Edited version of private advice

Authorisation Number: 1052357865300

Date of advice: 4 February 2025

Ruling

Subject: Deductions - legal expenses

Question 1

Can you claim a deduction for the portion of your legal expenses incurred in initially consulting the law firm on the dispute with your employer regarding your employment performance and for them to send the letter to your employer requesting additional information about the matter?

Answer

Yes.

Question 2

Can you claim a deduction for the portion of your legal expenses incurred in claiming for payments in lieu of notice and unused annual leave?

Answer

Yes.

Question 3

Can you claim a deduction for the portion of your legal expenses that relate to your claim for an ex-gratia payment?

Answer

No.

This ruling applies for the following period:

Year ended XX XXXX 20YY

The scheme commenced on:

XX XXXX 20YY

Relevant facts and circumstances

On XX XXXX 20YY, you commenced employment with Company A.

On XX XXXX 20YY, you received notification from a third-party human resources management system that you had fully met expectations.

On XX XXXX 20YY, you received a further notification stating you only partially met expectations.

On XX XXXX 20YY, you tendered your resignation with Company A. You withdrew your resignation. You attended a meeting with a supervisor on the same day accepting the withdrawal of the resignation.

On XX XXXX 20YY, you received correspondence with allegations of poor conduct or performance alleged by other staff within written complaints. You were instructed to respond either in writing or to attend an in-person meeting.

On XX XXXX 20YY, you attended an in-person meeting to respond to the allegations. During this meeting it was advised to you that the two options available to them were to consider resigning or being placed on an improvement plan.

On XX XXXX 20YY, you received an email requesting you attend a second meeting to discuss the preliminary findings of the allegations.

On XX XXXX 20YY, you attended the second meeting which detailed that the two options available were:

•                     Company A would provide a payment in lieu of notice, 16 weeks' worth of termination pay and a positive reference; or

•                     You undergo a performance improvement plan.

On XX XXXX 20YY, you received formal written warning, and you were advised to adhere to a performance improvement plan. You were instructed to return to work on XX XXXX 20YY.

On XX XXXX 20YY, you took personal leave on account of medical reasons. You attended the office of a legal practitioner specialising in employment law for a consultation. You received an invoice totalling $XX inclusive of GST for this consultation.

On XX XXXX 20YY, you provided instructions to your legal practitioner to prepare a letter to your employer. The letter requested further details and evidence regarding the allegations of poor conduct and performance at work. You received an invoice totalling $XX inclusive of GST for these services.

On XX XXXX 20YY, you received an invoice from your legal practitioner totalling $XX for services preparing the letter of demand seeking a Deed of Release in which the employer would agree to certain claims by you.

On XX XXXX 20YY, your legal practitioner sent a letter to your employer providing a without prejudice offer to settle the matter with a Deed of Release.

On XX XXXX 20YY, you received a letter from your legal practitioner advising you of the outcome of the negotiation. You received a final invoice totalling $XX from your legal practitioner for services rendered to negotiate the Deed of Separation with Company A.

On XX XXXX 20YY, you executed a Deed of Separation with Company A. The relevant agreed terms of the Deed of Separation are as follows:

•                     You would resign from employment with Company A with effect on XX XXXX 20YY.

•                     You would receive ex gratia pay, lieu of notice pay, superannuation contributions and annual leave pay.

•                     You will receive a statement of service.

•                     Both parties release each other from all claims present and in future.

A Settlement Description provided the particulars of the benefits you will receive under the Deed as follows:

•                     $XX being the equivalent of 8 weeks of remuneration as an ex-gratia payment.

•                     $XX being the equivalent of 4 weeks payment in lieu of notice.

•                     $XX for accrued but untaken annual leave.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

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 expenses 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? Provides at paragraph

[5]...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.

The deductibility of legal expenses is determined by the nature of payments sought. As stated previously, the nature of legal expenses follows the nature of the advantage sought in incurring the legal expenses. Therefore, if you are seeking a capital payment then the advantage you are seeking is capital in nature and consequently the legal expenses incurred in trying to obtain that capital payment are not deductible.

Employment termination payments ('ETP's) ETP's are subject to special tax treatment that may result in some or all of the amounts being included in assessable income. However, the fact that a capital payment is specifically brought to account as assessable income will not change the nature of the payment. An amount that is capital in nature will remain capital notwithstanding that it is specifically included in assessable income.

As ETP's are capital in nature, any legal expenses associated with obtaining the ETP are also capital in nature and not deductible. A redundancy type payment such as an ex-gratia payment is a capital payment. Therefore, legal expenses incurred in seeking this type of payment are also capital in nature and consequently not deductible.

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 Income tax: if an employee incurs legal expenses 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?

•                     instituting proceedings and settling disputes arising out of employment agreements, such as to enforce a contractual entitlement.

•                     defending the manner in which employment duties are performed.

In Romanin v FC of T [2008] FCA 1532 ('Romanin') it was held that a payment of a lump sum that would otherwise be received by way of regular payments did not, of itself, change the character of the payment. Legal expenses incurred in enforcing a contractual entitlement to a payment 'in lieu of notice' are generally deductible under this principle, despite being received as a lump sum.

When legal expenses are incurred in relation to proceedings that relate both to claims that are revenue in nature as well as those of a capital nature, there must be some fair and reasonable apportionment of the extent of the relation of the outlay to the revenue claim.

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

[7] Where the solicitors 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 solicitors account is not itemised, a possible basis for apportionment would be either a reasonable 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.

Application to your circumstances

Workplace allegations

You incurred legal expenses in relation to seeking advice on your legal rights about your employment and seeking an opportunity to defend yourself from the allegations. Your legal practitioner requested Company A to particularise the allegations and to provide a reasonable time to respond with a defence.

It is considered that this portion of your legal expenses was a consequence of your day-to-day activities as an employee from which you derived assessable income. Therefore, the associated legal expenses incurred up to this point in time totalling $XX are deductible under section 8-1 of the ITAA 1997.

Deed of Release

You also incurred a portion of the legal expenses for preparation of a letter of demand and advising on a Deed of Separation including settlement negotiations (including the ex-gratia payment). The advantages sought includes an ex-gratia payment, a payment in lieu of notice and untaken unused annual leave.

An ex-gratia payment such as yours is considered capital in nature due to being a one-time, voluntary lump sum often included in settlement agreements to resolve disputes. Since the payment is capital in nature, you cannot deduct legal expenses associated with this claim under section 8-1 of the ITAA 1997. This is not changed by the fact that a capital payment received on termination of employment may be subject to tax as an ETP.

Payments for contractually entitled salary in lieu of notice and unused annual leave are revenue in nature and therefore, legal expenses incurred in seeking those payments are also revenue in nature and deductible.

As the legal expenses you have incurred are both revenue and capital in nature, you will need to apportion the legal expenses in a reasonable manner. You will need to apply the principles in paragraph 7 of TD 93/29 in undertaking the apportionment.

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