Edited version of private advice

Authorisation Number:1052330138551

Date of advice: 15 November 2024

Ruling

Subject: Deduction - legal expenses

Question

Are legal fees incurred by you in defending allegations of workplace harassment deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No. The legal fees incurred by you in defending allegations of harassment are not deductible under section 8-1 of the ITAA 1997.This is because the legal expenses incurred by you in defending the allegations of unlawful discrimination arose from your personal conduct. They did not arise from the performance of your duties as a medical professional from which you derived assessable income. As such, the legal fees incurred by you are not an allowable deduction under section 8-1 of the ITAA 1997.

See ATO Interpretative Decision ATO ID 2002/664 Income Tax Deductions & Expenses: Legal fees incurred in defending a claim of harassment and victimisation (ATO ID 2002/664).

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

You are employed as a X professional by Employers A, B and C.

On or around DD MM 20XX, Person X lodged a complaint with X Commission alleging you had harassed them between MM and MM 20XX, in contravention of the X Act. Your employers were included as respondents.

Between MM 20XX and MM 20XX, you sought legal advice and representation from X regarding the complaint.

•         Invoice dated DD MM 20XX for $X. Copy provided to us.

•         Invoice dated DD MM 20XX for $X. Copy provided to us.

On or around DD MM 20XX, the case was terminated by the Commission.

On or around DD MM 20XX, Person X made an application to X Court alleging unlawful discrimination. You and your employers were named as respondents.

The Statement of Claim details alleged contraventions of the X Act including allegations that the course of conduct towards Person X by you was unwelcome, of a sexual nature and constituted sexual advances and in contravention of the XAct. Copy provided to us.

On or around DD MM 20XX you filed your Statement of Defence in the X Court outlining your denial of the allegations. You have provided us with a copy of your Statement of Defence.

Between late MM 20XX and MM 20XX, you were suspended from your position with Employers A and B

During this time:

•         Employer A ceased paying wages on DD MM 20XX

•         Employer B ceased paying wages on DD MM 20XX.

•         Employer C continued to pay wages.

Between MM 2024 and MM 2024, you sought legal advice and representation from Firm X and Barrister X, regarding the X Court proceedings.

•         Invoice for MM dated DD MM 2024 for $X

•         invoice issued by barrister X dated DD MM 2024 for $X. Copy provided to us.

•         invoice dated DD MM 2024 for $X. Copy provided to us.

•         Invoice for MM for $X

In total, between MM 20XX and MM 20XX, you incurred legal expenses of $X.

On DD MM 20XX, the proceedings were dismissed with no costs order made by the X Court.

You advise the matter is now settled.

You are not covered through professional indemnity insurance for the legal expenses incurred.

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

In total, between August 2023 and June 2024, you incurred legal expenses of $XXX.

Contentions

You contend it was paramount that expert legal assistance be engaged at significant expense to defend unwarranted charges against you, so as to ensure your ongoing role as X and continuation of your income earning capacity.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Detailed reasoning

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent that they are incurred in 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. Therefore, in determining whether a deduction is allowable under section 8-1 of the ITAA 1997, the nature of the expense must be considered.

The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 3 AITR 436; (1946) 8 ATD 190). If the advantage to be gained is of a revenue nature, then the expenses incurred in gaining the advantage will also be of a revenue nature.

For legal expenses to constitute an allowable deduction, it must be shown that they were incidental or relevant to the production of the taxpayer's assessable income, (Ronpibon Tin NL & Tong Kah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; [1949] HCA 15; (1949) 4 AITR 236; (1949) 8 ATD 431). 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 your assessable income (Lunney's case). These principles have been affirmed by the High Court in Commissioner of Taxation v Payne [2001] HCA 3.

Further, legal expenses are generally deductible if the expenses 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).

ATO Interpretative Decision ATO ID 2002/664 Income Tax Deductions & Expenses: Legal fees incurred in defending a claim of harassment and victimisation (ATO ID 2002/664 states the Commissioner's view that legal fees incurred by the taxpayer in defending a sexual harassment and victimisation charge are not deductible under section 8-1 of the ITAA 1997 as they were not incurred in gaining or producing assessable income.

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? (TD 93/29) 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. Expenses incurred to receive compensation for loss of future earnings are not deductible as they are considered to provide an enduring advantage and are therefore capital in nature. Similarly, legal expenses incurred in preserving employment are not deductible as they are considered to provide an enduring advantage and are therefore capital in nature.

Taxation Ruling TR 2000/5 Income tax and fringe benefits tax: costs incurred in preparing and administering employment agreements, states that costs associated with attempting to settle a dispute arising out of an existing employment agreement including the cost of representation are deductible. When legal action is undertaken to obtain a payment, then the deductibility of the legal expenses depends on whether the payment sought is revenue in nature, such as unpaid wages, or whether the payment sought is capital in nature, such as a redundancy type payment or compensation for unfair dismissal. This principle is confirmed in Taxation Determination TD 93/29 as outlined above. 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.

In FC of T v. Rowe (1995) 60 FCR 99; (1995) 31 ATR 392; 95 ATC 4691, the court accepted that legal expenses incurred in defending the manner in which a taxpayer performed his employment duties were allowable. No significance was placed by the court on the taxpayer's status as an employee. In FC of T v 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 Case W94 89 ATC 792; AAT Case 5376 (1989) 20 ATR 4001 the taxpayer, a public servant incurred legal fees in defending and then appealing against disciplinary charges of improper conduct resulting from his compulsive gambling. It was found that the expenses incurred were not incidental or relevant to the gaining of the taxpayer's assessable income. It was the conduct of the taxpayer through his compulsive gambling which led to the charges which, in turn, led to him incurring legal costs. The expenses incurred were not incidental or relevant to the gaining of the taxpayer's assessable income.

In Case U102 87 ATC 621 the taxpayer was a secretary-manager of a large sporting club. Comments about the management of the trust funds were made on television that were defamatory in nature in respect to the trustees. The trustees commenced proceedings for damages for defamation. The Administrative Appeals Tribunal (AAT) held that a deduction for the legal expenses incurred was not allowable. It was found that the events which gave rise to the expenses incurred were not regarded as what is normally expected of a secretary-manager of a club in the course of producing assessable income. The expenses were considered private in nature as the need for them arose out of the taxpayer's reaction to what he saw as a slur upon his personal good name and reputation. Alternatively, it was stated that the expenditure was capital in nature as it was incurred in an endeavour to retain and restore his position as a leading figure in the sports management industry and with it a standing sufficient to pursue his own interest away from the club in the future. The character of legal expenses is not determined by the success or failure of the legal action (No. 3 Board of Review Case B31, 70 ATC 148).

In Commissioner of Taxation v Day [2008] HCA 53 (Day's case), a majority of the High Court held that the legal expenses were incurred by the taxpayer in the course of gaining or producing his assessable income and therefore that paragraph 8-1(1)(a) of the ITAA 1997 was satisfied. The majority also held that the expenses were not of a private nature, because they were incurred in connection with the taxpayer's position as a public servant and were not unconnected to his service like some fines and penalties are. Kirby J held that the taxpayer had not incurred the legal expenses in gaining or producing his assessable income. The matters giving rise to the expenditure lacked the requisite temporal or other connection with gaining or producing his assessable income.

Alternatively, the expenditure was a loss or outgoing of a private nature and therefore excluded from deductibility. The ATO view on the Day's case decision is expressed in the Decision Impact Statement where relevantly, it states: 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 which is a question of fact and degree.

Application to your circumstances

In your situation, you engaged legal representation to defend allegations made against you by a former colleague.

We acknowledge there is a general connection between your employment and your legal expenses. However, as the High Court found in Commissioner of Taxation v Payne [2001] HCA 3, for expenses to be considered 'incurred in the course of producing assessable income', it is not enough to show that these is some general link or casual connection between the expenditure and the production of income. The expenditure must have a sufficiently close connection to the performance of the employment duties and activities through which the employee earns income. In your case, legal expenses incurred by you in defending the allegations arose from your personal conduct and not in the defending the manner in which you performed your duties.

As stated in ATO Interpretative Decision ATO ID 2002 /664 Income Tax Deductions & Expenses: Legal fees incurred in defending a claim of harassment and victimisation (ATO ID 2002/664), legal fees incurred by the taxpayer in defending a sexual harassment and victimisation charge are not deductible under section 8-1 of the ITAA 1997 as they were not incurred in gaining or producing assessable income. We have applied ATO ID 2002/664, to your situation.

You contend it was paramount that expert legal assistance be engaged at significant expense to defend unwarranted charges against you, so as to ensure your ongoing role and continuation of your income earning capacity. Legal expenses incurred in preserving employment are not deductible as they are considered to provide an enduring advantage and are therefore capital in nature. This means you would not be entitled to claim a deduction under paragraph 8-1(2)(a) of the ITAA 1997.We acknowledge that you were suspended without pay for a period between MM and MM 20XX, however, as legal fees incurred by the taxpayer in defending a sexual harassment and victimisation charge are not deductible under section 8-1 of the ITAA 1997, you are not entitled to deduct an apportionment of expenses related to the recovery of wages.

In summary, the legal fees incurred by you in defending allegations of harassment are not deductible under section 8-1 of the ITAA 1997 because the legal expenses incurred by you in defending the allegations arose from your personal conduct. They did not arise from the performance of your duties as a X professional from which you derived assessable income. Further, legal expenses incurred to preserve employment are not deductible as they are considered to provide an enduring advantage and are therefore capital in nature.

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