Edited version of private advice

Authorisation Number: 1051618628475

Date of advice: 18 December 2019

Ruling

Subject: Legal expenses

Question 1

Is a deduction allowed for the legal expenses incurred?

Answer

No.

Question 2

Do any amount of the legal expenses form part of the cost base of the shares?

Answer

No.

This ruling applies for the following period

Year ended 30 June 2018

The scheme commenced on

1 July 2017

Relevant facts

Entity A is the director of entity B, where shares were issued to the following entities:

·        Entity C,

·        Entity D, and

·        Entity E.

Entity F is a corporate trust and trustee for entity D, where entity A's spouse, entity G, is the sole director and shareholder.

Entity F paid for entity D's shares in entity B.

The trust deed of entity D lists entity G as the named beneficiary with a general clause of eligible beneficiaries including the spouse of the named beneficiary.

Entity B was set up in xxxx and acquired shares in entity B in xxxx.

In xxxx, the entity H entered into a binding term agreement with entity F to purchase the shares in entity B in return for ordinary shares in entity J. The term sheet also included a three year employment contract for entity A which was executed on xxxx.

In xxxx, the share Sale and Subscription Agreement between entity D, entity C, entity J and entity A is executed for the sale of shares in entity B and the acquisition of shares in the buying entity, however a share certificate is not issued to entity D.

In xxxx, the Executive Chairman informs entity A in a meeting that entity B is no longer a strategic fit and wishes to pass 100% of its shares in entity B back to entity F. Entity H threatened to wind up entity B in the event entity F and entity A declined the offer. At this time entity A and entity F seek legal action advice.

Entity D's share certificate in entity J is dated xxxx.

On xxxx, entity A is formally suspended from attending the work place and forced to take special leave pending an investigation into matters that may lead to a charge of serious misconduct. An investigator is to be appointed and entity A will be given the opportunity to respond.

Through legal intervention, entity A and his lawyer force entity J to issue the share certificate. An investigation into entity A's potential serious misconduct is not commenced and an investigator is not appointed. Entity A and their lawyer seek the enforcement of the employment contract terms and the payout of the remaining two years of the three year contract. The company counters with the transfer of the original business back to entity A with no consideration. Through a series of meetings, no agreement is reached between the two parties. On the basis that the company will form a constructive dismissal case against entity A, they resign their position on xxxx giving four weeks' notice. Entity A reserves their rights.

In xxxx, neither an investigation nor an investigator has been advised and no matters have been documented to entity A that would potentially lead to a dismissal. Entity A has retained the shareholding in entity J. The company intends to wind up entity B and legal advice suggests that any post-employment restraints would disappear on the wind up of the original business.

On xxxx, entity A lodged a small claims submission to the Federal Circuit Court as entity H did not pay their final payment of approximately $xxxx which included salary, leave benefits and expense reimbursements.

The above matters have not been settled at this time.

Invoices from the lawyer were made out to entity F.

Legal expenses relating to entity A's employment agreement were paid by entity A & entity G's personal bank account.

Entity D remains as the shareholder of entity J.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Income Tax Assessment Act 1997 Section 110-25.

Reasons for decision

Allowable deductions - legal expenses

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income or are necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income, or a provision of the ITAA 1997 prevents it.

A number of significant court decisions have determined that for an expense to be an allowable deduction:

·        it must have 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, (Lunney's case)),

·        there must be a nexus between the outgoing 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), and

·        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 his or her 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 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 or business operations. Also, 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. If the advantage to be gained is of a capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature.

Legal expenses are generally deductible if they arise out of the day to day income earning activities (Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 39 ALR 46; (1932) 2 ATD 169 (the Herald and Weekly Times Case)) 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 80 ATC 4542; (1980) 11 ATR 276).

An expense, will usually be capital in nature where it is incurred with the intention to create an asset or advantage of a lasting and enduring nature. (British Insulated & Helsby Cables Ltd v. Atherton (1926) AC 205) The nature of the advantage sought by the taxpayer is therefore relevant.

It is a long standing principle that a taxpayer does not satisfy section 8-1 of the ITAA 1997 merely by demonstrating some casual connection between the expenditure and the derivation of income. What must be shown is a closer and more immediate connection. The expenditure must be incurred in gaining or producing assessable income (Lunney's case). These principles have been affirmed by the High Court in Commissioner of Taxation v Payne [2001] HCA 3.

In order to determine whether the legal fees are deductible under section 8-1 of the ITAA 1997, we first need to look at the reason for the legal fees, which entity incurred the expenses and why they were incurred.

The legal expenses incurred relate the issue of a share certificate to entity D, the winding up of entity B and entity A's employment contract.

Entering into a Binding Term Sheet and a Share Sale and Subscription Agreement and requesting the issue of a Share Certificate all relate to the share ownership of entity D. Shares in a company are a capital asset and any legal expenses incurred in relation to defending your ownership of the shares and related matters are capital in nature. As such, the associated legal expenses are not deductible under section 8-1 of the ITAA 1997.

Furthermore, some of the legal expenses relate to other entities and not to the assessable income of entity D. Therefore no deduction is allowed.

Additionally, the invoices from the lawyers are made out to entity F and not entity D. We acknowledge that entity F is the trustee of entity D, however for taxation matters, entity F and entity D are two separate entities. As entity D has not incurred any legal expenses, no deduction is allowed.

Capital gains tax provisions

In certain circumstances, legal expenses may form part of the cost base for capital gains tax (CGT) purposes.

Section 102-20 of the ITAA 1997 states that a capital gain or capital loss is made only if a CGT event happens. Under section 104-10 of the ITAA 1997, CGT event A1 happens when you dispose of a CGT asset.

The cost base

Section 110-25 of the ITAA 1997 provides general rules about the cost base.

Under subsection 110-25(6) of the ITAA 1997, the fifth element of the cost base is capital expenditure that you incurred to establish, preserve or defend your title to the asset, or a right over the asset.

Where an entity does not incur such capital expenditure, then such expenditure is not part of the cost base.

In this case, entity D has not incurred any legal expenses, therefore no part of the legal expenses form part of the cost base of the shares.

Taxation Ruling TR 97/7 provides further information on the meaning of incurred.

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