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Ruling

Subject: Legal expenses

Question 1

Are you entitled to a deduction for legal expenses incurred for a claim of unfair dismissal?

Answer

No.

Question 2

Are you entitled to a deduction for interest and bank charges incurred on a line of credit established to pay your legal expenses?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 2002

Year ended 30 June 2003

Year ended 30 June 2004

The scheme commences on:

1 July 2001

Relevant facts and circumstances

The arrangement that is the subject of the private ruling is described below. This description is based on the following documents. These documents form part of and are to be read with this description. The relevant documents are:

· the application for a private ruling;

· the documents provided with the application for private ruling; and

· the documents provided in response to a request for further information.

You were employed by an organisation during the 2001-02 financial year.

Due to a medical condition, your day to day activities were hampered and you were no longer able to meet deadlines.

Separation from the organisation occurred during the 2001-02 financial year.

You commenced legal action for unfair dismissal against the organisation.

You were seeking reinstatement of your position on the grounds that you had been unfairly dismissed.

During the 2001-02 and 2002-03 financial year you incurred legal fees.

You established a line of credit in order to take pay the legal fees.

You have incurred interest, bank fees and other charges in relation to this credit.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1 and

Income Tax Assessment Act 1997 section 25-25.

Reasons for decision

Summary

Expenses are deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) if they are incurred in the course of gaining or producing your assessable income and are not of a capital or private nature.

The legal expenses you incurred in seeking reinstatement are considered to be incurred at a point in time too soon to be regarded as expenses incurred in the course of gaining or producing your assessable income. That is, the outlay was a necessary step prior to gaining or producing the income to be earned after reinstatement (if successful) but it was not an outlay incurred in the course of gaining or producing such income.

Also, the legal expenses are considered to be capital in nature. This is because the advantage sought in incurring the expenses was of a capital nature rather than of an income nature.  The purpose of the expenditure was to re-establish an income stream or for gaining an enduring benefit, that is, the reinstatement of your employment position.

The interest expenses you incurred are not deductible under section 8-1 of the ITAA 1997 as they are not considered to have been incurred in the course of gaining or producing your assessable income.

The bank fees and charges you incurred are not deductible under section 25-25 of the ITAA 1997 as the money borrowed was not used in the production of your assessable income.

Detailed reasoning

Legal expenses

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.

In determining whether a deduction for legal expenses is allowed 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.  For example, if the advantage to be gained is of a capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature. Therefore, to determine the deductibility of the legal expenses, it is necessary to consider the reason for which expenses were incurred. 

The Courts have consistently held that legal expenses incurred by taxpayers in seeking to regain their employment following dismissal are not deductible. The expenses have been incurred too early to be regarded as having been incurred in gaining or producing the taxpayers' income from that employment.

In Administrative Appeals Tribunal Case L26, 79 ATC 126; 23 CTBR (NS) Case 32 a teacher was denied a claim for legal expenses incurred in appealing against her dismissal from employment because she could not control classes.  It was found that the outlay was a necessary step prior to gaining or producing the taxpayer's income but it was not an outlay incurred in the course of gaining or producing such income. 

Taxation Determination TD 93/29 which considers the deductibility of legal expenses also states at paragraph 5:

...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, the legal costs would not be deductible because they are capital in nature. For example, legal expenses relating to an action for damages for wrongful dismissal are not deductible.

Accordingly legal expenses incurred in seeking reinstatement of employment are of a capital nature and, therefore, not deductible.  This is because the advantage sought in incurring the expenses is of a capital nature rather than of an income nature.  The purpose of the expenditure is to re-establish an income stream or for gaining an enduring benefit, that is, the reinstatement of the employment position.

In your case, following the dismissal from your employment, you lodged an unfair dismissal claim against your employer and incurred legal expenses to seek reinstatement of your position.  The legal expenses you incurred in seeking reinstatement are considered to be incurred at a point in time too soon to be regarded as expenses incurred in the actual course of gaining or producing your assessable income. Also, the legal expenses are capital in nature.

Interest expenses

Whether interest has been incurred in the course of producing assessable income generally depends on the use to which the borrowed funds have been put. The 'use' test, established in FC of T v Munro (1926) 38 CLR 153, is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion.

In your case you incurred interest expenses on a line of credit established to pay for legal expenses that are considered to be insufficiently connected to your income earning activities. Therefore, the interest expenses are not deductible under section 8-1 of the ITAA 1997

Borrowing expenses

Section 25-25 of the ITAA 1997 allows a deduction for expenditure incurred for borrowing money to the extent that the money is used for the purpose of producing assessable income.

The borrowing expenses you have incurred such as bank fees and charges relate solely to the line of credit established to pay your legal expenses. As stated previously the legal expenses are considered to be insufficiently connected to your income earning activities.

Therefore, the borrowing expenses are not deductible under section 25-25 of the ITAA 1997.

Additional Information

As the legal, interest and borrowing expenses you incurred are not deductible, the matter of carried forward losses is no longer applicable to your situation and therefore has not been considered.