Edited version of private advice

Authorisation Number: 1051834928689

Date of advice: 14 May 2021

Ruling

Subject: Legal expenses

Question 1

Are the legal expenses incurred deductible under section 8-1 of the ITAA 1997?

Answer

No

Question 2

Are the costs awarded an assessable recoupment?

Answer

No

This ruling applies for the following period periods:

Year ended 30 June 20XX

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You are a former XXXX.

Whilst employed you authored a letter alleging certain actions were done by your colleagues and submitted the letter to the relevant investigation body.

Your employer obtained a copy of that letter under a search warrant obtained for an unrelated matter.

Your employer commenced disciplinary action due to the unrelated matter.

You were suspended without pay.

You resigned from your employer.

You took legal action claiming damages against your employer for a tort committed by them.

The decision of the court caused your proceeding to fail. You were ordered to pay the other parties' costs.

You appealed against the decision and the consequential costs orders.

The original decision was set aside by the Court of Appeal.

You were awarded costs.

You did not receive an order for damages.

There are no further legal actions currently on foot.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 Subdivision 20-A

Income Tax Assessment Act 1997 Chapter 3

Reasons for decision

Question 1

Summary

The expenses were not incurred in gaining or producing your assessable income and they were of a capital nature, they are therefore not deductible under Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997).

Detailed reasoning

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income or are necessarily incurred in carrying on a business for the purpose of 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, or a provision of the ITAA 1997 prevents it.

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, (Lunney's case)),

•            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.

Legal expenses are generally deductible if they arise out of the day to day income earning activities (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).

An expense, will usually be capital in nature where it is incurred with the intention to create an asset or advantage of a lasting and enduring nature. (British Insulated & Helsby Cables Ltd v. Atherton (1926) AC 205) The nature of the advantage sought by the taxpayer is therefore relevant.

It is a long standing principle that a taxpayer does not satisfy section 8-1 of the ITAA 1997 merely by demonstrating some casual connection between the expenditure and the derivation of income. What must be shown is a closer and more immediate connection. The expenditure must be incurred in gaining or producing assessable income (Lunney's case). These principles have been affirmed by the High Court in Commissioner of Taxation v Payne [2001] HCA 3.

As noted by the High Court in Commissioner of Taxation v Day [2008] HCA 53 (Day), section 8-1 is intended to cover such a wide variety of cases it is impossible to provide a formula capable of application to every case. The decision does not lay down any rule for the deduction of legal expenses by an employee beyond the requirement that the occasion for the expenses must be found in what is productive of the assessable income of the employee, which will turn on consideration of the scope of the taxpayer's employment.

The scope of a particular taxpayer's employment is a question of fact and degree. It is not confined to the day-to-day activities performed by the employee. In the circumstances of Day the majority had regard to the nature of the employment (in particular the role of public servants), the terms and conditions of the employment and the tasks performed and duties to be observed under the employment. 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.

Where legal expenses are incurred by the employee in an ongoing employment relationship the majority's decision clarifies that the requisite connection required by paragraph 8-1(1)(a) of the ITAA 1997 will not only be satisfied where the connection between the outgoing and the income is identified as being incurred to defend the manner of performance of positive duties, or as arising out of the day-to-day activities of employment. The decision 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.

Where the terms of employment do not oblige a taxpayer to observe certain standards of conduct, as the High Court observed, the incurring of expenditure by an employee to defend a charge because it may result in his or her dismissal may not itself be sufficient in every case to establish the necessary connection to the employment or service which is productive of income. Although the legal expenses in such a case may be incurred for a purpose of deriving employment income it does not necessarily follow that they were incurred in the course of gaining or producing that income. In particular, the Commissioner considers that the costs of defending criminal proceedings will rarely, if ever, be deductible under section 8-1.

Taxation Ruling TR 2020/1 Income tax: employees: deductions for work expenses under section 8-1 of the Income Tax Assessment Act 1997 provides at paragraphs 13 to 15 in relation to gaining or producing assessable income:

In gaining or producing assessable income

13. The pivotal element of section 8-1 for work expenses is the requirement that expenses be incurred 'in gaining or producing assessable income'. The High Court majority in Payne said it is well established that these words are to be understood as meaning incurred 'in the course of' gaining or producing assessable income, and do not convey the meaning of outgoings incurred 'in connection with' or 'for the purpose' of deriving assessable income.

14. The majority further stated that the meaning of 'in the course of' gaining or producing income was amplified in Ronpibon Tin NL where it was held that:

... to come within the initial part of [section 8-1] it is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income, or if none be produced, would be expected to produce assessable income...

15. While the High Court authority indicates the nature of the connection that needs to be found between outgoings and assessable income, the sufficiency of the connection in a given case cannot simply be determined by reference to a precise formula. Section 8-1 is expressed in such terms that it is intended to cover any number of legal and factual situations. In many cases, only a proper consideration of all the relevant facts and circumstances will reveal whether the occasion of a particular outgoing is to be found in what produces assessable income.

The requirement that expenses be incurred in the course of producing assessable income means that it is not enough to show only that there is some general link or causal connection between expenditure and the production of income. The expenditure must have a sufficiently close connection to the activities through which the taxpayer earns income.

Accordingly, in some cases, expenditure would be regarded as too remote from the income-earning activities or incurred only as a prerequisite to earning income, and not incurred in the course of producing that income.

You ceased your employment prior to the commencement of the legal action for damages. There is no connection between earning of your employment income and the expenses incurred in filing the appeal.

You did not incur the costs in the course of carrying out your day to day duties and the expenses only have a peripheral connection to your former employment.

You claimed damages for a tort committed by your former employer. The right to receive compensation, such as damages, is a Capital Gains Tax asset. Therefore, had you been awarded damages, the compensation receipt would have been treated under the capital gains provisions contained in the ITAA 1997 and the approach outlined in Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts. Accordingly, the benefit you were seeking was of a capital nature.

The outcome sought in the appeal was to have the decision made in the original case overturned. This is also of a capital nature.

The expenses were also not incurred in fighting a disciplinary action or misconduct charges, such as the case in Day, they were incurred to seek damages for a tort committed by your former employer.

The damages you sought were of a capital nature, consequently they are not of a revenue nature. Therefore, the expenses incurred in gaining the advantage are also of a capital nature.

For these reasons you do not meet either the positive or negative limbs of section 8-1 of the ITAA 1997 and you are therefore unable to claim a deduction for the legal expenses.

Question 2

Summary

The outcome sought by incurring the legal costs was of a capital nature, there is no deduction available and the costs are not an assessable recoupment.

Detailed reasoning

Paragraph 5 of Taxation ruling TR 2012/8 Income tax and fringe benefits tax: assessability of amounts received to reimburse legal costs incurred in disputes concerning termination of employment provides:

5. Where a deduction for legal costs is available to the recipient under section 8-1, a settlement or award in respect of legal costs will be included in the recipient's assessable income as an assessable recoupment under Subdivision 20-A.

An amount of costs awarded is only an assessable recoupment if the award in respect of legal costs is deductible under section 8-1 of the ITAA 1997. As the outcome sought by incurring the legal costs was of a capital nature, there is no deduction available and the costs are not an assessable recoupment.

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