Edited version of private advice

Authorisation Number: 1052280924976

Date of advice: 5 September 2024

Ruling

Subject: Deductions - legal expenses

Question 1

Are all the legal fees paid for advice on the ownership and continued carriage of the business of a professional practice deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Are 70% of the legal fees paid for advice on the ownership and continued carriage of the business of a professional practice deductible under section 8-1 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 2023

The scheme commenced on:

1 July 2022

Relevant facts and circumstances

Trust A and Trust B were unitholders in Trust C

A proprietary limited company formed by the trustees for Trust A and Trust B is the trustee for Trust C.

Trust C commenced a professional practice some years ago.

The trustees for Trust A and Trust B worked for the professional practice.

On 11 May 2023 the trustee of Trust B advised the trustee of Trust A that they wished to discontinue their role in their shared practice.

The trustee of Trust A sought legal advice on how to continue practicing under the existing practice name and retain the clientele. The trustee of Trust A also sought legal advice at this time on how obligations shared with the other party to the working arrangements, such as expenses and tax liabilities, could be managed.

The outcome of the legal consultation were 2 legal documents, a Separation Deed and an Asset Acquisition Agreement.

The trustee of Trust A, as trustee for Trust A, received 2 invoices for the legal work done in preparing these 2 documents.

Topics covered by the Separation Deed include:

•         Interim conduct of the Practice

•         Trust income and liabilities

•         Transfer Securities

•         Transfer Assets

•         Business Premises

•         Contracts

•         Orderly separation and Transfer of work in progress

•         Trust Account

•         Administrative matters.

The interim conduct of the practice is provided for in Clause a) of the deed.

Clause b) of this deed relates to salary, superannuation, and other remuneration payable prior to completion of the settlement agreement,

Clause c) of the deed recognises outstanding sums owed to the 2 unitholders in the trust for the previous financial year and makes arrangement for the distribution of monies due for the relevant financial year.

Clause c) of this deed also deals with the responsibility for outstanding taxation and insurance liabilities of the practice.

Under clause d) of the deed the trustee of Trust B must sell her shares in the proprietary limited company that acts as the trustee for Trust C to the trustee for Trust A, and Trust B must sell its units in Trust C to Trust A.

Clause e) of the deed passes rights, title, and interest in and to the transfer Assets to the trustee for Trust B. Transfer assets are described in the definitions section of the separation deed as those assets that are not retained assets.

Retained assets as described in the definitions section of the separation deed include:

•         All rights, title, and interest in and to all work in progress on completion of the separation

•         The business records

•         Furniture and chattels associated with offices at the practice address

•         All cash at bank or on hand held by the proprietary limited company acting as trustee for Trust C

•         All insurance policies held by the proprietary limited company acting as trustee for Trust C

•         All trade debts and receivables owing to the proprietary limited company acting as trustee for Trust C

•         All rights, title, and interest in and to the telephone numbers, the website and its content, the domain name, and the business name of the practice

•         The services contract

•         Software licences.

Under clause f) of the deed the practice assigns all of its rights and obligations under each contract to the trustee of Trust B.

Under clause g) the trustee for Trust B and Trust B undertake to not;

•         solicit or induce any retained client from the practice.

•         assume the conduct of any retained client contract or accept instructions from any retained client on the subject matter of the contract

•         use the name of the practice.

Under clause h) of the deed the trustee of Trust B undertakes to continue administering and maintaining the account belonging to Trust C, and to ensure all client monies held in that account are disbursed or returned to clients in accordance with the practice rules as at the date of completion of the separation.

Clause i) of the deed is concerned with the ongoing operation and ultimate handover to the trustee of Trust A and Trust A the bank accounts of Trust C and the practice website and post office boxes.

Clause j) of the deed outlines the parties obligations on completion of the separation, and clause k) the parties warranties as at that date.

Clause l) outlines the parties obligations with respect to the continued liability for GST on payments made in connection with the deed, and other GST related matters.

The File Acquisition Agreement is entirely concerned with the sale to another practice of;

•         the client contracts

•         the proprietary limited company's right, title, and interest in and to its practice contracts

•         and the records relating to the open cases of transferring clients.

The partner at the Law firm who prepared the Separation Deed and Asset Acquisition Agreement has estimated, based on their records, that 70% of the fee charged for the preparation of these documents relates to clauses b), c), f), h), i), and l) of the Separation Deed.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Question 1

Are all the legal fees paid for advice on the ownership and continued carriage of the business of a professional practice deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Question 2

Are 70% of the legal fees paid for advice on the ownership and continued carriage of the business of a professional practice deductible under section 8-1 of the ITAA 1997?

Summary

Only those portions of the legal fees that relate to advice on the ongoing carriage of the business will be deductible under section 8-1 of the ITAA 1997. 70% of the costs incurred in obtaining that advice will be deductible as 70% of the legal expense relates to the ongoing day to day running of the business.

Detailed reasoning

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income, except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.

Expenses incurred in gaining or producing revenue in the form of assessable income are incurred in the process of producing that income. Expenses of a capital nature are characterised as those that establish or extend the means of producing that income. The distinction between expenses incurred in the process of producing assessable income and those that are incurred in acquiring or extending the means of producing that income has been discussed at some length throughout case law. In Sun Newspapers Ltd v Federal Commissioner of Taxation [1939] 61 CLR 337 Dixon J observed that the:

...distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure, or organisation set up or established for the earning of profit and the process by which such an organisation operates to obtain regular returns by means of regular outlay, the difference between the outlay and returns representing profit or loss.

In determining whether expenses are of a revenue or capital nature in this case Dixon J considered;

•         the character of the advantage sought,

•         the manner in which it is to be used, and

•         the means adopted to obtain it.

Advantages that are capital include the acquisition of assets, the rights to use those assets, and the goodwill that is attached to these for use as a means for the ongoing production of income. Capital assets are typically obtained through single or non-recurrent transactions.

Legal expenses are generally considered to be revenue in nature and deductible if they are related to the process of producing assessable income, and arise out of the day-to-day operation or activities of a business. For legal expenses to constitute an allowable deduction it must be shown that they were incidental or relevant to the production of assessable income in the course of these activities.

As expenses are only deductible under section 8-1 of the ITAA 1997 to the extent to which they are incurred in gaining or producing assessable income apportionment of an expense may be necessary where it relates to both the process of producing assessable income and the means of its production. As noted in Ronpibon Tin N.L. v. FC of T [1949] 78 CLR 47 at 59:

'....there must be some fair and reasonable assessment of the extent of the relation of the outlay to assessable income.'

If legal expenses relate to work done for both deductible and non-deductible purposes then the onus is on the taxpayer to explain how the costs have been apportioned and provide evidence supporting calculation of the deductible amount. As noted in Buckley & Young Ltd v Commissioner of Inland Revenue [1978] 2 NZLR 485:

...the onus of proof must be applied in a broad and commonsense way. So that in such an apportionment case as the present the taxpayer must be able to point to some intelligible basis upon which a positive finding can be made that a defined part of the total sum is deductible.

The Commissioner's view on the apportioning of legal expenses is discussed in paragraph 7 of Taxation Determination TD 93/29 Income tax: if an employee incurs legal expenses recovering wages paid by a dishonoured cheque, are these legal expenses an allowable deduction under section 8-1 of the Income Tax Assessment Act 1997?

7. Where the solicitors account is itemised, one reasonable basis for apportionment would be the time spent involving the revenue claim, relative to the time spent on the capital claim. If the solicitors account is not itemised, a possible basis for apportionment would be either a reasonable costing of the work undertaken by the solicitor in relation to the revenue claim, or, where this is not possible, an apportionment on the basis of the monetary value of the revenue claim relative to the capital claim.

Trust A has incurred legal costs for advice on the preparation of two documents relating to its interest in and the ongoing operation of the proprietary limited company that acts as the trustee for Trust C and the professional practice run by that trust. These documents are titled Separation Deed and Asset Acquisition Agreement.

In determining whether these expenses are of a revenue or capital nature the character of the advantage sought, the manner in which it is to be used, and the means adopted to obtain it must be established.

The advantage gained by Trust A from clauses d), e), and g) of the Separation Deed includes the full ownership and control of proprietary limited company formed by the trustees for Trust A and Trust B is the trustee for Trust C and the practice run by Trust C. The rights and assets gained through the extension of your ownership and control of these entities are outlined in the Separation Deed.

As these assets and rights are to be used as a means for Trust A to produce income through Trust C on an ongoing basis the legal costs for drafting clauses d), e), and g) in this agreement will be capital in nature. This being the case they are not deductible under clause 8-1 of the ITAA 1997.

Clauses b), c), f), h), i), and l) relate to the ongoing day to day running of the practice until the undertakings in the separation deed are completed. These clauses are about remuneration, superannuation, taxation, operation of trust and practice accounts, operation of the practice website and post office box, and GST related matters.

Costs relating to the drafting of these clauses are deductible under section 8-1 of the ITAA 1997 as a portion of the total cost of producing these documents.

The Asset Acquisition Agreement is entirely about the sale of an asset in the form of open practice contracts and as such is capital in nature. The legal costs related to the drafting of this document are capital and non-deductible under section 8-1 of the ITAA 1997.

The legal advice sought on the ownership and ongoing carriage of Trust C is on matters that are related to both the day to day running and the capital assets of the practice. This being the case the expenses incurred for that advice will not all be deductible under section 8-1 of the ITAA 1997.

Costs relating to the drafting of clauses b), c), f), h), i), and l) of the Separation Deed are deductible under section 8-1 of the ITAA 1997. As the costs relating to the drafting of these clauses have not been itemised on the invoices received other means of apportioning the cost of drafting these clauses will be needed. As outlined in paragraph 7 of TD 93/29 a reasonable costing of the work undertaken by the solicitor in relation to these clauses is appropriate in these circumstances.

The partner of the legal firm who prepared these documents for you has estimated that 70% of the work undertaken in providing advice and preparing the Separation Deed and File Acquisition documents for you was attributable to clauses b), c), f), h), i), and l) of the Separation Deed. As the costs relating to the drafting of these clauses are deductible 70% of the total cost of advice on drafting and preparation of the 2 documents will be deductible. The remaining 30% is not deductible as it is of a capital nature.