Edited version of your written advice

Authorisation Number: 1012856522135

Date of advice: 10 August 2015

Ruling

Subject: Legal expenses

Question 1

Are you entitled to a deduction for legal fees associated with taking legal action against your employer for unfair dismissal?

Answer

No.

Question 2

Does a payment of reimbursed legal fees made under a settlement agreement form part of your assessable income?

Answer

No.

This ruling applies for the following periods

Year ended 30 June 2015

Year ending 30 June 2016

The scheme commences on

1 July 2014

Relevant facts and circumstances

You took legal action against your former employer for unfair dismissal.

You have entered into a settlement agreement with your former employer under which they will pay you:

• a reimbursement for legal costs incurred by you during the proceedings, and

• an eligible termination payment.

The legal expenses you incurred exceeded the reimbursement.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

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

Income Tax Assessment Act 1997 Section 6-10

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 20-20

Income Tax Assessment Act 1997 Subsection 20-20(2)

Income Tax Assessment Act 1997 Section 82-130

Reasons for decision

Legal expenses

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 (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.

Generally, legal expenses incurred in an unfair dismissal action (seeking reinstatement and/or damages) are of a capital nature and therefore, not deductible.

Paragraph five of Taxation Determination TD93/29 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, 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.

A compensation payment made by an employer to a former employee in settlement of an unfair dismissal action qualifies as an ETP, as it is considered to be made 'in consequence of the termination of any employment of the taxpayer' (Taxation Ruling IT 2424, paragraph 24).  For this reason an ETP, whether it is made in one lump sum or through several amounts, is capital in nature.

ETP's are subject to special tax treatment that may result in some or all of the amounts being included in assessable 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 assessable income.

In your case, you incurred expenses in taking legal action against your employer for unfair dismissal. This action has gone beyond a claim for revenue. You entered into a settlement with your employer the majority of which is considered to be an ETP. ETP's are capital in nature.

As your legal expenses related to items which were capital in nature, the legal expenses are also considered to be capital in nature. Therefore the legal expenses are not deductible under section 8-1 of the ITAA 1997.

The fact that the legal expenses incurred exceeded the reimbursement received from your former employer does not change the character of the legal expense. No part, of the legal expenses, are deductible.

Reimbursement of legal fees

Reimbursement of legal costs as ordinary income

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 income year.

Ordinary income has generally been held to include three categories, namely, income from rendering personal services, income from property and income from carrying on a business.

Other characteristics of income that have evolved from case law include receipts that:

• are earned

• are expected

• are relied upon, and

• have an element of periodicity, recurrence or regularity.

In your case, you have not earned the reimbursement of your legal costs as it does not relate to services performed. The payment is a one-off payment and thus does not have an element of periodicity, recurrence or regularity.

Therefore, the reimbursement is not considered to be ordinary income and is not assessable under section 6-5(2) of the ITAA 1997.

Reimbursement of legal costs as an assessable recoupment

Section 6-10 of the ITAA 1997 provides that amounts that are not ordinary income but are included in assessable income by another provision, are called statutory income.

Assessable recoupments are a form of statutory income.

Subsection 20-20(2) of the ITAA 1997 provides that an amount you have received as a recoupment of a loss or outgoing is an assessable recoupment if:

• you received the amount by way of insurance or indemnity, and

• you can deduct an amount for the loss or outgoing for the current year, or you have deducted or can deduct an amount for it in an earlier income year, under any provision of this Act.

As discussed above, no deduction is allowable for the legal expenses incurred as they are capital in nature.

As you are not entitled to deduct, the legal expenses the reimbursement of your legal expenses will not meet the requirements of subsection 20-20 of the ITAA 1997.

Therefore, the reimbursement is not considered to be an assessable recoupment and is not assessable under section 20-20 of the ITAA 1997.

Reimbursement of legal costs as an ETP

Statutory income includes ETPs which are governed by the provisions contained within Division 82 of the ITAA 1997.

Section 82-130 of the ITAA 1997 states a payment is an ETP if it is received by you in consequence of the termination of your employment.

Taxation Ruling TR 2003/13 explains the Commissioner's view of the meaning of 'in consequence' in relation to ETPs. In relation to settlement of litigation proceedings, the ruling states at paragraph 31:

It is clear from the decision in Le Grand [Le Grand v. Federal Commissioner of Taxation (2003) 51 ATR 139, 2002 ATC 4907], that when a payment is made to settle a claim brought by a taxpayer for wrongful dismissal or claims of a similar nature that arise as a result of an employer terminating the employment of a taxpayer, the payment will have a sufficient causal connection with the termination of the taxpayer's employment. The payment will be taken to have been made in consequence of the termination of employment because it would not have been made but for the termination.

Legal cost awards are paid to reimburse the expenses incurred in engaging in legal proceedings. Although an award for legal costs may be paid in relation to litigation concerning the termination of employment, an award for legal costs is not paid 'in consequence of termination' of employment.

In your case your former employer agreed to reimburse $X of your legal expenses incurred in taking legal action against them. Whilst you received an ETP as a result of the original legal action, the reimbursement of legal costs is not considered to be in consequence of the termination of your employment.

Therefore, the reimbursement of your legal costs is not considered to be an ETP and does not form part of your assessable income.

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