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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 2010

Year ended 30 June 2011

The scheme commences on:

1 July 2009

Relevant facts and circumstances

You were made redundant by your employer.

Prior to your redundancy, your employer changed the redundancy entitlements of employees in effect reducing the amount payable to long term employees who were made redundant.

At the time of the change, your employer re-issued employment contracts with the amended redundancy rules which you were asked to sign.

You felt theses changes disadvantaged you and refused to sign the new employment contract.

When you were advised your position was being made redundant, the redundancy calculation provided by your employer was in accordance with the new arrangements.

The new arrangements meant you would receive a reduction in entitlements.

You engaged a law firm to act on your behalf and they instituted proceedings against your employer to recover your entitlements.

After several meetings and negotiation between your solicitors and legal council for your employer an out of court settlement was paid to you.

The amount was an eligible termination payment (ETP).

You incurred legal expenses to obtain the payment.

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 an additional termination payment as the expenses are capital in nature.

Detailed reasons for decision

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 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 an additional termination payment. As the additional 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.