Edited version of your written advice

Authorisation Number: 1012929096628

Date of advice: 17 December 2015

Ruling

Subject: Compensation and legal expenses

Question 1

Is the performance payment regarded as assessable income?

Answer

Yes.

Question 2

Is the additional payment regarded as ordinary assessable income?

Answer

No.

Question 3

Is the additional payment an employment termination payment in accordance with section 82-130 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 4

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

Answer

Yes.

Question 5

Are you entitled to a deduction for the portion of your legal expenses that relate to the employment termination payment?

Answer

No.

This ruling applies for the following period

Year ended 30 June 20XX

The scheme commenced on

1 July 20XX

Relevant facts

You were employed with entity A.

You were harassed at your workplace.

You sought legal counsel and submitted a harassment claim.

An out of court settlement was agreed to.

You state that entity A agreed to pay the capital payment for humiliation, embarrassment, stress and suffering you endured in return for your resignation.

You signed a deed of release and withdrew and discontinued the proceedings.

The settlement payment included a performance payment. This amount was included as gross payments on your PAYG payment summary.

A PAYG payment summary - employment termination payment for the year ending 30 June 20XX indicates you received a payment comprising of a taxable component.

An additional payment equivalent of 3 months' pay was part of the settlement payment and included as a taxable component on your PAYG payment summary - employment termination payment.

You incurred legal fees in relation to the above.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5.

Income Tax Assessment Act 1997 section 15-2.

Income Tax Assessment Act 1997 section 8-1.

Income Tax Assessment Act 1997 section 82-130.

Income Tax Assessment Act 1997 section 82-135.

Reasons for decision

Ordinary income

Subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of an Australian resident includes the ordinary income they derived directly or indirectly from all sources, whether in or out of Australia, 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.

For income tax purposes, an amount paid to compensate for a loss generally acquires the character of that for which it is substituted (Federal Commissioner of Taxation v. Dixon (1952) 86 CLR 540; (1952) 5 AITR 443; 10 ATD 82).

Compensation payments which substitute income have been held by the courts to be income under ordinary concepts (Federal Commissioner of Taxation v. Inkster (1989) 24 FCR 53; (1989) 20 ATR 1516; 89 ATC 5142, Tinkler v. FC of T (1979) 10 ATR 411; 79 ATC 4641, and Case Y47 (1991) 22 ATR 3422; 91 ATC 433).

On the other hand, if the compensation is paid for the loss of a capital asset or amount then it will be regarded as a capital receipt and not ordinary income. Damages awarded for past or future loss or impairment of earning capacity is not ordinary income (Groves v. United Pacific Transport Pty Ltd [1965] Qd R 62).

Taxation Determination TD 93/58 Income tax: under what circumstances is the receipt of a lump sum compensation/settlement payment assessable? explains the circumstances in which a lump sum compensation/settlement payment is assessable, and states that such a payment is assessable income:

• if the payment is compensation for loss of income only (even when the basis of the calculation of the lump sum cannot be determined), or

• to the extent that a portion of the lump sum payment is identifiable and quantifiable as income. This will be possible where the parties either expressly or impliedly agree that a certain portion of the payment relates to a loss of an income nature.

IT 2424 Income tax: compensation payments in respect of unlawful acts of discrimination state that payments for personal injury are not liable to income tax and are capital in nature. However IT 2424 also states that if dismissal is part of the settlement, then a compensation payment may qualify as a termination payment and subject to special taxation treatment. Whether a particular payment of compensation is assessable depends on the facts of each given case.

In your case, you received compensation in relation to the harassment you suffered at work. In the deed of release, the settlement figure included an amount described as a performance payment. Such a payment relates to personal services provided as an employee and is regarded as assessable income. We acknowledge that you didn't meet all the criteria to receive the annual bonus as you didn't work past 1 July, however the payment is considered to be compensation for the loss of the bonus and therefore has the character of income. Please see below for further details on bonuses.

The additional payment does not directly relate to your loss of income. Although the payment was equivalent to three months' pay, the payment is not considered to be compensation for loss of income only and it does not relate to services performed. Rather the payment was included on the finalisation of your harassment claim. The payment is a one-off payment and thus does not have an element of recurrence or regularity. Although the payment can be said to be expected, and perhaps relied upon, this expectation does not arise from any personal services performed. The additional payment is not regarded as ordinary income and is therefore not assessable under subsection 6-5(2) of the ITAA 1997.

Statutory income

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 and are also included in assessable income.

Under section 15-2 of the ITAA 1997 your assessable income includes the value to you of all allowances, gratuities, compensations, benefits, bonuses and premiums received in respect of your employment, either directly or indirectly.

The performance payment is an annual bonus paid by the employer. This amount is in respect of your employment and is assessable under section 15-2 of the ITAA 1997.

Employment termination payment

A payment is an employment termination payment (ETP) if it satisfies all the requirements in section 82-130 of ITAA 1997.

Subsection 82-130(1) of the ITAA 1997 states that a payment is an ETP 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

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

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

To find that a payment is an ETP, all the conditions in subsection 82-130(1) of the ITAA 1997 must be satisfied. Failure to satisfy any of one the three conditions will result in the payment not being considered an ETP.

Payment is made 'in consequence of the termination of' your employment

The phrase 'in consequence of' is not defined in the ITAA 1997. However, the courts have interpreted the phrase in a number of cases. Whilst the courts have divergent views on the meaning of this phrase, the Commissioner's view on the meaning and application of the 'in consequence of' test are set out in Taxation Ruling TR 2003/13 Income tax: eligible termination payments (ETP): payments made in consequence of the termination of any employment: meaning of the phrase 'in consequence of' (TR 2003/13).

While TR 2003/13 contains references to repealed provisions, some of which may have been rewritten, the ruling still has effect as both the former provision under the Income Tax Assessment Act 1936 and the current provision under the ITAA 1997 both use the term 'in consequence of' in the same manner.

In paragraphs 5 and 6 of TR 2003/13 the Commissioner states:

5. ...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.

6. The phrase requires a causal connection between the termination and the payment, although the termination need not be the dominant cause of the payment. 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.

In this case, you were subject to harassment at your workplace and engaged a lawyer to pursue the matter.

You state that your employer agreed to pay the capital payment for humiliation, embarrassment, stress and suffering you endured in return for your resignation. A letter from your workplace and discrimination representative supports this fact.

Based on the above, the additional payment is made in consequence of the settlement of a dispute between you and your employer. As the payment requires the termination of your employment, it can be said that the payment follows as an effect or result of the termination of your employment. That is, there was a sequence of connected events following the termination which ultimately lead to the payment.

Therefore, the additional payment is in consequence of the termination of your employment.

Payment is received no later than 12 months after that termination

In this case, the additional payment will be received no more than 12 months after the termination of your employment.

Payments mentioned in section 82-135 of the ITAA 1997

Section 82-135 of the ITAA 1997 lists certain payments that are not ETPs. The additional payment is not a payment mentioned in subsection 82-135 of the ITAA 1997.

Conclusion

The additional payment received is an ETP in accordance with section 82-130 of the ITAA 1997.

Legal expenses

Section 8-1 of the 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.

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 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.

You incurred legal expenses to seek compensation. Part of the amount you received was a performance payment which, as discussed previously, is considered to be ordinary assessable income. The portion of your legal expenses related to this performance payment was incurred in earning assessable income and is not capital in nature. Therefore, this portion of your legal expenses is 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.

Although you did not receive a redundancy payment, the above principles are relevant.

The additional payment that formed part of the compensation you received constitutes an ETP. An ETP is capital in nature. Although it 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.

As stated previously, the nature or character of legal expenses follows the advantage that is sought to be gained by incurring the expenses. As the ETP is capital in nature, the portion of your legal expenses that relate to gaining the ETP is also capital in nature and therefore not deductible.

Other information and apportionment of expenses

As your legal expenses in seeking compensation 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, you will need to calculate the deductible portion. One way to apportion your expenses is according to the dollar value of the ordinary assessable amount as compared to the total amount. The relevant percentage that relates to your ordinary assessable income can then be applied to the legal expenses incurred.

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