Edited version of private advice

Authorisation Number: 1052271741934

Subject: Legal expenses

Issues

Is the Taxpayer entitled to claim a deduction under section 40-880 of the Income Tax Assessment Act 1997 (ITAA 1997) for legal expenses incurred in taking action against the Entity seeking compensation for the loss of goodwill?.

Answer

Yes: there was no goodwill as asserted by the Taxpayer.

This ruling applies for the following periods:

1 July XXXX to 30 June XXXX

Relevant facts and circumstances

The Taxpayer is a company incorporated in Australia.

The Taxpayer owns and operates a business operated under Agreement A with the Entity.

Between approximately XXXX and XXXX, the Entity developed and implemented a new model to replace the existing Agreement A, being Agreement B.

Approximately X out of X Business Owners across Australia, including the Taxpayer, jointly initiated legal proceedings against the Entity.

The Taxpayer contended certain features under the Agreement B were disadvantageous to its business and caused a reduction in the value of its business.

In accordance with the Statement of Claim File, the Business Owners, including the Taxpayer, sought compensation for the loss of goodwill associated with moving from Agreement A to Agreement B.

The Business Owners, including the Taxpayer, claimed the change from the Agreement A model to the Agreement B model caused economic distress to the Business Owners in the form of loss of goodwill, noting that whilst the business continued, it was operating differently with reduced profit margins.

In essence, the Business Owners asserted that Agreement B involved the appropriation of their goodwill and customer relationships for no or inadequate compensation and provided a worse financial return to the Business Owners than existed under the previous Agreement A model. The Business Owners contended that the change from Agreement A to Agreement B involved a transfer of goodwill from the Business Owners to the Entity.

The Court confirmed that there was no goodwill as asserted by the Business Owners. including the Taxpayer.

The Taxpayer incurred costs in relation to these legal proceedings, amounting to approximately $X million, during the XXXX and XXXX income years. The expenses covered solicitor's fees and various legal activities including filing claims (legal expenses).

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 40-880

Income Tax Assessment Act 1997 Division 110-25

Income Tax Assessment Act 1997 Division 110-35

Reasons for decision

Summary

All of the legal expenses incurred by the Taxpayer with respect to their legal action against the Entity will give rise to a deduction under section 40-880 of the ITAA 1997.

The income tax treatment of legal expenses

Legal expenses

Legal expenses involve expenditure incurred in pursuing or defending legal actions, or meeting legal obligations, whether via self or 'in-house' representation, or external legal representation. Legal expenses include things such as solicitor or counsel fees for legal services, disbursements charged by legal practitioners for out-of-pocket expenses such as photocopying, telephone and travel costs, costs incurred in obtaining expert opinions, court fees, government department fees, legal costs, damages or settlements in respect of legal actions, but not amounts that can be described as fines or penalties.

Meaning of 'incurred'

You must incur the legal expenses for the expenditure to be deductible under section 8-1 of the ITAA 1997.

Taxation Ruling TR 97/7 Income Tax: section 8-1 - meaning of 'incurred' - timing of deductions sets out the Commissioner's view about the meaning of incurred.

In the context of legal expenses, you incur a legal expense when you have a presently existing liability to pay a pecuniary sum equal to that expense, or when payment of the expense is made in the absence of such a presently existing liability.

Nexus with assessable income / business

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

•                incurred voluntarily, and

•                either:

o        no actual or expected assessable income can be identified

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

o        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.

Apportionment

The use of the phrase 'to the extent that' in section 8-1 of the ITAA 1997 contemplates apportionment between the following:

•                legal expenses incurred in gaining or producing your assessable income of a non-capital nature, or necessarily incurred in carrying on your business for the purpose of gaining or producing assessable income that is ordinary income or statutory income of a non-capital nature); and

•                legal expenses that are of a capital, private or domestic nature, or incurred in relation to gaining or producing your exempt income or your NANE income, or for which you are entitled to a specific deduction or disallowed a deduction.

In determining the extent of your entitlement to deduction for your legal expenses under section 8-1 of the ITAA 1997, you can use any apportionment method that is fair and reasonable in your circumstances.

Legal expenses that are capital in nature

Interaction between expenses that form part of the cost base of a CGT asset pursuant to section 110-25 of the ITAA 1997 and whether it is blackhole expenditure for the purposes of section 40-880 of the ITAA 1997

Taxation Ruling TR 2011/6 Income tax: business related capital expenditure - section 40-880 of the Income Tax Assessment Act 1997 core issues sets out the Commissioner's view on the operation of the blackhole expenditure regime.

In broad terms. section 40-880 of the ITAA 1997 allows a deduction over five years for certain business capital expenditure, incurred on or after 1 July 2005, that is not otherwise taken into account or denied deduction by some other provision, and where the business is, was or is proposed to be carried on for a taxable purpose (blackhole expenditure).

Under paragraphs 40-880(2)(a), 40-880(2)(b) and 40-880(2)(c) of the ITAA 1997 the taxpayer can deduct capital expenditure they incur if it is in relation to their business, or in relation to a business that used to be carried on or is proposed to be carried on. Relevantly, where the partnership is a business, each of the partners are also considered to be carrying on a business.

The expression 'capital expenditure' is also not a defined term. As discussed above, whether expenditure is capital in nature is determined on the facts of each particular case having regard to the principles established by case law. Merely because expenditure fails the positive limbs of section 8-1 of the ITAA 1997 does not necessarily mean that it will be capital expenditure.

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.

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

Both subsection 40-880(3) and 40-880(4) of the ITAA 1997 limit the deduction for the expenditure to the extent that the business is, was or will be carried on for a taxable purpose (the 'taxable purpose test').

The taxable purpose test is applied to the business rather than the expenditure. This means the test apportions the expenditure on the basis of the income earning activities of the business rather than on the basis of what the expenditure is for.

Relevantly, 'taxable purpose' is defined in subsection 40-25(7) of the ITAA 1997 to include the *purpose of producing assessable income.

The term 'purpose of producing assessable income' is in turn defined in subsection 995-1(1) of the ITAA 1997 as being something done:

•                for the purpose of gaining or producing assessable income; or

•                in carrying on a *business for the purpose of gaining or producing assessable income.

The taxable purpose of the business is tested as at the time the expenditure is incurred. Where expenditure is incurred for an existing or proposed business, the test takes into account all known and predictable facts about the taxable purpose of the business in future years - not just in the year the expenditure is incurred or the years for which a deduction under section 40-880 of the ITAA 1997 is sought.

Consequently, the taxpayer must consider current and proposed business plans (for example, restructure or expansion) and how those plans affect the taxable purpose of the business in the year in which the expenditure is incurred in light of what is foreseeable and intended.

If, at the time the taxpayer incurs the expenditure, the business in relation to which the expenditure is incurred is carried on wholly for a taxable purpose and there are no proposals or plans for activities from which exempt income or non-assessable non-exempt income could be derived, no apportionment will be required under subsection 40-880(3) or paragraph 40-880(4)(a) of the ITAA 1997.

Conversely, the taxable purpose test for a former business is applied to the period which reasonably reflects the taxable purpose of the former business. Generally, the period of five years before the taxpayer permanently ceased operating the business or permanently ended their association with the business will give a reasonable reflection.

Relevantly, paragraph 40-880(5)(f) of the ITAA 1997 provides that the taxpayer cannot claim a deduction under section 40-880 for an amount of expenditure they incur to the extent that it could be taken into account in working out the amount of a capital gain or capital loss from a CGT event. This means that expenses that form part of the cost base or reduced cost of an asset for the purposes of Division 110 of the ITAA 1997, including expenditure to establish, preserve or defend your title to the asset, or a right over the asset that falls within the ambit of subsection 110-25(6) or 110-55(2), would not be deductible blackhole expenditure.

Goodwill

Noting that subsection 110-25(5A) of the ITAA 1997 specifically excludes expenditure incurred to preserve the value of goodwill, subsection 40-880(6) of the ITAA 1997 provides that the exception in paragraph 40-880(5)(d) does not apply to expenditure incurred by the taxpayer to preserve (but not enhance) the value of goodwill if the expenditure is in relation to a legal or equitable right and the value to the taxpayer of the right is solely attributable to the effect that the right has on goodwill.

In Taxation Ruling TR 1999/16 Income tax: capital gains: goodwill of a business the Commissioner explains the relationship between goodwill of a business and other assets of the business:

27. Goodwill is one CGT asset separate and distinct from other assets of the business such as plant, licences (whether exclusive or non-exclusive licences), statutory permits, quotas, entitlements, valuable contractual rights and items of intellectual property (for example, a trade mark, patent, copyright or registered design).

In Federal Commissioner of Taxation v Murry (1998) 193 CLR 605 the Court explained the concept of goodwill for income tax purposes, relevantly noting that:

[23] From the viewpoint of the proprietors of a business and subsequent purchasers, goodwill is an asset of the business because it is the valuable right or privilege to use the other assets of the business as a business to produce income. It is the right or privilege to make use of all that constitutes "the attractive force which brings in custom." Goodwill is correctly identified as property therefore, because it is the legal right or privilege to conduct a business in substantially the same manner and by substantially the same means that have attracted custom to it. It is a right or privilege that is inseparable from the conduct of the business.

[45] Once goodwill as property is recognised as the legal right or privilege to conduct a business in substantially the same manner and by substantially the same means which in the past have attracted custom to the business, it follows that a person acquires goodwill when he or she acquires that right or privilege. The sources of the goodwill of a business may change and the part that various sources play in maintaining the goodwill may vary during the life of the business. But, as long as the business remains the "same business" the goodwill acquired or created by a taxpayer is the same asset as that which is disposed of when the goodwill of the business is sold or otherwise or transferred.

[48] Goodwill has value because it can be bought and sold as part of a business and its loss or impairment can be compensated for by an action for damages. An existing business is the sine qua non of goodwill which cannot exist independently of the business which created and maintains it. The value of the goodwill of a business is therefore tied to the fortunes of the business. It varies with the earning capacity of the business and the value of the other identifiable assets and liabilities. It is seldom constant for other than short periods.

Taxation Ruling TR 95/3 Income tax and capital gains: application of subsections 160M(6) and 160M(7) to restrictive covenants and trade ties sets outs principles that are relevant to contracts tied to a product or to the supply of services and explains:

75. Entering into an exclusive trade tie, exclusive dealing contract or an exclusive agreement not to compete in trade, including a covenant granting a right to market a particular product, is an act, transaction or event affecting the goodwill of the business, provided the nexus requirement... is met.

The act, transaction or event must affect an existing asset.

Relevantly, in Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts (TR 95/35) the Commissioner explains that:

Goodwill

228. Goodwill is an asset, as defined in section 160A. If a taxpayer conducting a business suffers some damage to his or her business operations, or becomes entitled to receive compensation in respect of that business, some part of the compensation amount may relate to his or her goodwill. In considering the effect on the goodwill it is necessary to consider whether, as a question of fact, the taxpayer has disposed of his or her goodwill, or whether there has been permanent damage to goodwill.

229. Goodwill is generally either purchased or created by the taxpayer. Purchased goodwill is generally considered to be acquired at the time when the taxpayer enters into the purchase contract in respect of the business to which the goodwill is attached. Created goodwill is acquired when the taxpayer commences his or her business activities (Taxation Ruling IT 2328). If a taxpayer disposes of a business, or an interest in a business, and the disposal includes the taxpayer's goodwill, or an interest in the goodwill, any capital gain on disposal is subject to the specific exemption provided by section 160ZZR.

230. Goodwill of a business continually fluctuates in value and a taxpayer is not entitled to reduce the cost of that goodwill in terms of subsection 160ZH(11) for those temporary fluctuations.

231. In certain limited circumstances a taxpayer may be able to demonstrate that he or she has suffered some permanent damage to his or her goodwill, or that it has been permanently reduced in value by some act or event which has generated the right to seek compensation. In these circumstances the taxpayer is entitled to reduce the total acquisition costs of his or her goodwill by so much of the compensation that relates to the permanent damage or permanent reduction in value.

232. It is generally very difficult, however, for the taxpayer to demonstrate that there has been some permanent damage to, or permanent reduction in value of, the goodwill, rather than an actual disposal of that goodwill, or a temporary fluctuation in the value of the goodwill.

The use of the expression 'to the extent that' in subsections 40-880(3), 40-880(4) and 40-880(5) of the ITAA 1997 indicates that an apportionment may be required when applying those subsections. In contrast, subsection 40-880(2) does not contain the expression 'to the extent that'. The Commissioner does not consider the absence of the expression 'to the extent that' in subsection 40-880(2) prevents an apportionment of expenditure on a single thing or service which serves more than one purpose or object. This is equally so whether the thing or service serves distinct and separate purposes or objects, or whether the thing or service serves two or more purposes or objects indifferently. The basis for any such apportionment must be fair and reasonable.

Application to the Taxpayer's circumstances

It is noted that no part of the expenditure was incurred with a view to deriving assessable income (in the form of recoupment of past profits).

The legal expenses were incurred for the purposes of seeking compensation for the impact on the business (including purported loss of goodwill) as a result of the transition from Agreement A to the Agreement B model. In this case, the Court confirmed that the Taxpayer did not suffer any permanent damage to the goodwill of the business as contended by the Business Owners, including the Taxpayer, in their legal action against the Entity.

The Taxpayer has nothing to show for the expenditure they have incurred. While it was incurred on capital account it neither served to increase nor preserve the value of any existing assets nor led to the creation/acquisition of any new capital asset. Accordingly, the expenditure cannot be included in the cost base of any of the Taxpayer's capital assets (including goodwill). While The Taxpayer continues to hold goodwill, which may only be internally generated goodwill, the legal expenses incurred have not served to enhance or preserve this goodwill. Relevantly, whilst incidental costs may be included in the cost base of an asset under subsection 110-25(3) of the ITAA 1997, the legal expenses incurred by the Taxpayer do not fall within any of the nine elements of incidental cost set out in section 110-35.

In conclusion the expenditure incurred is not dealt with under the CGT provisions and was not incurred on revenue account. While the Taxpayer maintains that the expenditure was not incurred in preserving the goodwill of the business it is nevertheless capital expenditure that falls within the ambit of section 40-880 of the ITAA 1997.

(It should be noted that, having regard to TR 95/35 or TR 1999/16, the Commissioner does not necessarily agree with the Taxpayer's characterisation of these amounts as goodwill. However, this characterisation does not impact the resolution of the issue.)

Consequently, all of the legal expenses incurred by the Taxpayer with respect to their legal action against the Entity will give rise to deductions under section 40-880 of the ITAA 1997.