Edited version of private advice

Authorisation Number: 1051991078726

Date of advice: 20 June 2022

Ruling

Subject: Deductibility of legal expenses/interest expenses

Question 1

Are the legal fees deductible under section 8-1 of the Income Tax Assessment Act 1997?

Answer

No.

Question 2

Are the legal fees considered a capital expense under subsection 110-25 (6) of the Income Tax Assessment Act 1997 and therefore form part of the cost base?

Answer

Yes.

Question 3

Is the interest on the loan for the financial settlement in regard to the disputed inheritance of the property deductible under section 8-1 of the Income Tax Assessment Act 1997?

Answer

No.

Question 4

Can GST be claimed on the legal expenses incurred?

Answer

No.

This ruling applies for the following period:

Year ending 30 June 20XX

Year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You inherited land where you have for many years operated a primary production business including for many of those years with other members of your family and on your own prior to receiving the inheritance and continue to do so.

A dispute has arisen whereby the will is being contested by members of the family who did not receive allocation of the land in the will.

You have spent significant amounts on legal fees in defending your inheritance of the land.

If you were not to keep your inheritance you are fearful of your livelihood/business being taken away.

A settlement has been reached and you need to pay a significant amount to other family members to be the sole proprietor of the farmland.

You took a business loan from National Australia Bank; the purpose of the loan is to purchase of the farmland. You will use the fund to pay a lump sum to the family members, for you to keep the land.

Relevant legislative provisions

Section 8-1 of the Income Tax Assessment Act 1997

Section 110-25 of the Income Tax Assessment Act 1997

Division 11 of the A New Tax System (Goods and Services Tax) Act 1999

Reasons for decision

Deductibility of legal fees

Summary

As the owner of a property used to produce assessable income, legal fees incurred in taking action to defend your right over an asset are not an allowable deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) as the expense is of a capital nature.

It is considered that the legal expenses were not sufficiently connected with your income earning activities and were essentially private or capital in nature and character. Therefore, the legal expenses are not deductible under section 8-1 of the ITAA 1997.

Detailed reasoning

Section 8-1 of ITAA 1997 allows a deduction for a loss or an outgoing to the extent to which it is incurred in gaining or producing assessable income, except where the loss or outgoing is 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, the nature or character of the expenditure must be considered, that is, whether the legal expenses are incurred for a capital or a revenue purpose (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. For example, if the advantage to be gained is of a capital nature, then the legal expenses incurred in gaining the advantage will also be of a capital nature and are not deductible.

Capital Gains Tax and legal fees

Summary

The legal expenses were incurred for a capital purpose, that is the right to a capital asset being the land. Therefore, the expenses are considered capital in nature.

Detailed reasoning

As the owner of a property used to produce assessable income, legal fees incurred in taking action to defend your right over an asset are an allowable deduction under subsection 110-25(6) of ITAA 1997. This deduction will form part of the cost base of your asset for the purpose of determining any capital gains or losses when the asset is sold.

Under subsection 110-35(1) of the ITAA 1997 there are a number of incidental costs you may have incurred that are eligible to reduce your cost base. They are costs you may have incurred:

(a) to acquire a CGT asset; or

(b) that relate to a CGT event.

Capital expenditure incurred by a taxpayer to establish, preserve or defend their title to an asset, or a right over an asset forms the fifth element of the cost base of the asset under subsection 110-25(6) of the ITAA 1997.

As stated in Cooper, GS 1992, Capital gains tax, 2nd edn, Butterworths, Sydney, p. 87:

Defending the taxpayer's title or right seems to refer to action taken when the title or right is put in dispute. The most obvious example of this is where someone else lays a claim to the asset in whole or in part and institutes legal proceedings to establish that claim. Costs of the taxpayer in defending those proceedings would be costs in defending the taxpayer's title.

In your case, as this expense was incurred to preserve your right over the land, it forms part of the cost base of the land when the land is sold pursuant to subsection 110-25(6) of the ITAA 1997.

Deductibility of interest on loans

Summary

Deductibility of interest expense under section 8-1 of ITAA 1997 depends on the use to which the borrowed money is put. In your case the loan is to keep your title to the land rather than to produce income.

Detailed reasoning

Where borrowed funds are used for private purposes, such as the acquisition of a home or other personal or private asset, the interest will generally not be deductible even if there is a secondary result that other assessable income-producing assets are thereby able to be retained. Where borrowed funds are used to acquire assessable income-producing assets, to finance business operations or to meet current business expenses, interest will generally be deductible. However, where there is a disproportion between the outgoing and the assessable income produced, the courts may look to an independent motive to determine whether the outgoing was incurred only partly to produce assessable income.

The deductibility of a loss or outgoing comprising interest under section 8-1 of ITAA 1997 depends upon satisfying the words of the section, that is, being able to show that the loss or outgoing (or the part of the loss or outgoing in an appropriate case of apportionment) is:

(a) incurred by the taxpayer in gaining or producing assessable income of the taxpayer and the loss or outgoing is not capital, or of a capital, private or domestic nature ('first limb'); or

(b) necessarily incurred by the taxpayer in carrying on a business for the purpose of gaining or producing assessable income of the taxpayer and the loss or outgoing is not capital, or of a capital, private or domestic nature ('second limb').

In your case, although the loan is a business loan, the reason for incurring the legal costs did not arise from the commercial activities of conducting your farming enterprise. The purpose of the loan is to pay off a settlement to defend your title to the land. The expenses of defending title to a capital asset will be of a capital nature, and not deductible under section 8-1 of ITAA 1997. It may form part of the cost base of the land when the land is sold pursuant to section 110-25 of the ITAA 1997.

GST and legal fees

Summary

The acquisition of the legal fees occurred as a result of litigation which was connected to a private and domestic matter. The requirements for a creditable acquisition are not met because the acquisition was not for a creditable purpose. Therefore, you are not entitled to input tax credits in relation to the legal fees.

Detailed reasoning

Entities that are registered for GST are entitled to claim input tax credits for creditable acquisitions they make.

You make a creditable acquisition if:

(a) you acquire anything solely or partly for a creditable purpose; and

(b) the supply of the thing to you is a taxable supply; and

(c) you provide, or are liable to provide, consideration for the supply; and

(d) you are registered or required to be registered.

Section 11-15 of the GST Act states:

(1) You acquire a thing for a creditable purpose to the extent that you acquire it in carrying on your enterprise.

(2) However, you do not acquire the thing for a creditable purpose to the extent that:

(a) the acquisition relates to making supplies that would be input taxed; or

(b) the acquisition is of a private or domestic nature.

Subsection 11-15(1) of the A New Tax System (Goods and Services Tax) Act 1999 (GST Act) states that you acquire a thing for a creditable purpose to the extent that you acquire it in carrying on your enterprise. It is therefore necessary firstly to identify the enterprise that is being carried on and secondly to determine whether there is a connection between the acquisition and the enterprise being carried on.

You have carried out a primary production business for many years.

The second requirement in subsection 11-15(1) of the GST Act is that the acquisition (legal fees) has a connection to the enterprise being carried on.

Whether something is acquired in carrying on an enterprise requires a connection or link between the thing acquired and the enterprise.

Goods and Services Tax Ruling GSTR 2008/1 Goods and services tax: when do you acquire anything or import goods solely or partly for a creditable purpose? (GSTR 2008/1) at paragraph 70 lists some factors that would suggest that an acquisition is made in carrying on an enterprise. Of most relevance to your circumstances is:

•         the acquisition secures a real benefit or advantage for the commencement, continuance or termination of the enterprise;

•         the acquisition helps to protect or preserve the enterprise entity, structure or organisation; and

These factors are discussed further:

92. [...] In Magna Alloys, the Federal Court considered whether legal expenses incurred by a company in defending criminal action against several of its agents, the company directors and the company itself were deductible under subsection 51(1) of the ITAA 1936. The criminal action arose from allegations that secret commissions were being paid to employees of purchasers of their products to encourage them to recommend the use of Magna's products, rather than those of its competitors.

93. The Federal Court found that while the directors of the company may have been motivated by consideration of their own position in making the payments, this did not prevent the conclusion that the outgoings were reasonably capable of being seen as desirable and appropriate from the point of view of the business ends of the taxpayer's business. The Court also concluded that the expenditure was not of a private or domestic nature as the criminal charges arose from commercial activities carried on by the relevant company officers on the taxpayer's behalf.

94. In a GST context, the acquisitions would be made in carrying on the enterprise if the acquisitions had a sufficient connection to the commercial activities of the enterprise.

Applying these factors to your circumstances, the reason for incurring the legal costs did not arise from the commercial activities of conducting your farming enterprise. If the legal action was commenced to obtain a share in the farming business, then your acquisitions would have the required nexus to your enterprise. However, this is not the case here. Therefore, you are not entitled to input tax credits in relation to the legal fees.

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