Deductions after cessation of business - professional indemnity levies

Is the taxpayer entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for professional indemnity levies paid after cessation of the taxpayer's business?

Yes. The taxpayer is entitled to a deduction under section 8-1 of the ITAA 1997 for professional indemnity levies paid after cessation of the taxpayer's business.

The taxpayer ceased their professional practice during the year immediately prior to the current income year.

While in their professional practice, the taxpayer was a fully subscribed member of a professional indemnity association. The subscriptions indemnified members for any claims made against the member for professional services they had provided.

The association imposed an additional levy on its members to cover professional services provided in prior years. The association imposed this levy prior to the taxpayer ceasing their professional practice.

The association advised its members that if they failed to pay the additional levy they would forfeit their membership and would cease to be indemnified for claims made in relation to professional services they had provided in prior years.

The taxpayer paid the additional levy by instalments the last of which were paid after they had ceased their professional practice.

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, or relate to the earning of exempt income.

Paragraph 136 of Taxation Ruling TR 95/9 states that 'a deduction is allowable for the cost of professional indemnity insurance taken out for work-related purposes'. The additional levy paid by the taxpayer is considered to be a form of professional indemnity insurance that would normally be deductible for a taxpayer engaged in a professional practice. However, the issue is whether the additional levy paid after the cessation of the taxpayer's business was sufficiently relevant and incidental to the gaining or producing of their assessable income in earlier years of income.

The courts have considered a number of cases involving the deductibility of losses and expenditure incurred after the cessation of a business. Commissioner of Taxation v. Jones (2002) 117 FCR 95; 2002 ATC 4135; (2002) 47 ATR 638 (the Jones Case ) involved the deductibility of interest payments incurred on a loan re-financed prior to the cessation of a business, where the interest payments related to later years of income in which no relevant assessable income was derived. In dismissing the appeal by the Commissioner, Beaumont, Finn and Sundberg JJ agreed with the earlier reasoning of Dowsett J ( Commissioner of Taxation v. Jones 2001 ATC 4607; (2001) 47 ATR 638 that the taking out of the loan while the business was still operating created an 'obligation' to pay interest until such time as the loan was re-paid. In other words, the 'obligation' to pay interest would continue after the business had ceased until an 'event or circumstance arose to break the necessary nexus'. As a result, it was determined that the interest payments were allowable deductions.

The decision in the Jones Case also supported earlier court decisions that business losses incurred in later years of income could be deductible as long as the 'occasion of the outgoing' could be related back to a period prior to the business ceasing operations ( AAT Case 5/ 95 95 ATC 126; AAT Case 9605 (1994) 30 ATR 1001, and Placer Pacific Management Pty Ltd v. Federal Commissioner of Taxation (1995) 31 ATR 253; 95 ATC 4459).

Another determining factor that has emerged from court decisions on this issue is whether or not the 'passage of time' can break the nexus between the earning of income in an earlier year, and an outgoing paid in a later year. For example, in AAT Case U177 87 ATC 1020; AAT Case 119 (1987) 18 ATR 3870, the taxpayer ceased to carry on a business on 1 September 1977 and claimed deductions for payments made in relation to a judgement debt in the 1982 and 1983 income years. In disallowing the deduction, Nicholson RD stated that: 'It is not that the applicant's claim is defeated by the law or any prior decision but rather that, as a question of fact, he is unable to establish the nexus required by s 51 (1) in circumstances where so much time has elapsed between the cessation of income producing activity and the claimed expenditures'.

The obligation to pay the additional levy was imposed prior to the time the taxpayer ceased their professional practice. The taxpayer had paid a portion of the levy prior to this. The remaining portion was paid after they had ceased their professional practice. The additional levy imposed by the association related solely to protection against claims for professional services provided during the period before the taxpayer ceased their professional practice. As a result, the 'occasion for the outgoing' in the current year of income can be directly related back to the taxpayer's provision of professional services in prior years of income.

The association required the taxpayer to pay the additional levy in order to maintain already established indemnity cover. Therefore, the taxpayer was effectively placed under an 'obligation' to pay the levy in order to maintain the indemnity cover that had built up over previous years.

Consequently, the additional levy paid after the taxpayer ceased their professional practice was relevant and incidental to the gaining or producing of their assessable income in earlier years of income, and the expenses are deductible under section 8-1 of the ITAA 1997.