carrying on your business is a question of fact to be determined by reference to all relevant facts and circumstances.

There will be such a sufficient connection where the legal expenses are incidental and relevant to the gaining or producing of your assessable income such that there is a requisite nexus between the legal expenses and the activities that you carry out to gain or produce assessable income (see, for example, Ronpibon Tin NL v. Federal Commissioner of Taxation (1949) 78 CLR 47 at 56; (1949) 8 ATD 431 at 435).

There will also be such a sufficient connection where the legal expenses are necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income such that there is the necessary connection between the legal expenses and the carrying on of your business for gaining or producing assessable income (see, for example. Federal Commissioner of Taxation v. Roberts & Smith 92 ATC 4380 at 4386; (1992) 23 ATR 494 at 502).

Essentially, the necessary connection will be established where:

• the occasion of the legal expense is found in your income earning activity or business operation (see for example Ronpibon Tin N.L. and Tongkah Compound N.L. v Federal Commissioner of Taxation (1949) 78 CLR 47) - including where the occasion of the expense arose out of the day to day activities of your business or out of dealing with a normal incident to which you had been exposed in the day to day conduct of your business (see for example Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 2 ATD 169); and
• the connection between the legal expense and whatever is productive of your assessable income or, if none is produced, would be expected to produce assessable income is not too remote (see for example, Magna Alloys and Research Pty Ltd v FC of T (1980) 11 ATR 276; 80 ATC 4542).

Where an examination of the objective facts and circumstances does not disclose an obvious significant connection between your legal expenses and your income earning activities or relevant business, it may be necessary and relevant to have regard to your subjective purpose, motive or intention (see, for example, Magna Alloys and Research Pty Ltd v. FC of T (1980) 11 ATR 276; 80 ATC 4542 and Taxation Ruling TR 95/33Income tax: subsection 51(1) - relevance of subjective purpose, motive or intention in determining the deductibility of losses and outgoings). This may be particularly so where the legal expenses are:

• are incurred voluntarily, and
• either:

•         no actual or expected assessable income can be identified,

•         your actual or expected assessable income is less than your legal expenses, or

•         the connection between your legal expenses and the derivation of your assessable income or the carrying on of your business is not obvious.

The essential character of an expense is a decisive factor in determining the deductibility of a loss or outgoing for the purposes of section 8-1 of the ITAA 1997. A deduction will only be potentially available under section 8-1 to the extent the essential character of your legal expenses is of an income nature and not of a capital, private or domestic nature.

A legal expense can have more than one characterisation depending on the facts and circumstances. In these cases, issues of apportionment may arise.

Legal expenses take their character from the cause or purpose of incurring the expenditure. This in turn is also a question of fact, to be determined by reference to all relevant (and not irrelevant) facts and circumstances.

Sun Newspapers Ltd v Federal Commissioner of Taxation (1939) 61 CLR 337 (Sun Newspapers) set out, and entrenched, the matters that are relevant in distinguishing between capital and revenue expenditure. These include:

• distinguishing between the profit- yielding subject and the process of operating it;
• the nature of the asset or advantage obtained by the outlay; and
• the difference between an outlay which is recurrent, repeated or continual and that which is final or made 'once and for all'.

In the context of legal expenses:

• distinguishing between the profit- yielding subject and the process of operating it -requires examining the purpose for which the expenses were incurred to determine whether they relate to the income earning process or income earning structure (with the former more likely to be income in nature and the latter to be capital in nature); and
• the nature of the asset or advantage obtained by the outlay - a legal expense that gives rise to an enduring benefit is more likely to be capital in nature; and the difference between an outlay which is recurrent, repeated or continual and that which is final or made 'once and for all' - notwithstanding that a recurrent expense is more likely to be of an income nature and a one-off expense is more likely to be capital in nature, it is considered that this factor has little or no influence in determining the character of legal expenses, because the previous factors will not be negated by the manner of payment of a legal expense: that is, the method of payment will not overcome whether the legal expense relates to the profit-yielding structure or income process, or gives rise to an enduring benefit.

No one matter is necessarily a determining factor.

As with considering the relevant connection to your income activities or relevant business, it may also be necessary to consider your subjective purpose when determining the character of your legal expenses.

Taking the Sun Newspapers factors into account, legal expenses tend to take their character from the cause or purpose for which they were incurred (see, for example, Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634). The main considerations in determining whether a legal expense is on revenue or capital account are:

• whether the legal expenses relate to the profit yielding subject (which is indicative of a capital nature) or the process or operations of the profit-yielding structure (which is indicative of an income nature); and
• whether the nature of the advantage sought to be gained is that of an enduring benefit (which is indicative of a capital nature).

On the other hand, factors that are not relevant in determining the deductibility of legal expenses include:

• whether the legal action or litigation succeeds or fails, and
• whether amounts (if any) received as a consequence of the legal action, are assessable or otherwise.

Relevantly, legal expenses incurred defending Family Court proceedings are seen as expenses that relate to a private or domestic matter (see, for example ATO ID 2002/98 (Withdrawn) Income Tax Legal expenses incurred for Family Court matters - withdrawn as it is seen a straightforward applicant of the law).

Application in these circumstances

The Taxpayer was exposed to Family Court proceedings as a result of the relationship break-down between Individual C and Individual D.

In broad terms, it relates to Individual C's claim to 50% of the income of Trust with respect to the division of property between the de facto husband and wife.

Any legal expenses incurred by the Trustee to defend against Individual C's claim do not have a connection with the operations or activities by which the Trustee gains or produce assessable income, or with the carrying on of any business by the Trustee for the purpose gaining or producing assessable income.

It cannot be said that the occasion of the legal expense is found in the Trustee's income earning activity or business operation: that the occasion of the expense arose out of the day to day activities of the Trustee's business or out of dealing with a normal incident to which the Trustee has been exposed in the day to day conduct of the Trustee's business - noting that Individual C had no role with the respect to the Trust.

The legal expenses were incurred to defend the Trust's funds. Consequently, the legal expenses are of a capital nature as they were incurred for the purpose of purpose of protecting the profit yielding structure or preserving rights over the assets that will provide a lasting benefit.

Furthermore, the legal proceedings arose as a result of the breakdown of the relationship of the de facto husband and wife (i.e. Individual C and Individual D) and there is no connection between the legal action and the income producing activities of the Trustee.

The legal expenses relate to the private and domestic affairs of the spouses in the dissolution of their relationship and arises from the legal relationship between the spouses. This is similar to the circumstanced in In ATO ID 2002/98 where the taxpayer, a partner, was engaged in Family Court proceedings and incurred legal expenses defending claims in respect of assets owned by the partnership. Consequently, the legal expenses are of a private or domestic nature.

Therefore, the legal expenses are not deductible as they fail to satisfy both the first and the second limb of subsection 8-1(1) of the ITAA 1997, in that there is no connection between the expenses and the income earning activities or the business of the Trustee. Moreover, the expenses are also capital and/or domestic or private in nature such that subsection 8-1(2) is satisfied and the expenses cannot be deducted.