Deductibility of legal expenses incurred after cessation of business

Is a taxpayer entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for legal expenses incurred after the cessation of business?

Yes. A taxpayer is entitled to a deduction under section 8-1 of the ITAA 1997 for legal expenses incurred after the cessation of business where the occasion of the outgoing was in their previous business activities.

The taxpayer operated a business as a sole practitioner providing professional services.

The taxpayer later ceased business.

After they had ceased business legal action for negligence and misrepresentation was commenced against the taxpayer in relation to professional services they had provided while in business.

The legal action was settled out of court with the taxpayer paying a settlement sum and incurring solicitor and barristers fees.

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 outgoings are of a capital, private or domestic nature.

Legal expenses are deductible provided the legal action: • arose out of, or concerns the day to day income producing activities of the taxpayer ( Herald & Weekly Times v. Federal Commissioner of Taxation ( Herald & Weekly Times )(1932) 48 CLR 113; (1932) 2 ATD 169) • is not undertaken to protect the taxpayer's profit-yielding subject • has more than a peripheral connection to the taxpayer's business ( Magna Alloys and Research Pty Ltd v. FC of T 80 ATC 4542; (1980) 11 ATR 276)

In Herald & Weekly Times the High Court dealt with a claim for legal expenses incurred by a newspaper proprietor in defending a charge of libel. In allowing the claim the Court stated: The liability to damages was incurred, or the claim was encountered, because of the very act of publishing the newspaper. The thing which produced the assessable income was the thing which exposed the taxpayer to the liability or charged by the expenditure.

In the case of this taxpayer the legal expenses, including the settlement payment, were incurred as a direct result of the professional services they provided in their business. The provision of such services was part of the day to day activities of their business. As such, it was directly related to their income earning activities and is, therefore, an allowable deduction.

The fact that the expenses were incurred after the cessation of the business does not prevent the deduction from being allowable.

In Placer Pacific Management Pty Ltd v. FC of T 95 ATC 4459; (1995) 31 ATR 253 the taxpayer was the manufacturer of a conveyor belt system. It sold this business to another entity. As part of the sales agreement it continued to be liable for any repairs arising from the installation of systems prior to the sale. Some time after the business was sold a claim was made against the taxpayer. A settlement was reached whereby it paid amount of $325000. It also incurred legal expenses of $58,379.

In allowing the deduction for both expenses the Full Federal Court after referring to the High Court decision in AGC (Advances) Ltd v. Federal Commissioner of Taxation (1975) 132 CLR 175; 75 ATC 4057; (1975) 5 ATR 243 unanimously held that: 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 ....

The occasion of the taxpayer's outgoing is to be found in their previous business operations. The fact that the outgoing was incurred after the business had ceased does not sever this connection. Accordingly the taxpayer is entitled to a deduction under section 8-1 of the ITAA 1997 for the legal expenses incurred after the cessation of their business.