Edited version of private advice

Authorisation Number: 1052349979526

Date of advice: 16 January 2025

Ruling

Subject: Deduction - legal expenses

Question 1

Whether the amount paid by P1 for the settlement of a dispute can be claimed as an allowable deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer 1

No.

This ruling applies for the following period:

Income year ended 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

The Trust operated a business (TB).

P1, P2, P3 and P4 each operated a business.

The Trust provided services to each of the businesses of P1, P2, P3 and P4.

The Trust provided its services to P1, P2, P3 and P4 in accordance with an agreement (the Agreement). The Agreement sets out how the business of the Trust will be conducted.

The beneficiaries of the Trust were entities controlled by P1, P2, P3 and P4. Each of the beneficiaries of the Trust were presently and absolutely entitled to part of the net income of the Trust.

The beneficiary of the Trust controlled by P1 was T1 which is a discretionary trust.

A dispute arose between the beneficiaries of the Trust (and their controllers) in relation to the Agreement. As a consequence, P4 commenced legal action.

A mediation was held by the parties to the dispute where it was agreed that P1 would pay a settlement amount to P4.

The payment was a lump sum that included:

•                     an amount for P1 (or their nominee) to acquire P4's interests in TB,

•                     an amount to discharge loans owed by TB to P4,

•                     an amount to compensate P4 in relation to alleged breaches of the Agreement, and

•                     an amount to compensate P4 for alleged bullying and harassment.

P1 paid the settlement amount to P4.

Relevant legislative provisions

Section 8-1 of the Income Tax Assessment Act 1997

Reasons for decision

Subsection 8-1(1) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that 'you can deduct from your assessable income any loss and outgoing to the extent that it is incurred in gaining or producing your assessable income, or it is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income'. However, no deduction is allowed under subsection 8-1(2) of the ITAA 1997 if the loss or outgoing is of a capital nature, a private or domestic nature, or relates to gaining or producing exempt income or non-assessable non-exempt income.

The characterisation of legal expenses as an outgoing on revenue account or an outgoing of capital nature will depend on the cause or purpose for which the legal expenses were incurred (Hallstroms Pty Ltd v Federal Commissioner of Taxation (1946) 72 CLR 634; [1946] HCA 34; 8 ATD 190; (1946) 3 AITR 436).

The question of whether expenditure is of a capital nature revolves around the character of the advantage sought by the expenditure; whether an enduring benefit is obtained as a result of the outgoing (Sun Newspapers v FCT (1938) 61 CLR 337 and BP Australia Limited v FCT (1965)112 CLR 386). Where expenditure is devoted towards a structural rather than an operational purpose, the expenditure is of a capital nature and the expenses are not deductible (Sun Newspapers).

For legal expenses to constitute an allowable deduction, it must be shown that they were incidental or relevant to the production of the taxpayer's assessable income, (Ronpibon Tin NL & Tong Kah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 4 AITR 236; (1949) 8 ATD 431).

Generally, legal expenses are deductible under section 8-1 of the ITAA 1997 if the:

•                     expenditure arose out of, or concerned the day-to-day activities of the taxpayer's business (Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113)

•                     expenditure is not undertaken to alter the organisation or structure of the taxpayer's profit yielding subject (Foley Brothers Pty Ltd v. FC of T (1965) 13 ATD 562)

•                     legal action has more than a peripheral connection to the taxpayer's income producing activities(Magna Alloys and Research Pty Ltd v. Commissioner of Taxation (1980) 49 FLR 183; (1980) 11 ATR 276; 80 ATC 4542; (1980) 33 ALR 213; Putnin v. Commissioner of Taxation (1991) 27 FCR 508; 91 ATC 4097; (1991) 21 ATR 1245)

Generally, the treatment of a settlement sum or damages payment will follow the treatment of the other legal costs incurred in relation to a particular matter (see ATO ID 2002/663 Income Tax: Deductions & Expenses: Sum paid in settlement of a harassment and victimisation claim).

The legal action by P4 was taken in order to dispose of their interests in the Trust, to have loans owed to them by TB repaid, to be compensated for breaches of the Agreement, and to be compensated for alleged bullying and harassment.

Acquisition of interests in the Trust

To be deductible under section 8-1 of the ITAA 1997, subsection 8-1(1) requires there to be a nexus between the outgoing and the gaining or production of assessable income, or the carrying on of a business for that purpose.

In determining whether a loss or outgoing is characterised as having been incurred in gaining or producing assessable income, the courts have considered whether the loss or outgoing is incidental and relevant to the operation, or activities regularly carried on by the taxpayer for the production of income.

The High Court in Ronpibon Tin NL v Federal Commissioner of Taxation [1949] HCA 15; (1949) 78 CLR 47 at 57 stated that:

For expenditure to form an allowable deduction as an outgoing incurred in gaining or producing the assessable income it must be incidental and relevant to that end. The words "incurred in gaining or producing the assessable income" means in the course of gaining or producing such income...

Notwithstanding the difference in other respects in the present provision, the expression 'incurred in gaining or producing the assessable income' has been left unchanged and bears the same meaning. In brief substance, to come within the initial part of the sub-section it is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income or, if none by produced, would be expected to produce assessable income.

Upon payment of the settlement sum, the interests of P4 in the Trust were transferred to P1 or their nominee.

The settlement amount that relates to the acquisition of the interests of P4 in the Trust is not an outgoing incurred in producing assessable income (there is no nexus between the outgoing and an income producing activity), but is a payment for a capital asset.

P1 will not be able to claim a deduction under section 8-1 of the ITAA 1997 in respect of the amount that relates to the acquisition of the interests of P4 in the Trust.

The income tax recognition of the settlement amount to the extent it represents consideration for these interests is first element cost base under the capital gains tax regime in Part 3-1 of the ITAA 1997.

Breaches of the Agreement

The Agreement sets out how the business of the Trust will be conducted. The Agreement provides the framework for the operation of that business. Any breach of the Agreement will relate to the business operated by the Trust.

The net profits of the Trust in each financial year are divided among the beneficiaries. T1 (controlled by P1) is a beneficiary of the Trust. T1 is a discretionary trust.

The settlement amount relating to the breach of the Agreement has no nexus to the income producing activity of P1's business. To be deductible under section 8-1 of the ITAA 1997, there will need to be nexus between the settlement amount relating to the breach of the Agreement (paid by P1) and the income of T1 (which, as a beneficiary of the Trust, receives a distribution of income from the Trust).

Taxation Determination TD 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 (TD 2018/9) provides that a beneficiary of a discretionary trust will not usually be entitled to a deduction under section 8-1 of the ITAA 1997 for an outgoing incurred by the beneficiary in relation to the trust unless the beneficiary is presently entitled to income of the trust estate at the time the expense is incurred, and the expense has nexus with the income to which the beneficiary is presently entitled (paragraphs 1 and 2).

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. (Paragraph 10 of TD 2018/9)

A beneficiary is only presently entitled to income if they have:

(a)           an interest in the income which is both vested in interest and vested in possession, and

(b)           a present legal right to demand and receive payment of the income, whether or not the precise entitlement can be ascertained before the end of the relevant year of income and whether or not the trustee has the funds available for immediate payment. (paragraph 13 of TD 2018/9)

Until income is derived by the trust to which a beneficiary can be made entitled and an irrevocable resolution has been made by a trustee of a discretionary trust to appoint income in favour of a beneficiary, that beneficiary cannot be presently entitled to income of the trust estate. Ordinarily, present entitlement will not arise until the end of the income year, even if the income is appointed under an early resolution. This is because ordinarily it is not possible to know until at or after year end whether there is any income of the trust in respect of the year available to be distributed. (paragraph 14 of TD 2018/9)

A beneficiary of the Trust is presently and absolutely entitled to an amount of the net income of that trust. The net income or the Trust for a financial year would not be known until the end of the financial year and would not be distributed until the end of the financial year. As a consequence, the income of T1 for the same financial year would also not be known until the end of the financial year, because it would not receive an income distribution (if any) from the Trust until that time. At the time the settlement amount relating to the breach of the Agreement was incurred by P1, they could not be presently entitled to any income of T1 as it was uncertain if there would be any distributable income in T1, and present entitlement in any event requires the trustee to actually exercise their power of appointment in favour of P1.

On the ATO view in TD 2018/9 there can be no nexus between the settlement amount relating to the alleged breach of the Agreement and P1's mere expectancy of the exercise of a power of appointment by the trustee of T1 in favour of P1.

P1 will not be able to claim a deduction under section 8-1 of the ITAA 1997 in respect of the amount that relates to the alleged breach of the Agreement.

Repayment of P4's loans

Similarly, to the extent the settlement amount represents repayment of the loans owed by the Trust to P4, it is not an outgoing incurred in gaining or producing assessable income (there is no nexus between the outgoing and an income producing activity given P1's mere expectancy of an exercise of a power of appointment by the respective trustees in their favour). Otherwise, these payments are to or for the benefit of the debtor entities and represent either loans or gratuitous payments.

Bullying and harassment

ATO ID 2002 664 Income Tax: Deductions and Expenses: Legal fees incurred in defending a claim of harassment and victimisation provides that expenses incurred in defending a sexual harassment and victimisation claim by another employee are not deductible under section 8-1 of the ITAA 1997 as the expenses arose from the personal conduct of the taxpayer and not from the performance of their income producing activity. Similarly, ATO ID 2002/663 Income Tax: Deductions and Expenses: Sum paid in Settlement of a harassment and victimisation claim provides that a settlement sum paid in relation to a sexual harassment and victimisation claim is not an allowable deduction under section 8-1 of the ITAA 1997 as it was not incurred in gaining or producing assessable income.

The alleged bullying and harassment arose from personal conduct and not in the performance of P1's obligations under either the Agreement or in their business from which P1 derives assessable income.

The outgoing (the settlement amount relating to the bullying and harassment) was therefore not incurred in gaining or producing assessable income.

P1 will not be able to claim a deduction under section 8-1 of the ITAA 1997 in respect of the amount that relates to the bullying and harassment claim.

Conclusion

P1 will not be able to claim a deduction under section 8-1 of the ITAA 1997 for the lump sum settlement amount.

No other provisions of the ITAA 1997 or the Income Tax Assessment Act 1936 will otherwise allow a deduction to be claimed for the settlement amount.