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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 periods:

Year ending 30 June 2011

The scheme commences on:

1 July 2010

Relevant facts and circumstances

You commenced your employment under a X year Employment Agreement.

You were subjected to unfair treatment by your employer and became seriously ill.

You ceased working due to your illness but under a Deed of Settlement you later resigned.

You sought medical assistance.

Your statement of claim included:

· payment of the remainder of your fixed term contract

· payment of your statutory entitlements

· termination letter with acceptable terms to both parties.

· single point of contact in respect of prospective employers

· costs.

Solicitors on behalf of your employer were instructed to make a counter offered as follows:

· payment of X months salary in lieu of notice

· payment of any accrued but unused statutory entitlements

· termination of your employment.

You again instructed your solicitor to offer the following claim:

· payment of 12 months salary

· payment of accrued unused statutory entitlements

· termination letter to be provided to you with terms acceptable to both parties

· single point of contact in respect of prospective employers

· your willingness to enter into a Deed of Release with terms acceptable to both parties

· payments made to you within X week of executing the Deed of Release.

· payment of your costs.

You further instructed your solicitor to negotiate an acceptable settlement due to your continued medical condition and not being able to return to work.

You agreed to a Deed of Settlement to avoid a protracted court process due to your ill health that included:

· termination of your employment

· retainment of your mobile phone but returning your blackberry handset

· payment salary in lieu of notice on receipt of the above and execution of Deed of Settlement.

You are currently not employed and still receiving medical treatment and workers compensation for your workplace injury.

Your doctor has stated in a letter that you are unfit to continue work.

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.

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 CLR47; (1949) 4 AITR 236; (1949) 8 ATD 431).

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

In Romanin v. The Commissioner of Taxation [2008] FCA 1532; 2008 ATC 20-055

(Romanin Case), Mckerracher J held that legal expenses were deductible under section 8-1 of the ITAA 1997 if the proceedings were undertaken to enforce an entitlement to income that was contractually owed to the taxpayer; and the payment received was of an income nature and not of a capital nature.

Your situation can be distinguished from Romanin's case because your legal expenses were incurred seeking payment of the monthly salary amount for the full duration of the contract but, because of your illness, you could not complete the two year contract.

While it is accepted that your illness may have made it difficult, if not impossible to return to work, your contract was of two years and your employer had not terminated your employment. As such, the payment you sought was not for an existing entitlement. Rather, it is considered that the payment you sought represented what you felt you were entitled to because of the employer's behaviour toward you.

While it maybe argued that entering into a contract of employment has ultimately led to income being received, it cannot be said that the expenses were incurred to enforce an entitlement to that income. Rather, the expenses were incurred to procure an employment termination payment (ETP).

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 a payment is considered to be an ETP as it is a payment made in consequence of the termination of employment.

An ETP is defined as a payment made in respect of a taxpayer in consequence of the termination of any employment of the taxpayer, and includes bona fide redundancy payments and payments made under commercial separation agreements.

ETPs are subject to special tax treatment that may result in some or all of the amounts being included in assessable income. 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 assessable income.

As stated above, if the advantage to be gained from incurring legal expenses is of a capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature.

In your case, you were subjected to unfair treatment by your employer and as a result you became ill. You incurred legal expenses when seeking advice to continue your monthly payments under your employment contract.

The payment you received was made in termination of your employment and is capital in nature. As a payment in lieu of notice is a capital payment, the legal expenses you have incurred to obtain this payment are also capital in nature. Therefore, you are not entitled to claim a deduction under section 8-1 of the ITAA 1997.