Tax deductibility of legal costs

In this series of articles, Cameron Kotze – the Tax Partner at Ernst and Young – discusses some topical tax issues for our readers.

THE Income Tax Act has a very specific provision dealing with the deduction of legal costs when determining the taxable income of a taxpayer in addition to the general deduction for expenses or losses that applies in determining the taxable income of a taxpayer. With regard to the general deduction provision (s17 (1)(a)), the taxpayer must satisfy the Receiver of Revenue that the legal expenses are linked to an operation undertaken with the object of producing income.The legal expense will not be tax deductible if it is incurred to protect an existing source of income.If the legal expense is not tax deductible under section 17(1)(a), it may nevertheless be tax deductible under section 17(1)(c).This section provides for the deduction of legal expenses incurred in respect of any claim, dispute or action arising in the ordinary course of operations in carrying on the taxpayer’s trade provided the expense is not of a capital nature.Many legal expenses disallowable under the general deduction provision are tax deductible under this provision.Examples of these legal expenses include expenses incurred to protect income, to prevent a reduction in income or expenses incurred to avoid a loss or to resist a claim for compensation.The tax-deductible legal fees provided for in section 17(1)(c) include the fees of legal practitioners, expenses incurred to procure evidence or expert advice, witness fees, court fees and any other similar expenses.As long as the legal fees are not of a capital nature and the claim, dispute or action arises in the ordinary course of operations in carrying on the taxpayer’s trade, the legal fees will be tax deductible.The legal costs incurred by a newspaper to resist a claim for damages for libel would be deductible under section 17(1)(c) because the damages paid should the claimant be successful will be deductible under section 17(1)(a) given the nature of the business of a newspaper where libel claims could be filed against it.The tax courts have considered various cases with regard to the tax deductibility of legal expenses.Legal contract costs to acquire a capital asset (for example a building to earn rental income) have been held to be of a capital nature and therefore not tax deductible.The tax courts have held that expenses incurred for a standard employment contact or to recover trade debts are not capital in nature and therefore tax deductible under section 17(1)(c).Legal expenses incurred to defend a claim of a negligent driver employed by a taxpayer or claiming compensation from a supplier for the supply of defective merchandise have been regarded as legal expenses arising from the ordinary course of carrying on the taxpayer’s trade.Legal expenses incurred to defend a claim for damages due to the bad design of a building by an architect or damages resulting from a person crashing into a trailer parked outside the taxpayer’s premises overnight have been held by the court not to arise out of the ordinary operations of the taxpayer’s trade.The tax courts have held that where a professional has been grossly negligent in the carrying out of his work, the cost of damages paid is not a tax-deductible expense.The cost of damages paid for the delivery of defective goods to customers or for infringing another person’s patent is however tax deductible.The deduction of legal expenses has not come under close scrutiny by the Receiver of Revenue in recent times.When it is closely scrutinised, you should not be surprised if some expenses are added back to determine taxable income because all legal expenses are generally claimed for tax purposes.With regard to the general deduction provision (s17 (1)(a)), the taxpayer must satisfy the Receiver of Revenue that the legal expenses are linked to an operation undertaken with the object of producing income.The legal expense will not be tax deductible if it is incurred to protect an existing source of income.If the legal expense is not tax deductible under section 17(1)(a), it may nevertheless be tax deductible under section 17(1)(c).This section provides for the deduction of legal expenses incurred in respect of any claim, dispute or action arising in the ordinary course of operations in carrying on the taxpayer’s trade provided the expense is not of a capital nature.Many legal expenses disallowable under the general deduction provision are tax deductible under this provision.Examples of these legal expenses include expenses incurred to protect income, to prevent a reduction in income or expenses incurred to avoid a loss or to resist a claim for compensation.The tax-deductible legal fees provided for in section 17(1)(c) include the fees of legal practitioners, expenses incurred to procure evidence or expert advice, witness fees, court fees and any other similar expenses.As long as the legal fees are not of a capital nature and the claim, dispute or action arises in the ordinary course of operations in carrying on the taxpayer’s trade, the legal fees will be tax deductible.The legal costs incurred by a newspaper to resist a claim for damages for libel would be deductible under section 17(1)(c) because the damages paid should the claimant be successful will be deductible under section 17(1)(a) given the nature of the business of a newspaper where libel claims could be filed against it.The tax courts have considered various cases with regard to the tax deductibility of legal expenses. Legal contract costs to acquire a capital asset (for example a building to earn rental income) have been held to be of a capital nature and therefore not tax deductible.The tax courts have held that expenses incurred for a standard employment contact or to recover trade debts are not capital in nature and therefore tax deductible under section 17(1)(c).Legal expenses incurred to defend a claim of a negligent driver employed by a taxpayer or claiming compensation from a supplier for the supply of defective merchandise have been regarded as legal expenses arising from the ordinary course of carrying on the taxpayer’s trade.Legal expenses incurred to defend a claim for damages due to the bad design of a building by an architect or damages resulting from a person crashing into a trailer parked outside the taxpayer’s premises overnight have been held by the court not to arise out of the ordinary operations of the taxpayer’s trade.The tax courts have held that where a professional has been grossly negligent in the carrying out of his work, the cost of damages paid is not a tax-deductible expense.The cost of damages paid for the delivery of defective goods to customers or for infringing another person’s patent is however tax deductible.The deduction of legal expenses has not come under close scrutiny by the Receiver of Revenue in recent times.When it is closely scrutinised, you should not be surprised if some expenses are added back to determine taxable income because all legal expenses are generally claimed for tax purposes.