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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

You were dismissed by your employer for whom you had worked for over five years.

You took legal action for unfair dismissal seeking entitlements under the redundancy clause of your employment agreement.

Your claim relates to breaches of Sections 352 of the Fair Work Act 2009 (Temporary absence-illness or injury).

Your employment agreement sets out your entitlement to a redundancy payment.

The agreement also states the period for notice of termination does not apply in the case of dismissal for serious misconduct.

In the background contained in the Deed of Release it states that employment ceased due to your alleged performance and misconduct.

Settlement was agreed between yourself and your employer without any admission of liability.

In settlement, your employer agreed to pay an amount less taxation as an Employment Termination Payment (ETP).

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

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).

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 (the Herald and Weekly Times Case)) 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 80 ATC 4542; (1980) 11 ATR 276).

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.

Consequently, it is necessary to consider the reason for which your legal expenses were incurred.

In your case, you were dismissed by your employer and filed for unfair dismissal claiming your employer owed you entitlements under the redundancy clause of your employment agreement. You later withdrew your claim for unlawful termination.

Taxation Ruling TR 2000/5 sets out the Commissioner's view on the costs incurred in preparing and administering employment agreements. Paragraph 2 of this ruling provides that costs incurred by an employee that are associated with the settlement of disputes arising out of an existing employment agreement including the cost of representation are deductible.

The taxpayer in Romanin v. FC of T [2008] FCA 1532; 2008 ATC 20-055 (Romanin's case), was pursuing his entitlement under his employment contract to receive 12 months notice or payment in lieu after his employment was terminated on seven days notice. Had the taxpayer received the appropriate notice required under his contract, he would have worked out the 12 months and been assessed on that income.

The Federal Court held that the fact that the taxpayer recovered that income as a lump sum, which was then assessed as an eligible termination payment, did not change its character to one of a capital nature. The Tax Office accepts that the taxpayer was entitled to a deduction for the legal expenses because the occasion of the expenditure was the enforcement of his contractual entitlement as an employee to income (in the form of payment in lieu of notice). However, the deductibility of legal expenses incurred in obtaining such a payment will depend upon the particular circumstances of each case.

Legal expenses incurred to recover income payments such as were at issue in Romanin's case - that is, salary that would have been derived during the notice of termination period, had it been given - will be deductible, even if the receipt was paid as a lump sum and subject to assessment as an employment termination payment.

In your case, you sought entitlements stated in the redundancy clause of your agreement. That is, a redundancy. However, your employer claims you were dismissed because of misconduct. The issue of your position being redundant was not mentioned in the Deed of Release. Therefore, it cannot be said that you were pursuing entitlements under your employment agreement.

As the Deed of Release that you signed was not in respect of entitlements under your employment contract, but rather to bring all claims either you or your employer had, to an end, the decision in Romanin's case does not apply.

Unfair dismissal

Taxation Determination TD 93/29 provides the Commissioner's view on the deductibility of legal expenses incurred in relation to a wrongful dismissal action.  Paragraph 5 of TD 93/29 states that the expenses:

will be deductible to the extent to which they relate to a claim for items of a revenue nature such as unpaid salary or wages; but will not be deductible to the extent to which they relate to a claim for items of a capital nature such as damages for breach of contract of employment or for damages for wrongful dismissal.

The Courts, Boards and Tribunals 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. 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.

The deductibility of legal expenses incurred in relation to an action for unfair dismissal was considered in Case L26 79 ATC 126; 23 CTBR (NS) Case 32. In that case, the taxpayer was employed as a music teacher by the Commonwealth Teaching Service. She was dismissed from her employment as a school teacher on the ground that she could not control classes. She unsuccessfully appealed to the Disciplinary Appeal Board against her dismissal. The taxpayer claimed a deduction for her legal expenses in relation to the appeal. It was held that the expenditure was a necessary step prior to regaining income from the employment from which the taxpayer had been dismissed but it was not expenditure incurred in the course of gaining or producing such income. Thus, the expenditure was not deductible.

In the High Court decision in Federal Commissioner of Taxation v. Day [2008] HCA 53; (2008) 70 ATR 14; 2008 ATC 20-064, (Days case), Mr Day was charged with breaching the standards of conduct and failing to fulfil his duty as an officer. He was suspended without pay. It was found that the requisite connection with his assessable income was present and that he was exposed to the charges by reason of his office.

As highlighted in Day's case, the incurring of expenditure by an employee to defend a charge because it may result in dismissal may not be sufficient in every case to establish the necessary connection to the employment or service which is productive of income. Much will depend upon what is entailed in the employment and duties of the employee. Whether expenses are incurred in gaining or producing assessable income looks to the scope of the operations or activities and the relevance to any legal expenses incurred. The scope of a taxpayer's employment is a question of fact and degree.

The legal expenses in your case were not incurred in defending the way you carried out your employment duties. Rather, you withdrew your unfair dismissal claim and pursued a claim for a redundancy payment. Therefore, the expenses were incurred in relation to your termination. Consequently, Day's case does not apply.

Redundancy payments are treated as ETPs and subject to special tax treatment that may result in some or the entire amount being included in the taxpayer's 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 the assessable income of the taxpayer.

In your case, you incurred the legal expenses in order to obtain the ETP. Although the ETP may be included in the assessable income, the ETP retains its character as a capital receipt.

As the legal expenses were incurred in gaining a capital sum, they will also be of a capital nature and are therefore not deductible.