Edited version of private ruling

Authorisation Number: 1011751025303

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Ruling

Subject: legal expenses

Question 1

Are you entitled to a deduction for legal expenses to recover unpaid wages and annual leave?

Answer: Yes

Question 2

Are you entitled to a deduction for legal expenses to recover reimbursement of work expenses?

Answer: No

This ruling applies for the following periods:

Income year ended 30 June 2007

Income year ended 30 June 2009

The scheme commences on:

1 July 2006

Relevant facts and circumstances

You were a working director of a company.

You did not have a written contract of employment.

Your employment was terminated without notice and did not receive accumulated entitlements.

You commenced legal proceedings to recover unpaid wages, accrued annual leave and reimbursement of work expenses you incurred.

You have provided a copy of your Statement of Claim that states that you had a verbal employment agreement that included a payment of salary, superannuation, providing a car, reimbursement of expenses incurred in performance of your duties and four weeks pro rata annual leave. Your agreement could be terminated by either party giving reasonable notice to the other of their intentions.

Your employer made a counter claim against you.

The legal action was subsequently settled. You did not receive any unpaid pay or leave entitlements and expenses as a result of the settlement with both parties agreeing that the proceedings between them be struck out with each party bearing their own costs.

You have provided a copy of the terms of settlement.

You have provided a list of the legal expenses that you have paid.

Reasons for decision

Summary

You are entitled to a deduction for the legal expenses you incurred in relation to the recovery of your salary and annual leave as it is accepted these expenses were incurred in producing your assessable income.

However, you are not entitled to a deduction for the legal expenses that you incurred in relation to the reimbursement of the work expenses as these expenses were not incurred in producing your assessable income.

Detailed reasoning

Section 8-1 of the Income Tax Assessment Act 1997 (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 to the earning of exempt income.

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

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

Unpaid annual leave

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

However, unused annual leave (although acquired through personal services and thus characterised as ordinary income) is considered to be a form of statutory income under section 6-10 of the ITAA 1997.

Section 26AC of the Income Tax Assessment Act 1936 provides concessional tax treatment for unused annual leave received as a lump sum. Although the tax treatment of these amounts is different to salary and wages (including payments in respect of leave taken) earned during the course of employment, it does not alter the character of the payments as ordinary income.

Unpaid wages

Taxation Determination TD 93/29 states that where legal expenses are incurred in pursuing an amount of assessable income which is owed, such as salary and wages, those legal expenses are directly incurred in the process of deriving assessable income and therefore deductible.

Expenses not reimbursed

In Case W101 89 ATC 821; (1989) 20 ATR 3421 a taxpayer obtained a corporate credit card as required by his employer who directed him to charge to the credit card the air fares for three of the companies executives. Before the taxpayer could be reimbursed by the employer for these expenses the company went into receivership. The taxpayer initially resisted the attempts of the credit card company to recover the debt from him, but eventually paid the debt.

The Tribunal disallowed the deduction claimed by the taxpayer for the cost of legal expenses and for the amount of the credit card debt he was required to pay. The outgoings were held not to have been incurred in the course of gaining or producing the taxpayer's assessable income. Rather, it was held that the expense could be regarded as more in the nature of a loan to the company.

Your circumstances are similar here in that you personally incurred expenditure on behalf of your employer. These expenses were incurred to meet the general expenses of the employer and did not relate directly to the performance of your duties.

Therefore the legal expenses relating to the reimbursement of work expenses are not incurred in the process of deriving your assessable income and therefore not deductible.

Conclusion

In your situation, you incurred legal expenses to recover unpaid salary and wages, including unpaid annual leave. Accordingly you are entitled to a deduction for this portion of the legal expenses.

However in respect of the recovery of the expenses not reimbursed, you personally incurred expenditure on behalf of your employer to meet the general expenses of the employer and did not relate directly to the performance of your duties. Therefore the legal expenses relating to the reimbursement of work expenses are not incurred in the process of deriving your assessable income and are not deductible.