Edited version of private advice

Authorisation Number: 1052398243019

Date of advice: 26 May 2025

Ruling

Subject: Deductions - legal expenses

Question 1

Can you claim a deduction for legal expenses incurred under section 8-1 of the Income Tax Assessment Act (ITAA 1997) for your unfair dismissal?

Answer 1

No.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

On DD MM 20XX, you commenced working for an employer.

Your employment duties included the following:

•                     managed and developed staff

•                     ensured data accuracy and compliance

•                     maintained stakeholder communication

•                     led quality improvement initiatives

•                     ensured policy compliance

•                     applied advanced IT skills

•                     promoted professional development

•                     innovated for organisational challenges

•                     made Informed decisions

•                     reported to leadership

•                     complied with workplace safety

•                     took responsibility for safety

•                     upheld Information security

•                     followed safety instructions

•                     stayed informed on safety matters

On DD MM 20XX, you were dismissed from your employment due to allegations against you for misconduct.

On DD MM 20XX, you engaged legal representation from Lawyer A with the intent to pursue reinstatement of your employment and the continuation of your salary.

On DD MM 20XX, you lodged an application for reinstatement with the Queensland Industrial Relations Commission (QIRC).

On DD MM 20XX the QIRC concluded that your termination did not meet the definition or criteria of misconduct.

In MM 20XX, Lawyer A ceased acting on your behalf due to the increasing complexity of your matter, which required escalation to more specialised legal representation. Consequently, Lawyer B assumed responsibility as your legal counsel until MM 20XX, with Lawyer A stepping aside. Additionally, an employment law barrister, was engaged through Lawyer B to provide expert assistance in your unfair dismissal case.

On DD MM 20XX, a hearing for your unfair dismissal case commenced with the QIRC.

On DD MM 20XX, the QIRC determined that your dismissal was unfair because it was unreasonable and not proportionate to the conduct alleged against you. QIRC also found that reinstatement of your position was impracticable because the position had been abolished. As a result, a court order for compensation was made for unfair dismissal.

On DD MM 20XX, you received a payout of $XX. The amount was paid for your dismissal equal to 6 months wages.

During the 20XX financial year you incurred legal fees of $XX.

During the 20XX financial year you incurred legal fees of $XX.

You have no professional indemnity insurance.

You have not received a reimbursement for any legal expenses you incurred from a lawyer's trust fund.

You have not sought to recover your costs from anyone other parties involved.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 6-5(2)

Reasons for decision

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for a loss or an outgoing to the extent to which it is incurred in gaining or producing assessable income, except where the loss or outgoing is of a capital, private or domestic nature.

Subsection 6-5(2) of the ITAA 1997 provides that the assessable income of an Australian resident includes ordinary income derived directly or indirectly from all sources during the year. Salary and wages, including leave payments, is considered ordinary income as it is paid directly as a result of personal services an employee renders for their employer.

To be deductible in a particular year under section 8-1 of the ITAA 1997, a loss or outgoing must generally have been 'incurred' in that year. 'Incurred' is not defined in the Act and in general terms, an outgoing is incurred at the time a taxpayer owes a present money debt that the taxpayer cannot escape. The courts have been reluctant to attempt an exhaustive definition of incurred, but they have developed a series of guidelines that can be used in assisting to determine whether an item has been incurred in a current year.

The guiding principles from case law and Taxation Rulings TR 94/26 (TR 94/26) Income tax: subsection 51(1) - meaning of incurred - implications of the High Court decision in Coles Myer Finance and TR 97/7 (TR 97/7) Income tax: section 8-1 - meaning of 'incurred' - timing of deductions are as follows.

A liability will be a loss or outgoing 'incurred' under section 8-1 of the ITAA even though it remains unpaid, provided the taxpayer is 'definitively committed' or has 'completely subjected' itself to the liability (FC of T v James Flood Pty Ltd (1953) 10 ATD 240 at p 244; (1953) 88 CLR 492 at p 506).

A number of significant court decisions have determined that for an expense to be an allowable deduction:

•                     it must have the essential character of an outgoing incurred in gaining assessable income or, in other words, of an income-producing expense (Lunney v. FC of T; (1958) 100 CLR 478),

•                     there must be a nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income (Ronpibon Tin NL v. FC of T, (1949) 78 CLR 47), and

•                     it is necessary to determine the connection between the particular outgoing and the operations or activities by which the taxpayer most directly gains or produces his or her assessable income (Charles Moore Co (WA) Pty Ltd v. FC of T, (1956) 95 CLR 344; FC of T v. Hatchett, 71 ATC 4184).

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) 3 AITR 436; (1946) 8 ATD 190).

The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses. If the advantage to be gained is of a capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature.

Generally, legal expenses incurred in an unfair dismissal action, such as seeking reinstatement after termination and/or damages, are of a capital nature and therefore, not deductible. Alternatively, if the advantage being sought is of a revenue nature, such as unpaid wages, then the legal expenses will be of revenue nature.

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

This principle is confirmed in Taxation Determination TD 93/29 (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? which states that if an employee incurs legal expenses in recovering wages, the legal expenses are an allowable deduction providing that the legal action relates solely to the recovery of wages. The ruling includes the following paragraphs:

2. Salary or wage income is only assessable when it has been derived, and salary or wages are generally derived when paid.

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 expense 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. FC of T (1949) 78 CLR 47 at 59).

6A. A deduction for legal expenses by an employee depends on the particular facts of anycase. To be deductible the occasion of the expenditure must be found in what is productive in the gaining of assessable income by the employee. If expenses are incurred to dispute the receipt of income contractually owed under an employment contract, then the expenses are on revenue account and allowable as a deduction.

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 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.

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.

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 TD 93/29

•                     instituting proceedings and settling disputes arising out of employment agreements, such as to enforce a contractual entitlement (Romanin v FCT (2008) 73 ATR 760)

•                     preventing redundancy or dismissal. In FC of T v. Rowe (1995) 31 ATR 392; 95 ATC 4691, 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; and

•                     defending the manner in which employment duties are performed: (Inglis and FCT 87 STC 2037)

In contrast, legal expenses incurred in seeking compensation for loss of employment, such as in an action for wrongful dismissal, are not deductible. As outlined at paragraph 5 of TD 93/29, legal expense relating to an action for damages for wrongful dismissal are not deductible as the claim is of a capital nature.

The deductibility of legal expenses incurred in relation to an action for unfair dismissal 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. When dismissed from employment as a school teacher on the ground that they could not control classes. They were unsuccessful in their appeal to the Disciplinary Appeal Board against their dismissal.

The taxpayer claimed a deduction for their 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. Thus, the expenditure was not deductible.

Application to your situation

In your case, you sought reinstatement to your former position on the grounds of wrongful dismissal. However, the QIRC determined that reinstatement was not practicable, as the position had been abolished. As a result, the QIRC ordered compensation be made to you from your former employer.

The compensation payment you received in connection with your unfair dismissal claim is considered capital in nature. Accordingly, the expenses you incurred in pursuing the claim and securing the compensation payment are also capital in nature. Therefore, under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997), these expenses are not deductible.

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).