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The impact of this case on ATO policy is discussed in Decision Impact Statement: Commissioner of Taxation v Wood (NSD 1162 of 2022 (Federal Court) 2020/0079 (Administrative Appeals Tribunal)).
XPTC v FC of T
Members:R Reitano M
Tribunal:
Administrative Appeals Tribunal, Sydney
MEDIA NEUTRAL CITATION:
[2022] AATA 4147
R Reitano (Member)
1. This matter is about whether payments made in settlement of litigation and legal costs are deductible under s. 8-1 of the Income Tax Assessment Act 1997 (Cth) (ITAA).
2. During the 2014 income tax year the Applicant paid $200,000 in settlement of some litigation and $72,554 to lawyers for legal costs associated with that litigation. The Applicant claimed those amounts as deductions from his assessable income in the 2014 tax year. On objection the Commissioner disallowed the amounts as deductions. The Applicant then brought this application for review of the Commissioner's decision.
3. Before the hearing commenced I made an order, as requested by the Applicant and not opposed by the Commissioner, that required, amongst other things, that the proceedings be kept private to the parties in accordance with the terms of the order and that the Applicant be known by a pseudonym and the relevant people and entities have their identities anonymised so as to prevent the identification of the Applicant.
4. I have decided to vary the decision made on 13 November 2019 to the extent that the Applicant's allowable deductions for the
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2014 taxation year shall include the amount of $200,000 paid in settlement of the litigation. What follows are my reasons for doing so.What are the relevant regulatory provisions?
5. Before dealing with the substantive provisions that are relevant it is necessary to recall s.14ZZK of the Taxation Administration Act 1953 (Cth) (TA Act). Section 14ZZK provides:
On an application for review of a reviewable objection decision:
- (a) the applicant is, unless the Tribunal orders otherwise, limited to the grounds stated in the taxation objection to which the decision relates; and
- (b) the applicant has the burden of proving:
- (i) if the taxation decision concerned is an assessment--that the assessment is excessive or otherwise incorrect and what the assessment should have been; or
- (ii) in any other case--that the taxation decision concerned should not have been made or should have been made differently.
6. Sub-section 14ZZK(b)(i) provides that in a review the taxpayer must prove that the Commissioner's assessment is excessive or otherwise incorrect and, significantly, what the assessment should have been. The burden of proof is not generally discharged by simply showing that the methodology or aspects of the content of the assessment undertaken by the Commissioner was or were flawed or wrong.
7. In this review both parties proceeded on the basis that the effect of the section meant that the burden on the Applicant was to demonstrate on the balance of probabilities that 'the character of the payments made by [the Applicant] are properly deductible.' That is, in the strict terms of s. 14ZZK(b)(i), the Applicant was not required to prove on the balance of probabilities what his actual taxable income was in order to show the amount by which the Commissioner's assessment was excessive or incorrect, he was only required to prove on the balance of probabilities that the amounts he claimed as deductions were properly to be treated as deductible.
8. Next, it is necessary to refer to the two substantive provisions which lay at the centre of the current dispute.
9. Sub-section 8-1 of the ITAA provides:
- (1) You can
deduct
from your assessable income any loss or outgoing to the extent that:
- (a) it is incurred in gaining or producing your assessable income; or
- (b) it is necessarily incurred in carrying on a *business for the purpose of gaining or producing your assessable income.
Note: Division 35 prevents losses from non-commercial business activities that may contribute to a tax loss being offset against other assessable income.
- (2) However, you cannot deduct a loss or outgoing under this section to the extent that:
- (c) it is a loss or outgoing of capital, or of a capital nature; or
- (d) it is a loss or outgoing of a private or domestic nature; or
- (e) it is incurred in relation to gaining or producing your *exempt income or your *non-assessable non-exempt income; or
- (f) a provision of this Act prevents you from deducting it.
For a summary list of provisions about deductions, see section 12-5.
- (3) A loss or outgoing that you can deduct under this section is called a general deduction.
For the effect of the GST in working out deductions, see Division 27.
Note: If you receive an amount as insurance, indemnity or other recoupment of a loss or outgoing that you can deduct under this section, the amount may be included in your assessable income: see Subdivision 20-A.
10. Sub-section 25-5(1) of the ITAA provides:
- (1) You can deduct expenditure you incur to the extent that it is for:
- (g) managing your *tax affairs; or
- (h) complying with an obligation imposed on you by a *Commonwealth
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law, insofar as that obligation relates to the *tax affairs of an entity; or - (i) the *general interest charge or the *shortfall interest charge; or
- (ca) a penalty under Subdivision 162-D of the *GST Act; or
- (cb) levy under the Major Bank Levy Act 2017; or
- (j) obtaining a valuation in accordance with section 30-212 or 31-15.
Note 1: To find out whether a trustee of a deceased estate can deduct expenditure under this section, see subsection 69(7) of the Income Tax Assessment Act 1936.
Note 2: If you receive an amount as recoupment of the expenditure, the amount may be included in your assessable income: see Subdivision 20-A.
11. For completeness it is necessary to note that s.8-10 precludes the claiming of deductions twice where two provisions of the ITAA allow for a deduction to be made.
12. I will deal with the relevant principles that apply to each of these sections when I return to deal with the issues. It is convenient first to deal with the facts which were, for the most part, not seriously in issue.
What happened?
13. In order to understand the Applicant's claim for deduction it is necessary to set out in a little detail the background to the litigation to which the Applicant was a party and how the settlement payment and legal costs came to be incurred by the Applicant.
14. The Applicant was a director and shareholder of a company which I will refer to as CFIPL. The only other director and shareholder of CFIPL was the Applicant's wife. The Applicant was also an employee of CFIPL. CFIPL was in the business of providing consultancy services which included financial asset broking services. In his capacity as an employee of CFIPL the Applicant provided consultancy services on behalf of CFIPL. The income generated by CFIPL was mainly generated through the provision of the Applicant's services. The Applicant was paid income in the form of director's fees for his services by CFIPL.
15. From 2 February 1998 until 28 October 2011 CFIPL provided consultancy services to a company which I will refer to as APL and to another company, which I will refer to as RL, under the terms of a series of consultancy agreements. From 2 June 2005 the consultancy agreements were only with APL. The services and work undertaken was much the same irrespective of the entity to which they were provided.
16. On 28 October 2010 CFIPL and APL entered into the most recent of the consultancy agreements. I will refer to this as the 'Agreement'. The negotiations that preceded making the Agreement included a suggestion by the Applicant that he be 'converted to a common law employee'. The negotiations failed to arrive at a position where the Applicant would be a 'common law employee' because APL were not prepared to engage the Applicant in that capacity given the remuneration and accrued annual leave that the Applicant was seeking.
17. The Agreement contained a term for the provision of consultancy services by CFIPL to APL as principal and independent contractor. The Agreement provided that the consultancy services provided by CFIPL were to be provided through the Applicant as an employee and representative of CFIPL. By this means the Applicant's services were secured through the corporate vehicle CFIPL. The Applicant described in his affidavit that this involved 'the business affairs of CFIPL' being 'limited to being the contracting entity through which I provided financial advisory and brokerage services'. Neither party appeared to dispute that description. Generally speaking, the services involved work associated with structured asset leasing deals and, in particular, negotiation of those deals.
18. CFIPL was able to provide services through others with the approval of APL, but that never happened. Under the Agreement CFIPL was paid remuneration by APL in the form of a consultancy fee of $12,500 per month and participated in what was described as an incentive scheme. Under the incentive scheme CFIPL received some ordinary and preference shares in APL's holding company which I will refer to as HLPL. CFIPL was obliged
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under the Agreement to accept all liability for the Applicant's acts and omissions and was responsible for all employment related obligations to the Applicant. Under the Agreement CFIPL and the Applicant indemnified APL against all loss arising from the Applicant's acts and omissions relating to the services provided.19. The Applicant's position was styled 'Senior Business Development Executive' for APL When performing work the Applicant was described using an APL title, used an APL business card, was represented to customers as an APL employee, attended work at APL's business place except when he was required to attend upon customers, reported to APL managers, was required to abide by APL policies and procedures and used an APL email address and CFIPL paid tax on the income paid to it. The Applicant paid tax on the income and fees that were paid to him by CFIPL.
20. In early 2011 the Applicant was approached about working for a company which I will refer to as HP. He told APL he wanted to leave APL, which was a reference to him ending his relationship with APL through CFIPL, and work for HP. Many months passed, but eventually in September 2011 the Applicant's request was processed by APL giving CFIPL and the Applicant notice that the services were no longer required.
21. On 26 October 2011 the Applicant, CFIPL, APL and HLPL entered into a deed which was known as a Separation Deed. The Separation Deed terminated the Agreement with effect from 28 October 2011. The Separation Deed obliged APL to pay to CFIPL all money then outstanding under the Agreement and for HLPL to enter into a buy back agreement with CFIPL and the Applicant to buy back all of the ordinary shares and preference shares that CFIPL held in HLPL for $136,433.13. The amount was to be paid to CFIPL and the shares were to be transferred to HLPL.
22. After the Separation Deed was made there was what appeared to be a fairly serious dispute over claimed breaches of the Agreement. The dispute culminated in the commencement of litigation involving claims by APL that the Applicant and CFIPL had done things in or about 2006 or 2007 that were in breach of the Agreement, in breach of fiduciary obligations, and in breach of the Consumer and Competition Act 2010 (Cth). The details of the allegations so far as the Applicant understood them concerned APL's 'key contention' that the Applicant had acted wrongly in 'negotiating a $1 residual value for some assets instead of a 15% residual value.' The dispute, and later the litigation, concerned matters that were connected to the services that were provided by the Applicant through CFIPL and specifically the work that was done by the Applicant concerning the negotiation of leased finance deals on behalf of APL in 2006 or 2007. APL and HLPL were not prepared to carry out the obligations under the Separation Deed so far as the share buyback was concerned.
23. In December 2011 after the Applicant had commenced employment with HP he had a conversation with a senior person of HP in which he was told that someone from APL had said that the Applicant 'was being investigated for fraudulent activity in the discharge of [his] services at APL' which involved an accusation of a 'wilful act of fraud and larceny by APL'. The senior person at HP told the Applicant that if the allegations were true HP 'would have to let [the Applicant] go.' The Applicant said he would vigorously defend the accusation. He considered he had 'no recourse but to defend [himself] so that I would not lose my role at HP'. The Applicant said in his evidence that under the terms of his employment with HP he could be dismissed if he was found to have engaged in criminal activity. The employment contract was not produced in the material before me and I do not know whether the Applicant's employment could have been terminated by HP for any other reasons.
24. The Applicant did not at that time commence proceedings involving alleged defamation, but he threatened to do so in a letter. A threat was made to the Applicant by APL to 'spend as much as it takes to destroy you and your family'. A threat was also made to the Applicant to 'ensure that [the Applicant] would not be able to pursue [his] career in [his] chosen field of endeavour as [APL] would disseminate information to the market about [the Applicant's] 'fraud, larceny and perjury.'
25.
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A consequence of the Agreement having been terminated was that CFIPL ceased trading although it continued to collect money owed to it presumably including, if it were paid, the amount that was to be paid under the share buyback aspect of the Separation Deed. The Applicant said in his evidence that the consequence of this was that CFIPL did not have the financial resources to fund any defence of the litigation that meant that he would need to pay any legal fees personally.26. On 10 July 2012 APL and HLPL commenced proceedings in the Federal Court of Australia against the Applicant and CFIPL seeking damages based on the allegation I have earlier referred to involving the Applicant having negotiated a $1 residual value over certain assets rather than a 15% residual value. The claim was for damages of something like $2.4 million plus interest and legal costs. The Applicant and CFIPL denied the various allegations and defended the proceedings. The proceedings also involved the bringing of a cross claim by which the Applicant sought performance of the share buyback by HLPL, payment of some debts owed to CFIPL and claims that the relationship between the Applicant and APL was that of employer and employee despite the various consultancy agreements so that the Applicant was said to be owed accrued annual and long service leave which accrued from February 1998 to October 2011. The total amount claimed by the Applicant and CFIPL was in excess of $400,000 of which a little more than half related to the claim for leave entitlements. The Applicant did not commence proceedings for defamation concerning what had been about him by the person from APL about his claimed fraud and stealing.
27. On 26 April 2013 a liquidator was appointed to CFIPL which resulted in the proceedings brought by APL against it being stayed.
28. On 6 December 2013 the Applicant, APL, HLPL and another party related to APL compromised the proceedings and entered into a Settlement Deed. The recitals to the Settlement Deed confirm that the crux of the dispute between the parties that the Applicant had 'allegedly negotiated a number of unauthorised transactions'. The Settlement Deed was entered into without admissions by anyone. Under the Settlement Deed the Applicant was to pay APL $200,000, each party was to pay their own costs, the proceedings were dismissed, and APL was to obtain CFIPL's consent to the dismissal of the proceedings. The terms of the Settlement Deed were to remain confidential to the parties. The Applicant sought tax advice from both his accountant and lawyer relating to the settlement. The amount eventually paid by the Applicant was paid by him in consideration for APL not proceeding with its various claims against him and he 'unconditionally and irrevocably' agreeing that he no longer had any claims against APL or 'any of its predecessors'.
29. In the course of argument something was made by the Applicant of the definition in the Settlement Deed of the words 'Settlement payment' which were defined as meaning '$200,000 (net)'. The suggestion was that the use of '(net)' was relevant to the characterisation of the payment. The word 'net' it was said was a reference to the 'netting off' of the respective claims by each party. It is only necessary to say that generally speaking the word 'net' where appearing alongside a payment is referable to the amount paid after the deduction or bringing into account other things by way of deduction, most often taxation. In the end all that can reasonably and confidently be said is that the payment was made in relation to extinguishing both sides' respective claims in the dispute between them.
30. Also on 6 December 2013 the Applicant and APL entered into a Deed of Release which concerned the threatened but not by then commenced defamation proceedings. The terms of the Deed of Release included an agreement by APL not to publish or republish defined matters concerning the Applicant's conduct and character (which included the allegation concerning fraud and stealing referred to earlier), that APL would pay the Applicant $180,000, that the Applicant released APL and the senior executive concerning the alleged defamation and that the Deed of Release and its terms would remain confidential (including the fact of the Deed of Release) and the parties would not say bad things about each other..
31.
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On 29 January 2014 the parties agreed in a document titled 'Acknowledgement of Settlement' to set off their respective obligations under the Deed of Release and the Settlement Deed so that the Applicant paid $20,000 to APL.32. The proceedings so far as they concerned CFIPL were also resolved but the terms of that settlement appear to be unknown other than that the proceedings were stayed.
33. The liquidator's records disclose that the shares in HLPL were sold for $20,000 to avoid the need to make an application for a winding up order and that there was a loan from CFIPL to the Applicant for $200,000 of which $177,170 had not been repaid.
34. So far as the legal costs are concerned the solicitors for the Applicant and CFIPL were, until 27 June 2013, GD who after that date ceased acting for CFIPL. There were five invoices that were not the subject of any claim for deduction that were dated 21 December 2011, 29 February 2012, 31 March 2012, 30 April 2012 and 31 July 2012. Those invoices related to work undertaken before 19 July 2012. The invoices were addressed to the Applicant 'c/o CFIPL' and all bore the heading 'Employment dispute'. As I have said none of those invoices were the subject of a claim for deduction so I do not need to say any more about them.
35. GD's legal fees which were the subject of the claim for deduction were issued in four invoices on 29 July 2013 (for the period 13 August 2012 to 15 July 2013) for $42,702.50; 12 August 2013 for counsels fees on 9 October 2012 and 12 December 2012 in the amount of $11,797.50 which concerned work undertaken in the periods 12 September 2012 to 28 September 2012 and 17 October 2012 to 5 December 2012 respectively; 30 August 2013 for services between 2 July 2013 and 19 August 2013 for $10,320.75 and 28 February 2014 for legal services between 4 September 2013 and 30 January 2014 for $7,711. The first invoice was addressed to the Applicant 'c/o CFIPL' and the remainder were simply addressed to the Applicant. Again, all of them had the heading 'Employment Dispute.' Each of the invoices 'itemised' the services provided with a description of the work done, the time spent doing it and a rate that was charged for that particular work.
36. It is not possible to determine from the invoices what legal fees solely related to the claim by APL against the Applicant or to his claims against APL. There are several reasons for this. First, some of the work covered by the invoices concern a period during which the same solicitors acted for the Applicant and CFIPL. In particular, the first and second invoice included work during the period from 13 August 2012 to 28 June 2013 which spanned much of the period to 26 April 2013 when a liquidator was appointed to CFIPL. The solicitors for the Applicant ceased acting for CFIPL on 2 July 2013. It is not possible from the invoices to determine what work was undertaken for the Applicant and what work was conducted for CFIPL, in particular in the period 13 August 2012 to 26 April 2013. It would not be appropriate to speculate about what was going on between 26 April 2013 and 2 July 2013 and why the Applicant's solicitors continued acting for CFIPL, but in any event much of the same problem exists. There was no other evidence to explain those invoices or their detail so as to determine what costs related to the Applicant and what costs related to CFIPL.
37. Second, although the third invoice appears to entirely relate to the legal expenses incurred at a time when the Applicant's solicitor was only acting for him (perhaps with the exception of the first entry for $110 in that invoice which relates to ceasing to act for CFIPL), many of the entries refer, in one way or another, to the mediation that resulted in the settlement. The Applicant's evidence confirmed that the mediation achieved a settlement of both the claim against him in the proceedings and his cross claim as well as the anticipated but not commenced defamation proceedings. That is, it is not possible to tell from the invoice alone what were costs in the proceedings and what were costs in the potential defamation proceedings. In any event the entries in the invoices do not sufficiently identify the link between the costs incurred and the proceedings.
38. Third, many of the entries in the invoices concern the Applicant's defamation claim and its resolution. In particular, in the fourth invoice there are entries such as 'draft deed of release
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39. Amongst the total costs there were amounts totalling $615 that were claimed to have been incurred in respect of taxation advice. The evidence that was said to support this conclusion was found in ten entries in the Applicant's lawyer's invoice dated 28 February 2014 which recorded:
| 1 Oct 13 | MJG | Review your reply | 55.00 |
| 2 Oct 13 | MJG | Review your email on tax deductibility of deed | 55.00 |
| 14 Oct 13 | MJG | Email to you on meeting with accountant and going | |
| forward with settlement | 55.00 | ||
| 14 Oct 13 | MJG | Review email from KVM | 55.00 |
| 14 Oct 13 | MJG | Email in response on delay in getting advice | 55.00 |
| 14 Oct 13 | MJG | Review your email on tax advice and deed | 55.00 |
| 15 Oct 13 | MJG | Review your email and reply | 55.00 |
| 4 Nov 13 | MJG | Review your email from [APL] solicitors | 55.00 |
| 7 Nov 13 | VJO | Draft amend/update Deed of Release for | |
| defamatory action (proposed action) | 105.00 | ||
| 7 Nov 13 | VJO | Review correspondence to Mr [XPTC] | 70.00 |
40. With the exception of the second and sixth entries it is not at all clear why it was suggested that these entries supported a conclusion that the costs incurred related to taxation advice. This is especially so where the wider context concerned incurring legal fees in respect of litigation. And even the two entries that refer to 'tax deductibility' and 'tax advice' are unclear as to the fact that they concerned tax advice at all. For example, so far as the first of those two entries are concerned on all that is known it may simply have been an email recording the Applicant's own view about 'tax deductibility'. I am not satisfied on the basis of the entries concerned that the expenses were incurred for the purpose of obtaining legal advice about taxation matters. Again, I will return to the importance of this later.
41. The Applicant's evidence was that he was prepared to pay the legal fees associated with the litigation personally because his work with APL and RL between early 1998 and October 2011 'formed the foundation of [his] professional experience and reputation in the finance industry'; because in that period CFIPL through the services provided to APL and RL was the main source of his income; he stood to recover in excess of $200,000 as employee entitlements; he lost income as a result of the failure by APL and HLPL to buy back CFIPL's shares and preference shares because if they were bought back the proceeds would be distributed to him as
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director's fees; and because he was at risk of losing his reputation and employment with HP if the allegations were proven.42. On 16 November 2018 the Applicant lodged his income tax return for the 2014 income tax year. In that return the Applicant included deductions in the amount of $272,554. The Commissioner sought further information from the Applicant about the deductions.
43. On 21 January 2019 the Applicant told the Commissioner that the deductions were for legal expenses which were comprised of the $200,000 he paid as the settlement amount and $72,554 he paid for legal costs.
44. On 6 May 2019 the Commissioner wrote to the Applicant advising him that the Commissioner had disallowed the deductions of $272,554.
45. On 14 May 2019 the Commissioner issued a Notice of Assessment to the Applicant in respect of the 2014 tax year which assessed the Applicant's taxable income as $216,792.
46. On 15 July 2019 the Applicant objected to the Commissioner's Notice of Assessment. The basis for the objection was set out in a letter to the Commissioner which immediately following the words 'We object to the above assessment for the reasons detailed below' contained three headings, namely the 'The Legal Expenses and Settlement Payment were incurred by [the Applicant]' 'Nexus to deriving Assessable Income' and 'Revenue Nature'. Fairly understood the basis for the objection was that the Applicant and not CFIPL had incurred the expenses, the expenses were incurred by the Applicant in gaining or producing the Applicant's assessable income, that it was not relevant that the deduction was claimed in a year later than in which the liability arose and it was not relevant that the expenses were revenue in nature and not capital.
47. On 13 November 2019 the Commissioner decided to disallow the Applicant's objection as a consequence of which this application for review was started.
What are the issues?
48. There are four issues. The first is whether the settlement payment of $200,000 was incurred by the Applicant in the course of gaining or producing assessable income, or necessarily incurred by the Applicant in carrying on a business for the purpose of gaining or producing assessable income as contemplated by s.8-1(1) of the ITAA.
49. The second issue is whether the $72,554 legal expenses paid by the Applicant to his lawyers was incurred by the Applicant in the course of gaining or producing assessable income, or necessarily incurred by the Applicant in carrying on business for the purpose of gaining or producing assessable income as contemplated by s.8-1(1) of the ITAA.
50. The third issue is that if either the settlement sum or the legal expenses are within s.8-1 of the ITAA, whether the expenses are outgoings of capital or of a capital nature or of a private or domestic nature so that it is precluded from being a deductible expense because of s.8-1(2) of the ITAA.
51. The fourth issue is whether the Applicant is entitled to deduct that part of legal fees totalling $615 exclusive of GST as a cost of managing his tax affairs because of the operation of s.25-5 of the ITAA.
Is the settlement sum deductible under s. 8-1(1)?
52. The issue concerns whether the settlement sum was a 'loss or outgoing'…'incurred in gaining or producing assessable income' or, alternatively, 'necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.' It is appropriate to put to one side any suggestion that s. 8-1(1)(b) is in play as the Applicant was not at any time carrying on a business which would engage s. 8-1(1)(b).
53. In
Commissioner of Taxation v Day [2008] HCA 53 (Day) at [21] the majority (Gummow, Hayne, Heydon and Kiefel JJ) observed that the words "incurred in gaining or producing . . . assessable income" … have long been "held to mean incurred 'in the course of gaining or producing' income." Day approved
Commissioner of Taxation v Payne [2001] HCA 3 (Payne) at [11] that posed the question as 'is the occasion of the outgoing found in whatever is productive of actual or expected income?' Payne involved a question
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as to the deductibility of travelling expenses incurred between two income earning activities, work as a pilot on the one hand and the conduct of a deer farm on the other. It was held that the expenses incurred in travelling between the two income earning activities were not occasioned either by the work as a pilot or the conduct of a business but were incurred so that the taxpayer was in a position to engage in income earning activities and were incurred in the interval between income earning activities.54. The majority in Day also referred to
Commissioner of Taxation v Cooper [1991] FCA 164 (Cooper) where Hill J dealt with the distinction between 'getting work' and 'doing work': expenses incurred in 'getting work' were considered to have come too soon in time to have been occasioned by the income earning activity. Day also approved Cooper so far as it held that an outgoing might be referable to a year other than the year in which it was incurred: the section only requires that the loss or outgoing be incurred 'in gaining or producing assessable income' (see also
AGC (Advances) Ltd v Federal Commissioner of Taxation [1975] HCA 7;
Federal Commissioner of Taxation v Fletcher [1991] HCA 42 at 16;
Schokker v Commissioner of Taxation [1999] FCA 600 at [18]).
55. The Commissioner vey helpfully referred to the recent judgment in
Clough Limited v Commissioner of Taxation [2021] FCA 108 where Colvin J brought together some of the relevant authorities and the principles to be taken from them:
[8] As was stated in
Fletcher v Federal Commissioner of Taxation [1991] HCA 42; (1991) 173 CLR 1 at 17 (dealing with the previous statutory provision which used the same language):The question whether an outgoing was … wholly or partly 'incurred in gaining or producing the assessable income' is a question of characterization. The relationship between the outgoing and the assessable income must be such as to impart to the outgoing the character of an outgoing of the relevant kind. It has been pointed out on many occasions in the cases that an outgoing will not properly be characterized as having been incurred in gaining or producing assessable income unless it was 'incidental and relevant to that end'.
It is to be noted that it is appropriate to have regard to predecessor provisions in this area where the language was not materially different:
Spriggs v Commissioner of Taxation [2009] HCA 22; (2009) 239 CLR 1 at [53] (French CJ, Gummow, Heydon, Crennan, Kiefel and Bell JJ).[9] The task of characterisation requires a focus upon the connection between the outgoing and the particular process by which income is derived in the instance under consideration. Where the case advanced is that the expenditure relates to a business that is being conducted then it is necessary to make both a wide survey and an exact scrutiny of the taxpayer's activities such that the whole of the operations of the business are considered in forming a view as to the proper characterisation of the outgoing: Spriggs at [60].
[10] The test is not to be couched in 'but for' terms. Rather, in undertaking 'the search for the necessary relationship which must exist between the outgoing and the activities which more directly produce the assessable income, it is necessary to look at the "essential character" of the expenditure': Trustees of the Estate Mortgage Fighting Fund
Trust v Commissioner of Taxation [2000] FCA 981; (2000) 102 FCR 15 at [19] (Hill J). It requires the adoption of a 'practical and business point of view': Hallstroms Pty
Ltd v Federal Commissioner of Taxation [1946] HCA 34; (1946) 72 CLR 634 at 648. The required inquiry is not a juristic analysis but rather a consideration of the commercial character of the outgoing and whether it was occasioned by producing assessable income or the conduct of a business of producing assessable income. (emphasis added)
56. Specifically, as to the words 'it is incurred in gaining or producing your assessable income', referred to in the quote below as 'the first limb', Colvin J said:
[12] The first limb requires the outgoing to be incurred 'in' gaining or producing assessable income. The preposition
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'in' has considerable semantic breadth. Having regard to context, it is used in s 8-1 to express a requirement as to a form of involvement or connection as between the incurring of the outgoing and the specified activity such that the outgoing might be said to be incurred in the course of that activity:
Amalgamated Zinc (De Bavay's) Ltd v Federal Commissioner of Taxation [1935] HCA 81; (1935) 54 CLR 295 at 309.[13] In the first limb of s 8-1 the preposition 'in' is used to describe a form of involvement or connection as between the incurrence of the outgoing on the one hand and the activity of gaining or producing assessable income on the other hand. It is not enough that the outgoing be incurred by a taxpayer who is involved in gaining or producing assessable income in a manner that bears some kind of unspecified relationship to the incurrence of the outgoing or was incurred for that subjective purpose. Rather, the requirement expressed in the first limb is that the incurrence of the outgoing was in the course of gaining or producing assessable income. The preposition 'in' focusses attention upon whether the expenditure happened as part of an activity that may be described as 'gaining or producing assessable income' (and may be contrasted with past formulations which used the preposition 'for', a formulation indicative of the object or purpose of the taxpayer:
Herald & Weekly Times Ltd v Federal Commissioner of Taxation (Cth) [1932] HCA 56; (1932) 48 CLR 113 at 123). Ultimately, the outgoing may or may not result in gaining or producing income. It is not the actual outcome achieved that is the focus of the provision or indeed whether a direct respect in which the particular outgoing was expected, or might be said to have the potential, to achieve that outcome. Rather, the question is whether the outgoing was incurred in the course of activities the nature of which might properly be characterised as gaining or producing assessable income.[14] As has been noted, the incurring of an outgoing will have the requisite degree of involvement or connection with gaining or producing the taxpayer's assessable income if it is incidental and relevant to the gaining or producing of that income: see Ronpibon at 56. As was said in Payne at [9]:
The connection which must be demonstrated between an outgoing and the assessable income, in order to fall within the first limb of s 51(1), is that the outgoing is 'incurred in gaining or producing' that income. The subsection does not speak of outgoings incurred 'in connection with' the derivation of assessable income or outgoings incurred 'for the purpose of' deriving assessable income. It has long been established that 'incurred in gaining or producing' is to be understood as meaning incurred 'in the course of' gaining or producing. What is meant by being incurred 'in the course of' gaining or producing income was amplified in Ronpibon … where it was said that:
to come within the initial part of [s 51 (1)] 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 be produced, would be expected to produce assessable income.
57. Applying these principles, it is necessary to identify the 'essential character' of the settlement payment. This involves adopting a 'practical and business point of view' with a view to identifying 'the commercial character of the payment and whether it was occasioned by producing assessable income'.
58. It is instructive to first have regard to the circumstances which gave rise to the settlement payment. Those circumstances involved the activities being undertaken by the Applicant, as an employee of CFIPL, which involved him negotiating leasing finance deals for APL. In performing that work the Applicant gained or produced assessable income, the director's fees paid to him by CFIPL. It was in the course of undertaking those activities and doing the lease negotiations sometime in 2006 or 2007 that it was claimed that the Applicant entered into 'unauthorised transactions'. APL sought to recover the losses it said it had suffered
ATC 10907
as a result of the 'unauthorised transactions' from the Applicant. The Applicant, in the end, paid to APL an amount of money that had its origins in the course of his performance of work for CFIPL for which he was paid by CFIPL. Those aspects of the settlement payment cannot be excluded or ignored in determining its character especially when viewed in a practical or common sense way. From a 'practical business point of view' the settlement payment bore the essential character of a payment related directly to the activities that the Applicant performed in negotiating leasing deals for APL. It was out of those activities that the Applicant gained or produced assessable income albeit that that assessable income was derived by reason of his position with CFIPL.59. The Commissioner submitted that in determining the issue it was appropriate to inquire as to what the objective of the settlement payment was. That approach would suggest that the objective of settling the proceedings and all the consequences that follow from that, savings in terms of cost, time and expense, protection of the Applicant's reputation and, in the circumstances peculiar to this matter, securing the payment under the Deed of Release, because that payment was conditional on execution of the Settlement Deed, are what gives the settlement payment its character. Those objectives are undoubtedly consequences of the execution of the Settlement Deed but they ignore that the very foundation and reason for the existence of the payment was the fact that it arose as result of, or out of, the Applicant doing work to derive his income. The loss or outgoing was incurred in the course of the activities engaged in by the Applicant which had as their object the gaining of assessable income for himself. The payment he ultimately made was therefore incidental and relevant to the Applicant gaining or producing assessable income.
60. The Commissioner also submitted that that the Applicant's conduct, referred to as the 'impugned conduct' (the subject of the Federal Court proceedings), whilst having 'arisen in the course of his employment with CFPIL, it was conduct which occurred in the course of the business carried on by CFPIL to produce assessable income for CFIPL and by which it, CFIPL received income including commissions for the lease with [the entity the subject of the unauthorised transactions]'. All of that can be taken to be given but s. 8-1(1)(a) directs attention to the Applicant's assessable income and, in particular, whether there was any loss or outgoing arising in the course of the Applicant gaining assessable income. The position of CFIPL does not have relevance to that issue.
61. It follows from this conclusion that the essential character in a practical business sense of the settlement payment was that it was a payment that arose from the Applicant's performance of his work with CFIPL in 2006 or 2007 which was in the course of his gaining or producing assessable income by way of the remuneration paid to him by CFIPL.
62. The Applicant submitted that there was another basis for finding that the settlement payment should be considered as having the necessary relationship with the gaining or production of assessable income which lay in his desire to protect his existing employment with HP from termination. The finding I have already made about the essential character of the settlement payment makes it strictly unnecessary to deal with this argument in any detail, but I should say something about it albeit briefly There was no evidence that would suggest that HP had any right to terminate the Applicant's employment as a result of anything that might be found to have been done by the Applicant in his employment with CFIPL or his activities in negotiating deals for APL. Cases like Day,
Commissioner for Taxation v Rowe [1995] FCA 1611 and
Shokker v Commissioner of Taxation [1999] FCA 600 all concerned employment from which assessable income was to be derived that was on foot and continuing and directly the subject of inquiry by way of proceedings, the outcome of which had a direct bearing on the taxpayer's continued employment. The relationship of the defence of proceedings here to assessable income does not have that direct connection with the producing of assessable income by and largely because of the lack of any direct relationship between the income generating activities and the expenses incurred.
ATC 10908
Are the legal expenses deductible under s. 8-1(1)?
63. I have already dealt with the relevant principles that apply to determining whether a particular expense is deductible. That requires attention to 'whether the outgoing was incurred in the course of activities the nature of which might properly be characterised as gaining or producing assessable income'. As I have said that question involves identification of the 'essential character' of the expenditure from a 'practical business point of view'.
64. The character of the legal fees, like the settlement payment, is informed by what the fees were incurred for in the first place. As I have found earlier, the evidence suggests that they were incurred for a range of reasons which included the Applicant's defence of the proceedings involving the 'impugned conduct', that is the allegation of the Applicant engaging in 'unauthorised transactions' whilst performing his work under the Agreements and claims for leave payments: they were the activities that led to the Applicant gaining or producing assessable income. But the legal expenses also involved expenditure which was not incurred at all by the Applicant gaining assessable income. The legal fees that were incurred by CFIPL but paid for by the Applicant, the legal fees relating to aspects of the liquidation of CFIPL and the Applicant's threatened defamation proceedings were not incurred in the course of activities connected to gaining or producing assessable income. The legal fees for those things were not incurred in the course of activities which can be characterised as 'gaining or producing assessable income.'
65. The Applicant submitted that he paid the legal fees personally after December 2011 'because even though CFIPL was no longer actively trading' his long period of service with CFIPL formed the foundation of his experience and reputation in the finance industry, CFIPL was the principal source of his income over that period, he stood to recover leave entitlements that were in excess of $200,000 from the proceedings, because settlement of the share buyback with CFIPL would mean the Applicant would receive more fees from CFIPL and that he considered he was at risk of losing his employment with HP. I have dealt with the last-mentioned matter earlier in dealing with the settlement payment. So far as the other matters are concerned, apart from the leave entitlements (for which no separate amount of legal expenses can be attributed), they identify no activity that was relevant to the gaining or producing of assessable income for which the legal fees were incurred. Those expenses seem very much in the category referred to in Payne and Cooper as being preparatory to gaining or producing assessable income so far as the Applicant was concerned rather than activities undertaken in order to generate assessable income. Whether they be directed at protecting the Applicants reputation for the future or putting CFIPL in a position that it had funds to pay the Applicant they were not activities that were activities in the course of gaining or producing assessable income'. At best they were steps preparatory to gaining income.
66. The real difficulty is in any event an evidentiary one: the evidence such as it is does not permit any quantification of what legal expenses were incurred in the course of producing assessable income. Specifically, it is not possible to determine what expenses were incurred as a result of the Applicant's defence of the proceedings concerning the unauthorised transactions and, perhaps even the cross claim for leave entitlements on the one hand and what costs related to CFIPL's defence of those proceedings, to dealing with CFIPL's liquidation and to the Applicant's threatened action in defamation on the other hand. The latter matters were not things that can be characterised as activities that involved gaining or producing assessable income.
67. I am not satisfied that the Applicant's legal expenses were incurred in the course of gaining or producing assessable income.
Are the payments capital in nature or of a private or domestic nature?
68. Neither party made any submissions that directed attention to this issue with respect to the settlement payment except to identify the issue. The settlement payment does not have the feature of capital payment in the sense that it was not made from the standpoint of producing some longer-term benefit that might endure. The settlement payment did not involve the
ATC 10909
acquisition of any tangible asset, but rather arose out of the very activities the Applicant performed in gaining assessable income. The discharge of the liability that arose out of those activities cannot sensibly be characterised as capital in nature. Nor was the payment domestic or personal in nature, it was commercial in nature having its origins in the Applicant's work activities from which he generated assessable income. It is unnecessary to consider the question of whether the legal fees were capital in nature or of a private or domestic nature because I have already found they are not deductible.Section 25
69. The Applicant alternatively claimed the amount of $615 as being deductible under s. 25-2 of the ITAA because it was said that that amount was incurred in managing his tax affairs. I am not satisfied on the evidence that the costs were incurred in managing the Applicant's tax affairs. The only evidence that was led about the matter is that which is contained in the invoice dated 28 February 2014 and based on the entries in that invoice I am not satisfied those costs were incurred in managing the Applicant's tax affairs because the entries in that invoice in most cases do not support such a conclusion. Although two entries refer to emails from the Applicant containing the words 'tax deductibility' and 'tax advice' that does not contain sufficient detail that would satisfy me that the costs incurred related to any such things. The Applicant brought no other evidence about the issue.
70. I should also add even though the matter was raised at a very late stage of proceedings and was not raised in the Applicant's objection I gave leave to the Applicant to raise it because it was able to be dealt with fully.
CONCLUSION
71. The Commissioner's decision on 13 November 2019 is varied by allowing the Applicant to deduct from his assessable income in the 2014 tax year the $200,000 settlement payment made by him on 29 January 2014.
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