Edited version of private ruling

Authorisation Number: 1011647099126

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Ruling

Subject: Compensation payment

1. Can legal expenses incurred in seeking reinstatement of your employment and are capital in nature be applied against a present or future capital loss?

No.

2. Is a lump sum payment ordered by a tribunal as compensation in lieu of your reinstatement to your former position assessable income?

Yes.

3. If the compensation amount is assessable income, can the legal expenses incurred be allowed as a deduction?

No.

Relevant facts and circumstances

Your employment was terminated.

In a previous private ruling for the year ended 30 June 2010 it was determined that legal expenses incurred in your attempt to have your employment re-instated were a capital expense and therefore not deductible.

A decision was handed down by a tribunal on your application seeking reinstatement to your position under the Fair Work Act 2009 and, insofar as it is relevant here, determined that:

· your dismissal from your employment was harsh, unjust and unreasonable

· your application for reinstatement was inappropriate

· compensation be paid in lieu of reinstatement.

Reasons for decision

Question 1

You have incurred legal expenses in seeking compensation for unfair termination of your employment and wish to be able to apply those legal expenses against some current or future capital gain.

A capital gain or capital loss made from a capital gains tax (CGT) event relating directly to a wrong you have suffered in, or as a result of, your occupation is disregarded by virtue of section 118-37(1) of the Income Tax Assessment Act 1997 (ITAA 1997).

The CGT event, in your case, which gave rise to the capital gain, was the right to seek compensation. In calculating the capital gain that may form part of your assessable income, the legal expenses incurred in gaining that compensation are deducted from the gross proceeds and it is the net amount that is potentially assessable under the CGT provisions of the ITAA 1997. However, because of the operation of section 118-37 of the ITAA 1997 such an event is disregarded.

The legal expenses therefore form part of a CGT event and are not able to be carried forward as a reduction of any future capital gain.

Question 2

Section 6-5 of the ITAA 1997 provides that the assessable income of a taxpayer includes income according to ordinary concepts (ordinary income) and section 6-10 of the ITAA 1997 also includes statutory income in your assessable income. A summary of the provisions relating to statutory income is set out at section 10-5 of the ITAA 1997.

Your assessable income therefore may include both ordinary income and statutory income.

Statutory income includes employment termination payments (ETP) (formerly known as eligible termination payments) through the operation of section 82-10 of the ITAA 1997.

Whether a lump sum compensation payment is income or capital depends on what the amount was designed to compensate the plaintiff for.

Taxation Ruling IT 2424 discusses compensation payments in respect of unlawful acts of discrimination. At paragraph 24 it states: 

A compensation payment received by way of settlement or under a determination of the Commission in respect of an unlawful act of dismissal qualifies as an eligible termination payment. Essentially, the compensation payment for unlawful dismissal, like a payment for wrongful dismissal settled or awarded under a common law action, is considered to be made in consequence of the termination of any employment of the taxpayer.

In your case, your employment was terminated. You took the matter to a tribunal seeking reinstatement and it was determined that this action was not appropriate. Nevertheless, your termination was determined to be unfair and you were awarded compensation.

In these circumstances, it is considered that the payment does not have the characteristics of ordinary income and is capital in nature. However, it is an ETP within the meaning of section 82-130 of the ITAA 1997. The lump sum was paid in consequence of the termination of your employment, payment was received no later than 12 months after the termination and was not a payment mentioned in section 82-135 of the ITAA 1997.

The lump sum is therefore considered to be a capital payment but is assessable as statutory income under section 82-10 of the ITAA 1997.

Question 3

Section 8-1 of the ITAA 1997 allows a deduction for losses and outgoings which are incurred in the course of gaining or producing assessable income, unless the losses or outgoings are capital, or are of a capital, private or domestic nature.

In determining whether a deduction for legal expenses is allowed 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 which 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.

A compensation payment for wrongful dismissal is included in the legislative definition of an ETP. An ETP includes a capital amount paid as compensation for the loss of the means of producing income. ETPs are included in assessable income under sections 82-10 to 82-160 of the ITAA 1997. 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 the taxable income of the taxpayer. 

You incurred the legal expenses in order to obtain compensation for unfair dismissal by your employer which is an ETP. The ETP lump sum, being a payment for the loss of your earning capacity, is a capital receipt.

As the ETP payment you received as a result of your legal action is capital in nature, the expenses incurred in pursuing your claim and obtaining the ETP are also capital in nature. Consequently, no deduction is allowable under section 8-1 of the ITAA 1997 for the legal expenses you incurred as expenditure of a capital nature is expressly excluded.