Edited version of private advice

Authorisation Number: 1052316748497

Date of advice: 20 November 2024

Ruling

Subject: Legal expenses - mortgage discharge expenses or borrowing expenses

Question 1

Are the legal fees incurred by Trust A deductible under either, section 25-25 or section 25-30 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Are the legal fees incurred by Trust B deductible under either, section 25-25 or section 25-30 of the ITAA 1997?

Answer

Yes.

Question 3

Is Trust B's reimbursement of Bank X's legal fees pursuant to the terms of the original financing documents covering the loans lent by Bank X to Trust B (Reimbursement) deductible under either, section 25-25 or section 25-30 of the ITAA 1997?

Answer

Yes.

This private ruling applies for the following periods:

Year ended 30 June 20XX

Year ended 30 June 20XX

The scheme commenced on:

X March 20XX

Relevant facts and circumstances

1.            The relevant taxpayers to whom this private ruling application applies are 2 related trusts:

(a)           Trust A

(b)           Trust B

2.            Trust A, Trust B and a number of other related entities (the X Group) own a portfolio of commercial properties (Retailer Properties) leased to a Retailer. The X Group hold the Retailer Properties to derive commercial rent and long-term capital growth. Further, other entities within the X Group have also undertaken property development activities.

3.            Person A is a director, shareholder and controlling mind of the entities comprising the X Group.

4.            The activities of the X Group, including the acquisition of the Retailer Properties, have been funded by private funds and loan funding from Bank X.

5.            The Developer is a unit trust which undertook property development activities, where 50% of its units were effectively controlled by Person A and his family.

6.            On X/XX/20XX, The Developer became the registered proprietor of the Disputed Property. The unit holders contributed to the purchase of the property via equity contribution and the remaining funds were provided by Trust A and Bank X.

7.            On X/XX/20XX, The Developer sold the Disputed Property to Person B and/or Person C and/or a nominee as purchasers for $3570,000.

8.            On X/XX/20XX, the nomination power in the contract of sale was exercised in favour of Person C. The Developer transferred the Disputed Property to Person C in XX/20XX.

9.            Person C paid for the purchase of the Disputed Property by borrowing the required funds from Trust A (i.e. the Person C Loan), advanced to her on X April and X April 20XX.

10.          Trust A further continued to loan funds to Person C to fund the maintenance and holding costs in relation to the Disputed Property.

11.          On X July 20XX, Bank X advised the following borrowers (collectively, the Borrowers) were listed on the Letter of Offer:

(a)           Company D

(b)           Company A in its own right and as trustee for Trust A

(c)           Company B in its own right and as trustee for Trust B

(d)           Company C in its own right and as trustee for Trust C

12.          Under the Letter of Offer, the following Security Provers were listed:

(a)           the Borrowers

(b)              Company E

(c)              Person A, and

(d)              Person C

13.          Over a number of years from July 20XX to July 20XX, Bank X provided significant loans to the X Group to fund its activities including:

(a)          $XXX by way of a loan facility to Trust A (Trust A Loan).

(b)          $XXX by way of two loan facilities to Trust B (Trust B Loan):

(i)            a loan facility of $XXX; and

(ii)           a loan facility of $XXX.

14.          Trust A used the Trust A Loan in its business and investment activities, including on-lending funds to other members of the X Group in order to derive interest income and funding the working capital requirements of the X Group, including ongoing costs for the existing Retailer Properties.

15.          Trust B used the Trust B Loan to fund the acquisition of a commercial property (Retail Property 1) leased to the Retailer to derive commercial rent and assist with the X Group's property development and investment activities.

16.          As security for the funds lent by Bank X to the X Group, including the Trust A Loan and Trust B Loan, Bank X registered a mortgage over the various Retailer Properties held by the X Group and the Disputed Property.

17.          The X Group faced financial pressures, particularly pressures in servicing The Bank X debt. Bank X had for some time pressured the X Group to dispose of its assets in order to reduce its debt owed to Bank X.

18.          In or around July 20XX, the X Group requested Person C consent to the sale of the Disputed Property to assist in paying down the Bank X debt.

19.          Person C refused to consent to the sale of the Disputed Property. Person C further refused to make any repayments in relation to the Person C Loan, effectively claiming that the Disputed Property had been gifted to her.

20.          Person C's refusal to consent and assertions that the Disputed Property had been gifted to her put at risk Bank X's security over the property and significantly reduced the net asset position of the X Group by the value of the Person C Loan. As a result, there was a serious risk of the Trust A and Trust B breaching its obligations under the Bank X Property Standard Terms and the triggering of an Event of Default, ultimately resulting in Bank X demanding repayment of its loans and forcing the sale of the Retailer Properties.

21.          On or around X/XX/20XX, Trust A notified Person C that under the terms of the Loan Deed the Lower Interest Rate was 10% per annum.

22.          On or about X/XX/20XX, Trust A notified Person C that the termination date under the Loan Deed would be X/XX/20XX and that the principal sum and interest were payable on this date.

23.          Person C failed, neglected, and/or refused to repay the principal sum and interest on X/XX/20XX.

24.          The failure to repay the principal sum and interest by the termination date constituted an event of default, under the terms of the Loan Deed.

25.          On or around X/XX/20XX, Trust A, Trust B and Person A together commenced proceedings against Person C (Legal Dispute).

26.          Person C subsequently made a counterclaim (with Bank X being included as a fourth defendant by counterclaim), alleging:

(a)          the Loan Deed was void in whole or in part because of the undue influence and / or unconscionable conduct of Person A

(b)          the security documents relevant to obtaining funds from the Bank X, including the mortgage and the guarantees and indemnities provided by Person C in relation to the Bank X funding to the X Group were void as against Bank X due to unconscionability

(c)           the Disputed Property was transferred to Person C as a gift. Further, as Person A was her father, Person C also contended for the Disputed Property through the presumption of advancement.

27.          On X November 20XX, the court delivered judgement finding in favour of Trust A, Trust B and Person A and dismissing Person C's counterclaim.

28.          The following declarations and orders (amongst others) were made on X December 20XX:

(a)          the Disputed Property is, and has at all relevant times, been held by Person C on constructive trust for the benefit of Trust A and Trust B and is charged with repayment of the sum owing to Trust A under the Loan Deed

(b)          Person C has no beneficial interest in the Disputed Property

(c)           the first and second plaintiffs (being Trust A and Trust B) conduct a judicial sale

(d)          Trust A and Trust B pay any amount owing to Bank X owing under the mortgage over the Disputed Property, including any unpaid legal costs on an indemnity basis

(e)          Trust A and Trust B pay to Trust A such sum as is due in respect of its charger over the Disputed Property

(f)            there be a judgement for Bank X by counterclaim against Person C.

29.          On X February 20XX, Person C appealed the judgement and the matter is awaiting a decision.

30.          In the 20XX and 20XX income years, Trust A incurred legal fees of $XXX and $ XXX, respectively. These fees were paid to lawyers and mediators.

31.          In the 20XX and 20XX income years, Trust B incurred legal fees of $XXX and $XXX, respectively. These fees were paid to lawyers and mediators.

32.          In around January 20XX, Bank X demanded that the X Group pay its legal costs to date as a result of its involvement in the Legal Dispute under the terms of the financing documents covering the Bank X debt.

33.          On X January 20XX, Trust B complied with Bank X's demand and paid Bank X's legal costs incurred from X April 20XX to X January 20XX of $ XXX.

34.          An email dated X April 20XX from Bank X to Person A, stating that it requires the full net proceeds from the sale of Retail Property 1 'in exchange for discharge of mortgage and will receive in priority from those proceeds, its legal costs of the proceeding that has yet to be reimbursed ($XXX), and will then apply the rest towards debt reduction'.

35.          On X April 20XX, Bank X withheld a further amount of $ XXX of proceeds from the sale by Trust B of Retail Property 1 as reimbursement for Bank X's legal costs incurred from X January 20XX in relation to the Legal Dispute. This increased Trust B's total reimbursement to Bank X (the Reimbursement) to $ XXX.

36.          In order to alleviate the financial pressures on the X Group, including the cost of the Bank X debt and to pay legal and advisory costs incurred in relation to the Legal Dispute, the X Group sold 2 of its Retailer Properties, including Retail Property 1.

37.          The X Group intended to use only part of the proceeds from the sale to pay down the Bank X debt. However, under the terms of the original financing documents, Bank X retained the entire sales proceeds (other than a deposit received in relation to the sale of the Retail Property 1), to apply against the debt owed by the X Group as well as further legal costs incurred by Bank X in relation to the Legal Dispute. Bank X further refused to extend any additional finance to the X Group.

38.          On or around X September 20XX, the X Group refinanced with another bank and repaid all remaining loan amounts owing to Bank X including the Trust A Loan and Trust B Loan.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 25-25

Income Tax Assessment Act 1997 section 25-30

Income Tax Assessment Act 1997 subsection 25-30(1)

Income Tax Assessment Act 1997 subsection 25-30(2)

Does Part IVA apply to this private ruling?

Part IVA of the Income Tax Assessment Act 1936 contains anti-avoidance rules that can apply in certain circumstances where you or another taxpayer obtains a tax benefit, imputation benefit or diverted profits tax benefit in connection with an arrangement.

If Part IVA applies, the tax benefit or imputation benefit can be cancelled (for example, by disallowing a deduction that was otherwise allowable) or you or another taxpayer could be liable to the diverted profits tax.

We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

Reasons for decision

All legislative references are to the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise stated.

Question 1

Are the legal fees incurred by Trust A deductible under either, section 25-25 or section 25-30?

Summary

The legal fees are deductible under subsection 25-30(1).

Detailed Reasoning

Subsection 25-25(1) allows you to 'deduct expenditure you incur for borrowing money' to the extent you used the money for the purpose of producing assessable income.'

1.            As defined in subsection 995-1(1), for the purposes of section 25-25 borrowing 'means any form of borrowing, whether secured or unsecured, and includes the raising of funds by the issue of a bond, debenture, discounted security or other document evidencing indebtedness.'

2.            As stated at paragraph 28 of Taxation Ruling TR 2019/2 Income tax: whether penalty interest is deductible:

Capital expenditure incurred for borrowing money may be deductible under section 25-25. Penalty interest is not a cost of borrowing incurred in establishing the loan; it is incurred after money is borrowed (emphasis added). Therefore, it is not incurred for the borrowing and is not deductible under section 25-25.

3.            Section 25-30 permits deductions for the expenses of discharging a mortgage under the following circumstances:

Mortgage for borrowed money

(1)           You can deduct expenditure you incur to discharge a mortgage that you gave as security for the repayment of money that you ^* borrowed if you used the money solely for the ^* purpose of producing assessable income.

Mortgage for property bought

(2)           You can deduct expenditure you incur to discharge a mortgage that you gave as security for the payment of the whole or part of the purchase price of property that you bought if you used the property solely for the * purpose of producing assessable income.

4.            Trust A is not able to claim a deduction for the legal fees under section 25-25, as it was not expenditure incurred for the purposes of borrowing money in establishing a loan. Rather it is expenditure incurred after the money had already been borrowed. The purpose for incurring the legal fees was to procure the sale of the Disputed Property, discharge any encumbrances, and return profits to the X Group.

5.            However, Trust A is eligible to claim a deduction for the legal fees incurred in relation to the Legal Dispute under subsection 25-30(1) as:

(a)          the repayment of the funds borrowed by Trust A under the Trust A Loan was secured by a mortgage on the Disputed Property.

(b)          the funds borrowed by Trust A under the Trust A Loan were used in producing assessable income via its business and investment activities, to derive interest income and funding the working capital requirements of the X Group.

(c)           The legal fees were directly incurred in pursuit of the sale of the Disputed Property in order to discharge the mortgage on the same property by repaying the Trust A Loan.

Question 2

Are the legal fees incurred by Trust B deductible under either, section 25-25 or section 25-30?

Summary

The legal fees are deductible under subsection 25-30(2).

Detailed reasoning

6.            Trust B is not able to claim a deduction for the legal fees under section 25-25, as it was not expenditure incurred for the purposes of borrowing money in establishing a loan. Rather it is expenditure incurred after the money had already been borrowed. The purpose for incurring the legal fees was to procure the sale of the Disputed Property, discharge any encumbrances, and return profits to the X Group.

7.            However, Trust B is eligible to claim a deduction for the legal fees incurred in relation to the Legal Dispute under subsection 25-30(2) as:

(a)          the repayment of the funds borrowed by Trust B under Trust B Loan were secured by the mortgage on the Disputed Property.

(b)          the funds borrowed by Trust B under Trust B Loan were used to fund the acquisition of Retail Property 1 to derive commercial rent.

(c)           the legal fees were directly incurred in pursuit of the sale of the Disputed Property in order to discharge the mortgage on the same property by repaying the Trust B Loan.

Question 3

Is Trust B's reimbursement of Bank X's legal fees (Reimbursement) pursuant to the terms of the original financing documents covering the loans lent by Bank X to Trust B deductible under either, section 25-25 or section 25-30?

Summary

Trust B's reimbursement of Bank X fees are deductible under subsection 25-30(2).

Detailed reasoning

8.            Trust B is not able to claim a deduction for the legal fees under section 25-25, as it was not expenditure incurred for the purposes of borrowing money in establishing a loan. These were amounts that Trust B was required to reimburse Bank X who was also party to the litigation outlined at Question 2.

9.            However, Trust B is eligible to claim a deduction with respect to subsection 25-30(2) for the reimbursements of Bank X's fees, as:

(a)          the repayment of the funds borrowed by Trust B under Trust B Loan were secured by the mortgage on the Disputed Property.

(b)          the funds borrowed by Trust B under Trust B Loan were used to fund the acquisition of Retail Property 1 to derive commercial rent.

(c)          the legal fees were directly incurred by Bank X as it was a co-defendant in respect of the counterclaims, and Trust B had a contractual obligation to reimburse Bank X for these costs.

(d)          owing to Person C's attempts to prevent Trust B from discharging the mortgage on the Disputed Property by challenging the validity of Bank X's security over it, the legal costs borne by Bank X became additional expenses Trust B had to necessarily incur to discharge the mortgage.