Edited version of private advice

Authorisation Number: 1052230704179

Date of advice: 14 March 2024

Ruling

Subject: Income tax: deductions - legal expenses

Question

Whether legal fees incurred by you during the 20YY and 20YY financial years to enforce payments of income required under your employment agreement following termination of employment are deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) in the years incurred.

Answer

Yes

This ruling applies for the following periods:

Income year ending 30 June 20YY

Income year ending 30 June 20YY

The scheme commenced on:

1 July 20YY

Relevant facts and circumstances

1.    You were CEO of the Company until October 20XX. You founded the Company in 20XX and the Company was originally listed on the ASX in 20XX.

2.    The most recent employment contract (the Contract) was entered into in September 20YY.

3.    The Contract provided for a Notice period of XX months' salary in the event of your termination of employment.

4.    The Board terminated the Contract in October 20XX and thereafter the parties were in dispute regarding the payment of Notice under the Contract.

5.    Further letters received by you in November 20XX further terminated your employment effective on that date with no Notice period provided.

6.    You obtained legal advice and negotiated a settlement with the employer with a Deed being executed in November 20XX.

7.    The employer subsequently paid an amount of $XXXX gross, less Pay As You Go Withholding of $XXXX.

8.    The legal fees invoiced to you (and therefore incurred) during the 20XX income year was $XXXX.

9.    Further legal fees have been incurred since June 20XX.

10. All legal fees have now been paid.

Relevant legislative provisions

section 8-1 of the Income Tax Assessment Act 1997

Does IVA apply to this private ruling?

No

Reasons for decision

Summary

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. Legal costs take their quality as an outgoing of capital or revenue in nature from the advantage sought in incurring the expenditure.

Your legal expenses in enforcing payment of your contractual entitlement to payment in lieu of notice are outgoings with nexus to assessable income and where the character of the advantage sought is on revenue account. The legal expenses are therefore deductible under section 8-1 of the ITAA 1997 in the income year in which the costs were incurred.

Detailed reasoning

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) is the operative provision and states that a loss or outgoing may be deducted from assessable income to the extent that:

a)            it is incurred in gaining or producing assessable income; or

b)            it is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income.

However, under subsection 8-1(2) of the ITAA 1997, a loss or outgoing is not deductible to the extent that it is a loss or outgoing of capital or of a capital nature, private or domestic in nature.

In determining whether a deduction for legal expenses is available, the nature or character of the expenditure must be considered, that is, whether the legal expenses are incurred for a capital or revenue purpose (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 2012/8 Income tax and fringe benefits tax: assessability of amounts received to reimburse legal costs incurred in disputes concerning termination of employment (TR 2012/8) states the nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses. For example, if the advantage to be gained is of a capital nature, then the legal expenses incurred in gaining the advantage will also be of a capital nature and not deductible.

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

Paragraph 44 of TR 2012/8 states that a deduction for legal costs 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 the receipt of income contractually owed under an employment contract. If the costs are on revenue account then they are allowable as a deduction.

Paragraph 45 of TR 2012/8 discusses the differences between compensation for loss of employment as demonstrated in Scott v. Commissioner of Taxation (1935) 35 SR (NSW) 215 and payment in lieu of notice of termination. In Scott's case the advantage sought was one of a capital nature and therefore not deductible.

A payment in lieu of notice is a payment that an employer is obliged to make to an employee if they have terminated the employee without giving the required notice set out in the employment contract.

Paragraph 42 of TR 2012/8 briefly discusses Romanin v. Commissioner of Taxation [2008] FCA 1532; 2008 ATC 20-055; (2008) 73 ATR 760 (Romanin) where McKerracher J held that:In my view, the requisite connection exists between the outgoing claimed (legal expense) and the incurrence of assessable income. On this point, I accept Mr Romanin's submission that he pursued proceedings in the Commission to obtain income that was contractually owed to him and that the costs incurred in doing so are deductible under subsection 8-1(1) of the ITAA 1997.

In Romanin's case, the taxpayer was pursuing his entitlement under his employment contract to receive 12 months' payment in lieu of notice after his employment was terminated on seven days' notice. Had the taxpayer received the notice required under his contract, he would have worked out the 12 months and been assessed on that income.

The Federal Court accepted that the taxpayer was entitled to a deduction for the legal expenses because the occasion of the expenditure was the enforcement of his contractual entitlement as an employee to income (in the form of payment in lieu of notice).

Application to your circumstances

In this case, your legal expenses were incurred to settle a dispute arising out of your existing employment agreement and your entitlements under that agreement. This included pursuing an entitlement to XX weeks' income that would have been derived had your employer allowed you to serve out the period of notice as per your employment agreement.

The legal expenses incurred by you in order to enforce your payment in lieu of notice are sufficiently connected to your assessable income. The character of each loss or outgoing is on revenue account. As such, your legal expenses are deductible under section 8-1 of the ITAA 1997 in the income year incurred.

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