Edited version of your written advice

Authorisation Number: 1051267687000

Date of advice: 11 August 2017

Ruling

Subject: Termination of employment contract

Question 1

Is the cost incurred by the taxpayer in terminating their employment contract deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Question 2

Is the cost incurred by the taxpayer in terminating their employment contract deductible under Part 3-1 of the ITAA 1997?

Answer

No

This ruling applies for the following periods:

Year ended 30 June 2017

The scheme commences on:

1 July 2016

Relevant facts and circumstances

You entered into a contract of employment with your former employer.

The contract contained a clause with stated that should the employment contract be terminated prior to the expiration of four years from the date of agreement, the employee shall be liable to the employer for a sum equivalent to $X for each unexpired month of the term.

You terminated the employment agreement early to take up another job opportunity.

The Deed of Release stated the compensation was compensation for losses suffered by the employer.

You paid an amount to the employer in the 2016/17 income year.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 subsection 100-25(3)

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 section 104-35

Reasons for decision

Question 1

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for all losses or outgoings to the extent to which they are incurred in gaining or producing assessable income, except to the extent that they are outgoings of a capital, private or domestic nature.

The courts have considered the meaning of 'incurred in gaining or producing assessable income'. In Ronpibon Tin NL & Tongkah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; [1949] HCA 15; (1949) 4 AITR 236; (1949) 8 ATD 431 the High Court stated that:

'For expenditure to form an allowable deduction as an outgoing incurred in gaining or producing assessable income it must be incidental and relevant to that end. The words "incurred in gaining or producing assessable income" mean in the course of gaining or producing such income.'

The guidelines for distinguishing between capital and revenue were laid down in Sun Newspapers Limited v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 23; (1938) 1 AITR 403 (Sun Newspapers). The test laid down in Sun Newspapers involved three elements, although none is in itself decisive:

● the nature of the advantage sought

● the way it is to be used or enjoyed, and

● the means adopted to get it.

In your case, your termination payment did not arise out of the performance of your day to day activities in the course of gaining or producing your income with your former employer. Instead, your termination payment was capital in nature because it brought into existence an advantage for an enduring benefit, namely, allowing you to legally break your contract with your former employer and allowing you to take up your new employment.

Accordingly, the damages paid for breach of employment contract is not an allowable deduction under section 8-1 of the ITAA 1997 as it was not incurred in gaining or producing assessable income.

Question 2

Paragraph 35 of Taxation Ruling TR 95/3 Income tax and capital gains: application of subsections 160M(6) and 160M(7) to restrictive covenants and trade ties, states a contract of employment stipulating exclusive service by the employee during its term is an example of a restrictive covenant which is a contractual obligation. A right to enforce a contractual obligation is a Capital Gains Tax (CGT) asset under subsection 100-25(3) of the ITAA 1997.

The nature and CGT implications of restrictive covenants were most thoroughly explained in the Explanatory Memorandum ('EM') to the Taxation Laws Amendment Act (No. 4) 1992, where it was stated that rights under a contract of personal services are CGT assets.

In your case, your employment contract that stipulated exclusive service by you during its term was a restrictive covenant. Its creation was a CGT event D1 under section 104-35 of the ITAA 1997. Its termination was a CGT event C2 under section 104-25 of the ITAA 1997.

However, the restrictive covenant and its right to enforce a contractual obligation is held by your former employer. As you do not hold the CGT asset, your compensation payment does not form part of the cost base of a CGT asset and cannot be taken into account in working out a CGT loss under the CGT provisions contained with Part 3-1 of the Income Tax Assessment Act 1997.

An alternative argument is that your compensation payment forms part of the cost base of a new right, namely, the right to a release from the contract (CGT event D1). The look through approach or the underlying asset approach described in Taxation Ruling TR 95/35; Income tax: capital gains: treatment of compensation receipts, is the process of identifying the most relevant asset which the compensation amount is most directly related to. Your compensation payment was for ending the right or restriction your former employer had over you. The right to a release from the contract that occurred was merely the restoration of your personal freedom to work or trade.

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