Edited version of your private ruling

Authorisation Number: 1012027221489

This edited version of your ruling will be published in the public register of private binding rulings after 28 days from the issue date of the ruling. The attached private rulings fact sheet has more information.

Please check this edited version to be sure that there are no details remaining that you think may allow you to be identified. If you have any concerns about this ruling you wish to discuss, you will find our contact details in the fact sheet.

Ruling

Subject: Legal expenses and settlement

Question 1

Are you entitled to a deduction for legal expenses in relation to the defamation action and counterclaim?

Answer

No. 

Question 2

Are you entitled to a deduction for the settlement amount you were required to pay to your former employer?

Answer

No. 

Question 3

Are you entitled to a deduction for the interest on a loan to pay the settlement amount to your former employer?

Answer

No. 

This ruling applies for the following period

Year ended 30 June 2009

Year ended 30 June 2010

Year ended 30 June 2011

Year ended 30 June 2012

The scheme commenced on

1 July 2008

Relevant facts

You were an employee of your previous employer.

Your employment agreement stated if you left your employer, you could not use any information about clients gained in your employment in a similar field and you could not work in the field for a period of six months

You resigned from your position and commenced employment at another firm.

Six months after your resignation your previous employer issued and distributed a defamatory letter about your actions and behaviour throughout and after your employment with them.

You lodged a defamation claim in the Supreme Court.

Your former employer lodged a counter claim seeking damages for breaches of your employment contract.

An out of court settlement was reached whereby, among other things, you were required to pay your former employer an amount.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1 

Reasons for decision

Section 8-1 of the Income Taxation Assessment Act 1997 (ITAA 1997) allows a deduction for all losses and outgoings to the extent they are incurred in gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature.

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

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.

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; (1932) 39 ALR 46; (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) 49 FLR 183; (1980) 11 ATR 276; 80 ATC 4542).

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).

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.

However, there must be an evident connection between the expenditure in instituting the proceedings and the taxpayer's earning activities. Legal expenses are capital or private in nature where the legal action is taken to protect the taxpayer's personal good name and reputation (Case U102 87 ATC 621; AAT Case 72 (1987) 18 ATR 3515).

Defamation

In your case, your employer issued and distributed a defamatory letter about your actions and behaviour and they counterclaimed that you had breached your employment contract.

While it is accepted that the distributed letter may have damaged your reputation, the proceedings were not in defending your actions in carrying out your duties. Rather, the need for the action arose out of what you saw as damage to your reputation.

As legal expenses associated with protecting a taxpayer's good name and reputation are considered to be private or capital in nature, the expenses you have incurred are not an allowable deduction under section 8-1 of the ITAA 1997.

Settlement amount

You undertook activities which resulted in a breach of your employment agreement 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 your duties from which you derived assessable income.

The out of court payment settled in full any claims made by the former employer in relation to the clients. It thereby allowed you to continue to derive assessable income in the course of your current employment, bringing into existence an asset or an advantage (tangible or intangible) for your enduring benefit. The settlement amount and the legal expenses associated with the settlement are capital in nature (British Insulated & Helsby Cables v. Atherton (1926) AC 205). Therefore, the settlement amount and the associated legal expenses are not deductible under section 8-1 of the ITAA 1997.

Interest

Taxation Ruling TR 95/25 deals with the general principles governing deductibility of interest following the decision of the Full Federal Court in FC of T v. Roberts; FC of T v. Smith 92 ATC 4380; (1992) 23 ATR 494.

TR 95/25 provides that the deductibility of interest is determined by the use to which the borrowed money is put. The use test is the basic test for the deductibility of interest and looks at the application of the borrowed funds as the main criteria (Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153).

In your case, you took out a loan to pay the settlement amount to your former employer. As the use of the funds was for a capital purpose, interest on the loan is likewise capital in nature and is not deductible.