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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 2011

The scheme commenced on

1 July 2010

Relevant facts and circumstances

You left one employer and commenced employment with another.

Your former employer commenced legal action against you in relation to a certain matter.

In accepting new employment within some months of termination of your employment you were in direct breach of your ongoing contractual obligations.

You incurred legal expenses in relation to the action.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Section 8-1 of the Income Tax Assessment Act ITAA 1997 (ITAA 1997) allows a deduction for all losses and outgoings to the extent that they are incurred in gaining or producing assessable income, or necessarily incurred in carrying on a business for the purpose of 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 the settlement sum to constitute an allowable deduction, it must be shown that it was incidental or 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).

Also, in determining whether a deduction for the settlement sum 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 settlement sum follows the advantage that is sought to be gained by incurring the expenditure.

Therefore, payments as a result of legal action 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).

Similarly, in FC of T v. Rowe (1995) 60 FCR 99; (1995) 31 ATR 392; 95 ATC 4691, 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. No significance was placed by the court on the taxpayer's status as an employee.

In your case you were subject to the legal action in relation to activities you had undertaken which resulted in a breach of your employment contract with your previous employer. The activities to which the breach related were not employment duties and did not arise as a consequence of the performance of the taxpayer's duties from which they derived assessable income.

Accordingly, the legal fees incurred by you for breach of an employment contract are not deductible under section 8-1 of the ITAA 1997.