Edited version of private advice

Authorisation Number: 1052133105898

Date of advice: 30 June 2023

Ruling

Subject: Deductibility of legal expenses

Question 1

Are you able to deduct $X from your assessable income in the year ended 30 June 20XX pursuant to section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?[1]

Answer

No.

Question 2

Are you able to deduct $X from your assessable income in the year ended 30 June 20XX pursuant to section 25-5?

Answer

Yes.

This ruling applies for the following period

Income year ended 30 June 20AA

Relevant facts and circumstances

Background

1.         You and X are spouses.

Individual ATO Tax Affairs matters:

2.         In 20XX, you were audited by the ATO. The audit reviewed your tax affairs for the years ended 30 June 20AA to 30 June 20XX. During this time, you engaged the lawyer as a representative for auditing your tax affairs.

3.         As a result of the audit of your tax affairs, the Commissioner amended your assessments for the years ended 30 June 20AA to 30 June 20XX.

Objections to assessments:

4.         In 20ZZ, you lodged an objection to your amended assessments issued as a result the Commissioner's audit of your tax affairs for years ended 30 June 20AA to 30 June 20XX. The Commissioner disallowed your objection for these years.

Appeal with the Administration Appeals Tribunal:

5.         In 20ZZ, your lawyer lodged an application for review of the Commissioner's decision to disallow your objection in the Administrative Appeals Tribunal (AAT).

6.         Your lawyer later withdrew your application for appeal against the objection decision.

Legal fees incurred in managing your tax affairs

7.         As explained above, your lawyer represented you in relation to the audit of your tax affairs, your objection, and the appeal with the AAT. Consequently, you incurred legal fees associated with these actions.

8.         In 20ZZ, your lawyer sent a letter to you and your spouse summarising the remaining amount of legal fees owing to them. This amount comprised of an amount relating to:

a.         legal fees associated with your and your spouse's individual tax affairs, with regards to your tax audit, objection, and appeal, and

b.         matters unrelated to your tax affairs.

9.         The outstanding amount owing to your lawyer relate to legal fees with invoice dates in the year ended 30 June 20XX.

10.      You and your spouse then disputed the amount of legal fees owing to the lawyer and entered into settlement negotiations regarding this. As a result of the settlement negotiations, you and your spouse executed a Deed of Settlement and Release with your lawyer in which all parties agreed to settle the outstanding legal fees for a lesser amount.

11.      The lesser settlement sum was apportioned between legal fees for the management of your and your spouse's tax affairs and for matters unrelated to your individual tax affairs.

Relevant legislative provisions

Section 8-1 of the Income Tax Assessment Act 1997

Section 25-5 of the Income Tax Assessment Act 1997

Section 995-1 of the Income Tax Assessment Act 1997

Reasons for decision

Question 1

Are you able to deduct $X from your assessable income in the year ended 30 June 20XX pursuant to section 8-1?

Detailed reasoning

General deductions

12.      Section 8-1 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income except where the outgoings are of capital, private or domestic in nature, or relate to the earning of exempt income or a provision of the taxation legislation excludes it.

13.      Taxation Ruling 1999/10 Income tax and fringe benefits tax: Members of Parliament - allowances, reimbursements, donations and gifts, benefits, deductions, and recoupments (TR 1999/10) explains that legal expenses will be an allowable deduction when incurred out of day-to-day activities through which the taxpayer's assessable income is gained or produced as work-related activities, where the expenses are not capital, private or domestic in nature. Paragraph 93 of TR 1999/10 explains that for an expense to be deductible:

a.         it must have the essential character of an expense incurred in gaining your assessable income or, in other words, of an income producing expense

b.         there must be a nexus, or link, between the expense and your assessable income so that the expense is incidental and relevant to the gaining of the assessable income, and

c. it is necessary to determine the connection between the expense and the operations or activities by which you more directly gain or produce your assessable income.

Application to your circumstances:

14.      Under section 8-1, a deduction is allowable when a loss or outgoing is incurred in gaining or producing assessable income. In your case, the legal expenses were not incurred in gaining or producing your assessable income. Rather, the legal expenses were incurred in managing your tax affairs. As such, section 8-1 has not been satisfied and you are unable to deduct the $X pursuant to this provision.

Question 2

Are you able to deduct $X from your assessable income in the year ended 30 June 20XX pursuant to section 25-5?

Detailed reasoning

Tax-related expenses:

15.      Subsection 25-5(1) provides an allowable deduction for expenditure to the extent it was incurred for:

a.         managing your tax affairs

b.         complying with an obligation imposed by a Commonwealth law to the extent the obligation is in relation to your tax affairs

c.         the general or shortfall interest charge

d.         a penalty under Subdivision 162-D of the GST Act

e.         a levy under the Major Bank Levy Act 2017, or

f.          obtaining a valuation pursuant to section 30-212 or 31-15.

16.      Section 995-1 defines the term 'tax affairs' as affairs in relation to all income taxes.

17.      However, subsection 25-5(4) provides that a taxpayer cannot deduct capital expenditure.

When is an expense incurred?

18.      For an expense to be claimed as a deduction pursuant to subsection 25-5(1), a taxpayer must have 'incurred' an expense.

19.      The term 'incurred' is not defined in the legislation, hence guidance on the meaning of the term can be found in case law.

20.      FC of T v. James Flood (1953) (James Flood) 88 CLR 492 establishes that a loss or outgoing is incurred where the taxpayer has 'completely subjected itself' to the loss or outgoing. Further, the court commented at page 506:

Because of the word 'incurred' the provision has been interpreted to cover outgoings to which the taxpayer is definitely committed in the year of income although there has been no actual disbursement.

21.      In Nilsen Development Laboratories Pty Ltd v. Federal Commissioner of Taxation (1981) 144 CLR 616 (Nilsen), the term 'incurred' was used as meaning when a taxpayer has 'presently existing liability'. In particular, Barwick CJ stated of the judgment that 'there can be no warrant for treating a liability which has not 'come home' in the year of income, in the sense of a pecuniary obligation which has become due, as having been incurred in that year.'[2]

22.      Barwick CJ further emphasised that the word incurred does not include a loss or expenditure which is no more than pending, threatened, or expected' no matter how certain it is in the year of income that that loss or expenditure will occur in the future.[3]

23.      In New Zealand Flax Investments Ltd v. FC of T (1938) 61 CLR 179, Dixon J commented at page 207 that incurred does not include expenditure which is 'no more than impending, threatened or expected.'

Application to your circumstances:

24.      In order to deduct your legal expenses pursuant to section 25-5, these legal expenses must relate to one of the six conditions contained in the provision. Of relevance to your circumstances is paragraph 25-5(1)(a), which provides that the legal fees must have been incurred in relation to managing your taxation affairs.

25.      As you were subject to an audit, you engaged a lawyer to manage your personal tax affairs and for legal advice in relation to the audit for your individual tax affairs. You also incurred litigation costs for the service of a lawyer in managing your tax affairs (court fees, AAT fees and solicitor/barrister/other legal fees).

26.      Of the $X in legal fees incurred, a portion related to the management of your and your spouse's tax affairs. You and your lawyer reached a mutual agreement to reduce the total amount owing for the service of all legal fees.

27.      Therefore, the legal expenses were apportioned between amounts that related for the management of your personal tax affairs and matters unrelated to the management of your tax affairs.

28.      As per the principle in Nilsen, you incurred the legal fees when you had 'presently existing liability' to pay them. Consistent with the principle in James Flood, you were committed to pay these legal fees at the invoice dates as the expenses had been incurred despite the fact that you had yet made payment on them. That is, you had a present existing liability to pay the legal fees upon the dates of the invoices provided to you by the lawyer. Consequently, you incurred the legal fees on the dates as provided by the invoices, that is, between October to December 20XX.

29.      In conclusion, you incurred legal fees of $X in relation to the management of your personal tax affairs in the year ended 30 June 20XX. Therefore, paragraph 25-5(1)(a) has been satisfied and you are entitled to deduct $X from your assessable income in the year ended 30 June 20XX.

[1] All future references are to the Income Tax Assessment Act 1997, unless otherwise indicated.

[2] at page 623.

[3] at page 624.

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