Edited version of your written advice

Authorisation Number: 1012778840001

Ruling

Subject: Legal expenses

Question 1

Are you entitled to a deduction for legal expenses incurred in relation to your dismissal and redundancy entitlements?

Answer

No.

Question 2

Are you entitled to a deduction for legal expenses incurred in relation to your unpaid long service leave and unpaid annual leave?

Answer

Yes.

This ruling applies for the following period

Year ended 30 June 2014

The scheme commenced on

1 July 20XX

Relevant facts

You were an employee and had your existing role for several years.

When a new supervisor was appointed, your role changed and when you tried to enter into consultation or debate you were rebuffed or discouraged.

Over a period of time you consider that the actions of your supervisor undermined your position.

Eventually you received a constructive dismissal letter.

You then sought legal advice in relation to the above.

You commenced a period of extended personal leave and the supervisor allocated your various duties to other employees and as a consequence it was determined that your position is no longer required.

Two letters prepared by your solicitor were remitted to the supervisor, one making a settlement offer and the other was an open letter seeking particulars.

You agreed to terminate your employment.

As outlined in the Deed of Separation it was agreed to pay you for your unused long service leave and unused annual leave as well as a bona fide redundancy payment inclusive of pay in lieu of notice.

You agreed to release and forever discharge present and future claims, including claims in contract, tort or statute in relation to your employment.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

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.

A number of significant court decisions have determined that for an expense to be an allowable deduction:

• it must have the essential character of an outgoing incurred in gaining assessable income or, in other words, of an income-producing expense (Lunney v. FC of T; (1958) 100 CLR 478), 

• there must be a nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income (Ronpibon Tin NL v. FC of T, (1949) 78 CLR 47), and

• it is necessary to determine the connection between the particular outgoing and the operations or activities by which the taxpayer most directly gains or produces his or her assessable income (Charles Moore Co (WA) Pty Ltd v. FC of T, (1956) 95 CLR 344; FC of T v. Hatchett, 71 ATC 4184).

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.

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).

However, 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 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.

Taxation Determination TD 93/29 Income tax: if an employee incurs legal expenses recovering wages paid by a dishonoured cheque, are these legal expenses an allowable deduction under section 8-1 of the Income Tax Assessment Act 1997? states:

If the legal action goes beyond a claim for a revenue item such as wages, and constitutes an action for breach of the contract of employment where the essential character of the advantage sought relates to an enduring advantage that is of a capital nature, the legal costs would not be deductible. For example, legal expense 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 are of a capital nature 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.

In your case, your position was made redundant.

A redundancy payment, being compensation for the loss of the expectation of continuity of service, is a payment that is capital in nature. Such a payment is made to compensate the taxpayer for the loss of their employment position and is regarded as a capital payment (Case Y24 91 ATC 268; AAT Case 6942 (1991) 22 ATR 3184).

You first sought legal action on the day you received your constructive dismissal letter.

It is acknowledged that you were concerned that the actions by the supervisor interfered with the carrying out of your employment duties, however legal advice was not sought during the period when this was occurring and it was only upon the receipt of the letter that you sought legal advice.

It follows that your legal action taken is not considered to be sufficiently connected to your income earning activities as an employee. It more relates to your dismissal and redundancy. As highlighted above, action taken in relation to a redundancy is capital in nature.

Therefore as a redundancy payment is capital in nature, the legal expenses incurred in negotiating your redundancy package is also capital in nature. Accordingly, no deduction is allowable for the associated legal expenses incurred.

Long service leave and annual leave

Legal expenses incurred in recovering salary or wages are considered to be of a revenue nature and therefore deductible under section 8-1 of the ITAA 1997.

Similarly, legal expenses incurred in recovering unused long service leave and unused annual leave are generally allowable as they directly relate to gaining or producing assessable income.

In your case the terms of your settlement included obtaining payments for your unused long service leave and unused annual leave. It is considered that the associated legal expenses in relation to your unpaid leave payments related sufficiently to the earning of your assessable income and are therefore deductible under section 8-1 of the ITAA 1997.

Apportionment of expenses

As your legal expenses are not fully deductible, you will need to apportion the expenses using a reasonable basis. Apportionment is a question of fact and involves a determination of the proportion of the expenditure that is attributable to deductible purposes. The Commissioner believes that the method of apportionment must be fair and reasonable in all the circumstances.

Where legal expenses are not broken up into the relevant parts by your solicitor, you will need to calculate the deductible portion. One way to apportion your expenses is according to the dollar value of the assessable unused leave amount as compared to the total amount being sought. The relevant percentage that relates to your assessable unused leave payments can then be applied to the legal expenses incurred.

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