Edited version of private advice

Authorisation Number: 1052140770594

Date of advice: 13 July 2023

Ruling

Subject: Deductions - legal expenses

Question

Are the legal fees incurred in relation to a wrongful dismissal claim tax deductible?

Answer

No.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

You were employed with Employer X from XX/XX/20XX in position A.

On XX/XX/20XX, you were offered and accepted a varied contract for the role of Position A with Employer X. The varied contract was provided.

You were terminated from employment by way of redundancy effective from XX/XX/20XX. A copy of the termination letter from Employer X was provided. The letter provided reasons for your redundancy.

On XX/XX/20XX, your employment with Employer X ended.

You received a second letter from Employer X clarifying the redundancy and notice periods to which you were entitled.

You sought legal representation from Lawyers.

Your Lawyer received an email from a professional association indicating you are a member, your role has been made redundant, they believe that this may not have been a genuine redundancy and you may have been unfairly dismissed.

You initiated legal action to challenge the decision to terminate your employment and lodged Form F2 - Unfair dismissal application. A copy of Form F2 was provided.

Form F2 indicates the outcome you were seeking by lodging the application:

•         Reinstatement

•         Compensation

•         An order maintaining continuity of service upon any reinstatement.

You considered the compensation was for loss of the wages you would have earned had your employment continued. You did not explore further job opportunities as you were not informed about your role being made redundant until a couple of weeks prior to returning back to work from leave.

Form F2 describes the relevant facts and circumstances and specify why you say the dismissal was unfair.

During the legal proceedings your Lawyer argued Employer X had not complied with the provisions outlined in Section 389 of the Fair Work Act 2009 (Cth), which stipulate the criteria for a legitimate redundancy.

Your Lawyers sent an email to you advising they will prepare a notice of discontinuance and attached the payslip which is the settlement sum.

Your Lawyer provided a letter to you advising that the matter has now been finalised.

You were not reinstated.

An itemised tax invoice from the Lawyer was provided for the legal expenses incurred. The invoice shows fees for work performed for unfair dismissal claim between the dates XX/XX/20XX and XX/XX/20XX totalling $XX,XXX.XX.

You have not or will not seek to recover costs from the other party.

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).

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 38 states:

38. Legal costs take their quality as an outgoing of capital or revenue nature from the cause or purpose of incurring the expenditure. If the advantage sought to be gained is of a revenue nature, then the costs incurred in gaining the advantage will also be of a revenue nature.

Therefore, if the advantage being sought is of a revenue nature, then the legal expenses will be of a 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 been deductible.

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

Paragraph 40 of TR 2012/8 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.

Paragraph 45 of TR 2012/8 relates to action for wrongful dismissal and states:

45. Compensation for loss of employment, such as an action from 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.

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 Commissioner's view on legal expenses. The ruling provides 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).

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 Federal Commissioner of Taxation v. Day [2008] 236 CLR 163; 2008 ATC 20- 064; [2008] 70 ATR 14 (Day), 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 the Day case 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.

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).

Application to your circumstances

You were employed in Position A with Employer X. You were terminated from employment by way of redundancy. Your employment ended on XX/XX/20XX. It was believed this may not have been a genuine redundancy and you may have been unfairly dismissed. You initiated legal action to seek reinstatement into your previous position with Employer X and seek compensation for 'loss of wages'. As a result of the legal action, you incurred legal expenses.

Any legal expenses incurred relating to seeking reinstatement are considered to be incurred in order to obtain an enduring advantage, being regaining your employment. You did not incur the legal expenses to prevent you from being made redundant or being dismissed as your employment and employment contact had already ended when the expenses were incurred.

You state the compensation claim was for 'loss of wages'. We appreciate you did not search for a new job as you may not have been informed that your position was made redundant. However, based on the information provided, the 'loss of wages' you were seeking compensation for was not for an amount that was contractually owed to you by Employer X. You had been paid all remuneration owing to you at the time your employment has ended in accordance with the varied employment contract.

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 Employer X. 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 your position of Pharmacy Manager. It is not considered you were exposed to the legal action by reason of your employment.

The advantage sought by you was to seek reinstatement into your former position with Employer X which relates to securing an enduring advantage. The purpose was not to deal with something that can be expected to arise in you day to day employment. It was not in relation to the conduct of how you performed your duties.

Based on the information provided we consider the legal expenses were not incurred in the course of your gaining or producing your assessable income. The legal expenses incurred are capital in nature. You are not entitled to a deduction under section 8-1 of the ITAA 1997 for the legal expenses incurred in relation to the legal action.

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