Edited version of private ruling

Authorisation Number: 1011833471050

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Ruling

Subject: Income-salary sacrifice

Question 1:

Can unpaid accrued leave entitlements which are paid by your former employer form part of an effective salary sacrifice arrangement (SSA)?

Answer: No.

Question 2:

Can payments for in lieu of notice and redundancy paid by your former employer form part of an effective SSA?

Answer: No.

Question 3:

Are you entitled to a deduction for your legal expenses incurred in relation to the payment made in lieu of notice?

Answer: No.

Question 4:

Are you entitled to a deduction for your legal expenses incurred in relation to an order to preserve your salary entitlements?

Answer: Yes.

Question 5:

Are you entitled to a deduction for your legal expenses incurred in relation to the redundancy payment?

Answer: No.

Question 6:

Are you entitled to a deduction for your legal expenses incurred in relation to your unfair dismissal claim?

Answer: No.

Question 7:

Are you entitled to a deduction for your legal expenses incurred in relation to your unpaid leave entitlements?

Answer: Yes.

Question 8:

Are you entitled to a deduction for your legal expenses incurred in relation to your unpaid superannuation entitlements?

Answer: No.

This ruling applies for the following period:

Year ending 30 June 2011

The scheme commenced on:

1 July 2010

Relevant facts:

The arrangement that is the subject of the private 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:

· a private ruling application

· an employment agreement

· letters from your former employer

· a deed of settlement

· a payment schedule

· letters from your solicitor

· an application for a general protection dispute

· a number of emails

· an application for Unfair Dismissal Remedy

· statements of account from your solicitors

· a trust account receipt

· a letter from your accountant.

You commenced employment with your former employer a number of years ago.

You and your former employer had agreed verbally to salary sacrifice your leave entitlements.

Your employment agreement with your former employer stated an amount of salary was to be salary sacrificed.

You employment agreement does not state that your leave entitlement were to be salary sacrificed.

Your employer requested you take a reduction in wages.

You lodged a protection order with a tribunal to deal with a General Protection Dispute.

You were dismissed from your employment.

You received some of your entitlements on termination of your employment.

You engaged solicitors to undertake legal action and lodged a claim for unfair dismissal.

In undertaking the legal action you were seeking to recover your entitlements in accordance with you employment contract.

You also sought to recover number of weeks pay in lieu of notice.

You were entitled to two weeks pay in lieu of notice upon termination of your employment under you employment contract.

You signed a deed of settlement with your former employer and you were awarded further payments of your entitlement including a redundancy payment and additional payment on lieu of notice.

Under the term of the deed of settlement your former employer was to pay an amount as salary sacrifice.

You do not have professional indemnity insurance.

You were not reimbursed for any legal expenses.

You will not be seeking and have not sought, to recover any legal or other costs from any other party.

You do not have a copy of the SSA agreement with your former employer or emails confirming the terms of the agreement to salary sacrifice your leave entitlements.

Relevant legislative provisions:

Income Tax Assessment Act 1936 section 23L.

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 6-10

Income Tax Assessment Act 1997 subsection 6-15(2)

Income Tax Assessment Act 1997 section 8-1.

Reasons for decision

Section 6-5 of the Income Tax assessment Act (ITAA 1997) provides that the assessable income of an Australian resident includes the income according to ordinary concepts (ordinary income) which is derived during the income year.

Subsection 6-10(2) of the ITAA 1997 provides that an amount is statutory income if it is not ordinary income but is included in assessable income by a provision of the Income Tax Assessment Act 1936 (ITAA 1936) or the ITAA 1997.

Salary and wages received for the rendering of services are considered assessable income under section 6-5 of the ITAA 1997.

However, subsection 6-15(2) of the ITAA 1997 operates to exclude from assessable income those amounts that are made exempt by a provision of tax law. In the case of benefits provided under an 'effective' SSA, section 23L of the Income Tax Assessment Act 1936 (ITAA 1936) provides that income which is regarded as a fringe benefit is not assessable income.

The Commissioners view on the taxation and superannuation implications of SSAs is discussed in Taxation Ruling TR 2001/10 Income Tax: fringe benefits tax and superannuation guarantee: salary sacrifice arrangements.

This ruling defines a SSA to mean an arrangement under which an employee agrees to forgo part of his or her total remuneration that he or she would otherwise expect to receive as salary or wages, in return for the employer or someone associated with the employer providing benefits of a similar value. If the salary sacrifice is effective, the employee will only be liable for income tax on the reduced salary and that the employer is liable to pay fringe benefits tax, if any, on the benefits provided.

There are two types of SSAs:

1. Effective SSA -an effective SSA involves the employee agreeing to receive part of his or her total amount of remuneration as benefits before the employee has earned the entitlement to receive that amount as salary or wages.

2. Ineffective SSA -an ineffective SSA involves the employee directing that an entitlement to receive salary or wages that has been earned is to be paid in a form other than as salary or wages.

It can be seen from the above that an SSA requires a contractual relationship between an employer and an employee and is required prior to services being performed. The employment contracts may be amended during the course of an employee's employment to reflect changes made to employment conditions and remuneration arrangements.

The requirements for an effective salary sacrifice arrangement are:

1) There is an agreement between you and your employer.

2) The arrangement must be made before you are entitled to payment.

3) There must be no access to the sacrificed salary.

Whether an effective SSA exists is a question of fact to be determined by reference to all the facts of the particular case.

In respect of salary sacrificing leave entitlements paragraphs 89 to 92 in TR 2001/10 states the following:

SSAs that involve leave entitlements

89. Once an employee has completed the relevant qualifying period of employment and has an entitlement to take annual leave, long service or sick leave, the employee has an entitlement to be paid salary or wages. An entitlement to take leave is synonymous with an entitlement to be paid salary or wages because the employee has done everything necessary, apart from taking the leave, to be entitled to be paid.

90. It then follows that a SSA exchanging an entitlement to take leave that is accruing, or that has accrued, for past services performed in return for benefits is ineffective. Benefits paid under an ineffective SSA are payments of salary or wages and form part of the employee's assessable income under section 6-5 or 6-10 of the ITAA 1997.

91. We recognise that a SSA exchanging any expected entitlement to leave that will accrue for future services rendered in return for benefits will be effective. While benefits provided under an effective SSA may be derived as ordinary or statutory income by the employee (see paragraph 28 above), the income is exempt because of the operation of section 23L of the ITAA 1936.

92. Whether the conditions necessary for the taking of leave have been met is a question of fact. Statute, award conditions, individual contracts, enterprise workplace agreements or similar agreements may be relevant to determining whether the conditions have been met. Where there is a lengthy qualifying period which must be completed before any entitlement to leave accrues (as is generally the situation for long service leave entitlements), until that qualifying period has been completed, the conditions have not been met. Most employees must complete a minimum period of service before any entitlement to long service leave accrues. If the employee terminates employment prior to completing the required minimum period of service, the employee has no enforceable right to payment in lieu of long service leave. Some employees' employment conditions give a pro rata entitlement to be paid salary or wages once a lesser period of service has been completed, if employment terminates after that lesser period but before the full qualifying period. An employee who has not completed sufficient service to be entitled to take long service leave or receive a pro rata entitlement of salary or wages on termination of employment can enter into an effective SSA. Once the conditions for taking long service leave have been met, the employee can only enter into an effective SSA in respect of future entitlements to take long service leave.

Entitlement to annual leave and long service leave are based on employment services already provided thus attempting to sacrifice annual leave and long service leave do not satisfy the essential qualification of prospectivity of an effective SSA.

If a SSA was entered into to apply to leave that will accrue in the future, it will constitute an effective SSA (that is, if the SSA arrangement entered into prior to the unused annual leave and long service leave clearly specify that future leave entitlements that will accrue can be salary sacrificed).

In your case, you commenced your former employment a number of years ago. You employment agreement states that an amount of your salary would be salary sacrificed. We acknowledge that there was a verbal agreement between your former employer in regards to what entitlements may have been subject to SSA. However, there is no supporting documentation as to what leave entitlements were agreed to be salary sacrificed between you and your former employer.

A review of your employment contract in regards to your entitlements does not indicate what amounts were to be salary sacrificed. The deed of settlement indicates that an amount is to be paid into salary sacrifice by way of direct deposit. However it does not identify which entitlement or the amount of your entitlements were to be paid. The salary sacrificing of your leave entitlements or other payments after they have accrued in not considered an effective SSA.

In Heinrich v FC of T 2011 AATA16 the taxpayer was employed in the aviation industry and had his remuneration packaged in a "salary sacrifice" arrangement, that is, the first $2,000 of his fortnightly remuneration entitlement was paid into a superannuation fund. When the parties entered into the agreement to forgo salary in exchange for superannuation contributions they did not specifically agree to forgo annual and long service leave entitlements. The taxpayer's employment ended on medical grounds whereupon he received a payment in respect of his unused annual and long service leave entitlements.

The taxpayer subsequently sought a ruling that part of the payment he received be treated as it would have been treated had his salary sacrifice arrangement continued. The Commissioner ruled unfavourably, determining that the payments were properly assessable under s 83-10 of the ITAA 1997 for the unused annual leave and s 83-80 of the ITAA 1997 for the unused long service leave.

The taxpayer then sought review by the AAT. The AAT held that the payment of unused annual leave and long service leave entitlements following the termination of a taxpayer's employment was not covered by an effective salary sacrifice agreement. The AAT held that once the conditions for the taxpayer's entitlement to the payments had been satisfied, the amounts were the taxpayer's assessable income as unused leave payments under sections 83-10 and 83-80 of the ITAA 1997.

Similarly in your case there is no effective SSA as there is no evidence to support that you and your former employer agreed to salary sacrifice your leave or any other entitlements under your employment agreement. We acknowledge your argument that that leave entitlements are salary and wages. However for these entitlements to be salary sacrificed there must be an agreement specifically stating what leave entitlements are to be salary sacrificed before they accrue in the future. The Commissioner has no discretion or power to treat the payments of leave or any other payments other than assessable income when derived.

Therefore your leave entitlements and other payments made by your former employer are included in your assessable income as either ordinary or statutory income as the entitlements are not regarded as fringe benefits.

Legal expenses

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 to the earning of exempt income.

For legal expenses to constitute an allowable deduction it must be shown that they were incidental and relevant to the production of the taxpayer's assessable income (Ronpibon Tin NL & Tong Kah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 4 AITR 236; (1949) 8 ATD 431).

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 (the Herald and Weekly Times Case) 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 80 ATC 4542; (1980) 11 ATR 276).

The nature of the expenditure must also be considered (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 8 ATD 190). The nature or character of the legal expense 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 expense incurred in gaining the advantage will also be of a capital nature.

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

Consequently, it is necessary to consider the reason why your legal expenses were incurred. The nature of each of the advantage sought from your legal proceedings is considered below.

Payment for in lieu of notice

A lump sum payment in lieu of notice is considered to be a capital amount paid as compensation for the loss of the means of producing income (Scott v. Commissioner of Taxation (1935) 35 SR (NSW) 215; (1953) 3 ATD 142). Such an amount is considered to be an employment termination payment (ETP) as it is a payment made in consequence of the termination of employment.

An ETP, including a lump sum payment in lieu of notice is included in assessable income under specific provisions 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 assessable income of the taxpayer.

Taxation Ruling TR 2000/5 sets out the Commissioners view on the costs incurred in preparing and administering employment agreements. Paragraph 2 of this ruling provides that costs incurred by an employee that are associated with the settlement of disputes arising out of an existing employment agreement including the cost of representation are deductible.

In Romanin V Federal Commission of Taxation [2008] FCA 1532 (Romanin's case) the taxpayer was entitled to a deduction under section 8-1 for the legal expenses he incurred because the Court found that the occasion of the expenditure was the enforcement of the taxpayer's contractual entitlement as an employee to income (in the form of payment in lieu of notice).

The legal expenses were found not to be capital in nature because the character of the advantage which the taxpayer sought in bringing the proceedings was on revenue account, namely receipt of his contractual entitlement to salary he would have received had he been given 12 months notice.

Your case can be distinguished from Romanin's case in that under your employment agreement you are only entitled a payment for two weeks in lieu of notice which has subsequently been paid by your former employer. Your claims for a further payments of salary in lieu of notice is considered compensation for the loss of the means of producing income and are therefore capital in nature.

Therefore, those legal expenses in relation to seeking the payment in lieu of notice are not deductible under section 8-1 of the ITAA 1997.

Protection order

A review of the relevant legislation covering the protection order and your protection order application indicated that legal expenses were incurred in trying to resolve a dispute with your employer in relation to your existing employment contract and the entitlement to income paid under your former employment contract. The legal cost incurred in relation to lodging the protection order to preserve your salary is not capital in nature and is deductible under section 8-1 of the ITAA 1997.

Redundancy payment and unfair dismissal claim

A termination payment (redundancy payment), being compensation for the loss of the expectation of continuity of service, is a payment that is capital in nature. Such a payment is made to compensate you for the loss of an employment position and is regarded as an affair of capital (Case Y24 91 ATC 268; AAT Case 6942 (1991) 22 ATR 3184).

The redundancy payment on termination is not considered to be a payment in lieu of notice as in Romanin's case.

The redundancy payment upon termination that you sought is regarded as compensation for loss of your employment, and is capital in nature. Although an employment termination payment is subject to special tax treatment that results in the amount being included in your assessable income, this does not change the character of the payment.

As the nature of your redundancy payment is capital in nature, the associated legal expenses are also considered to be capital in nature and therefore not deductible under section 8-1 of the ITAA 1997.

Similarly, as highlighted in Taxation Determination TD 93/29, legal expenses relating to an action for wrongful dismissal is capital in nature and not deductible.

Leave entitlements

Legal expenses incurred in order to obtain unused annual leave or long service and sick leave generally results in the taxpayer gaining assessable income. Therefore there is a clear connection between the assessable income and the expenses incurred. Furthermore the expenses are not in respect of income that is capital, private or domestic in nature.

Accordingly, the legal expenses incurred in gaining your assessable leave entitlements are deductible under section 8-1 of the ITAA 1997.

Superannuation contribution

Mandatory employer superannuation contributions do not form part of your assessable income. They are paid as a requirement of the Superannuation Guarantee (Administration) Act 1992. Although you may have suffered a loss as a result of the non-payment of these contributions, the loss cannot be said to be a loss or outgoing incurred in order to earn your assessable income. The amount of your assessable income is not affected by the non-payment of employer's superannuation contributions.

Part of your legal costs related to recovering unpaid superannuation contributions. As the superannuation contributions are not considered part of your assessable income it cannot be said that the legal expenses were incurred in the process of deriving assessable income. As such you are not entitled to a deduction under section 8-1 of the ITAA 1997 for the associated legal expenses.

Apportionment of expenses

As your legal expenses relate to both deductible and non-deductible amounts, a reasonable apportionment is required to determine the portion of the legal expenses that are deductible. Paragraph 7 of TD 93/29 states that:

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.

You should apply the above principles in determining the portion of the legal expenses allowable that relate to the claims as noted above.