Edited version of private ruling

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Ruling

Subject: legal expenses

Question 1

Are you entitled to a deduction for the portion of legal expenses which relate to the payment of unused annual leave and the payment in lieu of notice?

Answer

Yes.

Question 2

Are you entitled to a deduction for the portion of legal expenses which relate to the recovery of salary payment from your employer?

Answer

Yes.

Question 3

Are you entitled to a deduction for the portion of legal expenses which relate to your redundancy payment?

Answer

No.

Question 4

Are you entitled to a deduction for the travel expenses which relate to the legal expenses for unused annual leave, payment in lieu of notice and unpaid salary entitlements?

Answer

Yes.

Question 5

If legal fees and travel expenses are an allowable deduction, what is a reasonable basis of apportionment in determining the deductible amount which may be claimed given the termination payment received comprises both assessable and non-assessable components?

Answer

Withdrawn - refer to general guidance.

This ruling applies for the following period:

Year ended 30 June 2009

The scheme commences on:

1 July 2008

Relevant facts and circumstances

You commenced employment with Company X (your employer) on date A.

The terms of your employment agreement included:

- Annual salary of a certain amount plus superannuation of a certain amount per annum (the Remuneration Term)

- Annual leave of four weeks (paid) for each year worked, or part thereof, and upon termination of your employment, you would be entitled to payment in lieu of such annual based on your total annual remuneration package (the Annual Leave Term)

In the event of your employer terminating your employment for reason of redundancy, your employer would pay you a redundancy payment of M weeks remuneration plus N weeks remuneration per years of service (the Redundancy Term)

A few years after commencement of employment you took a period of unpaid leave.

You were unable to return to work on the planned date due to health reasons.

You applied for and were granted unpaid sick leave by your employer for a period and it was agreed that your leave would be extended until date P.

You contacted your employer to confirm that you would be fit and ready to return to work on date P.

You were subsequently notified that your position had been made redundant. You were advised that your options were to accept a redundancy package and exit the business, accept an interim role or resign and return as an independent contractor.

You endeavoured to negotiate a settlement with your employer without success.

You commenced legal proceedings, filing a statement of claim in a Court for unpaid salary, unpaid annual leave, payment in lieu of notice and a redundancy payment.

You received a settlement payment comprising a redundancy payment of and an eligible termination payment.

The total settlement amount you received was calculated with the following components:

- eligible termination payment

- gross salary

- total assessable amount

- redundancy payment, and

- total settlement amount.

In pursuing your legal claim, you incurred legal costs with a lawyer, barrister and a mediator.

No amount of the settlement you received represented reimbursement of your costs. You also incurred minor travel costs to attend meetings at the office of your legal advisors.

You have provided a copy of certain documents, including itemised accounts of legal fees, which form part of this ruling:

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Income Tax Assessment Act 1997 Subsection 6-5(2).

Income Tax Assessment Act 1997 Section 6-10.

Income Tax Assessment Act 1997 Section 83-10.

Income Tax Assessment Act 1997 Section 83-80.

Reasons for Decision

Section 8-1 of the Income Tax Assessment Act 1997 (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.

In determining whether a deduction for legal expenses is allowed, the nature of the expenditure must be considered. The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses. If the advantage to be gained is of a capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature.

Where an expense relates to multiple purposes, the expense must be apportioned between the purposes on a fair and reasonable basis: Ronpibon Tin NL & Tongkah Compound NL v. FC of T (1949) 78 CLR 47.

Apportioning legal expenses based on the proportion of each amount of entitlement claimed in a legal proceeding would be considered a fair and reasonable basis. For example, where the revenue portion of a claim amounts to 80% of the total claim, 80% of the legal expenses relates to this portion.

In your situation, your legal expenses relate to a claim for unpaid entitlements of differing natures (unpaid salary, unpaid annual leave, payment in lieu of notice and a redundancy payment).and accordingly must be examined individually.

Unused leave and unpaid wages

Subsection 6-5(2) of the ITAA 1997 provides that the assessable income of a resident taxpayer includes ordinary income derived directly or indirectly from all sources during the year. Salary and wages, including annual leave payments, is considered ordinary income as it is paid directly as a result of the personal services an employee renders for their employer.

However, unused annual leave and unused long service leave (although acquired through personal services and thus characterised as ordinary income) are considered to be forms of statutory income under section 6-10 of the ITAA 1997.

Sections 83-10 and 83-80 of the ITAA 1997 provide concessional tax treatment for unused annual leave and unused long service leave received as a lump sum. Although the tax treatment of these amounts is different to salary and wages (including payments in respect of leave taken) earned during the course of employment, it does not alter the character of the payments as ordinary income.

In your case, the unpaid salary and unpaid annual leave constitute assessable income. Accordingly, the legal expenses related to these payments will be deductible.

Payment in lieu of notice

In Romanin v. FC of T 2008 ATC 20-055; FCA 1532 (Romanin) the court considered the deductibility of legal expense incurred by the taxpayer for proceedings at the Industrial Relations Commission. In the proceedings, the taxpayer argued that an employment contract existed where they were entitled to 12 months notice, or a payment in lieu of this notice. The employer had denied such a contract existed and had given seven days notice.

The proceedings found in favour of the taxpayer and the employer was ordered to pay them the total value of the employment package for the period of 12 months less any salary and other earnings that they had earned in alternative employment during the 12 months following the termination of his employment.

The legal expenses were found not to be capital in nature because the character of the advantage which the taxpayer sought in bringing the proceedings was on revenue account, namely receipt of his contractual entitlement to salary he would have received had he been given 12 months notice.

Legal expenses incurred to recover income payments such as were at issue in Romanin - that is, salary that would have been derived during the notice of termination period, had it been given - will be deductible, even if the receipt was paid as a lump sum and subject to assessment as an eligible termination payment.

This case can be distinguished from cases in which legal expenses are incurred in seeking compensation for loss of employment, such as in an action for wrongful dismissal or loss of office where the advantage sought is of a capital nature. In such cases, the legal expenses are of a capital nature, even if the amount awarded is calculated by reference to unpaid salary or lost income, or is assessable as statutory income.

Your situation is similar to that in Romanin's Case. Your legal expenses in enforcing payment of your contractual entitlement to payment in lieu of notice are outgoings with nexus to assessable income. The character of the advantage sought is on revenue account. The legal expenses are therefore deductible.

Redundancy payment

A redundancy payment, being compensation for the loss of the expectation of continuity of service, is a payment that is capital in nature. The payment is made to compensate the taxpayer for the loss of their employment position.

Redundancy payments are treated as eligible termination payments and subject to special tax treatment that may result in some or all of the amount being included in your income. However the fact that a capital payment is specifically brought to account as assessable income will not change the nature of the payment.

An amount that is capital in nature will remain capital notwithstanding that it is specifically included in your assessable income. Consequently the portion of legal expenses relating to your redundancy payment is also capital in nature and not deductible.

Travel expenses

The treatment of travel expenses incurred in respect of legal action follows the treatment of other legal costs in relation to a particular matter. In your case you incurred travel costs to attend meetings at the office of your legal advisors. The travel expenses relating to payment of your unpaid salary, annual leave and payment in lieu of notice are deductible as they were incurred in earning assessable income.

Conclusion

In your situation, it is accepted that the portion of legal expenses and travel expenses relating to your application for unpaid salary, unpaid annual leave and payment in lieu of notice were incurred in earning assessable income. Accordingly you are entitled to a deduction for this portion of your legal expenses.

The redundancy payment is capital in nature and consequently the portion of legal expenses and travel expenses relating to this is also capital in nature. Accordingly no deduction is allowable for this portion of your legal and travel expenses.

General Guidance

We offer the following general guidance.

A taxpayer who relies on guidance will remain liable for any tax shortfall if the guidance is incorrect or misleading and they make a mistake as a result (unless a time limit imposed by the law precludes the liability). However, they will be protected against the shortfall penalty and interest on the tax shortfall provided they relied on that guidance reasonably and in good faith.

Apportionment of legal fees

Where legal expenses are incurred in relation to proceedings that relate both to amounts that are revenue in nature as well as amounts which are capital in nature, there must be some fair and reasonable assessment of the extent of the relation of the outlay to assessable income.

Taxation Determination TD 93/29 discusses the apportionment of legal expenses.

Where the solicitors account is itemised, one reasonable basis for apportionment would be the time spent involving the revenue claim, relative to the time spent on the capital claim.

If the solicitors account is not itemised, a possible basis for apportionment would be either a reasonable costing of the work undertaken by the solicitor in relation to the revenue claim, or, where this is not possible, an apportionment on the basis of the monetary value of the revenue claim relative to the capital claim.

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