Protecting your reputation: Deductibility of legal expenses

legal expensesAuthors: Nicole Paulsen and Danielle Botha (DLA Cliff Dekker Hofmeyer)

The question of deductibility of legal expenses incurred to protect one’s reputation or the goodwill of a business seems to be a recent hot topic of conversation, especially when following the news. Interestingly, two international cases relating to the deductibility of legal expenses, both related to reducing reputational risk and challenging alleged unfounded allegations against the taxpayer, have recently been handed down in Australia and England, respectively.

In the Australian matter of Taxpayer and the Commissioner of Taxation 2013 AATA 783, the taxpayer applied for a private ruling from the Commissioner of Taxation regarding the deductibility of legal expenses incurred in challenging a banning order made against the latter by the Australian Securities and Investments Commission. The banning resulted in the taxpayer not being permitted to provide financial services for a period of five years. The court reiterated that legal expenses, like any other expenditure, are deductible to the extent that they are incurred ‘in gaining or producing’ assessable income. Legal expenses are not, however, deductible to the extent that they are capital or private in nature. The court found that the incurral of the legal expenses in question was aimed at enabling the taxpayer to re-enter the financial services industry and as such related to his income-earning structure. It follows that the expenditure was capital in nature and not deductible.

In the English case of Duckmanton v Revenue and Customs Commissioners [2013] UKUT 305 (TCC), the taxpayer lodged an appeal to the Upper Tribunal, against the decision of the First-Tier Tribunal (FTT), regarding the deductibility of legal expenses incurred in defending criminal proceedings instituted against the taxpayer.

By way of general background, the taxpayer was the owner of an unincorporated transport business. As a result of a fatal accident involving one of the taxpayer’s vehicles, the taxpayer incurred substantial legal costs in defending the criminal proceedings instituted against him. In computing his profits for the relevant year of assessment, the taxpayer claimed a deduction for sums paid in preparation of his defence against the criminal proceedings. The taxpayer based his argument on the fact that the expenditure had been principally incurred not to protect his liberty, but to protect his operator’s license and business reputation, both of which were an integral part of his trading operation.

The FTT rejected the taxpayer’s argument and found that the main reason for incurring the expenditure was to support the taxpayer’s defence in the criminal proceedings and to prevent a civil claim for damages against the taxpayer.

The taxpayer subsequently appealed to the Upper Tribunal who confirmed the decision of the FTT by reiterating that the preservation of the taxpayer’s business and more specifically his reputation was not his only object when the taxpayer incurred expenditure on legal fees. The reasons behind the incurred expenditure were that they minimised the risk of imprisonment and prevented a substantial civil claim for damages. Accordingly, the expenditure was not wholly and exclusively incurred for purposes of the taxpayer’s trade and the taxpayer was therefore not entitled to deduct the legal expenditure so incurred.

Based on the latter judgement it is clear that, in England at least, it is a specific requirement that legal expenditure must be ‘wholly and exclusively’ incurred for the purpose of producing income, in order for it to be deductible.

Before 1993, the Income Tax Act, No 58 of 1962 (Act), contained a similar requirement in that expenditure had to be ‘wholly and exclusively’ laid out for purposes of trade to be deductible. This requirement was of great concern in circumstances where expenditure was incurred with a dual motive.

This provision has, fortunately, been amended. The Act contains a general deduction formula which provides that, in determining the taxable income derived by a person from the carrying on of any trade, there shall be allowed as a deduction expenditure and losses actually incurred in the production of income, provided that ] such expenditure and losses are not of a capital nature. However, the deduction formula is further qualified by s 23(g) of the Act, which prohibits the deduction of any moneys claimed as a deduction from income derived from trade, to the extent that they are not laid out or expended for the purposes of trade. This provision enables the disallowance of expenditure which has been incurred in carrying on a trade, but has not been expended exclusively for the purposes of that trade.

In light of the above it is important to note that in the South African context, courts will apportion legal expenditure where the expenditure has been incurred for a dual purpose, ie where the expenditure has been incurred to preserve the taxpayer’s business and to prevent a civil claim for damages, and it is therefore not a requirement that the expenditure be incurred ‘wholly and exclusively’ for the purposes of trade in order for it to be deductible. This principle relating to the deductibility of expenditure incurred for a dual purpose was applied in the case of CIR v Nemojim (Pty) Limited 45 SATC.

However, as illustrated by the Australian case cited above, expenditure that is capital in nature, and that relates to the income-earning structure of a taxpayer, will be disallowed.