Edited version of private advice

Authorisation Number: 1052230736882

Subject: Legal expenses

Issues

Question 1

Is the Company entitled to claim a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for the payment of 50% of the Settlement Sum due under the Deed of Settlement and Release (the Deed)?

Answer

Yes

Question 2

Is the Ex-Partner entitled to claim a deduction under section 8-1 of the ITAA 1997 for the payment of 50% of the Settlement Sum due under the Deed?

Answer

Yes

Question 3

Is the Company entitled to claim a tax deduction under section 8-1 of the ITAA 1997 for legal expenses incurred in defending a claim against the Company pursuant to a State Act?

Answer

Yes

Question 4

Is the Ex-Partner entitled to claim a tax deduction under section 8-1 of the ITAA 1997 for legal expenses incurred in defending a claim against the Company pursuant to a State Act

Answer

Yes

This ruling applies for the following periods:

1 July XXXX to 30 June XXXX

Relevant facts and circumstances

The Company

The Company was registered on XXXX.

The Company carried on a construction business.

The Partnership

In or around XXXX, the following individuals formed a partnership (the Partnership) for the

purpose of acquiring the Property:

•        Partner 1 (the Deceased);

•        Partner 2 (the Ex-Partner);

•        Partner 3;

•        Partner 4;

•        Partner 5; and

•        Partner 6

(collectively referred to as the Partners or Ex-Partners as relevant).

The Property was acquired as tenants in common in equal shares.

Each Partner had a one-sixth interest in the Partnership which entered into a business to

carry out the land development.

In or around XXXX, the Company constructed a development on the Property comprising X units (however, there was no partnership between the Company and the Partners).

Dissolution of the Partnership

The Partnership ceased to exist upon completion of the partnership business in XXXX. At which time, all Partnership liabilities were paid and all remaining Partnership assets distributed. The Partners subsequently lodged their final tax returns (for the Partnership) in XXXX and cancelled the Partnership's ABN and GST registrations.

The Estate of the Deceased

The Deceased died on XXXX.

The grant of probate was issued on XXXX and the estate administered shortly thereafter. Subject to our comments below, any interest that the Deceased held in the partnership formed part of the balance of their estate. Under their Will and Codicil, the Deceased gifted the balance of their estate in equal shares to the trustees of the testamentary trusts constituted under their Will.

Legal proceedings in relation to the development of the Property

In or around XXXX, it came to light that there were significant defects in the building.

In XXXX, the Owners commenced proceedings against the Company and the Ex-Partners in the Supreme Court of the State.

Relevantly, the Act of that State sets out the statutory warranties which are implied into all contracts for residential building work. The statutory warranties are given by the holder of a contract licence and serve as a guarantee that the work will be to the requisite standard and will be in accordance with contract plans and specifications.

On XXXX, the Owners, the Company and the Ex-Partners entered into a Deed of Settlement and Release (the Deed) to resolve the proceedings on commercial terms.

Pursuant to the Deed, the Settlement Amount and the Invoices (Settlement Amount) have been and will be paid as follows:

•        50% of the total amount by the Ex-Partner; and

•        50% of the total amount by the Company.

The Settlement Sum will be approximately $x,000,000, meaning that each of Ex-Partner and the Company will be liable to pay approximately $x,000,000.

The Company and Ex-Partner have, under a separate verbal agreement, agreed that the Company and Ex-Partner will pay the entirety of the Settlement Amount in return for which the other partners agree not to sue them for negligence.

The Company and the Ex-Partner incurred legal expenses with respect to the legal proceedings. The expenses covered various legal activities including responding to claims, filing counter-affidavits, attending mediation sessions, and engaging in negotiations towards a settlement (Legal Fees).

Each, i.e. the Company and the Ex-Partner, are claiming a deduction for the Legal Fees in proportion to the extent that they were incurred by each taxpayer.

Taxpayers' contentions

The Ex-Partner paid more than their share of the joint obligation (noting that the settlement relates to the Owners' claim against the Partnership and the Company) and did not seek contributions from the other Ex-Partners. The reason for this is because it was the Ex-Partner and the Deceased who were involved in the building work, utilising the builder license of the Company. The other Ex- Partners were simply investors in the project.

Further, given that the Deceased had passed away, the Ex-Partner became responsible for their share as well.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Summary

The Company and Ex-Partner are each entitled to claim a deduction under section 8-1 of the ITAA 1997 for their portion of the Settlement Sum and for the Legal Fees in proportion to the extent that they were incurred by each taxpayer.

Detailed reasoning

The deductibility of the settlement sum and legal fees.

You are entitled to a general deduction under section 8-1 for a loss or outgoing where the loss or outgoing satisfies either one of the two positive limbs under subsection 8-1(1) of the ITAA 1997 and are not prevented from claiming a deduction under any one of the four negative limbs in subsection 8-1(2). That is, there is an entitlement to a deduction for 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 to the extent to which they are losses or outgoings of a capital, private or domestic nature, or are incurred in relation to the gaining or production of exempt or non-assessable non-exempt income, or where another provision specially denies a deduction for the loss or outgoing

Company

Section 995-1 of the ITAA 1997 defines a company to mean:

(a) a body corporate; or

(b) any other unincorporated association or body of persons;

but does not include a partnership or a ^* non-entity joint venture.

Note 1:

Division 830 treats foreign hybrid companies as partnerships.

Note 2:

A reference to a company includes a reference to a corporate limited partnership: see section 94J of the Income Tax Assessment Act 1936

A company is a separate legal identity that determines its taxable income in accordance with Division 4 of the ITAA 1997 (having regard to the interaction between Division 4 and section 960-100 of the ITAA 1997 as it relates to a company). Broadly, this means a company subtracts its deductions from its assessable income.

Relevantly, this means that a company is entitled to a deduction for any loss or outgoing to the extent that the requirements of section 8-1 of the ITAA 1997 are satisfied.

Partnerships

A partnership is defined in section 995-1 of the ITAA 1997 to mean:

(a)          an association of persons (other than a company or a *limited partnership) carrying on business as partners or in receipt of *ordinary income or *statutory income jointly; or

(b)          a limited partnership.

The first limb of paragraph (a) of the definition refers to 'an association of persons (other than a company or limited partnership) carrying on business as partners'. This reflects the general law definition of a partnership, which is 'the relation which subsists between persons carrying on a business in common with a view of profit' (a general law partnership).

The Commissioner's view on the nature and income tax consequences of general law partnerships is set out in Goods and Services Tax Ruling GSTR 2003/13 Goods and services tax: general law partnerships, which explains that whilst a partnership is not a separate legal entity distinct from the individual partners under general law in relation to partnerships, it is treated as a separate entity for certain income tax purposes.

Income and deductions of a partner

Section 90 of the Income Tax Assessment Act 1936 (ITAA 1936) provides that the net income of the partnership is calculated 'as if the partnership was a taxpayer, less all allowable deductions' (except deductions allowable under section 290-150 or division 36 of the ITAA 1997). Section 91 then provides that a partnership shall lodge an income tax return but is not liable to pay tax on the income of the partnership.

Broadly, section 92 of the ITAA 1936 provides that the assessable income or deductions of a partner must include their individual interest in the net income or partnership loss, respectively.

Consequently, as a result of the operation of Division 5, any allowable deductions pursuant to section 8-1 of the ITAA 1997 are to be included in the calculation of the partnership's net income or loss (and not in the calculation of the assessable income of the partners).

Relevantly, this means that a partner in a partnership is not entitled to deduction for expenses or outgoings of a partnership that satisfy the requirements of section 8-1 of the ITAA 1997 in their own right.

Meaning of 'incurred'

You must incur the expenses or outgoings for the amounts to be deductible under section 8-1 of the ITAA 1997.

The word 'incurred' is not defined in the legislation.

FC of T v. James Flood (1953) 88 CLR 492 establishes that a loss or outgoing is incurred where the taxpayer has 'completely subjected itself' to the loss or outgoing:

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.

Taxation Ruling TR 97/7 Income Tax: section 8-1 - meaning of 'incurred' - timing of deductions (TR 97/7) sets out the Commissioner's view about the meaning of incurred which explains that you incur an expense when you have a presently existing liability to pay a pecuniary sum equal to that expense, or when payment of the expense is made in the absence of such a presently existing liability.

TR 97/7 explains that:

The courts have been reluctant to attempt an exhaustive definition of a term such as 'incurred'. The following propositions do not purport to do this, they help to outline the scope of the definition. The following general rules, settled by case law, assist in most cases in defining whether and when a loss or outgoing has been incurred:

(a)          a taxpayer need not actually have paid any money to have incurred an outgoing provided the taxpayer is definitively committed in the year of income. Accordingly, a loss or outgoing may be incurred within section 8-1 even though it remains unpaid, provided the taxpayer is 'completely subjected' to the loss or outgoing. That is, subject to the principles set out below, it is not sufficient if the liability is merely contingent or no more than pending, threatened or expected, no matter how certain it is in the year of income that the loss or outgoing will be incurred in the future. It must be a presently existing liability to pay a pecuniary sum;

(b)          a taxpayer may have a presently existing liability, even though the liability may be defeasible by others;

(c)           a taxpayer may have a presently existing liability, even though the amount of the liability cannot be precisely ascertained, provided it is capable of reasonable estimation (based on probabilities);

(d)          whether there is a presently existing liability is a legal question in each case, having regard to the circumstances under which the liability is claimed to arise;

(e)          in the case of a payment made in the absence of a presently existing liability (where the money ceases to be the taxpayer's funds) the expense is incurred when the money is paid.

TR 97/7 explains for the purposes of section 8-1 of the ITAA 1997, that even when a liability is defeasible by others, a taxpayer can be completely subjected to a liability:

... the taxpayer must be definitively committed to the outgoing, even though it may be defeasible. A taxpayer who takes goods on approval for example could not be said to be definitively committed to their purchase.

Nexus with assessable income / carrying on a business

Relevantly, to be deductible under section 8-1 of the ITAA 1997, expenses or outgoings must have a sufficient connection with:

•        the operations or activities by which you gain or produce your assessable income, or

•        the carrying on of your business for the purpose of gaining or producing assessable income.

Whether there is the necessary nexus between your expenses and outgoings and your income producing activities or carrying on your business is a question of fact to be determined by reference to all relevant facts and circumstances.

There will be such a sufficient connection where the expenses are incidental and relevant to the gaining or producing of your assessable income such that there is a requisite nexus between the expenses and the activities that you carry out to gain or produce assessable income (see, for example, Ronpibon Tin NL v. Federal Commissioner of Taxation (1949) 78 CLR 47 at 56; (1949) 8 ATD 431 at 435).

There will also be such a sufficient connection where the expenses are necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income such that there is the necessary connection between the expenses and the carrying on of your business for gaining or producing assessable income (see, for example. Federal Commissioner of Taxation v. Roberts & Smith 92 ATC 4380 at 4386; (1992) 23 ATR 494 at 502).

Essentially, the necessary connection will be established where:

•        the occasion of the expense is found in your income earning activity or business operation (see for example Ronpibon Tin N.L. and Tongkah Compound N.L. v Federal Commissioner of Taxation (1949) 78 CLR 47) - including where the occasion of the expense arose out of the day to day activities of your business or out of dealing with a normal incident to which you had been exposed in the day to day conduct of your business (see for example Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 2 ATD 169); and

•        the connection between the expense and whatever is productive of your assessable income or, if none is produced, would be expected to produce assessable income is not too remote (see for example, Magna Alloys and Research Pty Ltd v FC of T (1980) 11 ATR 276; 80 ATC 4542).

In Placer Pacific Management Pty Ltd v. FC of T 95 ATC 4459; (1995) 31 ATR 253 (Placer), the Court considered whether amounts incurred by the company as a result of a settlement of claim relating to business activities which the company had ceased prior to settlement would be allowable deductions in later years of income. Placer confirms that provided the occasion of loss or outgoing is to be found in the business operations or income-earning activity directed towards the gaining or production of assessable income generally, there may still be an entitlement to a deduction after the business or income- earning activity has ceased (i.e the cessation of the business or income-earning activity does not sever the nexus):

In our view AGC should be taken as establishing the proposition that provided the occasion of a business outgoing is to be found in the business operations directed towards the gaining or production of assessable income generally, the fact that that outgoing was incurred in a year later that the year in which the income was incurred and the fact that in the meantime business in the ordinary sense may have ceased will not determine the issue of deductibility. ... Provided the occasion for the loss or outgoing is to be found in the business operations directed to gaining or producing assessable income, that loss or outgoing will be deductible

On the facts of the present case the occasion of the loss or outgoing ultimately incurred in the year of income was the business arrangement entered into between Placer and NWCC for the supply of the conveyor belt which was alleged to be defective. The fact that the division had subsequently been sold and its active manufacturing business terminated does not deny deductibility to the outgoing. A finding to the contrary would lead to great inequity. Many businesses generate liabilities which may arise in the considerable future. Such liabilities are sometimes referred to as "long tail liabilities". To preclude deductibility when those liabilities come to fruition on the basis that the active trading business which gave rise to them had ceased would be unjust.

The Commissioner confirms these principles in TR 2004/4 Income tax: deductions for interest incurred prior to the commencement of, or following the cessation of, relevant income earning activities, noting that the principles from FC of T v. Jones 2002 ATC 4135; (2002) 49 ATR 188 (Jones), which relied on Placer, would apply to income earning activities that do not constitute a business, such as passive investments.

Relevantly, in Jones, the taxpayer and her late husband conducted a business in partnership. It continued until it was terminated by the death of the husband. Prior to the husband's death, the partners had entered into a re-financing arrangement with the bank. Following the cessation of the partnership business (and the termination of the partnership), the taxpayer was engaged in full-time employment and used her salary to repay the bank debt.

In determining that the taxpayer was entitled to claim a deduction in her own right under subsection 51(1) of the ITAA 1936 (noting subsection 51(1) of the ITAA 1936 preceded section 8-1 of the ITAA 1997 and that decisions on the former are equally relevant to the application of the latter - see e.g TR 2004/4), the court found that:

... interest payments on the indebtedness to the ANZ Bank made after the cessation of business were occasioned by the loan effected for the purpose of earning assessable income. Neither that cessation nor the passage of time thereafter until 22 May 1996 had the effect of breaking the nexus between such payments and the obligations incurred whilst the partnership was trading.

Where an examination of the objective facts and circumstances does not disclose an obvious significant connection between your expenses and your income earning activities or relevant business, it may be necessary and relevant to have regard to your subjective purpose, motive or intention (see, for example, Magna Alloys and Research Pty Ltd v. FC of T (1980) 11 ATR 276; 80 ATC 4542 and Taxation Ruling TR 95/33Income tax: subsection 51(1) - relevance of subjective purpose, motive or intention in determining the deductibility of losses and outgoings). This may be particularly so where the expenses are:

•        are incurred voluntarily, and

•        either:

o        no actual or expected assessable income can be identified

o        your actual or expected assessable income is less than your expenses, or

o        the connection between your expenses and the derivation of your assessable income or the carrying on of your business is not obvious.

The essential character of an expense is a decisive factor in determining the deductibility of a loss or outgoing for the purposes of section 8-1 of the ITAA 1997. A deduction will only be potentially available under section 8-1 to the extent the essential character of your expenses is of an income nature and not of a capital, private or domestic nature.

An expense can have more than one characterisation depending on the facts and circumstances. In these cases, issues of apportionment may arise.

Expenses take their character from the cause or purpose of incurring the expenditure. This in turn is also a question of fact, to be determined by reference to all relevant (and not irrelevant) facts and circumstances.

Sun Newspapers Ltd v Federal Commissioner of Taxation (1939) 61 CLR 337 (Sun Newspapers) set out, and entrenched, the matters that are relevant in distinguishing between capital and revenue expenditure. These include:

•        distinguishing between the profit-yielding subject and the process of operating it;

•        the nature of the asset or advantage obtained by the outlay; and

•        the difference between an outlay which is recurrent, repeated or continual and that which is final or made 'once and for all'.

No one matter is necessarily a determining factor.

As with considering the relevant connection to your income activities or relevant business, it may also be necessary to consider your subjective purpose when determining the character of your expenses.

Taking the Sun Newspapers factors into account, expenses tend to take their character from the cause or purpose for which they were incurred (see, for example, Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634). The main considerations in determining whether an expense is on revenue or capital account are:

•        whether the expenses relate to the profit yielding subject (which is indicative of a capital nature) or the process or operations of the profit-yielding structure (which is indicative of an income nature); and

•        whether the nature of the advantage sought to be gained is that of an enduring benefit (which is indicative of a capital nature).

On the other hand, factors that are not relevant in determining the deductibility of expenses include whether amounts (if any) received as a consequence of the legal action, are assessable or otherwise.

Apportionment

The use of the phrase 'to the extent that' in section 8-1 of the ITAA 1997 contemplates apportionment between the following:

•        expenses incurred in gaining or producing your assessable income of a non-capital nature, or necessarily incurred in carrying on your business for the purpose of gaining or producing assessable income that is ordinary income or statutory income of a non-capital nature); and

•        expenses that are of a capital, private or domestic nature, or incurred in relation to gaining or producing your exempt income or your NANE income, or for which you are entitled to a specific deduction or disallowed a deduction.

In determining the extent of your entitlement to deduction for your expenses under section 8-1 of the ITAA 1997, you can use any apportionment method that is fair and reasonable in your circumstances.

Joint and several liability

'Joint and several liability' relates to circumstances where a number of entities are both separately liable or obligated as well as together as a group liable or obligated to the specified liability. Consequently, it is a liability or obligation that can be discharged by one of the entities, some of the entities or all of the entities that are jointly and severally liable. As such, each entity will remain liable or obligated until the entire liability or obligation is discharged. For instance, where A and B are jointly and severally liable for a debt of $100 and A pays the entire $100, A will be entitled to claim against B in respect of B's respective obligation.

Broadly, in these circumstances the amount of a co-obligor's contribution with respect to a joint and several liability is prima facie to be assessed by dividing the amount of the common obligation by the number of solvent co-obligors still bound at the relevant time (see e.g. Staples v Milner as Trustee of Property of Staples, Baker, Firth & Campbell (1998) 83 FCR 203 and Gye v Davies (1995) 131 ALR 723).

Co-obligators

The Commissioner's view on guarantor's rights for capital gains tax purposes in Taxation Ruling TR 96/23 Income tax: capital gains: implications of a guarantee to pay a debt (TR 96/23) sets out principles that are generally relevant in this context in determining the CGT consequences for an entity who has paid or provided more than their share of a joint debt or liability.

Relevantly, TR 96/23 explains that, having regard to the principles enunciated in Leisureking Ltd v. Cushing (Inspector of Taxes) [1993] STC 46 (Leisureking), any capital loss is reduced if the guarantor is entitled to a contribution from co-guarantors.

Leisureking considered whether a capital loss relief was available in respect of whole amount paid under guarantee or part or none, where the taxpayer had paid the of whole debt/liability under guarantee made by taxpayer but took no steps taken to recover from its co-guarantors. The Court made the following observations:

•        Under the general law, a co-guarantor who discharged more than his share of a debt had an immediate right to be indemnified by the borrower. To the extent that a co-guarantor had paid more than his due share, he also had the right to contribution from other co-guarantors. Those who could pay had to make good the share of those who could not.

•        A guarantor claiming relief under the Capital Gain Tax Act 1979 had to satisfy the requirement that the loan could not be recovered from the borrower but there was no specific requirement that taken any steps had to be taken to recover contribution from co-guarantors. The possibility of recovery from co-guarantors was taken into account in the formula in the Capital Gain Tax Act 1979 (where the relevant provision prescribed the manner in which the loss was to be computed). There is no indication that a different test applied in relation to the possibility of recovery from a co-guarantor and from the borrower so that a co-guarantor's share of a debt had to be irrecoverable before relief could be granted to another co-guarantor discharging his liability.

•        The taxpayer had lost that part of the payment which he could not recover. He had not lost, in any real sense, that which he could, but did not choose, to recover. Reading the words "contribution payable to him" in Capital Gain Tax Act 1979 in the light of the general law it followed that, unless the special commissioner was satisfied on the evidence that the eight group companies whose contributions he had disregarded were not merely insolvent but had no assets available to meet the claims of unsecured creditors, he was wrong to disregard any possibility of recovery from them.

The Commissioner considers that it is relevant to consider all of the facts and circumstances surrounding the discharge of a joint and several liability in determining the deductibility of expenses where the manner in which the liability is discharged does not appear to reflect the ratio that would arise from dividing the amount of the common obligation by the number of solvent co-obligors (i.e. whether any part of the loss or outgoing in such circumstances are on capital account).

Application in these circumstances

The Deed provides that the Company, the Ex-Partner and other partners are jointly and severally liable for the Settlement Sum.

The Company and Ex-Partner have also incurred the Legal Fees.

The Company

The Company carried on a construction business. Relevantly, the State Act allows the purchaser and unrelated purchaser to pursue action against the Company by suing the Company (as the builder) for breach of contractual warranties for defective building work carried out on the Property by the Company.

It can be said that the occasion of the Settlement Sum paid by the Company in accordance with the Deed and its portion of the Legal Fees is found in the Company's income earning activity or business operation: that the occasion of the expenses arose out of the day-to-day activities of the Company's business or out of dealing with a normal incident to which the Company has been exposed in the day-to-day conduct of the Company's business.

With respect to the Settlement Sum, pursuant to the agreement between the defendants to the legal proceedings, the Company agreed to pay 50% of the Settlement Sum due under the Deed and the Ex-Partner agreed to pay the remaining 50%.

The Commissioner considers that it is appropriate in these circumstances to allow a deduction to the Company and the Ex-Partner for the monies paid under the agreement, having regard to the other Ex-Partners' right to sue for damages from the Company and the Ex-Partner due to their negligence in undertaking construction of the Property. While from the perspective of the aggrieved party, the Company and all Ex-Partners are jointly and severally liable, and this is accordingly reflected in the Deed, it does not mean that the Company and Ex-Partner who have agreed to pay the amount equally between them are not potentially liable for damages to the other Ex-Partners.

The Company is in the business of building and owes a duty of care to the (albeit related) Partners who engaged its services.

As the Company and Ex-Partner have, under a separate agreement with the other partners, agreed that the Company and Ex-Partner will between them pay the entirety of the Settlement Sum in return for which the other former partners agree not to sue them for negligence, it is reasonable to accept that the Company and Ex-Partner each have an entitlement to deduction with respect to their 50% of the Settlement Sum.

Consequently, the Company is entitled to claim a deduction for 50% Settlement Sum and its Legal Fees under section 8-1 of the ITAA 1997.

The Ex-Partner

The State Act also allows the purchaser to sue the Ex-Partners as developers of the Property with respect to defective building work carried out on the Property.

For the reasons set out above, the Ex-Partner is entitled to claim a deduction for 50% Settlement Sum and her Legal Expenses under section 8-1 of the ITAA 1997 - relevantly:

•        It can be said that the occasion of the Settlement Sum paid by the Ex-Partner in accordance with the Deed and their portion of the Legal Fees is found in the Ex-Partner's income earning activity or business operation (through the Partnership): that the occasion of the expenses arose out of the day-to-day activities of the Partnership's business or out of dealing with a normal incident to which the Ex-Partner has been exposed in the day-to-day conduct of the Partnerships business.

•        The Ex-Partner and their late spouse (the Deceased) were the Partners primarily responsible for the undertaking of the project, owed a duty of care to the other Partners (notwithstanding they remained jointly and severally liable for any damages arising from their activities). Having regard to Placer and Jones, it is considered that it is appropriate for the Ex-Partner, being the surviving active Partner, to claim a deduction for their share of the Settlement Sum, notwithstanding the dissolution of the Partnership prior to the commencement of the legal proceedings.

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