Edited version of private advice

Authorisation Number: 1051830696517

Date of advice: 22 April 2021

Ruling

Subject: Deductions - legal breach work contract

Question

Are the legal fees you incurred deductible?

Answer

No.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You were dismissed from your employment with Company A.

No explanation was provided for your dismissal. You were handed a letter, asked to leave the office, cut off from your clients and told not to contact any of them as this would be a breach of your contract.

You were offered a position at Company B and you commenced employment with them.

Soon after starting at Company B, you were sent a letter threatening and demanding that you cease working with various clients and suggesting that your employment with Company B was in breach of your previous employment.

Company A claimed that you breached the following clauses of your employment agreement:

(a)  being engaged, involved or materially interested in any activity, on behalf of a another business, of substantially the same kind as the activity you performed during your employment with Company A in which use or disclosure of Confidential Information (as defined in the Employment Agreement) may be useful or advantageous to that other business or to you;

(b)  approaching, inducing, soliciting, persuading or accepting any approach from any client of Company A with whom you had contact or dealings in the course of your last twelve months of employment with Company A, to cease or reduce the amount of their business with Company A; or

(c)   soliciting, procuring, inducing or encouraging any person who was an employee of Company A at the date of your termination to end his or her employment with Company A.

On the advice of your lawyers, you lodged a General Protections Application with Fair Work Australia with the aim of having your previous contract voided.

A mediation meeting was held where Company A agreed to remove all restraints within your previous employment and seek no further action against yourself going forward.

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.

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. 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.

Legal expenses are generally deductible if they arise out of the day to day activities of the taxpayer's business (Herald Weekly Times Pty ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 2 ATD 169) and the legal action has more than a peripheral connection to the taxpayer's income producing activities (Manga Alloys and Research Pty Ltd v. FC of T (1980) 11 ATR 276; 80 ATC 4542).

However, 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).

In FC of T v. Rowe (1995) 60 FCR 99; (1995) 31 ATR 392; 95 ATC 4691 (Rowe's case), the court accepted that legal expenses incurred in defending the manner in which a taxpayer performed his employment duties were allowable. The activities which produced the taxpayer's income were what exposed them to the liability against which they were defending themselves.

The expenditure must be related to the production of assessable income and not incurred at a point too soon to be deductible (FC of T v. Maddalena (1971) 45 ALJR 426; 2 ATR 541; 71 ATC 4161).

Taxation Ruling TR 2000/5 sets out the Commissioner's view of the application of section 8-1 of the ITAA 1997 to costs incurred by employees and employers in preparing and administering employment agreements. Employment agreements are a written, legal and binding confirmation of the employer/employee relationship (paragraph 11 TR 2000/5).

As outlined in TR 2000/5, a deduction is allowed for an employee for costs associated with settlement of disputes arising out of an existing employment agreement including the cost of representation. Your employment agreement with your previous employer is no longer current. Therefore, your disputes do not arise out of an existing employment agreement.

Breach of contract

Taxation Determination TD 93/29 examines the deductibility of legal expenses in certain situations and states if the legal action goes beyond a claim for a revenue item such as wages, and constitutes an action for a breach of the contract of employment, the legal costs would not be deductible because they are capital in nature.

Restraint of Trade

Defending a right to practice a profession or employment is capital in nature, as the right to practice is considered a structural asset and the associated expenses are incurred to protect this right (Case V140 88 ATC 874; AAT Case 4596 (1988) 19 ATR 3859 and Case X84 90 ATC 609; AAT Case 6258 (1990) 21 ATR 3721). As the nature of the expense follows the nature of the advantage sought, the expense is also capital in nature.

Application to your circumstances

In your situation, you were defending action taken by your previous employer. The action by your former employer was in relation to the alleged breaches of the clauses in your previous employment agreement that relate to restrictive covenants. The action was not prompted or caused as a consequence of the performance of your then current duties.

It is considered your legal expenses were incurred to enable you to continue working in your new employment. They did not relate to the duties of your previous employment or your new employment and therefore, not incurred in earning your assessable income from either.

Although the claims may relate in part to the period of time you worked with your previous employer, the nexus to your income earning activities with your previous employer is not sufficient.

The legal expenses associated with the alleged breaches of contract do not have the necessary connection to your former employment activities. Therefore, these expenses are not deductible under section 8-1 of the ITAA 1997.

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