Edited version of private advice

Authorisation Number: 1051817758838

Date of advice: 19 March 2021

Ruling

Subject: Deduction - legal expenses

Question 1:

Are you entitled to claim a full deduction for the $X of legal expenses (the Legal Expenses) incurred in the 20XX-XX income year under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer:

No.

Question 2:

Are you entitled to claim a partial deduction for the Legal Expenses incurred in the 20XX-XX income year under section 8-1 of the ITAA 1997?

Answer:

Yes. To the extent that the nature of the benefit being sought in relation to the legal expenses you incurred during your employment, and after your employment ended, related to the earning of your assessable income and is not capital in nature.

This ruling applies for the following period:

Income year ending 30 June 20XX.

The scheme commences on:

1 July 20XX.

Relevant facts and circumstances

You raised workplace grievances with your employer, Organisation X for several years after you commenced your permanent and ongoing position.

You became involved in a dispute with Organisation X over their allegations against you in relation to your performance. The dispute continued for several months.

In 20XX, while communication regarding the dispute continued, you were advised by Organisation X that your position was proposed to be redundant.

A few weeks after this you were informed that your position would be terminated on a set date at the end of a notice period if redeployment was not achieved by the end of the notice period.

You lodged a dispute with Organisation X in relation to their intention to terminate your employment. The Organisation provided a response. Following this, your Union lodged forms on your behalf with the Fair Work Commission in relation to Organisation X's failure to follow the Enterprise Agreement (EA) in relation to your termination dispute.

A few days later you were advised by Organisation X that they were making an allegation of serious misconduct against you with your continued employment being untenable. It was outlined that you were suspended with pay and you were not to attend the workplace.

You took actions to refute the allegations. Among other things, you sought legal advice as follows:

•         You had a consultation with Company A in relation to their capacity to assist you in relation to saving your employment against wrongful dismissal and adverse action.

•         You engaged the services of Company B to assist you with your draft responses to the allegations of serious misconduct made against you, and to suggest remedies available to you under the Fair Work Act to challenge your termination and retain your employment. However, they did not represent you and did not draw up any legal claims on your behalf.

You received invoices from Company A and Company B in relation to your consultations.

During the following month you engaged Company C to represent you in relation to your employment matters of avoiding termination and refuting the misconduct allegations.

Organisation X issued a 'Final Written Warning' with regards the misconduct allegation.

Company C assisted you with your response to the Final Written Warning letter and to prepare the relevant application form (Form A) in relation to the failure of Organisation X to follow the EA in your notice of redundancy and allegation of misconduct. In this form you were seeking, among other things, the following relief:

•         an interim order restraining Organisation X from terminating your employment pending the determination of the matter.

•         an interim order requiring Organisation X to allow you to return to work pending the determination of the matter.

During the following month Company C prepared a different type of form on your behalf (Form B) in relation to adverse actions taken against you while you were employed, which it lodged with the Commission on your behalf, in which you were seeking, among other things, the following remedies:

•         Compensation for the hurt, humiliation and distress caused by the contravening conduct

•         Interlocutory and final injunctive relief preventing Organisation X from dismissing you in breach of the Fair Work Act 2009 (Cth) (the FW Act).

Organisation X extended your termination date on several occasions until your position was made redundant and you ceased your employment during the year after you had been advised of your potential redundancy. Organisation X paid all of your entitlement at law and in accordance with the EA upon the termination of your employment and you received a redundancy payment.

During the month following your termination, Company C prepared an application form on your behalf (Form C) in relation to adverse actions taken against you in your dismissal, which it lodged with the Commission during the same month, in which it was outlined that you were seeking, among other things:

•         Compensation for economic loss caused by the contravening conduct.

•         Compensation for the hurt, humiliation and distress caused by the contravening conduct.

During the period from your suspension from your employment until you were made redundant, you had received your salary and superannuation contributions.

You experienced chronic levels of stress, anxiety and deep mental trauma as a result of the issues with Organisation X and consider that you have suffered severe reputational damage.

You have not been successful in finding other employment commensurate with your training, skills, and experience, and your inability to meet your financial obligations is causing you additional anxiety.

You have been unemployed from the date your employment with Organisation X ended up to the present time.

You have paid all of the legal expenses incurred during the 20XX-XX income year during the period covered by this ruling.

You do not have any provision to recover the cost of the legal expenses from Organisation X and had to pay your own costs.

At this point in time you are not able to advise if you will settle the matter with Organisation X and recover the costs of your legal expenses.

You do not have any professional indemnity insurance.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Deductions for legal expenses

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.

Subsection 6-5(2) of the ITAA 1997 provides that the assessable income of an Australian resident includes ordinary income derived directly or indirectly from all sources during the year. Salary and wages, including leave payments, is considered ordinary income as it is paid directly as a result of personal services an employee renders for their employer.

To be deductible in a particular year under section 8-1 of the ITAA 1997, a loss or outgoing must generally have been 'incurred' in that year. 'Incurred' is not defined in the Act and in general terms, an outgoing is incurred at the time a taxpayer owes a present money debt that the taxpayer cannot escape. The courts have been reluctant to attempt an exhaustive definition of incurred, but they have developed a series of guidelines that can be used in assisting to determine whether an item has been incurred in a current year.

The guiding principles from case law and Taxation RulingsTR 94/26 and TR 97/7 are as follows.

A liability will be a loss or outgoing 'incurred' under section 8-1 of the ITAA even though it remains unpaid, provided the taxpayer is 'definitively committed' or has 'completely subjected' itself to the liability ( FC of T v James Flood Pty Ltd (1953) 10 ATD 240 at p 244; (1953) 88 CLR 492 at p 506).

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.

Generally, legal expenses incurred in an unfair dismissal action, such as seeking reinstatement after termination and/or damages, are of a capital nature and therefore, not deductible. Alternatively, if the advantage being sought is of a revenue nature, such as unpaid wages, then the legal expenses will be of revenue nature.

It also follows that the character of legal expenses is not determined by the success or failure of the legal action.

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 includes the following paragraphs:

2.         Salary or wage income is only assessable when it has been derived, and salary or wages are generally derived when paid.

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 amounts 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).

6A.      A deduction for legal expenses by an employee depends on the particular facts of anycase. To be deductible the occasion of the expenditure must be found in what is productive in the gaining of assessable income by the employee. If expenses are incurred to dispute the receipt of income contractually owed under an employment contract, then the expenses are on revenue account and allowable as a deduction.

7.         Where the solicitor's 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 solicitor's 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.

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) 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 (1980) 49 FLR 183; (1980) 11 ATR 276; 80 ATC 4542).

Similarly, in FC of T v. Day [2008] HCA 53 and FC of T v. Rowe (1995) 31 ATR 392; 95 ATC 4691, the courts accepted that legal expenses incurred in defending the manner in which a taxpayer performed his employment duties were allowable.

Legal expenses are generally deductible by employees and former employees if they arise out of:

•         recovering unpaid wages, unused annual leave and unused long service leave in accordance with the principles contained in Taxation Determination TD 93/29

•         instituting proceedings and settling disputes arising out of employment agreements, such as to enforce a contractual entitlement (Romanin v FCT (2008) 73 ATR 760)

•         preventing redundancy or dismissal. 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; and

•         defending the manner in which employment duties are performed: (Inglis and FCT 87 STC 2037)

In contrast, legal expenses incurred in seeking compensation for loss of employment, such as in an action for wrongful dismissal, are not deductible. It is irrelevant if any amount awarded to the employee is calculated by reference to unpaid salary or lost income. As outlined at paragraph 5 of TD 93/29, legal expense relating to an action for damages for wrongful dismissal are not deductible as the claim is of a capital nature.

Application to your situation

Organisation X made allegations against you in relation to your performance in your employment role with them which resulted in you addressing this dispute with them and seeking legal advice to assist you with the dispute. Additionally, Organisation X advised you during the following year that your position with them was proposed to be made redundant with you being made redundant after several extensions of time during the period covered by this ruling.

You incurred legal expenses in relation to consulting and/or engaging the services of several legal firms.

As outlined above, legal expenses take the nature of the benefit being sought. Based on the information provided not all of the legal expenses you incurred during the 20XX-XX income were incurred in relation to you seeking benefits that are solely of a revenue nature.

You will only be eligible to claim deductions for the legal expenses which relate to benefits/relief that is revenue in nature.

Therefore, you will need to review the benefit being sought in relation to the legal expenses and apportion them in accordance to the nature of the benefit and claim a deduction for those that are attributable to benefits of a revenue nature.

As outlined above, TD 93/29 provides some guidance on how to apportion the legal expenses.

Note: Based on the information provided the legal expenses incurred in the income year after the period covered by this ruling have been incurred in relation to both revenue and capital benefits being sought and will need to be apportioned on a reasonable basis as outlined in TD 93/29.

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