Edited version of your written advice

Authorisation Number: 1012934446805

Date of advice: 14 January 2016

Ruling

Subject: Legal expenses

Question 1

Are you entitled to a deduction for your legal expenses related to your claim for compensation?

Answer

No.

Question 2

Are you entitled to a deduction for all your other legal expenses related to your protracted dispute with your employer?

Answer

Yes.

Question 3

Is the portion of the reimbursement that relates to your deductible legal expenses an assessable recoupment?

Answer

Yes.

This ruling applies for the following period

Year ended 30 June 2015

The scheme commenced on

1 July 2014

Relevant facts

You were suspended from your employment after allegations were made relating to the way in which you undertook your work duties.

You were suspended with immediate effect on full pay.

You incurred legal expenses in seeking to have the suspension lifted while an investigation was undertaken.

After the investigation was completed, you were demoted.

You incurred expenses in relation to dealings between your legal representatives and your employer during and after the investigation where your legal representatives were defending the manner in which you undertook your work and were seeking to enable you to return to work on full duties.

You later commenced further proceedings against your employer seeking reinstatement to your previous position and compensation for:

• Financial loss as a result of the demotion,

• Hurt, humiliation and distress,

• Damage to professional reputation and

• Loss of enjoyment of profession.

You agreed to settle the proceedings. As part of the settlement you received a settlement sum and you agreed to resign. The settlement sum included an amount as reimbursement for a portion of your legal expenses.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Income Tax Assessment Act 1997 Section 20-20.

Reasons for decision

Summary

The nature or character of 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.

Your legal proceedings included a claim for compensation. As the advantage sought in relation to that claim was for a capital payment, the legal expenses related to that claim are also capital in nature and therefore not deductible.

None of your other legal expenses were related to seeking a capital payment and consequently are not capital in nature. As these other legal expenses are not capital in nature and are considered to be sufficiently related to the earning of your assessable income, they are deductible.

An amount is an assessable recoupment under subsection 20-20(2) of the Income Tax Assessment Act 1997 (ITAA 1997) if it is received by way of insurance or indemnity for a deductible expense. The reimbursement you received for your legal expenses as part of the settlement is a recoupment received by way of indemnity. Therefore the portion of the reimbursement that relates to your deductible legal expenses is an assessable recoupment.

Detailed reasoning

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.

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 or business operations. 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.

When a taxpayer incurs legal expenses in order to defend their actions in carrying out their employment duties through which they gain or produce assessable income, such expenses are characterised as being of a revenue nature and are deductible.

In FC of T v. Rowe (1995) 31 ATR 392; 95 ATC 4691 (Rowe's case), the taxpayer, an employee, was suspended from normal duties and was required to show cause why he should not be dismissed after several complaints were made against him. A statutory inquiry subsequently cleared him of any charges of misconduct or neglect. The court accepted that the legal expenses incurred by the taxpayer in defending the manner in which he performed his duties, in order to defend the threat of dismissal, were allowable. Since the inquiry was concerned with the day to day aspects of the taxpayer's employment, it was concluded that his costs of representation before the inquiry were incurred by him in gaining assessable income.

After you were suspended by your employer you incurred legal expenses in seeking to have the suspension lifted. You later also incurred expenses in relation to dealings between your legal representatives and your employer during and after an investigation where your legal representatives were defending the manner in which you undertook your work and were seeking to enable you to return to work on full duties. The nature of these expenses are similar to those in Rowe's case and are therefore deductible.

You later incurred expenses in relation to later proceedings where you sought reinstatement to the position you held before your demotion and compensation for:

• Financial loss as a result of the demotion,

• Hurt, humiliation and distress,

• Damage to professional reputation and

• Loss of enjoyment of profession.

Your legal expenses in relation to those proceedings are not fully deductible as one of your claims was for compensation and such a compensation payment would be capital in nature.

Compensation for financial loss as a result of the demotion would be a payment of a revenue nature as it is compensation for lost income. Therefore, the portion of the legal expenses that relate to this claim is deductible.

The portion of the legal expenses that relate to the seeking of your reinstatement to your previous position is not capital in nature and is sufficiently related to the earning of your assessable income. Therefore this portion of the legal expenses is deductible.

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 method of apportionment must be fair and reasonable in all the circumstances.

Assessable recoupment - reimbursement of legal expenses

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

• you receive 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.

In your case you received an amount as reimbursement for legal costs as part of your settlement. This is a recoupment by way of indemnity. As discussed above, you are entitled to claim a deduction for some of your legal expenses. The portion of the reimbursement that relates to your deductible legal expenses is an assessable recoupment under subsection 20-20(2) of the ITAA 1997.

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