Edited version of your written advice

Authorisation Number: 1051509207102

Date of advice: 24 April 2019

Ruling

Subject: Deductibility of legal expenses

Question

Can the Company deduct Legal Expenses and Associated Costs under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Question

Can the Company deduct Legal Expenses and Associated Costs under section 40-880 of the ITAA 1997?

Answer

No

This ruling applies for the following period:

1 July 20XX to 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

The Business

The Company operates a Business.

The Business has been operating for nearly 10 years and originally operated from a factory and yard space.

The New Property

The lease of the factory and yard space was not renewed as the Company intended to move its business operations to a New Property.

The New Property is owned by an Individual associated with the Company.

Council approval of purpose built sheds on the New Property

In 20XX, a planning application was lodged with the Council by the Individual to build purpose built sheds on the New Property (with the intention of moving the Business to theses premises). The planning application was approved for the new sheds to be built on the land.

The Council development application regarding the use of the New Property

In 20XX, a further development application was lodged with the Council by the Individual and this application sought approval to use the site (including existing and approved sheds) as a depot and ancillary office.

This application was considered by the Council and was refused for various reasons relating to the environment, safety and planning and land usage restrictions.

The Council consequently advised that the depot use was to cease immediately and all related machinery and equipment were to be removed from the site within 60 days from the date of notification or the Council would commence legal action for the proposed unauthorised activity.

The Appeal and the Legal Expenses and Associated Costs

In late 20XX, the Individual lodged an appeal with the Land and Environment Court against the decision. In preparation for the appeal, further investigations were undertaken and consultants were engaged to support the applicant’s contentions that the proposed use of the New Property was permissible and in accordance with the relevant legislation and guidelines regarding the environment, amenity, town planning and traffic.

Legal Expenses and Associated Costs were incurred by the Company for the preparation and presentation of the various reports, in chamber meetings with the commissioner and site hearings regarding the application for the Company’s operations (Legal Expenses and Associated Costs).

The Business during the period of dispute

The Company continued to conduct its Business throughout the period of time that the Legal Expenses and Associated Costs were being incurred however its use of the New Property in the Business was limited due to the refusal of the Council approvals. As a result, another premises was rented by the Company during this time to meet its business operations.

A commercial lease was entered into in 20XX between the Individual and the Company for the use of Sheds on the New Property. The lease agreement provides that the term of the lease shall be for 3 years, with an option to renew the lease for a further 3 years. The lease agreement further states that the premises shall only be used as an office and for the storage of equipment.

Relevant legislative provisions

Section 8-1 of the ITAA 1997

Section 40-880 of the ITAA 1997

Subsection 40-880(2) of the ITAA 1997

Paragraph 40-880(5)(d) of the ITAA 1997

Paragraph 40-880(5)(f) of the ITAA 1997

Reasons for decision

Question 1

Summary

The Legal Expenses and Associated Costs that the Company has incurred are not deductible under section 8-1 of the ITAA 1997 as they are considered to be outgoings of a capital nature.

Detailed reasoning

Legal expenses that are not deductible under specific provisions of the ITAA fall for consideration under section 8-1 of the ITAA 1997.

Section 8-1 of the ITAA 1997 allows a general deduction for a loss or outgoing to the extent that it is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However, no deduction is allowed where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.

In determining whether a deduction for 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). The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses.

Legal expenses are generally deductible if they arise out of the day to day activities of the taxpayer's business (Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 39 ALR 46; (1932) 2 ATD 169) and the legal action has more than a peripheral connection to the taxpayer's income producing activities (Magna Alloys and Research Pty Ltd v. FC of T (1980) 49 FLR 183; (1980) 11 ATR 276; 80 ATC 4542).

In the current circumstances, the Legal Expenses and Associated Costs were incurred in relation to contesting the refusal by the Council of a development application which would allow the Company to conduct its Business at the New Property. These expenses included the preparation and presentation of various reports, in-chamber meetings with the commissioner and site hearings regarding the application for the Company’s operations. The legal expenses do not arise out of the day to day activities of the Company’s Business. Although its ability to use the New Property in the Business has been limited by the development application dispute, there is no real threat to its current income earning operations, as the Company continued to operate the Business (by leasing another property close by) during the relevant period. In contrast, the expenses incurred in relation to the disputed development application and the use/lease of the New Premises are considered to relate to the profit yielding structure of the Business.

As a result, the Legal Expenses and Associated Costs are considered to be of a capital nature as the advantages sought from incurring these expenses are of a capital nature. Therefore, the Company is not entitled to a deduction for these expenses under section 8-1 of the ITAA 1997.

Question 2

Summary

The Legal Expenses and Associated Costs incurred by the Company in contesting the development application which would allow the Company to conduct its Business at the New Property are not deductible under section 40-880 of the ITAA 1997.

Detailed reasoning

Section 40-880 of the ITAA 1997 is a provision of last resort which allows a deduction over five income years for certain business capital expenditure incurred after 30 June 2005 which is not otherwise taken into account or denied a deduction by some other provision.

Subsection 40-880(2) of the ITAA 1997 specifically provides that you can deduct, in equal proportions over a period of five income years starting in the year in which you incur it, capital expenditure you incur:

(a) in relation to your business; or

(b) in relation to a business that used to be carried on; or

(c) in relation to a business proposed to be carried on; or

(d) to liquidate or deregister a company of which you were a member, to wind up a partnership of which you were a partner or to wind up a trust of which you were a beneficiary, that carried on a business.

As detailed above, it is considered that the expenditure incurred by the Company on the Legal Expenses and Associated Costs is of a capital nature. In addition, it is also considered that in these circumstances, there is a sufficient and relevant connection between the expenditure incurred on the legal fees contesting the refusal by the Council of the development application and the business carried on by the Company given that this application directly affects the Company’s ability to conduct its Business at the New Property. Accordingly, the expenditure the Company incurred on the Legal Expenses and Associated Costs is capital expenditure incurred in relation to its business and therefore satisfies the requirements of subsection 40-880(2) of the ITAA 1997.

Subsection 40-880(2) of the ITAA 1997 is however subject to the limitations and exclusions outlined in subsections 40-880(3) to 40-880(9) of the ITAA 1997. Of these exceptions, it is considered necessary to examine those contained in paragraphs 40-880(5)(d) and 40-880(5)(f) of the ITAA 1997 based on the facts of this case.

In this regard, paragraph 40-880(5)(d) of the ITAA 1997 provides that you cannot deduct any amount of expenditure you incur to the extent that it is in relation to a lease or other legal or equitable right.

The Commissioner’s view on the application of section 40-880 of the ITAA 1997 is set out in Taxation Ruling TR 2011/6: Income tax: business related capital expenditure – section 40-880 of the Income Tax Assessment Act 1997 core issues (TR 2011/6).

Paragraph 239 of TR 2011/6 elaborates on the application of this exception as it states:

The legislative context of section 40-880 indicates that expenditure ‘in relation to a lease or other legal or equitable right’ must be relevantly related to a lease or right. To be relevantly related there must be an objective connection between the expenditure and the acquisition, creation, alteration or termination of the lease or right. The context also indicates that the expenditure that relates to a lease or right is expenditure in addition to expenditure which falls within the other exceptions in subsection 40-880(5) such as paragraph 40-880(5)(a) or 40-880(5)(f). In other words, expenditure incurred by the taxpayer which has the requisite connection with a lease or right and which is not captured by another subsection 40-880(5) exception will fall within paragraph 40-880(5)(d).

In the current circumstances, the Legal Expenses and Associated Costs were incurred in relation to contesting the refusal by the Council of a development application regarding the use of the New Property. The New Property was leased by the Company and the development application directly affected the way in which the Company was able to utilise the New Property in its Business. Accordingly, it is considered the legal expenses would constitute expenditure that is ‘in relation to’ a lease or other equitable right and therefore paragraph 40-880(5)(d) of the ITAA 1997 would prevent the Company from claiming a deduction for the expenditure under section 40-880 of the ITAA 1997.

In addition, paragraph 40-880(5)(f) of the ITAA 1997 excludes from the operation of section 40-880 of the ITAA 1997 any expenditure that could be taken into account in working out the amount of a capital gain or a capital loss from a CGT event. Generally, two factors: capital proceeds and cost base (or reduced cost base) are taken into account in working out a capital gain or capital loss from a CGT event (section 100-40 of the ITAA 1997).

In the current circumstances, the lease of the New Property is a CGT asset of the Company. If the expenditure incurred by the Company forms part of the cost base of this asset, for example as part of the fourth cost base element in subsection 110-25(5) of the ITAA 1997, the expenses would also be precluded from the section 40-880 deduction under paragraph 40-880(5)(f) of the ITAA 1997.

This is because the expenditure may be taken into account in working out the amount of a capital gain or a capital loss from a later CGT event, for example, if CGT event C2 happens upon expiration of the lease. It is noted that to be included in the fourth cost base element it would be necessary to demonstrate that the Legal Expenses and Associated Costs are capital expenditure incurred the purpose or the expected effect of which is to increase or preserve the value of the lease.

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