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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 were employed for a number of years.

You went on annual leave and long service leave at a time that was inconvenient to your employer.

Prior to going on this leave your employer advised you that your position would be replaced. Your employer advised that upon your return to work you would be employed under a different role part time.

Your employer advised that should you decide not to continue in this new role after returning from your leave he would pay you a period of notice.

While you were on leave a sum of money was paid into your bank account by your employer. You have since been made aware that this payment was for your existing annual and long service leave entitlements.

After this payment was made you received an email from your employer's solicitor advising that he had been instructed that you had resigned.

You emailed your employer's solicitor advising that you did not agree with what he proposed had been agreed.

You took the position that you had effectively been terminated and you believed that a sum of money was payable.

You attempted to enter into negotiations with your employer, and requested they pay you the amount they had offered to pay you should you choose not to take up the new role.

Your employer refused to enter into such negotiations.

You took private legal action. Your solicitors advised that you should receive a minimum compensation payment equivalent to five weeks pay.

An application was made to Fair Work Australia, claiming that your employer had unlawfully dismissed you for taking annual leave and discrimination.

A mediation meeting was held with Industrial Relations. Your employer did not offer any payment to you.

The Commissioner negotiated a taxable termination payment to be payed to you by your employer.

You accepted this offer rather than choosing to take the matter to court.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

Summary

The legal expenses you incurred are capital in nature and are therefore not deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997).

Detailed reasoning

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.

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). For legal expenses to constitute an allowable deduction, it must be shown that they were 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).

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

Taxation Determination TD 93/29 states that legal expenses relating to an action for wrongful dismissal are not deductible. The advantage sought in these cases relates to an enduring advantage that is of a capital nature.

A compensation payment made by an employer to a former employee in settlement of an unfair dismissal action qualifies as an eligible termination payment (ETP), as it is considered to be made 'in consequence of the termination of any employment of the taxpayer' (Taxation Ruling IT 2424, paragraph 24).  For this reason an ETP, whether it is made in one lump sum or through several amounts, is capital in nature.

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.

In your case, after your employment was terminated and negotiations with your employer were unsuccessful, you took legal action in relation to claims for unlawful dismissal and 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. Rather it related to the loss of your employment as a whole which is a matter of a capital nature.

You incurred legal expenses to secure a payment. 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 therefore not deductible under section 8-1 of the ITAA 1997.