Edited version of your private ruling

Authorisation Number: 1012558872363

Ruling

Subject: Employment termination payment and deductibility of legal expenses

Questions:

1. Is any part of a settlement payment for 'General Damages' assessable income as an employment termination payment?

2. Is any part of the settlement payment exempt from tax as a payment for personal injury?

3. Is the taxpayer entitled to a deduction for legal fees?

Advice/Answers:

1. Yes.

2. No.

3. No.

This ruling applies for the following period:

1 July 2013 to 30 June 2014

The scheme commenced on:

1 July 2013

Relevant facts:

You are under 55 years of age.

You commenced employment with an organisation (the employer) at a certain branch.

You transferred to another branch.

You allege that you were subject to harassment by your manager. Subsequently you felt there was a change of behaviour of your manager towards you. This included abuse by your manager if you required sick leave, a number of letters regarding minor errors and a lack of positive recognition of how hard you were working.

You lodged a complaint with the employer regarding your treatment by your manager.

You received correspondence from the employer indicating their intention to terminate your employment.

Your employment terminated.

After your termination, you sought legal advice. You requested payment from your previous employer for economic and non-economic loss. You did not seek to be reinstated or request your job back. You requested that the Deed state that you had resigned instead of being dismissed.

Your solicitors lodged a complaint (the complaint) against the employer, on your behalf, with a Government body.

The employer wrote to your solicitors stating that you were guilty of misconduct. Further the letter stated that some of the instances of misconduct led to your termination of employment.

Your solicitors responded to the above letter stating that they rejected the employer's assertion that that there was a pattern of misconduct and that any performance issues were linked to the stress and humiliation you had experienced due to the harassment by your manager.

The employer and you have agreed to settle the complaint under a Deed of Release (the Deed). Under the Deed you were to receive a payment as a 'general damages' payment.

Your solicitors advised that within twelve months of your termination of employment they received an amount less tax of 31.5% on an employment termination payment. They deducted legal costs plus GST and disbursement from this amount.

The remaining amount was deposited into your bank account.

The Deed states that the employee releases the employer from all claims and liabilities of any nature arising out of or related directly or indirectly (other than worker's compensation) to the employment, the position, the termination, the complaint, the recitals and other circumstances known to the employee.

Issue 1

Employment termination payment

Relevant legislative provisions:

Income Tax Assessment Act 1997 Section 1-3.

Income Tax Assessment Act 1997 Section 82-130.

Income Tax Assessment Act 1997 Subsection 82-130(1).

Income Tax Assessment Act 1997 Paragraph 82-130(1)(a).

Income Tax Assessment Act 1997 Paragraph 82-130(1)(b).

Income Tax Assessment Act 1997 Paragraph 82-130(1)(c).

Income Tax Assessment Act 1997 Paragraph 82-130(2).

Income Tax Assessment Act 1997 Section 82-135.

Income Tax Assessment Act 1997 Paragraph 82-135(i).

Income Tax Assessment Act 1997 Section 995-1.

Income Tax Assessment Act 1936 Subsection 27A(1).

Reasons for decision

Summary

The payment is an employment termination payment (ETP) as it was made in consequence of your termination of employment within 12 months of your termination of employment and does not fall under any of the exclusions.

The payment is not exempt from being an ETP as a payment for personal injury.

Detailed reasoning

Is the payment an employment termination payment?

A payment made to an employee is an employment termination payment if the payment satisfies all the requirements in section 82-130 of the Income Tax Assessment Act 1997 (ITAA 1997), and is not specifically excluded under section 82-135 of the ITAA 1997.

Subsection 82-130(1) of the ITAA 1997 states:

82-130(1) A payment is an employment termination payment if:

(a) it is received by you:

(i) in consequence of the termination of your employment; or

(ii) after another person's death, in consequence of the termination of the other person's employment; and

(a) it is received no later than 12 months after the termination (but see subsection (4)); and

(b) it is not a payment mentioned in section 82-135.

The phrase 'in consequence of' is not defined in the ITAA 1997. However, the words have been interpreted by the courts in several cases. The Commissioner has also issued Taxation Ruling TR 2003/13 (TR 2003/13) which discusses the meaning of the phrase.

The Full High Court considered the expression 'in consequence of' in Reseck v. FC of T (1975) 133 CLR 45; (1975) 6 ALR 642; (1975) 49 ALJR 370; (1975) 5 ATR 538; (1975) 75 ATC 4213 (Reseck). Justice Gibbs stated:

Within the ordinary meaning of the words a lump sum is paid in consequence of the termination of employment when the payment follows as an effect or result of the termination… It is not in my opinion necessary that the termination of the services should be the dominant cause of the payment.

While Justice Jacobs stated:

It was submitted that the words 'in consequence of' import a concept that the termination of the employment was the dominant cause of the payment. This cannot be so. A consequence in this context is not the same as a result. It does not import causation but rather a 'following on'.

In looking at the phrase 'in consequence of' the Full Federal Court in McIntosh v. FC of T (1979) 25 ALR 557; (1979) 10 ATR 13; (1979) 45 FLR 279; (1979) 79 ATC 4325 (McIntosh) considered the decision in Reseck. Justice Brennan stated:

Though Jacobs J. speaks in different terms, his meaning may not be significantly different from the meaning of Gibbs J... His Honour denies the necessity to show that retirement is the dominant cause, but he does not allow a temporal sequence alone to suffice as the nexus. Though the language of causation often contains the seeds of confusion, I apprehend his Honour to hold the required nexus to be (at least) that the payment would not have been made but for the retirement.

The Commissioner in TR 2003/13 considered the phrase 'in consequence of' as interpreted by the Courts.

Paragraph 5 of TR 2003/13 states:

…the Commissioner considers that a payment is made in respect of a taxpayer in consequence of the termination of the employment of the taxpayer if the payment 'follows as an effect or result of' the termination. In other words, but for the termination of employment, the payment would not have been made to the taxpayer.

The question of whether a payment is made in consequence of the termination of employment will be determined by the relevant facts and circumstances of each case.

Payments made under a deed of release have also been held to be made in consequence of the termination of employment.

In Le Grand v. Commissioner of Taxation (2002) FCA 1258; (2002) 124 FCR 53; (2002) 195 ALR 194; 2002 ATC 4907; (2002) 51 ATR 139 (Le Grand), the payment received was not only in respect of the termination of employment. In holding the payment for damages to also be an ETP, Goldberg J stated at paragraph 35:

I am satisfied that the payment was an effect or result of that termination in that there were a sequence of events following the termination of the employment which had a relationship and connection which ultimately led to the payment. True it is that the payment was made not only to settle the applicant's claim for common law damages for breach of the employment agreement but also for statutory damages...

Justice Heerey in Dibb v. Commissioner of Taxation 2003 ATC 4613; (2003) 53 ATR 290; [2004] ALMD 5781; [2003] FCA 673 (Dibb) stated that:

22. The concept of a 'payment 'in consequence of the termination of any employment' was expounded by the High Court in Reseck v FC of T 75 ATC 4213; (1975) 133 CLR 45 and by the Full Court of the Federal Court in McIntosh v FC of T 79 ATC 4325; (1979) 25 ALR 557. These authorities are analysed by Goldberg J in Le Grand v FC of T 2002 ATC 4907 at 4911-4913 [25-30] and 4914 [33-34]; (2002) 195 ALR 194 at [25] to [30] and [33] to [34]. I adopt his Honour's analysis.

23. In my opinion the Commissioner was correct in ruling that the payment under the Deed was made 'in consequence of the termination' of the applicant's employment with AVCO. True it is there was a substantial lapse in time between the termination and the commencement of Federal Court proceeding and a further period of time until settlement. However the reason for that delay was the time taken up with the litigation first in the Commission and then in the Federal Court itself. The subject matter of the litigation in the Federal Court was clearly the termination, the allegedly wrongful way AVCO effected it and its financial and other consequences for the applicant. The various causes of action, whether breach of contract, conspiracy, breach of fiduciary duty or contravention of the Trade Practices Act were, as Goldberg J would say (Le Grand at ATC 4915 [36]; ALR [36]), 'interwoven and intertwined' with the termination. The payment was a consequence of the settlement, which was a consequence of the Federal Court proceeding, which in turn was a consequence of the termination.'

This reasoning was accepted by the Full Federal Court in Dibb v. Commissioner of Taxation (2004) 207 ALR 151; 2004 ATC 4555; (2004) 55 ATR 786; (2004) 136 FCR 388; [2004] ALMD 5780; [2004] FCAFC 126 by Justices Spender Dowsett and Allsop in determining the appeal against Justice Heerey's decision.

Therefore, the Courts have held that settlement amounts arising from actions that are in some way connected with the termination of employment are payments made in relation to the taxpayer in consequence of the termination of their employment.

In your case, on the basis of the information provided:

· you state that there was a dispute between yourself and the employer regarding a harassment claim inclusive of economic and non-economic loss;

· the employer has stated you were guilty of misconduct; and

· you lodged a complaint for harassment (the complaint) against the employer, with the Government body.

The settlement payment was made to you in consequence of entering into a Deed (the Deed) requiring your commitment to non-disparagement and confidentiality. You believe that the settlement payment was not made as an effect or result of the termination but was a compensation for the complaint.

The employer has classified the payment as 'general damages'. However, by signing the Deed you have agreed to what was written in the Deed.

Therefore, by entering into the Deed with the employer, you agreed to release the employer and the employer group from all claims and liabilities (other than worker's compensation), in relation to your employment and its termination and the complaint. This is in accordance with the Deed.

Although the dominant cause of the payment is to settle the dispute there is a causal connection between the termination of employment and payment. As per the decision in Reseck quoted above, it is not necessary that the termination of employment is the dominant cause of the payment.

The payment was made once the Deed was executed, and the employer made that payment, in part because you released it from any further legal action in respect of your employment and the termination of that employment.

Given its nature, the dispute, the Deed, the termination of employment and the payment are all intertwined and connected. Based on the principles stated in Reseck, McIntosh, Dibb and Le Grand; and the Commissioner's views expressed in TR 2003/13, the facts presented demonstrate a clear connection or a link exists between the termination of your employment and the payment.

Accordingly, it can only be concluded that the payment you have received satisfies the first condition of being an employment termination payment in accordance with subparagraph 82-130(1)(a)(i) of the ITAA 1997.

The other conditions of subsection 82-130(1) of the ITAA 1997 will now be considered.

The payment is received no later than 12 months after termination

The second condition is stated under paragraph 82-130(1)(b) of the ITAA 1997. The settlement sum must be received within 12 months of the employee's termination of employment, unless the payment is covered by a determination exempting them from the 12 month rule.

The settlement payment was made within 12 months of the termination of your employment. Therefore, this condition is satisfied.

Exclusions under section 82-135 of the ITAA 1997

Certain payments made on termination of employment are excluded from being an employment termination payment under section 82-135 of the ITAA 1997. These payments, among others, include:

· accrued annual leave and long service leave payments which are covered by Subdivision 83-A and Subdivision 83-B respectively

· superannuation benefits which are covered by Divisions 301 to 307

· the tax-free parts of a genuine redundancy payment or an early retirement scheme payment worked out under section 83-170; and

· certain capital payments for personal injury.

The payment does not fall within the various exclusions under section 82-135 of the ITAA 1997 except possibly a payment for personal injury. We will now consider whether the payment is a capital payment for personal injury.

Paragraph 82-135(i) of the ITAA 1997 specifically excludes from being an employment termination payment:

a capital payment for, or in respect of, personal injury to you so far as the payment is reasonable having regard to the nature of the personal injury and its likely effect on your capacity to derive income from personal exertion (within the meaning of the definition of income derived from personal exertion in subsection 6(1) of the Income Tax Assessment Act 1936).

This exclusion is for a payment or benefit that compensates or reimburses you for, or in respect of, the particular injury.

In relation to the payment, the Commissioner accepts:

· it is a capital payment; and

· you received a payment for general damages.

You have stated that your complaint was for harassment. In the letter from your solicitors to the employer in response to the employer's claim of your misconduct, they state that any performance issues were linked to the stress and humiliation you had experienced due to harassment. Consequently, the possible personal injury you could have had is 'stress and humiliation'.

The principal question for determination therefore is whether the payment can be characterised as 'a capital payment for, or in respect of, a 'personal injury'. The words require a relationship between the injury and payment.

The Explanatory Memorandum (EM) to the Tax Laws Amendment (Simplified Superannuation) Bill 2006 stated, in relation to section 82-135 of the ITAA 1997, that:

consistent with current legislation, certain payments are prevented from qualifying as employment termination payments.

In accordance with section 1-3 of the ITAA 1997, provisions in the ITAA 1936 which have been rewritten in the ITAA 1997 will have the same meaning where they express the same idea, even if the words used are different. It is therefore appropriate to cite cases that refer to the previous legislation.

The term 'personal injury' is not defined in the ITAA 1936.or in ITAA 1997. Justice Smith of the Victorian Supreme Court considered the meaning of the term, in Graham v Robinson [1992] 1 VR 279, (Graham v Robinson )and stated at 281:

In the absence of express authority, I have come to the conclusion that the expression personal injury does not extend beyond physical injury and mental illness to include emotional hurt. I am encouraged to this view by the fact that the law has rejected grief or sorrow as a form of injury which can be relied on to mount a claim in negligence: Mount Isa Mines Ltd. v. Pusey (1970) 125 CLR 383, at p. 394 and Jaensch v. Coffey (1984) 155 CLR 549, at p. 587. It is true that damages are awarded for pain and suffering in the typical personal injury case. They are awarded, however, where pain and suffering flow from and are connected with physical or mental injury and may therefore be said to be damages in respect of personal injury.

In considering the meaning of personal injury for the purpose of paragraph (n) the Administrative Appeals Tribunal (AAT) has cited Graham v Robinson, in AAT Case 20/97; No 11 722 (1997) 35 ATR 1114; (1997) 97 ATC 258 and McMahon (mentioned above), and held that personal injury does not extend beyond physical injury or mental illness.

In your case, you do not have a physical injury or a mental illness.

In Commissioner of Taxation v. Scully (2000) 201 CLR 148; [2000] HCA 6; 2000 ATC 4111; (2000) 169 ALR 459; (2000) 74 ALJR 504; (2000) 43 ATR 718 (Scully) the High Court, in considering former paragraph 27A(1)(n), held that compensation must be calculated by reference to the nature and extent of the injury or likely loss to the taxpayer.

The payment in Scully was held not to be in respect of personal injury. Acting Chief Justice Gaudron and Justices McHugh, Gummow and Callinan stated in their joint decision:

In our opinion, the payment in this case cannot be characterised as consideration... in respect of, personal injury. The fact that the payment is not calculated by reference to the nature and extent of the injury or likely loss to the respondent and the fact that the other benefits are similar to that for total and permanent disablement point inevitably to the conclusion that the payment was consideration... for, or in respect of the respondent's termination of employment and her rights under the Trust Deed and was not consideration... for, or in respect of her injury.

Therefore for an amount to meet the requirements of paragraph 82-135(i) of the ITAA 1997, the payment must be for, or in respect of, personal injury and be calculated by reference to the nature and extent of the injury or likely loss to the taxpayer.

In Purvis and Ors v. Federal Commissioner of Taxation (2013) 2013 ATC 10-296; (2013) AATA 58 (Purvis) the Administrative Appeals Tribunal held that the payment was not compensation for personal injury as the injury was not a factor in determining the amount of the payment.

In your case, the payment will be made in accordance with the Deed. This Deed states that the payment is for 'general damages' and does not specify any personal injury. There is no correspondence between the amount of the payment and the likely effect of any personal injury on your capacity to derive income from personal exertion.

Further, based on Graham v Robinson, as you do not have a physical injury or mental illness the payment is not for a personal injury and therefore is not excluded from being an employment termination payment.

Accordingly, it is considered that paragraph 82-135(i) of the ITAA 1997 does not exclude the lump sum payment from being an employment termination payment. As the payment is not a payment mentioned in section 82-135 of the ITAA 1997, paragraph 82-130(1)(c) of the ITAA 1997 is satisfied.

As discussed above, the payment is considered to be a payment received in consequence of the termination of employment and is not a payment mentioned in section 82-135 of the ITAA 1997; and is paid within 12 months of termination, all the conditions of subsection 82-130(1) of the ITAA 1997 will be met. Therefore, the payment is considered to be an employment termination payment.

Tax Treatment of the employment termination payment

An employment termination payment is comprised of the following components:

Ÿ Tax free component - this includes the pre-July 83 segment (if any) and/or the invalidity segment (if any); and

Ÿ Taxable component - the amount remaining after deducting the tax free component from the total payment.

The tax free component is not assessable income and is not exempt income.

The taxable component is included, in full, as assessable income.

You commenced employment with the employer after July 1983. Therefore, there will not be any pre-July 83 segment within the meaning of section 82-155 of the ITAA 1997.

As the payment is not made because you ceased being gainfully employed as a result of suffering from ill-health, there is no invalidity segment for the purposes of section 82-150 of the ITAA 1997.

Consequently, the employment termination payment will not contain a tax free component and will be comprised entirely of a taxable component (section 82-145 of the ITAA 1997).

From 1 July 2012, employment termination payments are subject to the 'whole-of-income- cap'. This cap is $180,000 less your other taxable income for the year.

The taxable component is subject to tax, depending on the person's age when the payment is received and on the lesser of the whole-of-income cap and the employment termination payments cap.

If the calculated whole-of-income-cap is less than the employment termination payment cap of $175,000 (2012-13 income year), the calculated whole-of-income-cap will apply to your employment termination payment.

For recipients below preservation age, the taxable component of an employment termination payment is taxed at 30% for amounts below the employment termination payments cap of $175,000 for the 2012-13 income year or 'whole-of-income- cap' and at the top marginal rate for amounts above the cap. Medicare levy of 1.5% is added to the tax rate that applies.

Preservation age is the age at which retirees can access their superannuation benefits. This will be 55 for persons born before 1 July 1960 and between 55 and 60 for persons born after 30 June 1960.

In your case, your preservation age is 60 and you were under preservation age on the last day of the income year in which the payment was made. Therefore the payment is taxed at 31.5%.

Issue 2

Deductibility of legal expenses

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Summary

Legal expenses incurred in relation to your termination and subsequent payment are capital in nature and do not sufficiently relate to your employment duties. Therefore no deduction is allowed for the associated legal expenses.

Reasons for decision

Legal expenses

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for a loss or an outgoing to the extent to which it is incurred in gaining or producing assessable income, except where the loss or outgoing is of a capital, private or domestic nature.

For legal expenses to constitute an allowable deduction, it must be shown that they are incidental or relevant to the production of the taxpayer's assessable income. 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. 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.

The success or failure of the legal action does not determine the deductibility of the legal expenses incurred.

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) 39 ALR 46; (1932) 2 ATD 169 (the Herald and Weekly Times Case)) 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 80 ATC 4542; (1980) 11 ATR 276).

Taxation Determination TD 93/29 states: 

If the legal action goes beyond a claim for a revenue item such as wages, and constitutes an action for a breach of the contract of employment, the legal costs would not be deductible because they are capital in nature. For example, legal expenses relating to an action for damages for wrongful dismissal are not deductible.

The Courts, Boards and Tribunals have consistently held that the legal expenses incurred by taxpayers in defending themselves against dismissal from their employment or seeking to regain employment following dismissal are of a capital nature and not deductible unless they are defending the way they carry out their day to day employment duties. This is because:

§ the legal expenses can be regarded as having been incurred once and for all, and

§ the advantage sought to be gained is the preservation of the taxpayer's employment.

The deductibility of legal expenses incurred in relation to an action for unfair dismissal was considered in Case L26 79 ATC 126; 23 CTBR (NS) Case 32. In that case, the taxpayer was employed as a music teacher by the Commonwealth Teaching Service. She was dismissed from her employment as a school teacher on the ground that she could not control classes. She unsuccessfully appealed to the Disciplinary Appeal Board against her dismissal. The taxpayer claimed a deduction for her legal expenses in relation to the appeal. It was held that the expenditure was a necessary step prior to regaining income from the employment from which the taxpayer had been dismissed but it was not expenditure incurred in the course of gaining or producing such income. Thus, the expenditure was not deductible.

The nature of a redundancy payment was considered in Case Y24 91 ATC 268; AAT Case 6942 (1991) 22 ATR 3184. In that case, it was held that 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 for the loss of employment position that is, as compensation for the sterilisation of a capital asset, and thus is an affair of capital.

In your case you incurred legal expenses in relation to the termination of your employment. The payment you received constitutes an employment termination payment. Your employment termination payment was paid to you as compensation for loss of your employment, and is capital in nature. Although the payment you received is subject to special tax treatment that results in the amount being included in assessable income, this does not change the character of the payment.

Legal expenses incurred in relation to an unfair dismissal do not sufficiently relate to your day to day employment duties. The expenses have been incurred too early to be regarded as having been incurred in gaining or producing the taxpayers' income from any future employment. The purpose of the expenditure is to re-establish an income stream or for gaining an enduring benefit. Such expenses are not deductible as they are capital in nature. Therefore no deduction is allowable under section 8-1 of the ITAA 1997 for the associated legal expenses.

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).