CHAPTER 10
Tax Deductibility of legal expenses
Introduction
10.1 Paragraph 7 of the terms of reference into legal aid that were referred
to the Committee by the Senate on 17 September 1996 asked the Committee
to examine:
the equity implications arising from the current tax deductibility regime
for legal expenses, including by the corporate sector.
10.2 Legal expenses, like other business expenses, are deductible under
the general provisions contained in s. 8-1 of the Income Tax Assessment
Act 1997. [1] Subsection 8-1(2) provides that
deductions cannot be made for outgoings of a capital nature or of a private
or domestic nature. However, subject to this, s. 8-1(1) provides that:
You can deduct from your assessable income any loss or outgoing to the
extent that:
(a) it is incurred in gaining or producing your assessable income; or
(b) it is necessarily incurred in carrying on a business for the purpose
of gaining or producing your assessable income.
10.3 Paragraph (a) generally relates to expenses incurred by taxpayers,
including individuals, not carrying on a business. For example, legal
expenses incurred in settling a dispute arising from an employment agreement
generally are deductable for both the individual employee and the employer.
[2]
10.4 Paragraph (b) clearly applies only to businesses. Thus, legal expenses
incurred in recovering a trade debt generally will be deductable, whereas,
expenses incurred by the individual defending such action generally will
not be deductable. Similarly, expenses incurred by a business in defending
or settling an action in tort or contract generally will be deductible
whereas deductibility will generally not be available to the individual
pursuing that action. [3]
10.5 Thus under the current law there will be some cases where the an
individual can deduct litigation expenses. Also, there will be some cases
where a business cannot deduct such expenses. [4]
However, broadly the position is that businesses can deduct while individuals
cannot. Many of the groups involved in public interest litigation are
unable to deduct litigation expenses because they fall outside the relevant
definition of a business engaged in producing assessable income. For example,
the Committee was told that the in the anti-smoking litigation in the
early 1990s, the tobacco industry was able to deduct its litigation expenses,
while the Australian Federation of Consumer Organisations was not. [5]
10.6 The effect of the rule that the winner generally pays the loser's
litigation costs magnifies this difference. If the business loses, it
can generally tax deduct both its own costs and the costs it has to pay
to the other side. If an individual loses, neither set of costs can be
deducted.
Recommendations on tax deductibility in recent reports
10.7 Several recent reports have noted the perception of inequality that
the current tax deductibility regime invokes and made proposals and recommendations.
10.8 The Trade Practices Commission concluded in March 1994:
The Commission maintains the view that an examination is warranted by
appropriate authorities of the tax deductibility of legal and litigation
expenses focusing on any adverse consequences for efficiency and equity
that may result. [6]
10.9 The Access to Justice Advisory Committee recommended in May 1994
that the `Government should commission a review of the current law and
practice governing the tax deductibility of litigation legal expenses'.
[7]
10.10 The Australian Law Reform Commission concluded in 1995 that the
`impact of the tax system on litigation should be examined further'. [8]
The issue has since arisen in the ALRC's review of the adversarial system
of litigation. [9]
10.11 The Committee notes that none of these proposals has been acted
upon.
Lack of data on the amount of deductions claimed
10.12 As a result of the lack of follow-up on the proposals in previous
reports, there is still no reliable data on the extent to which tax deductibility
for litigation expenses is utilised. In its 1995 report, the Australian
Law Reform Commission indicated that:
based on recent surveys, a rough guesstimate is that $700 million may
be claimed as deductions from assessable income for legal costs incurred
in litigation by businesses each year. At a 36 per cent tax rate this
represents a loss of taxation revenue of approximately $250 million. [10]
10.13 The Committee asked the Australian Taxation Office and the Department
of Treasury if they had any data on the amounts claimed and how difficult
it would be to collect such data. Both said taxation return forms do not
collect separate information on legal expenses and therefore it was not
possible with existing information to isolate this particular issue. [11]
To gather the data would be impose an additional cost on businesses and
their tax advisers to collect and separately report legal expenses. It
would also be an additional cost to the ATO.
To provide the information suggested would require a break down of the
legal costs into litigation and non-litigation legal costs. This level
of analysis would represent a significant impost at a time when the Government
and the ATO are actively seeking to reduce costs for business. [12]
10.14 The ATO also told the Committee that it could not find any audit
program it had conducted with a focus on business legal expenses which
might provide a sample from which the total amount of deductions might
be reliably estimated. It said that in the absence of information to suggest
that deduction of legal expenses represents a significant area of tax
evasion or avoidance, a sample audit program would involve costs that
would be difficult for it to justify. [13]
10.15 The insurance industry is involved in litigation as a regular part
of its day-to-day business and incurs significant litigation expenses.
However, the Insurance Council of Australia told the Committee that it
had tried to obtain data from the industry on the amounts involved without
success. [14]
10.16 The Committee notes the view put by the Combined Community Legal
Centres Group (NSW) that the cost to government of the tax foregone due
to the deductibility of litigation expenses is not usually canvassed in
discussions of the cost to government of supporting the legal system.
[15] The Committee considers that provision
of accurate data on the cost of deductibility would provide a valuable
addition to this discussion.
Criticisms of the current tax deductibility regime
10.17 The current law on tax deductibility of litigation expenses was
the subject of considerable criticism in evidence and submissions to the
Committee. The then Sex Discrimination Commissioner, Ms Sue Walpole, told
the Committee in February 1997 that there `is a fundamental issue there
in terms of the equality before the law argument'. [16]
Many submissions to the Committee argued that the current law was simply
inequitable. [17]
10.18 In addition, it was pointed out that the effect of the current
regime was to accentuate the imbalance in resources that often occurs
when a business and an individual face each other in litigation. [18]
The Springvale Legal Centre argued that the sense of inequity was increased
due to the way that resources allocated to non-business cases were being
reduced:
In a nutshell, our position is that it is morally repugnant to have,
by virtue of section 51(1) of the Income Tax Assessment Act, a system
whereby the government subsidises the legal expenses of business, most
notably the high fliers of the corporate sector, while on the other extreme
we see the emasculation of the system which aims to subsidise the legal
expenses of the most disadvantaged members of society. In the former situation
we are talking about legal fees spent in the course of earning income,
including costs relating to borrowing money, discharging mortgages, et
cetera. In the latter we are talking about the cost of proceedings to
promote or defend the rights and responsibilities of ordinary people in
areas of fundamental concern to them that is, concerning their liberty,
their children and their homes. [19]
10.19 Deductibility was seen as a subsidy from the public purse to one
category of litigants. [20] In addition to
being inequitable, was criticised because:
- unlike a grant of legal aid, is not subject to any sort of means or
merits tests, and may subsidise frivolous or oppressive litigation;
[21]
- it may reduce the incentive for the business to avoid or settle litigation,
which in turn may impose added costs on those assisting the non-business
party, such as legal aid services or community legal centres; [22]
- it encourages business litigants to use scarce court resources, thereby
making them less available for other types of proceedings such as criminal
and family law matters, whereas if deductibility was removed, the increased
tax revenue now being foregone could be used to increase resources to
these proceedings; [23]
- its availability to only one side in a dispute lowers the real cost
of litigation to that party and this can be exploited as a tactical
advantage; [24]
- it distorts the market for legal services in various ways, for example,
by inflating the amounts businesses are willing to pay for legal services
and thereby raising the perceived `market price' for those services to
the detriment of others, including legal aid commissions, competing in
the same market; [25] and
by assisting business to access scarce public resources (the court system)
without having to pay the full cost of doing so. [26]
10.20 Some of those criticising the present position did not distinguish
between the expenses involved in litigation and legal expenses generally.
The latter include many items, such as obtaining legal advice and drafting
documents which are unrelated to litigation. However, the debate about
deductibility has focused on litigation expenses for several reasons.
It is in litigation that the perceived inequity is greatest and most visible.
Moreover, legal work unrelated to litigation is seen as more beneficial:
it may, for example, assist a business to conduct its operations in ways
that comply with relevant regulatory regimes. Removal of deductibility
might discourage businesses from taking appropriate advice. [27]
Alternatively, it might distort the market by creating an incentive to
obtain advice from non-legal advisers. [28]
10.21 The Committee agrees that the primary focus for the debate should
be the deductibility of litigation expenses, not legal expenses more broadly
defined.
Responses to criticisms of the current tax deductibility regime
10.22 The Committee also received submissions and evidence supporting
the current tax deductibility regime and highlighting the problems that
would arise if it were altered.
10.23 The Commonwealth Department of the Treasury advised the Committee
that:
- Litigants, including defendants, can only claim a deduction for legal
expenses if they can prove a sufficient connection between the legal
fees and the carrying on of a business for the purpose of gaining or
producing assessable income. This is a fundamental principle of the
tax system as a whole.
- As a general rule, this will mean that a litigant able to claim a
deduction for legal expenses will also be subject to tax on the economic
benefit they stand to gain from the court case.
- On the other hand, a litigant unable to claim a deduction would not
normally be subject to tax on the benefits they stand to gain if successful.
- This symmetry ensures that no inequity exists. [29]
10.24 Others also argued that there was no inequity in allowing the ordinary
rules applying to deductibility of expenses to apply to litigation expenses.
[30] The Insurance Council of Australia, for
example, said that there was no inequity that needed to be corrected.
It pointed out that the insurance industry has heavy litigation expenses
as part of the ordinary costs of its business. To deny deductibility to
these costs would be to treat the industry differently to other industries,
which would remain able to deduct their main day-to-day business expenses.
[31] The Insurance Council also pointed out
that the effect of removing deductibility would increase industry costs
that policyholders would eventually bear. [32]
It was also argued that to remove the deduction could place Australian
businesses at a competitive disadvantage with businesses in other countries.
[33]
10.25 It was also questioned whether, from the business point of view,
tax deductibility was a significant factor influencing litigation decisions:
other incentives may be far more influential in business decisions to
litigate, such as protection of reputation or the need to make an example
of a breach of contract case. [34] The Law
Society of Western Australia asserted that the deductions `are not significant
and do not distort the market in relation to legal services'. [35]
10.26 The Committee notes that there is a lack of empirical evidence
and research on the extent to which the availability of tax deductibility
actually influences business decisions on litigation.
Alternatives to the present rules
10.27 Most of those who indicated to the Committee that they regard the
present law as unsatisfactory did not propose alternatives in any detail.
The assumption appeared to be that tax deductibility should be removed
for all litigation, and some expressly stated this. [36]
Others, recognising the complex issues involved in devising alternatives
to the current regime, asked that it be reviewed with a view to reform.
[37]
10.28 In regard to the practical difficulties that would arise if the
current regime were altered, Treasury advised:
Amending the existing taxation treatment of legal costs would present
practical problems for the design of taxation law, introduce distortions
in the taxation law and create an undesirable precedent for tax policy.
[38]
10.29 The Treasury pointed to the difficulty of defining in legislation
the category of expenses which was no longer to be deductible: if the
definition involved the commencement of court proceedings, than this would
create a taxation bias in favour of litigation and against out-of-court
settlements. [39] Introducing this exception
to the general rule on deductibility would add complexity to taxation
law, and would be difficult to audit and hence enforce. [40]
10.30 One suggestion made to the Committee was that, if deductibility
is to remain, it should be extended to non-business litigation. [41]
The Treasury commented that such an option would be costly to revenue
and would be poorly targeted in that it would confer greatest benefits
to those on the highest income tax rates and little or no benefit on the
typical recipient of legal aid. [42] In addition
it was seen as encouraging more resort to litigation, rather than to more
economical forms of resolving disputes.
10.31 Others suggested that tax deductibility should be linked to the
merits of the litigation, possibly measured by either the prospects of
winning or actually winning the case. [43]
Treasury responded to this suggestion by saying that the basic principle
of allowing deductions has always been interpreted to cover both successful
and unsuccessful attempts to gain or produce assessable income:
Under the tax law, deductibility hinges on the taxpayer being able to
demonstrate a sufficient connection between the outgoing and the taxpayer's
income earning activities; it does not hinge on the success of an attempt
to gain or produce assessable income. In this respect, the tax system
requires that legal fees satisfy the same objective tests as all other
expenditures for which deductibility is sought. [44]
10.32 An alternative reform proposal was that the amounts able to be
deducted should be capped in some way, so as to allow only `reasonable'
costs to be deducted. [45] For example, the
rate for counsel could be capped at say, $2,000 per day, with any excess
not allowed to be tax deducted. The way in which motor vehicle depreciation
expenses have been treated provides a rough comparison. Treasury was also
unsympathetic to this idea:
This proposal would increase the after-tax cost of hiring legal counsel
who charge fees over and above the arbitrarily determined cap. This proposal
also has the potential to disadvantage Australian firms engaged in litigation
with international firms, who can claim an uncapped deduction for their
legal expenses in their own country.
Treasury does not consider that there is a valid comparison to be drawn
between motor vehicles and legal counsel. A cap was placed on deductions
claimed for motor vehicles because of the element of personal consumption
enjoyed by the user of a luxury car. It is difficult to argue that there
is an element of personal consumption in appointing legal counsel who
charge fees above some cap. [46]
Conclusions and recommendations
10.33 The present law allows tax deductibility for litigation expenses
incurred in most circumstances by business, but similar deductions are
seldom available to non-business litigants.
10.34 Evidence to the Committee disclosed a widespread view that this
law is inequitable, and represents a form of public subsidy to one class
of litigants at a time when adequate public assistance to other classes
of litigants is proving increasingly difficult to obtain.
10.35 The Committee found that there is a lack of reliable data on the
value of these deductions claimed each year. The Committee also found
that there is also only anecdotal information on whether the availability
of the deductions significantly affects business decisions on litigation,
or distorts the market for legal services.
10.36 The Committee notes that three major reports in 1994-95 proposed
that the current law be reviewed, and that no such review has taken place.
The previous Labor Government had taken preliminary steps to undertake
such a review prior to the last election. The Committee regards the present
Government's failure to progress the issue as unsatisfactory, given the
widespread view that the legal system is operating unfairly due to tax
deductibility.
10.37 The Committee recognises that if any such review is to be conducted,
it needs to consider a broad range of issues concerning economic, social
and taxation policy.
Recommendation 22
Accordingly, the Committee recommends that the availability of
tax deductibility for litigation expenses be reviewed in order to ensure
just and equitable tax treatment of those expenses.
Footnotes
[1] This replaces s. 51(1) of the Income Tax
Assessment Act 1936, which is to the same effect. Other, more detailed,
provisions of both the 1936 and 1997 Acts also deal with deductibility
in specific circumstances: see for example s. 69 of the 1936 Act and s.
25-5 of the 1997 Act on the deduction of expenses related to managing
one's tax affairs.
[2] Submission No. 112, Australian Taxation
Office, Attachment, p. 2.
[3] Submission No. 112, Australian Taxation
Office, Attachment, p. 3.
[4] See Transcript of Evidence, Insurance
Council of Australia, pp. 1691-2 and Submission No. 112, Australian
Taxation Office, Attachment, p. 2 for examples.
[5] Transcript of Evidence, Australian
Plaintiff Lawyers Association, p. 1058; Submission No. 121, Australian
Plaintiff Lawyers Association, p. 6. See also Transcript of Evidence,
Environmental Defender's Office (NT), p. 68; Combined Community Legal
Centres Group; p. 959.
[6] Trade Practices Commission, Study of
the Professions: Legal: Final Report, March 1994, p. 216. See also
the similar proposal in Law Society of NSW, Accessible Justice Summit,
Discussion Paper: Access to the Civil Courts, July 1992, para. 120.
In Legislative Assembly for the ACT, Access to Justice in the A.C.T.,
(Report No. 2 of the Standing Committee on Legal Affairs) June 1993, para.
6.35, the Committee `recommends that the ACT Government approach the Commonwealth
Government to urge a review of the right of businesses to claim business
litigation as tax deductions'.
[7] Access to Justice Advisory Body, Access
to Justice An Action Plan, May 1994, Action 8.1. The Access to Justice
Advisory Body was an ad hoc committee established in October 1993
by the then Attorney-General and then Minister for Justice to make recommendations
for reform of the administration of the Commonwealth justice and legal
system.
[8] Australian Law Reform Commission, Costs
shifting – who pays for litigation, (ALRC Report No. 75) 1995,
para. 3.42.
[9] Submission No. 108A, Australian Law
Reform Commission, p. 5. See also the ALRC's Review of the adversarial
system of litigation: Rethinking the federal civil litigation system,
(ALRC Issues Paper No. 20) April 1997, p. 107.
[10] This figure is based on research by the
Civil Justice Research Centre which found that 43 per cent of time spent
by lawyers working in commercial law is spent on commercial litigation
work and the Australian Bureau of Statistics Legal and Accounting Services
Survey 1992-93 which found that $1,637.4 million was earned from legal
services in commercial, finance and business law during 1992-1993: see
Australian Law Reform Commission, Costs shifting – who pays for
litigation, (ALRC Report No. 75) 1995, para. 3.33 and footnote 41.
[11] Submission No. 112A, Australian
Taxation Office, p. 1; Submission No. 177A, Department of the Treasury,
p. 1.
[12] Submission No. 112A, Australian
Taxation Office, p. 1.
[13] Submission No. 112A, Australian
Taxation Office, p. 2.
[14] Transcript of Evidence, Insurance
Council of Australia; pp. 1696-7. Mr Paul Baker of the ICA told the Committee:
`Non-deductibility of legal expenses within the compulsory third-party
scheme within New South Wales, as I understand it, would roughly result
in an increase in premiums of about one per cent': ibid. pp. 1692-3.
[15] Submission No. 104, Combined Community
Legal Centres Group (NSW), p. 44. See also Transcript of Evidence,
Prof T Wright, p. 1011; D Marr, `It's legal, but is it moral?', Sydney
Morning Herald, 21 December 1996, p. 4s.
[16] Transcript of Evidence, Human Rights
and Equal Opportunity Commission, p. 556.
[17] Submission No. 3, NSW Council for
Civil Liberties, p. 5; Submission No. 39, Burnside, p. 6; Submission
No. 44, Legal Services Commission of SA, p. 23; Submission
No. 50, Tenants' Union of Queensland Inc, p. 4; Submission No.
60, National Council for Single Mothers and Their Children, p. 3;
Submission No. 93, Australian Society of Labor Lawyers, p. 20;
Submission No. 101, Springvale Legal Service Inc, p. 8; Submission
No. 111, Whistleblowers Australia (NSW Branch), p. 1; Submission
No. 120, Victorian Council for Civil Liberties, p. 7; Submission
No. 121, Australian Plaintiff Lawyers Association, p. 6. Transcript
of Evidence, Care Financial Counselling and Consumer Credit Legal
Service, p. 911; Federation of Community Legal Centres (WA), p. 1117.
[18] Submission No. 84, Legal Aid Commission
of NSW, section 7.1; Submission No. 98, Redfern Legal Centre, p.
8; Submission No. 105, Blue Mountains Community Legal Centre, p.
1; Submission No. 116, Justice Action, p. 4. Transcript of Evidence,
National Women's Justice Coalition, p. 865; Environmental Defender's Office
(NSW), p. 1363.
[19] Transcript of Evidence, Springvale
Community Legal Service, p. 1676.
[20] See for example, Submission No. 84,
Legal Aid Commission of NSW, section 7.2 where examples were give of cases
in which the value of the tax deduction to the business party was greater
than the total amount of public funding provided to the legally-aided
opponent.
[21] Submission No. 88, National Legal
Aid, p. 62; Submission No. 90, National Association of Community
Legal Centres, p. 53; Submission No. 98, Redfern Legal Centre,
p. 8; Submission No. 116, Justice Action, p. 4. Transcript of
Evidence, National Women's Justice Coalition, p. 865. See also D Marr,
`It's legal, but is it moral?', Sydney Morning Herald, 21 December
1996, p. 4s.
[22] See for example, Submission No. 88,
National Legal Aid, p. 62; Submission No. 90, National Association
of Community Legal Centres, p. 53; Submission No. 93, Australian
Society of Labor Lawyers, p. 20.
[23] See for example, Submission No. 93,
Australian Society of Labor Lawyers, p. 20; Transcript of Evidence,
Springvale Legal Service, p. 485.
[24] See for example, Submission No. 26,
Society of St Vincent de Paul, p. 9; Submission No. 84, Legal
Aid Commission of NSW, section 7.1; Submission No. 104, Combined
Community Legal Centres Group (NSW), p. 43.
[25] See for example, Submission No. 84,
Legal Aid Commission of NSW, section 7.1; Submission No. 88, National
Legal Aid, p. 62; Submission No. 101, Springvale Legal Service,
p. 9.
[26] Transcript of Evidence, Springvale
Legal Centre, p. 485 and pp. 1676-7; Prof C Williams, p. 486.
[27] Submission No. 126, Law Council
of Australia, para. 7.5. See also the discussion in Access to Justice
Advisory Body, Access to Justice An Action Plan, May 1994, paras.
8.11-12.
[28] Submission No. 183, Law Society
of Western Australia, p. 4.
[29] Submission No. 177A, Department
of the Treasury, p. 1. See also Submission No. 47, Justice Research
Centre, p. 5.
[30] Submission No. 58B, Insurance Council
of Australia, p. 2; Submission No. 102, Bar Association
of Queensland, p. 24; Submission No. 126, Law Council of Australia,
para. 7.5; Submission No. 126A, Law Council of Australia, para.
4.1; Submission No. 183, Law Society of WA, p. 4; Letter to the
editor from Taxation Institute of Australia, Australian Financial Review,
26 September 1997, p. 32. See also Submission No. 67, Mr D Murphy,
p. 18 (problem `a thorny one' but `not convinced that moving from present
system … is defensible').
[31] Submission No. 58, Insurance Council
of Australia, pp. 1-2; Transcript of Evidence, Insurance Council
of Australia, pp. 1692-3. The ICA also noted that, in relation to litigation
concerning insurance policies, it has successfully operated since 1991
a national complaints scheme to resolve complaints, largely informally
and through conciliation: Submission No. 58A, Insurance Council
of Australia, pp. 1-2.
[32] Submission No. 58B, Insurance Council
of Australia, p. 2.
[33] Submission No. 183, Law Society
of WA, p. 4.
[34] Submission No. 27, Australian Institute
of Criminology, pp. 4-5; Submission No. 177, Department of the
Treasury, p. 2.
[35] Submission No. 183, Law Society
of WA, p. 4.
[36] See for example, Submission No. 84,
Legal Aid Commission of NSW, section. 7.2; Submission No. 85, Women's
Legal Service (SA), para. 7.1.
[37] Submission No. 21A, Australian
Council of Social Service, p. 8; Submission No. 76, Aboriginal
Legal Rights Movement Inc, p. 8; Submission No. 80, Queensland
Legal Aid, p. 25; Submission No. 101, Springvale Legal Service
Inc, p. 9; Submission No. 104, Combined Community Legal Centres
Group (NSW), p. 44. Transcript of Evidence, Victorian Council of
Social Service, p. 493; National Women's Justice Coalition, p. 865.
[38] Submission No. 177, Department
of the Treasury, p. 1.
[39] Submission No. 177, Department
of the Treasury, p. 2.
[40] Submission No. 177, Department
of the Treasury, p. 2.
[41] Submission No. 88, National Legal
Aid, p. 62; Submission No 93, Australian Society of Labor Lawyers,
p. 20.
[42] Submission No. 177, Department
of the Treasury, p. 2. See also Submission No. 21A, Australian
Council of Social Service, p. 8; Submission No. 67, Mr D Murphy,
p. 18.
[43] Submission No. 111, Whistleblowers
Australia (NSW Branch), p. 1; Submission No. 121, Australian Plaintiff
Lawyers Association, p. 6.
[44] Submission No. 177A, Department
of the Treasury, p. 2.
[45] Submission No. 111, Whistleblowers
Australia (NSW Branch), p. 1. See Access to Justice Advisory Body, Access
to Justice An Action Plan, May 1994, para. 8.17 for discussion of
various ways in which limits might be imposed.
[46] Submission No. 177A, Department
of the Treasury, p. 2.