Edited version of your private ruling

Authorisation Number: 1012447683954

Ruling

Subject: Legal expenses

Question

Are you entitled to a deduction for the legal expenses incurred?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 2011

The scheme commences on:

1 July 2010

Relevant facts and circumstances

You were an employee with Company A.

You were offered a position at a rival business (Company B).

You informed Company A that you had entered into an employment agreement with Company B and your employment was immediately terminated.

You received notice from solicitors for Company A advising that they wished to enforce a non-compete clause.

You were partly successful in defending the proceedings.

You incurred legal costs comprising your own legal costs and those pursuant to the costs order.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Summary

You are not entitled to a deduction for the legal expenses incurred as they did not arise as a consequence of the performance of your duties in your previous employment or your new employment. The advantage sought in defending your ability to commence your new employment is capital in nature. Therefore the legal expenses that you incurred are also capital in nature.

Detailed reasoning

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for all losses and outgoings to the extent that they are incurred in gaining or producing assessable income, or necessarily incurred in carrying on a business for the purpose of 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.

For legal expenses to constitute an allowable deduction, it must be shown that they were incidental or relevant to the production of the taxpayer's assessable income, (Ronpibon Tin NL & Tong Kah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 4 AITR 236; (1949) 8 ATD 431).

Also, in determining whether a deduction for legal expenses is allowable under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 3 AITR 436; (1946) 8 ATD 190). The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses.

Legal expenses are generally deductible if they arise out of the day to day activities of the taxpayer's business. (Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 2 ATD 169) and the legal action has more than a peripheral connection to the taxpayer's income producing activities (Magna Alloys and Research Pty Ltd v. FC of T (1980) 11 ATR 276; 80 ATC 4542).

In FC of T v. Rowe (1995) 60 FCR 99; (1995) 31 ATR 392; 95 ATC 4691, the court accepted that legal expenses incurred in defending the manner in which a taxpayer performed his employment duties were allowable. The activities which produced the taxpayer's income were what exposed them to the liability against which they were defending themselves.

Additionally, where the expenditure is incurred for the purpose of securing an enduring benefit, rather than a revenue purpose, the expenditure is capital in nature and is not deductible (Sun Newspapers Ltd v. FC of T (1938) 61CLR 337; 5 ATD 87; (1938) 1 AITR 403).

In Case V140 88 ATC 874; AAT Case 4596 (1988) 19 ATR 3859, a solicitor was denied a deduction for expenses incurred in defending certain allegations before the Statutory Committee of the Law Society of New South Wales. The Committee ordered the taxpayer be suspended from practice for a certain period, and to pay the costs of the Law Society. Failure to pay these costs would have resulted in the taxpayer being further suspended from practice until they were paid. It was held that the obligation to pay the Law Society's costs was fundamental to the taxpayer's continuing right to derive his principal source of income through the practice of his profession. That right to earn money was regarded as a profit-yielding subject or as a structural asset. It was held that expenses of defending or acquiring a profit-yielding subject or structural asset are of a capital nature, and that the taxpayer's expenses were not deductible.

In Kemp v Federal Commissioner of Taxation (1992) 110 ALR 375; 24 ATR 75; 92 ATC 4542, the taxpayer was a New Zealand rugby league player who was contracted to play for a New South Wales club. He was required to obtain a clearance from his home league in order to play professionally in the New South Wales Rugby League. Following his home leagues failure to give him a clearance, the taxpayer commenced legal proceedings and obtained a court declaration that his home leagues rules constituted unreasonable restraint of trade. The Administrative Appeals Tribunal rejected the taxpayers claim to deduct legal expenses because the expenditure came at a point too soon to be regarded as incurred in gaining assessable income. The taxpayer appealed.

In dismissing the appeal the Federal Court held that the decisions in Hallstroms and Sun Newspapers applied. In order to determine whether expenditure is on revenue or capital account it is necessary to identify the advantage sought by a taxpayer. The taxpayer incurred legal expenses in order to obtain freedom from the restraint which prevented him from playing in Australia with the club of his choice. This was a structural advantage and expenditure incurred in pursuit of it took on the character of capital.

In your case, you incurred legal expenses in defending the action commenced by your former employer to enforce a non-compete clause contained in your former employment agreement. They did not arise as a consequence of the performance of your duties in your former employment.

Also your legal expenses were incurred to enable you to commence your employment with Company B. They did not relate to the duties of your new employment. Therefore, they are not incurred in earning your assessable income from either employment.

You made reference to Taxation Ruling TR 2000/5 which sets out the Commissioner's view of the application of section 8-1 of the ITAA 1997 to costs incurred by employees and employers in preparing and administering employment agreements.

As outlined in TR 2000/5, a deduction is allowed for an employee for costs associated with the settlement of disputes arising out of an existing employment agreement including the cost of representation. Your dispute arose due to a clause in your employment agreement with your previous employer. This agreement is no longer current. Therefore your disputes do not arise out of an existing employment agreement.

Additionally, you were defending your rights under your employment agreement with Company B. Costs incurred in defending a right to practice a profession or employment are capital in nature, as the right to practice is considered a profit yielding subject or structural asset and the associated expenses are incurred to protect this right.

The advantage that you sought in defending your ability to commence your employment with Company B is capital in nature. As the nature of legal expenses follows the nature of the advantage sought, the legal expenses that you incurred in defending the action are also capital in nature.

Therefore, as the expenses you incurred were not incurred in the gaining or producing of your assessable income and are considered to be capital in nature you are not entitled to a deduction for the legal expenses incurred under section 8-1 of the ITAA 1997.

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