Edited version of private ruling

Authorisation Number: 1011670488497

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Ruling

Subject: legal expenses

Question

Are you entitled to a deduction for legal expenses?

Answer

No.

This ruling applies for the following period

Year ended 30 June 2010

The scheme commenced on

1 July 2009

Relevant facts

The arrangement that is the subject of the Ruling is described below. This description is based on the following documents. These documents form part of and are to be read with this description. The relevant documents are:

· the application for private ruling

· employment agreement, and

· Deed of Release.

You commenced employment with company A several years ago.

You were made redundant. The termination date was in the 2010 income year.

Prior to your redundancy you sought legal advice regarding ending or varying your existing employment agreement and the consequences of doing such.

Because your existing employment contract was so restrictive, a new contract which allowed you to obtain new employment without breaching the terms of your contract needed to be prepared.

Upon obtaining new employment and having to amend the new contract to allow certain clauses to enable you to work and avoid litigation, further legal costs were incurred.

0 you were then forced to defend your new employment contract, which incurred further legal fees.

Your solicitor helped you negotiate a Deed of Release which dealt with the cessation of your employment with company A and provided that some terms of your existing employment contract would cease to operate, while some would continue to operate.

In order for you to obtain new employment, the existing employment had to be brought to an end. The Deed provided for protection of reputation and outplacement services. There was negation about the existing contract's post employment restraint, which the Deed confirmed was preserved.

You sought to avoid dispute with company A under your employment contract with them which had some terms which continued to apply after termination of your employment. After seeking legal advice you made amendments to ensure that the new contract did not give rise to any breach of the existing company A contract.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

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.

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. 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.

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) 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) 11 ATR 276; 80 ATC 4542).

However, where the expenditure is incurred for the purpose of securing an enduring benefit, rather than a revenue purpose, the expenditure is capital in nature and is not deductible (Sun Newspapers Ltd v. FC of T (1938) 61CLR 337; 5 ATD 87; (1938) 1 AITR 403).

In FC of T v. Rowe (1995) 60 FCR 99; (1995) 31 ATR 392; 95 ATC 4691 (Rowe's case), the court accepted that legal expenses incurred in defending the manner in which a taxpayer performed his employment duties were allowable. The activities which produced the taxpayer's income were what exposed them to the liability against which they were defending themselves.

Defending a right to practice a profession or employment is capital in nature, as the right to practice is considered a structural asset and the associated expenses are incurred to protect this right (Case V140 88 ATC 874; AAT Case 4596 (1988) 19 ATR 3859 and Case X84 90 ATC 609; AAT Case 6258 (1990) 21 ATR 3721). As the nature of the expense follows the nature of the advantage sought, the expense is also capital in nature.

The expenditure must be related to the production of assessable income and not incurred at a point too soon to be deductible (FC of T v. Maddalena (1971) 45 ALJR 426; 2 ATR 541; 71 ATC 4161).

Taxation Ruling TR 2000/5 sets out the Commissioner's view of the application of section 8-1 of the ITAA 1997 to costs incurred by employees and employers in preparing and administering employment agreements. Employment agreements are a written, legal and binding confirmation of the employer/employee relationship (paragraph 11 TR 2000/5).

Paragraph three of TR 2000/5 states that the costs of changing the conditions of an existing employment agreement with the same employer - providing the existing agreement allows for it, are an allowable deduction. This would include the costs of representation.

A deduction is not allowable for the costs of drawing up an employment agreement with a new employer or costs of drawing up an employment agreement upon re-employment with an employer following termination of a fixed term employment contract where the agreement makes no provision for renewal or extension.

In your case, you incurred legal expenses in relation to the amending the terms of your employment agreement with company A. The agreement contained certain restrictions that applied to you after the termination of the agreement.

These restrictions related to the period after the termination of your employment with company A and as such are not directly related to your actual day to day employment duties carried out while employed with company A. Unlike the situation in Rowe's case, the activities to which the legal action was sought were not employment duties and did not arise as a consequence of the performance of your duties as General Manager when you were employed by company A. That is, the clauses of the employment agreement that you wanted amended did not relate to your employment duties with company A.

The Deed of Release is considered to be a new agreement rather than the renewing, extending or renegotiating of your employment agreement with company A. Your actions related to your future income earning activities after your employment with company A was terminated. As the Deed of Release is with your now previous employer and in relation to the termination restrictions of your employment contract, the expenses are not incurred in earning your assessable income with company A. Also, the legal expenses are incurred at a point too soon to be considered as being incurred in the production of assessable income with your new employer. Therefore, you are not entitled to a deduction for the legal expenses incurred under section 8-1 of the ITAA 1997.

Furthermore, your actions sought to bring into existence an advantage for the enduring benefit of your income earning activities. By changing the terms of your employment agreement with company A, it will allow you to derive assessable income in your new employment without breaching certain clauses. Therefore it is considered that your legal expenses relate to an asset or an advantage (tangible or intangible) for the enduring benefit of your right to carry out future income earning activities. The legal expenses are therefore capital in nature (British Insulated & Helsby Cables v. Atherton (1926) AC 205). As such no deduction is allowable under section 8-1 of the ITAA 1997.

Given regard to the full circumstances, it is considered that you incurred legal expenses in seeking to obtain an amended employment agreement with company A to ensure you could work without risk of litigation in new employment. As this action is seeking an enduring benefit, it is regarded as capital in nature. Accordingly no deduction is allowable for your legal expenses.