Edited version of private advice

Authorisation Number: 1051792763499

Date of advice: 22 December 2020

Ruling

Subject: Legal expenses - capital versus revenue

Question

Are you entitled to a full deduction for all the legal expenses you incurred?

Answer

No

Question

Are you entitled to a partial deduction for the legal expenses you incurred?

Answer

Yes

This ruling applies for the following period(s)

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ending 30 June 20XX

The scheme commences on

1 July 20XX

Relevant facts and circumstances

You were employed in the XXXXX industry for several years as a manager.

In 20XX alleged complaints were made against you regarding your behaviour to clients and co-workers.

You were placed in an alternate position for approximately X months.

On DDMMYY, you received a letter from a senior Director, advising that the investigation had been finalised regarding the allegations against you. The director was proposing disciplinary action, recommending terminating your employment and allow you a right of reply.

On DDMMYY you engaged a solicitor, who filed an application for relief to unfair dismissal to the Industrial Relations Commission (IRC). Your solicitor was attempting to prevent your dismissal.

The matter was listed for hearing DDMMYY and subsequent hearings were held.

On DDMMYY, the Commissioner put in place a X month plan for exchange of evidence. It was negotiated with the employer that you would not attend work whilst being paid until the investigation was completed.

A full hearing date was set for DDMMYY with the hearing expected to take several days.

On the X day of the hearing, DDMMYY, the employer requested a settlement and agreed to clear your name so that you could obtain future employment in your industry and negotiate a financial outcome in exchange for you to leave your employment.

You agreed in principal to enter a Deed of Release (DOR) with your employer on DDMMYY. Your solicitor then negotiated the terms of the DOR, before execution of the DOR was signed by you and your employer on DDMMYY.

You received a gross settlement amount equivalent of several weeks salary.

You incurred legal expenses for engaging your solicitor.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

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. If the advantage to be gained is of a capital nature, then the expenses incurred in gaining this advantage will also be of a capital nature.

The courts, on a number of occasions, have determined legal expenses to be an allowable deduction if the expenses arise out of the day to day income producing activities of the taxpayer (The Herald and Weekly Times Ltd v. FC of T (1932) 48 CLR 113). The action out of which the legal expense arises has to have more than a peripheral connection to the taxpayer's business or income earning activities. The expense may arise out of litigation concerning the taxpayer's professional conduct (Magna Alloys and Research Pty Ltd v. FC of T (1980) 11 ATR 276; 80 ATC 4542; Putnin v. FC of T (1991) 21 ATR 1245; 91 ATC 4097).

When legal action is undertaken to obtain a payment, then the deductibility of the legal expenses depends on whether the payment sought is revenue in nature, such as unpaid wages, or whether the payment sought is capital in nature, such as a redundancy type payment or compensation for unfair dismissal.

This principle is confirmed in Taxation Determination TD 93/29 which states that if an employee incurs legal expenses in recovering wages, the legal expenses are an allowable deduction providing that the legal action relates solely to the recovery of wages. The ruling continues: -

5. However, 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 where the essential character of the advantage sought relates to an enduring advantage that is of a capital nature, the legal costs would not be deductible. For example, legal expense relating to an action for damages for wrongful dismissal, are not deductible.

6. There will often be occasions where the legal expenses are incurred in relation to proceedings that relate both to accounts that are revenue in nature as well as amounts which are capital in nature. For example, many proceedings in relation to wrongful dismissal will also involve the recovery of unpaid salary or wages. In these circumstances '....there must be some fair and reasonable assessment of the extent of the relation of the outlay to assessable income' (Ronpibon Tin N.L. v. FC of T (1949) 78 CLR 47 at 59).

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

When legal expenses are incurred in relation to proceedings that relate both to claims that are revenue in nature as well as those of a capital nature, there must be some fair and reasonable apportionment of the extent of the relation of the outlay to the revenue claim.

TD 93/29 paragraph 7 discusses the apportionment of legal expenses.

7. Where the solicitors account is itemised, one reasonable basis for apportionment would be the time spent involving the revenue claim, relative to the time spent on the capital claim. If the solicitors account is not itemised, a possible basis for apportionment would be either a reasonable costing of the work undertaken by the solicitor in relation to the revenue claim, or, where this is not possible, an apportionment on the basis of the monetary value of the revenue claim relative to the capital claim.

Application to your circumstances

In your case, alleged complaints were made against you on how you treated and spoke with clients and co-workers. You engaged the services of an industrial relations lawyer in defending yourself against these allegations.

However, when you agreed in principle to the settlement, the advantage sought changed as you were no longer defending the way you undertook your employment duties in order to continue in your employment. From that point you were instead seeking a golden handshake type payment for leaving your employment and to have your name cleared so that you could obtain future employment working in your profession. These advantages sought are considered to be capital in nature.

As the legal expenses you have incurred are both revenue and capital in nature, you will need to apportion the legal expenses in a reasonable manner. It is considered that the legal expenses you incurred to DDMMYY are revenue in nature and deductible as you were defending yourself in your employment duties in order to continue your employment. Any legal expenses incurred after DDMMYY are capital in nature and are not deductible as you were no longer defending yourself in your employment duties in order to continue your employment; rather, as stated above, you were now seeking advantages of a capital nature.

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