Edited version of private advice

Authorisation Number: 1052126811525

Date of advice: 8 June 2023

Ruling

Subject: Deductions - legal expenses

Question 1

Are the legal and other expenses you incurred in defending a claim made against you by your employer tax deductible?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ending 30 June 20XX

The scheme commenced on:

1 January 20XX

Relevant facts and circumstances

You were employed by Company A under the Terms and Conditions of a Contract of Employment (Contract) dated DDMMYYYY.

You were employed with Company A between DDMMYYYY and DDMMYYYY.

You were employed in Position A on a regular full-time basis. The Contract included, among other clauses, the following key clauses:

8. Employee Obligations

23. Policies & Procedures

26. Confidentiality

27. Intellectual Property and Moral Rights

29. Termination

You worked remotely during your tenure with Company A on a laptop provided by Company A from a residence in City A.

The Job Description for Position A shows key activities and responsibilities:

You travelled as part of your employment duties.

You made backups of work on personal external hard drive every X to X months.

On DDMMYYYY, Company A initiated legal proceedings in the Federal Court of Australia (FCA) against you and submitted an Originating Application and Statement of Claim.

Company A's final relief is outlined in the Originating Application.

As per the Originating Application, for the purposes of allowing Company A's independent computer expert to undertake non-destructive forensic examinations, you were ordered to deliver to Company A's solicitors by DDMMYYYY any computer or other device which has been connected to the digital hard drive device, any computer or other device which contains files, folders or emails used by you in relation to your employment and any other computer, device or hard-copy documents which contain Company A's Confidential Information or Copyright Works.

As per the Statement of Claim, Company A outlined your conduct which included:

On DDMMYYYY, during your employment, and without Company A's knowledge, licence or approval, you downloaded and copied files and folders and emails including Company A's Confidential Information and Company B's Copyright Works onto a USB storage device in your possession.

On DDMMYYYY you resigned from your employment with Company A and Company A and you agreed your employment would be terminated immediately without requiring any notice period.

On DDMMYYYY, without Company A's knowledge, licence or approval, you plugged the USB storage device into a computer not owned or controlled by Company A, and accessed and copied files and folders including Company A's Confidential Information and Company A's Copyright Works onto that computer.

On DDMMYYYY, without Company A's knowledge, licence or approval, you plugged the USB storage device into a computer not owned or controlled by Company A, and accessed and copied files and folders including Company A's Confidential Information and Company A's Copyright Works onto that computer.

You downloaded, copied, retained, and continues to retain Company A's Confidential Information and Company A's Copyright Works for the purpose of using those materials for the benefit of himself and/or a potential or actual new employer, in competition with and to the detriment of Company A.

By your conduct, you have breached and/or has threatened to breach clauses in the Contract

FCA order dated DDMMYYYY was provided.

You engaged the services of a lawyer to defend the claim and protect your name, professional career and reputation.

Itemised tax invoices from the lawyer for the legal expenses incurred show fees for professional services in the income year ended 30 June 20XX and in the income year ended 30 June 20XX.

On DDMMYYYY you received an email from the lawyer advising the end to Company A's proceedings against you with no orders as to costs. There is an ongoing obligation for you comply with the orders. The email included the final FCA orders dated DDMMYYYY.

The FCA order provides by Consent and without admissions by either party, the court orders that you be permanently restrained from retaining, copying, disseminating, or using any of Company A's Confidential Information or Company A's Copyright Works. The proceeding be otherwise dismissed, with each party to bear their own costs, including all reserved costs.

You did not seek reimbursement of the legal expenses from the other party.

You do not have professional indemnity insurance.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 8-1(2)

Reasons for decision

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, except where the outgoings are of a capital, private or domestic nature, or relate the earning of exempt income.

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) 8 ATD 190; (1946) 3 AITR 436). The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses. That is, whether the legal expenses are incurred for a capital or a revenue purpose.

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

Taxation Determination TD 93/29 Income tax: if an employee incurs legal expense recovering wages paid by a dishonoured cheque, are these legal expenses an allowable deduction under section 8-1 of the Income Tax Assessment Act 1997? outlines the Commissioners view on legal expenses. The ruling states that if an employee incurs legal expense 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 expenses 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. F C of T (1949) 78 CLR 47 at 59).

Paragraph 7 of TD 93/29 discusses the apportionment of legal expenses:

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 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.

The High Court in Federal Commissioner of Taxation v. Day [2008] 236 CLR 163; 2008 ATC 20- 064; [2008] 70 ATR 14 (Day) is concerned with the deductibility of legal expenses incurred by a public servant in defending charges in respect of conduct which occurred outside the course of normal day-to-day duties. It was held that for an employee's legal expenses to be deductible, the occasion for the expenses must be found in their employment.

In the Day case, the High Court held that where employment 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. The High Court had regard to the nature of the employment and the fact that the taxpayer was exposed to the action by reason of his employment.

In FC of T v. Rowe (1995) 31 ATR 392; 95 ATC 4691 (Rowe) 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.

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.

Taxation Ruling TR 2000/5 Income tax and fringe benefits tax: costs incurred in preparing and administering employee agreements, at paragraph 12 provides both the employer and employee may incur expenses in setting the conditions for and administering the employee agreement. These costs may include costs associated with settlement of disputes.

Where an employee incurs costs associated with settlement of disputes arising out of an existing employment agreement (includes the costs of legal representation), this as an allowable deduction. Similarly, where the employer incurs costs in the settling of disputes arising out of existing employment agreements, this is an allowable deduction (paragraphs 2 and 4 of TR 2000/5).

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, at paragraph 40 states:

40. Where the legal costs are 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.

An example of a situation to which paragraph 40 of TR 2012/8 would apply is where a former employee sues their former employer for a performance bonus, they claim that they were entitled to under their employment contract but which was never paid.

Application to your circumstances

You were employed in Position A with Company A. Responsibilities were extensive and varied based on the position's job description.

Legal action was taken against you by Company A naming you as a Respondent in legal proceedings commenced in the FCA. Claims included you breached clauses of your employment Contract with Company A.

We considered TR 2005/5. However, in your case the dispute did not arise out of an existing employment agreement as the legal proceedings and the expenses were incurred after you ceased employment with Company A. TR 2000/5 is not applicable to your circumstances.

Your situation differs to the Day case. Unlike the Day case, the legal expenses incurred by you were not considered defence of the way you performed your duties in Position A. It is not considered you were exposed to the legal action by reason of your employment activities.

The advantage sought by you was to preserve your name, reputation and professional career which relates to securing an enduring advantage. Therefore, the expenses incurred are primarily capital in nature and they arose in relation to your personal conduct. Therefore, you are not entitled to a deduction under section 8-1 of the ITAA 1997 for the legal expenses incurred in relation to the proceedings.

Apportionment of expenses

The itemised tax invoices were examined to determine if you incurred legal expenses of a revenue nature. However, it does not appear you were seeking contractual entitlements such as wages or unused leave. It cannot be determined your lawyer spent time on recovering ordinary income.

Amendment to your income tax return

Based on our private ruling decision, you need to consider revising your income tax return for the income year ended 30 June 20XX because you have incorrectly claimed the legal expenses. Further information on how to request an amendment to your tax return can be found by searching 'QC 65091' on ato.gov.au.

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