Edited version of your private ruling

Authorisation Number: 1011997295150

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Ruling

Subject: Legal expenses

Question

Are you entitled to a deduction for your legal expenses incurred as a result of action taken against your former employer?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 2009

Year ended 30 June 2010

Year ended 30 June 2011

The scheme commences on:

1 July 2008

Relevant facts and circumstances

You worked for a company for many years.

You went on paid sick leave due to health issues.

This continued up until your employment was terminated.

A few months after you were terminated you commenced legal action for claims of unlawful dismissal, breach of contract and age discrimination.

Various meetings and mediation sessions took place until an agreement was made that the company would pay you the sum of $XXX.

Upon acceptance of the $XXX, the company intended to withhold tax from the amount and treat it as an eligible termination payment (ETP).

The company initially withheld $XXX tax in their cheque dated XX/XX/XXXX. The cheque for $XXX was not cashed by you due to the amount of tax withheld.

You disputed the tax withheld component and additional mediation sessions were held to resolve the matter.

You eventually accepted the company's treatment of the payment; however you were still in disagreement regarding the amount of tax being withheld.

On XX/XX/XXXX, you received a cheque for $XXX. The amount of tax withheld from the payment was $XXX.

You accepted this payment, but were still not satisfied that the correct amount of tax had been withheld by the company.

You brought further claims before a Magistrate.

You contended that the tax payable should be nil as the settlement was for pain and suffering as well as loss and as such should not be taxed.

Alternatively, as you were dismissed as being redundant you contended the payment should be included as part of your redundancy.

The Magistrate found that the amount paid by the company was for making you redundant. The amount of tax withheld from the $XXX was reduced to $XXX.

You received an additional payment of $XXX as ordered by the Magistrate.

You incurred and paid legal expenses.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1.

Reasons for decision

Summary

You are not entitled to a deduction for the legal expenses you incurred in securing a payment of $XXX from your former employer as the expenses are capital in nature.

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 CLR 47; (1949) 4 AITR 236; (1949) 8 ATD 431).

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.

An eligible termination payment (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.

An ETP is capital in nature because it is a payment made to compensate for the loss of the employment position (Case Y24 91 ATC 268; AAT Case 6942 (1991) 22 ATR 3184). 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 expense incurred in gaining the advantage will also be of a capital nature.

In your case you incurred legal expenses to secure a payment of $XXX. The Magistrate found that the amount paid by your former employer was for making you redundant. As this payment is an ETP, and was paid to compensate for the loss of your employment position, it is considered to be capital in nature. For this reason, the legal expenses at issue would also be considered to be capital in nature. The legal expenses are not, therefore, deductible under section 8-1 of the ITAA 1997.

Your contentions

It was noted that in your application for private ruling you claimed that ATO Interpretative Decision 2001/549 supports your view that the legal expenses are deductible. The ATO ID states:

Legal expenses are deductible provided the legal action:

· arose out of, or concerns the day to day income producing activities of the taxpayer (The Herald and Weekly Times Ltd v. FC of T (1932) 48 CLR 113)

· is not undertaken to protect the taxpayer's profit-yielding subject

· have more than a peripheral connection to the taxpayer's business (Magna Alloys and Research Pty Ltd v. FC of T (1980) 11 ATR 276; 80 ATC 4542; Putnin v. FC of T (1991) 21 ATR 1245; 91 ATC 4097)

· may arise out of litigation concerning the taxpayer's professional conduct (Magna Alloys and Research Pty Ltd v. FC of T (1980) 11 ATR 276; 80 ATC 4542; Putnin v. FC of T (1991) 21 ATR 1245; 91 ATC 4097)

When the principal reason for incurring the legal expenses is defending the actions of the taxpayer in carrying out their employment duties through which they gain or produce assessable income, such expenses are characterised as being of a revenue nature and are deductible (Inglis v. FC of T 87 ATC 2037; and Case V116 88 ATC 737; AAT Case 4502 (1988) 19 ATR 3703).

In your case, after your employment was terminated you took legal action in relation to claims for unlawful dismissal, breach of contract and age discrimination. It is not considered that the legal action arose out of your day to day income producing activities or that you were defending the manner in which you carried out your employment duties. That is, the legal action was not in relation to the day to day aspects of your employment; rather it related to the loss of your employment as a whole which is a matter of a capital nature.

Taxation Determination TD 93/29 states that:

…if the legal action goes beyond a claim for a revenue item such as wages, and constitutes an action for breach of the contract of employment where the essential character of the advantage sought relates to an enduring advantage that is of a capital nature, the legal costs would not be deductible. For example, legal expense relating to an action for damages for wrongful dismissal are not deductible.

As the legal action you took related to matters that were capital rather than revenue in nature, the legal expenses are not deductible.