A major Australian bank employed Rayan Flip as a loans manager. He was charged with writing fraudulent loans for fictional customers and pocketing the loan proceeds once the loans were granted. The criminal charge received money by deception in the amount of $10 million over two years. Rayan vigorously defended the charges and was subsequently acquitted. While he was defending the charges, he was suspended by his employer. Once he was acquitted, Rayan felt unable to return to his previous employment and started driving taxis. In defending the charges, he incurred legal fees of $550,000, including GST. It was subsequently found that another employee at the bank had used Rayan's identity to commit the fraud on the bank.
As a result of the widespread notoriety of his acquittal, which was published in the newspaper, he was informed by his ex-employer about an article that Honest Newspaper published in the newspaper regarding Rayan. Once again, Rayan engaged his lawyers to bring an action, this time, in defamation against Honest Newspaper for publishing an untrue statement about him. Rayan alleged Honest Newspaper caused him harm and emotional distress because of the newspaper publication. Essentially, Rayan sued the media broadcaster, Honest Newspaper over an article published in the newspaper that alleged he was a perpetrator in receiving money by deception.
Rayan was invoiced by his legal firm $450,000, including GST, for defending the claim against Honest Newspaper. The newspaper did not mention that Rayan was acquitted of the charges and that another employee at the bank had used Rayan's identity to commit the fraud on the bank. The legal proceedings were commenced in the Supreme Court of NSW, however, was settled at Mediation for an undisclosed amount. Subsequently, Honest Newspaper withdrew the article published in the newspaper. Rayan informed you that he incurred these legal expenses as part of his income-producing structure and not income-producing processes.
(a) Advise Mr. Rayan whether the legal fees he incurred defending himself against the original criminal charges were a deductible outgoing.
Issue
Mr. Rayan Flip was a loan manager in a major Australian Bank. He was charged with fraudulently collecting proceeds from loans made to fictional customers. However, he defended the charges levied upon him and was subsequently acquitted of the criminal charge. He was suspended from his job by the employer. He could not get back to his previous employment and started driving taxis to continue his earnings. In the process, he had incurred legal fees of $550,000 in defending himself against the original criminal charges. Whether the legal fees incurred are a deductible outgoing or not is an issue to be addressed.
Rule
Calculation of tax payable
Taxation Law Legislation is interpreted based on the "doctrine of precedent" [PoTL 2022, Chapter 1]. S 4-10 of ITAA 1977 describes that tax payable by a taxpayer for a particular year is calculated by multiplying taxable income with the prevailing tax rate and deducting tax offsets. Further, section 4-15 provides that to calculate taxable income, and one must subtract deductions from assessable income [PoTL 2022, Chapter 3].
Deductions
As per the taxation law, outgoings are deductible when they are incurred. A deduction is an expense of the taxpayer which is deductible for tax purposes as it is incurred in gaining or producing income that is assessable for tax purposes.
Positive Limbs
A taxpayer can deduct from their assessable income a loss or outgoing to the extent that it is (s 8-1(1)):
Incurred in gaining or producing assessable income; or
Necessarily incurred in carrying on a business to gain or produce assessable income.
Only one of the two positive limbs needs to be satisfied. [PoTL 2022 Chapter 12, paragraph 12.20].
Negative Limbs
However, a loss or outgoing is not deductible under the general deductible rule if it satisfies any of the negative limbs (s 8-1(2)):
Capital or capital in nature;
Private or domestic;
Incurred in gaining exempt or non-assessable non-exempt income; or
Prevented from being deducted by a specific provision of the income tax legislation.
Deductibility is decided from the perspective of the taxpayer who incurs the loss or outgoing.
Expenses involving alleged or actual wrongdoing by the taxpayer
If the nexus between the expense and the production of assessable income is too remote, it is not deductible. Some cases exist where it is difficult to determine whether a nexus can be established or not. One such example is expenses involving alleged or actual wrongdoing by the taxpayer [PoTL 2022 Chapter 12, paragraph 12.80]. The expense relates to taxpayer's conduct which is "quasi-personal", i.e., incurred in a personal capacity rather than a business or professional capacity. The legal expenses are deductible if it is proved that the taxpayer incurred them in gaining or producing assessable income and the occasion of the expenditure arose out of his income-producing activities.
Application
Here Rayan had incurred a loss or outgoing in the form of legal fees to defend him against the original criminal charges. Referring to the Case: FCT v Day (2008) 70 ATR 14, [PoTL 2022 Chapter 12, paragraph 12.80] where the Court took a broad approach and found that the positive limbs of section 8-1 (or its predecessors) were satisfied. Legal Expenses are not private or domestic in nature [PoTL 2022 Chapter 12, Case study 12.17].
The Court held in FCT v Snowden & Willson Pty Ltd (1958) 99 CLR 431 that expenses incurred in defending the taxpayer's reputation and enabling the business's continued operation to gain or produce assessable income were clearly incurred for a legitimate business purpose. The Courts have also accepted that expenses resulting from the taxpayer's alleged or actual wrongdoing can satisfy the second positive limb despite the requirement that the expense be "necessarily incurred" in the carrying on of the taxpayer's business [PoTL 2022 Chapter 12, paragraph 12.80]
Conclusion
Rayan's employment exposed him to the charges resulting in the legal expenses. If he had not incurred those expenses, he would have been held guilty of fraud and could never take up employment elsewhere. An employee who is learned enough to be a loans manager in a major bank started driving taxis. His innocence was proved, and he was acquitted only because he incurred the legal fees to defend the charges. So, the legal fee incurred by Rayan is a deductible outgoing as the positive limb is satisfied.
(b) Advise Mr. Rayan as to the deductibility of legal expenses in relation to the defamation
matter?
Issue
Honest newspaper published an article regarding Rayan Flip, alleging him a perpetrator in receiving money by deception. Even though Rayan was acquitted of the criminal charge, the article caused harm and emotional distress to him. He filed a defamation case against Honest Newspaper for publishing an untrue statement about him. He paid $450,000 as legal expenses for this matter. After the legal proceedings, Honest Newspaper withdrew the article published in the newspaper against Rayan. He believes these legal expenses were incurred as a part of his income-producing structure and not income-producing processes. The issue is about the deductibility of these legal expenses.
Rule
Income Processes and Income Structure
Under section 8-1(2) (a) of ITAA 1997, a loss or outgoing that is capital or capital in nature will not be deductible under section 8-1.
Business processes (revenue) and business structure (capital) were distinguished by a key judicial decision as laid in Sun Newspapers Ltd and Associated Newspapers v FCT (1938) 61 CLR 337. Three factors to be considered are:
The character of the advantage sought, i.e., whether the expense has a lasting (capital) or temporary (revenue) benefit;
The manner in which it is used, relied upon or enjoyed, i.e., whether the benefit is used one-off (capital) or recurrently (revenue);
Means adapted to obtain the benefit, i.e., whether the benefit was obtained through one-off payment (capital) or recurring payments (revenue) [PoTL 2022 Chapter 12, paragraph 12.180].
The Court will examine the substance of payment and not just its form. Revenue expenses generally provide the taxpayer with benefits in the current year, while capital expenses provide typically the taxpayer with benefits over a period of years [PoTL 2022 Chapter 12, paragraph 12.210].
Legal Expenses against defamation
The Court held in FCT v Snowden & Willson Pty Ltd (1958) 99 CLR 431 that expenses incurred in defending the taxpayer's reputation and enabling the business's continued operation to gain or produce assessable income were clearly incurred for a legitimate business purpose. The Courts have also accepted that expenses resulting from the taxpayer's alleged or actual wrongdoing can satisfy the second positive limb despite the requirement that the expense be "necessarily incurred" in the carrying on of the taxpayer's business [PoTL 2022 Chapter 12, paragraph 12.80]
Application
Rayan believes that these legal expenses were incurred as a part of his income-producing structure and not income-producing processes. The legal expense has a long-lasting benefit because Honest Newspapers withdrew the article published in their newspaper against Rayan. Further, the payment for legal expenses was not recurring in nature. It was made as a one-off payment.
Rayan had incurred these expenses because of the mental distress caused to him and defamation that could lead to no employment anywhere in the future. He was proved innocent, but this fact was not mentioned in the original article leading to his loss of reputation and distrust for him. The legal fee paid to the law firm was to maintain a suit and protect his goodwill and fame. He would receive the same benefits later if he sought employment elsewhere.
Conclusion
The legal expenses incurred in relation to the defamation matter are deductible. Rayan's opinion of considering the legal expenses as an income-producing structure is correct as the three factors laid down by Dixon J in FCT v Snowden & Willson Pty Ltd (1958) 99 CLR 431 are satisfied. Although capital expenses are not immediately deductible under section 8-1 of ITAA 1997, the expenses may be deductible over a period of years.