Edited version of private advice

Authorisation Number: 1052059853424

Date of advice: 21 November 2022

Ruling

Subject: Deductions for legal expenses

Question

Are you entitled to claim a deduction for any of the legal expenses you incurred?

Answer

No.

This ruling applies for the following period:

Income year ended 30 June 20XX.

The scheme commences on:

1 July 20XX.

Relevant facts and circumstances

Background

You were contractually employed by Organisation X when you made several complaints in relation to some of your colleagues.

You were made aware by various parties that Organisation X wished to dismiss you on several occasions during the period your complaints were being reviewed.

You entered a Deed of settlement and release (the Deed) with Organisation X under which:

•         you and Organisation X agreed to finalise all matters arising out of or related to the complaints and any other action taken or proposed to be taken by Organisation X on the terms set out in the Deed, without an admission of liability

•         your employment with Organisation X would end on a specified date (Date 1) or at an earlier date you elected (the Termination date)

•         Organisation X would continue to pay you all remuneration and superannuation payable up until the Termination date based on total deemed salary of a specified amount, plus superannuation (Payment)

•         on the Termination date you would be paid an amount in lieu of all accrued but untaken benefits payable on termination, plus a specified amount less any gross amount paid to you in relation to the Payment

•         your obligations under the Deed were that you would discharge and indemnify Organisation X, and each member of Organisation X and its related parties, from and against all liability.

You paid your own costs in relation to the settlement as outlined in the Deed, and the preparation and execution of the Deed.

Your employment with Organisation X ended on Date 1.

After a short period, you filed a Form 8 General protections dismissal application involving dismissal with the Fair Work Commission (FWC) in which you were seeking the following remedy/outcomes:

•         Reinstatement

•         Damages, including aggravated and exemplary damages

•         Civil penalties; and

•         Right to proceed in tort, contract and statute against individual employees of Organisation X.

Your intention in adding the remedies of reinstatement (injunctive relief), damages, civil penalties and other rights in the Form 8 was to reserve those options should your issue with Organisation X proceed to the Federal Circuit Court/Federal Court. You brought the action to the FWC, invoking the arbitral powers of the Commission to be reinstated and recover the salary that Organisation X had discontinued since Date 1.

Legal expenses

Shortly after you lodged the form with the FWC you engaged the services of a legal firm, Company A, on a retainer for a fixed fee to provide you with advice in relation to the strengths, weaknesses, merits and prospects in relation to the public interest disclosures.

You then engaged the services of a second legal firm, Company B, after a short period incurring further legal expenses.

Your intention when incurring the legal expenses was for the purpose of conciliating your return to your employment with Organisation X and to receive compensation for your lost wages that Organisation X had discontinued from Date 1.

You have paid the legal expenses in full.

You have not, nor will not, be reimbursed for the legal expenses.

You do not have professional indemnity insurance.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subsection 6-5(2)

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 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.

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 income year under section 8-1 of the ITAA 1997, a loss or outgoing must generally have been 'incurred' in that income year. 'Incurred' is not defined in ITAA 1997 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 income year.

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).

Paragraph 38 of Taxation Ruling TR 2012/8 states that the nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses.

Therefore, if the advantage being sought is of is of a revenue nature, then the legal expenses will be of revenue nature and will be deductible Alternatively, if the advantage being sought is of a capital nature, then the legal expenses incurred in gaining the advantage will also be of a capital nature and will not be deductible.

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

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).

It is stated that the advantages you were seeking when you incurred the legal expenses were to be reinstated into your former position with Organisation X, and to receive 'lost earnings'.

The following discusses the eligibility to claim deductions for legal expenses in relation to those advantages.

Reinstatement/re-employment

Legal expenses incurred in relation to seeking reinstatement are considered to be incurred in order to obtain an enduring advantage, being the regaining of the employment position, and therefore is an advantage of a capital nature.

Paragraph 45 of TR 2012/8 states that compensation for loss of employment, such as in an action for wrongful dismissal or loss of office, is a capital receipt (Scott v. Commissioner of Taxation). Legal costs incurred in seeking such compensation are not deductible because the nature of the advantage sought is capital. This is so, even if the amount of compensation awarded is calculated by reference to unpaid salary or lost income, or is assessable as statutory income

The deductibility of legal expenses incurred in seeking reinstatement where the former employee claimed they were unfairly dismissed was considered in Case L26 79 ATC 126; 23 CTBR (NS) Case 32 (Case L26). In that case, the taxpayer was employed as a music teacher by the Commonwealth Teaching Service. She was dismissed from her employment as a schoolteacher on the ground that she could not control classes. She was unsuccessful in her appeal to the Disciplinary Appeal Board against her dismissal.

The taxpayer claimed a deduction for her legal expenses in relation to the appeal. It was held that although the expenditure was a necessary step prior to regaining income from the employment from which the taxpayer had been dismissed; it was not expenditure incurred in the course of gaining or producing such income and the expenditure was not deductible.

It is also viewed that legal costs incurred in obtaining employment or re-employment (including the costs of drawing up an employment agreement) are not deductible as the expenses are preliminary costs of a capital nature: FCT v Maddalena (1971) 2 ATR 541. which are incurred too early to make them deductible.

In Muesth v FC of T 2006 ATC 2217, the taxpayer was a police officer who had been suspended and then removed from the Police Service in May 2002, following a Police Integrity Commission inquiry. The taxpayer incurred legal expenses in seeking a review of the removal order in the New South Wales Industrial Relations Commission. Subsequently, the parties reached an agreement, and the taxpayer was re-employed at a lower rank from March 2003. The Administrative Appeals Tribunal held that the legal expenses were, in effect, re-employment expenses that had not been incurred in relation to the taxpayer's conduct of his day-to-day duties. Accordingly, the legal expenses were incurred too early to make them deductible in accordance with Maddalena ' s case.

Assessable income

Taxation Determination TD 93/29 states that if an employee incurs legal expenses in recovering wages that are contractually owed to them, 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.

6A. A deduction for legal expenses by an employee depends on the particular facts of any case. 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.

Paragraph 40 of Taxation Ruling TR 2012/8 states that where the legal costs were incurred to enforce a contractual entitlement which relates to a right to income, even if they were incurred after employment has ceased, the taxpayer will be entitled to a deduction under section 8-1 of the ITAA 1997.

Application to your situation

You entered the Deed prior to your employment with Organisation X ending on Date 1.

In accordance with the Deed, you continued to work for Organisation X and receive all of your remuneration and superannuation (the Payment) up until the date your employment ended, when you were paid for all accrued and unused benefits you were entitled to as of that date. You received a specified amount less any gross amount paid to you in relation to the Payment.

You engaged the services of both Company A and Company B after your employment with Organisation X ended, and had incurred legal expenses for the following stated purposes:

•         to be reinstated in your former position with Organisation X; and

•         to receive the remuneration that you would have received from Organisation X for the period after your employment ended based on the salary that a person in the position would be entitled to receive per annum, referred to as 'lost earnings'.

We have considered your eligibility to any deduction for the legal expenses you incurred in relation to the advantages as follows:

Reinstatement to your former position

Your position with Organisation X had ended at the time you incurred the legal expenses in seeking to be permitted to undertake your previous position again, seeking reinstated. Any legal expenses incurred related to seeking reinstatement into your previous position with Organisation X:

•         are considered to be incurred in order for you to obtain an enduring advantage, being the regaining of your employment; and

•         were not incurred in the course of you gaining, or producing, your assessable income given that your employment and contract had ended when the legal expenses were incurred.

Therefore, the nature of the advantage being sought was capital in nature and to the extent any of the legal expenses related to you seeking reinstatement to your former position with Organisation X, they are not deductible.

Remuneration for the period after your employment ended

Your contract with Organisation X ended on Date 1 when your employment had ended. The information provided with the ruling, and your stated purpose in incurring the legal expenses in relation to the 'lost earnings', supports that the legal expenses were incurred to enable you to obtain an amount equivalent to the remuneration that you would have received from the time your employment ended if you had continued to be employed/contracted by Organisation X.

However, nothing has been provided to support that the 'lost earnings' you were seeking to receive related to any amount that was contractually owed to you by Organisation X, or for which you had performed any service/s, or earned, in relation to your former position with Organisation X.

Therefore, the nature of the advantage being sought in relation to the payment of 'lost earnings' was capital in nature. It follows that you are not entitled to a deduction to the extent that the legal expenses were incurred in relation to you seeking the payment of the 'lost earnings'.

Conclusion

Based on the information provided:

•         It cannot be viewed that the legal expenses had been incurred in relation to you recovering any unpaid remuneration from Organisation X as you had been paid all remuneration owing to you at the time your employment had ended in accordance with the Deed.

•         You had not incurred the legal expenses to prevent you from being made redundant or being dismissed from your position with Organisation X, or in relation to your contractual agreement with Organisation X, as the legal expenses were incurred after your employment and contract had ended; and

•         The legal expenses were incurred in relation to re-employment expenses and an amount you considered to be 'lost earnings' and not in relation to the conduct of your day-to-day duties in your former position with Organisation X.

It is viewed that the advantages you were seeking in relation to the legal expenses you incurred go beyond a claim for revenue and were capital in nature. Additionally, there is no clear connection between the legal expenses and you receiving any assessable income.

Therefore, as the advantages that you were seeking from incurring the legal expenses were capital in nature, your legal expenses are not deductible under section 8-1 of the ITAA 1997.

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).