Edited version of private advice

Authorisation Number: 1052353585750

Date of advice: 07 February 2025

Ruling

Subject: Deductions - legal expenses

Question 1

Is the Trust entitled to claim a deduction under 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for the settlement payment paid to Person A?

Answer 1

No.

Question 2

Is the Trust entitled to claim a deduction under 8-1 of the ITAA 1997 for the legal fees paid in relation to the court hearing for Company B?

Answer 2

No.

Question 3

Is Person B entitled to claim a deduction under section 8-1 of the ITAA 1997 for the settlement payment paid to Person A?

Answer 3

No.

Question 4

Is Person B entitled to claim a deduction under 8-1 of the ITAA 1997 for the legal fees paid in relation to the court hearing of Company B?

Answer 4

No.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

You provided us with details on when the Trust was established.

The trustee of the Trust is Company A.

Person B is the sole director of Company A.

Person B and their spouse Person C are beneficiaries of the Trust.

Person B is the sole director of Company B and the Trust is the sole shareholder of the Company.

Person B is an experienced developer.

The Trust is involved in property development projects. Company B was also a property developer.

Company B was profitable and paid dividends to their sole shareholder, the Trust.

Person B as beneficiary of the Trust received trust distributions from the Trust.

On a specified date, a liquidator was appointed for Company B

Company B was deregistered with on a specified date.

Legal dispute in connection with sale of a property

Company B owned and sold a residential property, you provided us with the location of the property.

Company B entered into a contract to sell the Property to Person A on a specified date. You provided us with details on when the settlement occurred.

The Property was recorded as trading stock on the Company B's account with the proceeds from the sale being recorded on a revenue account.

Person A intended to build a new residential property on the land after demolishing the existing Property.

Prior to settlement of the Property an application to demolish the Property was lodged. The application was refused on a specified date due to no planning permit having been obtained.

Person A engaged a law firm with the view of obtaining a planning permit. The law firm's advice, after consulting heritage experts, was that a planning permit would not be possible due to the prospect of the temporary heritage overlay of the Property to be a final heritage overlay. The experts had advised that the Property meets the requirements to be heritage listed.

Person A contended that there was a difference between the market value and contract price of the Property, however Person B and Company B did not agree to this.

Person A commenced legal proceedings against Company B and Person B on a specified date for alleged breach of contract or misleading or deceptive conduct related to the sale of the Property.

Court order and settlement of claims

The case commenced on a specified date against Company B, with Person B being named as the second defendant. The decision was handed down on a specified date where the court ordered Company B to pay Person A a specified amount including interest plus costs.

The liquidator issued proceedings against Person B and Company A on a specified date for alleged contraventions of section 588FDA of the Corporations Act 2001, in relation to unreasonable director-related transactions. Person B and Company A denied this claim.

Person B and Company A entered into a terms of settlement contract with Person A on a specified date to pay a specified amount to resolve all issues without admitting liability to avoid further litigation expenses.

The settlement agreement discharged both parties from all claims.

The settlement payment was for the full and final settlement of the court proceedings.

You provided us with details on how the payment would be paid.

Settlement payment

Person B made the full settlement payment from their personal bank account on various dates.

Legal fees

Tax invoices for a specified amount were issued for legal fees in relation to the court case for Company B and Person B.

Person B paid the legal expenses for the court case from their personal bank account.

You provided us with copies of the tax invoices.

You provided us with copies of the tax invoices, bank payment receipts for payments made to Person A and liquidator of the Company A, the court case and the settlement contract.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extends 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 natures, 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 been 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 outgoings 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),

•                     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 their assessable income (Charles Moore Co (WA) Pty Ltd v FC of T, (1956) 95 CLR 344; FC of T v Hatchett, 71 ATC 4184).

For a settlement payment or legal expenses to constitute an allowable deduction, it must be shown that they are incidental or relevant to the production of the taxpayer's assessable income. Also, in determining whether a deduction for a settlement payment or legal expenses is allowable under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered (Hallstroms Pty Ltd v Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 3 AITR 436; (1946) 8 ATD 190).

Settlement payments and legal expenses are generally deductible if they arise out of the day to day income earning activities of the taxpayer and the legal action has more than a peripheral connection to the taxpayer's income producing activities. It therefore follows that, if the action goes beyond the normal business related duties, then there may be doubt about the nexus with income earning activities and the character of the associated expense changes from income earning to being of a private, domestic or capital nature.

The mere expectation of dividend income or trust distributions will not be sufficient for the purposes of section 8-1 of the ITAA 1997. The connection between the expenses incurred will be too remote.

Application to your circumstances

Question 1

The Trust derives assessable income as shareholder of Company B, by receiving a dividend. The Trust entered into an agreement to pay the settlement amount of a specified amount which was the judgment amount of the court case against Company B and Person B. The settlement payments were paid from the personal account of Person B, who is the director of Company B and receives a distribution from the Trust.

There is an insufficient connection between deriving the assessable income of the Trust and incurring the settlement payment expense. The expense was not incurred in gaining or producing the Trust's assessable income. Therefore, this is not an allowable deduction for the Trust under section 8-1 of the ITAA 1997.

Question 2

The Trust derives assessable income as shareholder of Company B, by receiving a dividend. The legal fees were paid as a result of the court case against Company B and Person B. The legal fees were paid from the personal account of Person B, who is the director of Company B and receives a distribution from the Trust.

There is an insufficient connection between deriving the assessable income of the Trust and incurring the legal expense. The expense was not incurred in gaining or producing the Trust's assessable income. Therefore, this is not an allowable deduction for the Trust under section 8-1 of the ITAA 1997.

Question 3

Person B is the director of Company B along with receiving a distribution from the Trust. Person B entered into an agreement to pay the settlement amount of a specified amount which was the judgment amount of the court case against Company B and Person B. The settlement payments were paid from the personal account of Person B, who is the director of Company B and receives a distribution from the Trust.

There is an insufficient connection between deriving the assessable income of Person B and incurring the settlement payment expense. The expense was not incurred in gaining or producing Person B's assessable income. Therefore, this is not an allowable deduction for Person B under section 8-1 of the ITAA 1997.

Question 4

Person B is the director of Company B along with receiving a distribution from the Trust. The legal fees were paid as a result of the court case against Company B and Person B. The legal fees were paid from the personal account of Person B, who is the director of Company B and receives a distribution from the Trust.

There is an insufficient connection between deriving the assessable income of Person B and incurring the legal expense. The expense was not incurred in gaining or producing Person B's assessable income. Therefore, this is not an allowable deduction for Person B under section 8-1 of the ITAA 1997.