Edited version of your written advice

Authorisation Number: 1051403091077

Date of advice: 24 July 2018

Ruling

Subject: Legal expenses

Question 1

Are you entitled to a deduction for the legal expenses incurred in respect of your employment position?

Answer

Yes.

Question 2

Are you entitled to a deduction for the legal expenses incurred in respect of an investigation and your employment position?

Answer

Yes.

Question 3

Are reimbursements to cover the cost of deductible legal expenses assessable recoupments?

Answer

Yes.

This ruling applies for the following periods

Year ended 30 June 2015

Year ended 30 June 2016

Year ended 30 June 2017

Year ended 30 June 2018

Year ending 30 June 2019

The scheme commenced on

1 July 2014

Relevant facts

You entered into a contract of employment with entity A.

Under the contract of employment you were employed to perform specific roles and any other duties as directed in accordance with the relevant rules.

You acted as a director of entity B for some years.

You later resigned from your employment position and your position as a director.

An investigation began.

You sought legal advice in relation to the matters raised.

A report found that you may have breached your fiduciary duties to your employer, but stated that no adverse finding that you may have contravened various sections of the relevant legislation was made.

You argued that there had been no breach of fiduciary duty.

In a subsequent letter, you were invited to respond to various findings of contraventions.

Your lawyers provided a response to the proposed findings.

You incurred legal expenses in relation to the above.

Some of your legal expenses were reimbursed.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 Subdivision 20-A

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 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.

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).

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) 39 ALR 46; (1932) 2 ATD 169 (the Herald and Weekly Times Case)) 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 80 ATC 4542; (1980) 11 ATR 276).

Where an expense is incurred involuntarily, the motives in pursuing the action will be irrelevant to the determination of its deductibility. It is the objective circumstances which compel a taxpayer to incur the expense which determine its deductibility (Shokker v. FC of T 99 ATC 4504; 42 ATR 257).

In FC of T v. Rowe (1995) 31 ATR 392; 95 ATC 4691, 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.

In Putnin v. FC of T 91 ATC 4097; (1991) 27 FCR 508 an accountant was trustee under a particular deed of arrangement. They administered the estate without obtaining an assignment of the debtor's share in a company and the share was subsequently dealt with by the debtor. They were later charged with conspiring with the debtor to defraud the Commonwealth and incurred legal expenses in defending this action. The court found the expenditure arose out of his prosecution, in which they were defending their activities by which income had been earned and they were allowed a deduction for this legal expenditure.

Their Honours stated:

It may be a natural incident of the conduct of the operations of a particular kind of business that claims of the commission of torts, or even crimes, may arise, although it is to be hoped not often, and have to be repelled.

In the High Court decision in Commissioner of Taxation v. Day [2008] HCA 53 (Day’s case), Mr Day, an employee, was charged with breaching the standards of conduct and failing to fulfil his duty as an officer. He was suspended without pay. It was found that the requisite connection with his assessable income was present and that he was exposed to the charges by reason of his office.

Of significance was the fact that the legal expenses were incurred in responding to disciplinary action internal to the employment relationship and existing for no other purpose. The taxpayer was exposed to the action by reason of his employment as a public servant, and the consequences of the action only affected his employment.

The decision in Day’s case establishes that where the connection between the legal expenses and the income is identified as being incurred to answer allegations of breaching negative duties imposed under the terms of the employment this may also be sufficient to satisfy paragraph 8-1(1)(a) of the ITAA 1997. It may be generalised that where employment or service is conducted on terms that standards of conduct be observed in a taxpayer's personal life on pain of dismissal or reduction in salary, legal expenses incurred in resisting civil disciplinary or legal action will be deductible.

However, the criminal law applies regardless of any employment obligation, and the duty to obey it and to respond to criminal proceedings is owed by every man or woman to the Crown as a subject of the law, and not as an employee to the employer. Costs incurred in defending criminal proceedings, in the Commissioner's opinion, are private expenses even when an employee is liable to be dismissed from employment on conviction.

A loss or outgoing may be deductible even if it is incurred after the cessation of the relevant income earning activities. But in order to be deductible the occasion of the outgoing must be found in those income earning activities. Whether or not the occasion of the outgoing is to be found in what was productive of assessable income of an earlier period requires a judgement about the nexus between the outgoing and the income earning activities (Taxation Ruling TR 2004/4 Income tax: deductions for interest incurred prior to the commencement of, or following the cessation of, relevant income earning activities).

In your situation, your involvement with the investigation was compelled and not voluntary. As a result the objective circumstances are relevant in determining the deductibility of your legal expenses.

As per the decision in Day’s case, it is considered that your legal expenses were incurred in responding to the investigation and your employment position. You were exposed to the action by reason of your employment. On a balanced view it is clear that you were required to provide evidence of your role and participation in a number of activities that you undertook in your employment capacity with entity A. Notwithstanding that some elements that were ventilated during the proceedings did not directly relate to your specific employment duties, it is accepted that these were merely incidental to the general nature of the enquiry. It is also accepted that you were exposed to the need to explain your actions because of your employment duties.

Even though you were required to incur the legal expenses well after your employment had ceased, applying the principles of TR 2004/4, it is considered that the occasion of the expenditure relates to the period of income earning activity with entity A and your capacity as an employee.

Therefore it is considered that your legal expenses incurred as a result of your employment position are an allowable deduction.

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.

Recoupment of a loss or outgoing is defined in subsection 20-25(1) of the ITAA 1997 to include any kind of recoupment, reimbursement, refund, insurance, indemnity or recovery, however described; and a grant in respect of the loss or outgoing.

If some other entity pays an amount for you in respect of a loss or outgoing that you incur, you are taken to receive the amount as recoupment of the loss or outgoing (subsection 20-25(2) of the ITAA 1997).

Indemnity is not a defined term in the ITAA 1997 and therefore must be given its ordinary meaning. Indemnity as defined in the Macquarie Dictionary includes compensation for damage or loss sustained; something paid by way of such compensation.

An indemnity contemplates an obligation (whether by virtue of a contract, statute or a breach of some common law duty of care) to make good, or to compensate for, a loss (Commercial Banking Company of Sydney Ltd v FCT (1983) 14 ATR 142, 83 ATC 4208).

The issue of whether an amount is received by way of indemnity has been considered in a number of cases including: Federal Commissioner of Taxation v. Wade (1951) 84 CLR 105; (1951) 9 ATD 337; 5 AITR 214, Robert v. Collier's Bulk Liquid Transport Pty Ltd (1959) VR 280 and Goldsbrough Mort & Co Ltd v FC of T (1976) 76 ATC 4343, 6 ATR 580.

The above cases make it clear that an amount received by way of indemnity is not restricted to payments received under a contract or deed of indemnity. For example, a payment by way of damages can be an indemnity. In Falk and FCT (2015) 101 ATR 445, a payment of just over $500,000 to meet the taxpayer's legal costs was considered to be a recoupment received by way of indemnity and thus assessable under subsection 20-20(2) of the ITAA 1997, notwithstanding that the payer considered it to be an ex gratia payment.

Therefore, the phrase 'by way of indemnity' broadens the range of receipts to be considered an assessable recoupment under subsection 20-20(2) of the ITAA 1997 to include receipts other than amounts received under a contract of indemnity.

In your case, you were eligible for legal financial assistance. The payments received are regarded as an amount received by way of indemnity due to your associated legal expenses incurred.

As the amounts for legal costs were recouped after an application was made by your lawyers, and the associated legal costs are deductible as outlined above, the payments received under the terms of the grant are an assessable recoupment under subsection 20-20(2) of the ITAA 1997.

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