Edited version of private advice

Authorisation Number: 1052182289358

Date of advice: 1 November 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 period:

Year ended 30 June 20XX

The scheme commenced on:

XX July 20XX

Relevant facts and circumstances

You are an Australian tax resident.

You were appointed a Director of Company A.

The Directorship Fee Agreement provided that a Director's fee would be charged as well as other fees relating to carrying out your duties as a Director.

You are a trustee and beneficiary for your Family Trust.

You invoiced through the Family Trust for your Director's Fees which Company A paid.

The Directors of Company A including you appointed receivers and Company A was placed into liquidation by resolution of shareholders.

You became a creditor of Company A during liquidation.

A liquidator was appointed and filed proceedings against you and the other Directors of Company A alleging a breach of director duties.

You filed a statement of defence in the proceedings where you disputed those allegations.

You settled outside of court. You settled because the cost of your defence would exceed the negotiated settlement amount.

A Settlement and Release Agreement was signed.

While Company A was operating, Company B of which you are the Director of was contracted to Company A.

It was agreed with Company B that there should be a clear delineation between your duties as a Director of Company A and your role with Company B such that:

•         If Company A required you to carry out work that would ordinarily fit within Company B's work, then Company B should be contracted by Company A

•         If you were to carry out Director's duties, then this would fall under your Director's agreement with Company A.

You invoiced Company A through your Family Trust where the trust distributed all income directly to yourself. Revenue generated by Company B for work carried out by yourself was also invoiced through your Family Trust.

The trust distributed income by way of a Trust Minute which you as the trustee at the end of each financial year created.

You have provided a copy of the Family Trust deed.

You were never a shareholder of Company A.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Do the legal and settlement expenses in respect of defending the allegation brought by the liquidator satisfy the elements of a deduction?

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)

•         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 and the legal action has more than a peripheral connection to the taxpayer's income producing activities.

Application to your situation

Where the main reason for incurring the legal expenses is defending the actions of the taxpayer in carrying out the employment duties through which they gain or produce assessable income, such expenses are revenue in nature and deductible under section 8-1. However, where the main reason for incurring the legal expenses is defending the actions of the taxpayer in essentially a personal or non-income producing capacity, the expenditure will not usually be deductible.

Your situation can be compared to Duncan v FC of T [2020] AATA 2540, where the taxpayer claimed a deduction for a payment that he made as full and final settlement to a liquidator of all legal action against him in his role as a director of his employer for trading while insolvent. The Commissioner submitted that the taxpayer was not employed by the company and had no ongoing entitlement to receive assessable income from the company when the settlement payment was made. Moreover, the outgoing was incurred in relation to the possible failure by the taxpayer to comply with his former obligations as a director to prevent insolvent trading.

The AAT upheld the objection decision. The advantage the taxpayer sought by incurring the expense was unrelated to the maintenance of his employment (which had ended). Although he continued to be recognised as a director, his director duties were very limited and defined due to the companies being under external administration. The outgoing was incapable of resulting in any future income for the taxpayer from the employer, as an employee or as a director, which was incidental to his employment.

Here, you also agreed to a full and final settlement which relates to alleged conduct during when you were a Director of Company A. It is not considered that these expenses were incurred in gaining or producing your assessable income as the expenses were unrelated to the maintenance of your employment and are capital in nature as the advantage sought was to avoid litigation.

While we believe that this deduction does not satisfy section 8-1, we have still considered the trust issue below.

Trust expenditure met by beneficiary

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).

Taxation Determination 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 if a beneficiary:

•         is presently entitled to income of the trust estate at the time the expense is incurred; and

•         the expense has a nexus with the income to which the beneficiary is presently entitled, then a deduction may be valid.

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. Until a beneficiary of a discretionary trust is made presently entitled to income, that beneficiary has no more than a right to be considered by the trustee in relation to the appointment of trust income. This right to be considered, or mere expectancy, is too contingent or uncertain to be a source of assessable income reasonably expected by the beneficiary.

Application to your situation

Your Family Trust Deed provides that the trustee has the discretion to distribute the net income of the trust to any beneficiary. For the relevant financial years, you as the trustee of the Family Trust exercised that discretion to distribute all the net income to yourself as a beneficiary.

Even if you had a present entitlement to income at the time the expenditure was incurred, there must be a sufficient nexus between the legal expenses and with the income to which you are presently entitled.

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

This is because you derived your assessable income as a beneficiary of the Family Trust however the expenditure is in respect of your duties as a Director of Company A from which the Family Trust was invoicing and contracted to. This expenditure is connected to the Family Trust and at most only has a peripheral connection to you as a beneficiary as you are not required to meet the expenditure to receive distributions from the Family Trust as a beneficiary. This reasoning also applies to Company B as there is no connection between receiving distributions from the Family Trust from profit generated by Company B and legal expenses incurred in settling an allegation you breached your director duties as a Director for Company A.

For example, in Lambert v FC of T [2013] AATA 442 where the taxpayer borrowed money in his capacity as a trustee (as opposed to his capacity as an individual) to purchase the trust's investment properties and consequently, the loan expenses were incurred in that capacity. The court upheld the objection decision to disallow the beneficiary a deduction for reasons including that the taxpayer was regarded as a different entity for tax purposes when acting in his capacity as trustee instead of his personal capacity.

This was also recently affirmed in Chadbourne v FC of T [2020] AATA 2441 where it needed to be determined if a taxpayer was entitled to deductions under section 8-1 for interest expenses incurred by the individual on the funds borrowed and used to acquire real property and shares owned by the discretionary trust. The Commissioner argued that there was no nexus between a beneficiary incurring interest expenses and deriving rental income and capital gains from shares. The shares were bought and sold in the name of the trustee, and while the property was bought by the taxpayer, the property was held by the trustee in accordance with their trust deed. The court agreed with the Commissioner for reasons including that the investments and trading were conducted in the name of the trustee, which acted in its capacity as trustee of the discretionary trust. It was the trustee of the trust that derived income from its investments and trading, not the taxpayer.

Here, you incurred expenses in your capacity as a Director of Company A but the income you received was invoiced through the Family Trust and received in your capacity as a beneficiary. As a result, a deduction for paying the expenses as a beneficiary is not allowable under section 8-1 as there is an insufficient connection between deriving your assessable income in the capacity of a beneficiary or individual and incurring the legal expenses as a director. Further, a deduction is not allowable as the expenses were not incurred in gaining or producing your assessable income and are capital in nature.