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Is the taxpayer entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for a loss of accumulated undrawn partnership profits upon resignation from the partnership?

No. The taxpayer is not entitled to a deduction under section 8-1 of the ITAA 1997 for a loss of accumulated undrawn partnership profits upon resignation from the partnership.

The taxpayer resigned from a partnership (old partnership) in order to commence a new partnership (new partnership). These partnerships carried on their income earning activities in the same professional field.

Under an agreement by which they resigned from the old partnership an amount of the old partnership's work in progress was transferred to the taxpayer. The transfer of the work in progress was made in full settlement of all claims the taxpayer had with regard to the old partnership.

At the date of their resignation the taxpayer had been entitled to an amount of accumulated undrawn profits.

Upon their resignation they did not receive any payment in respect of the accumulated undrawn profits.

Section 8-1 of the ITAA 1997 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 loss or outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income (subsection 8-1(2) of the ITAA 1997).

The phrase 'in gaining or producing' assessable income has been interpreted as meaning 'in the course of' gaining or producing assessable income ( Amalgamated Zinc (De Bavay's) Ltd v. Federal Commissioner of Taxation (1935) 54 CLR 295; 3 ATD 288).

In Peyton v. Federal Commissioner of Taxation (1963) 109 CLR 315; 13 ATD 133; (1963) 9 AITR 112 a taxpayer, wishing to sell a hotel business, was required to pay the lessor the estimated cost of repairs to the hotel premises prior to the lessor giving consent to the transfer of the lease to the new owner. The High Court held that the expense was not an allowable deduction on the basis that it was incurred in order to dispose of the business rather than in gaining or producing assessable income or to carry on a business for the purpose of gaining or producing assessable income.

In the circumstances here, the taxpayer's loss was incurred as a result of the agreement under which they resigned from the old partnership. Their decision to forfeit the accumulated undrawn profits was part of that agreement and was made in order to facilitate their resignation from that partnership. The loss was not incurred in gaining or producing assessable income or carrying on a business for the purpose of gaining or producing assessable income from the old partnership.

In addition, there is no nexus between the loss and the assessable income from the new partnership as the loss was incurred at a point too soon to be incidental and relevant to the earning of that income.

Neither was the loss incurred in earning income from the work in progress that was transferred to them as a result of the termination of the old partnership. It was not incurred in order to acquire the work in progress or in order to earn future income from it. It was simply something the taxpayer forfeited or gave up in order to facilitate their departure from the old partnership.

Accordingly, the loss has not been incurred in earning the assessable income of the taxpayer and therefore is not deductible under section 8-1 of the ITAA 1997.

In any event had the loss passed the positive limb under subsection 8-1(1) of the ITAA 1997 it would be necessary to consider whether the loss is of a capital nature and therefore excluded under subsection 8-1(2) of the ITAA 1997.

In Associated Newspapers Ltd & Sun Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; 5 ATD 87; (1938) 1 AITR 403 Dixon J explained distinction between a capital or revenue expense in the following terms: ... (the) distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure, or organization set up or established for the earning of profit and the process by which such an organization operates to obtain regular returns by means of regular outlay, the difference between the outlay and returns representing profit or loss.

In the taxpayer's case the loss was incurred in terminating the old partnership and commencing the new partnership. As such, it relates directly to the abolition of one '...business entity, structure, or organisation set up or established for the earning of profit...' and the creation of another. As such it would be considered to be a loss of a capital nature and excluded by subsection 8-1(2) of the ITAA 1997.

Therefore, the taxpayer is not entitled to a deduction under section 8-1 of the ITAA 1997 as the loss was not incurred in gaining or producing assessable income or in carrying on a business for the purpose of gaining or producing assessable income. In addition, it is a loss of a capital nature.