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Ruling

Subject: Deductibility of legal expenses

Questions and answers

Is the settlement payment made to you pursuant to a Deed of Release (the Deed) an employment termination payment (ETP) under section 82-130 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Yes.

Is any part of the payment received by you on termination of employment a transitional termination payment as defined in section 82-10 of the Income Tax (Transitional Provisions) Act 1997?

No.

Are you entitled to a deduction for legal expenses you incurred in relation to your claim to recover the balance of the taxable component of the severance amount?

Yes.

This ruling applies for the following period:

Year ended 30 June 2012

The scheme commenced on:

1 July 2011

Relevant facts and circumstances

You commenced employment with the Employer several years ago.

You were not made redundant by the Employer. On or in the 2011 income year, you resigned from your employment with the Employer.

You sought legal advice in relation to the interpretation of an ambiguous clause in your employment contract regarding his termination payout.

When your resignation took effect you claimed certain entitlements consequently arising from the contract, including a sum of money.

You did receive an ETP.

The Employer has disputed, and continues to dispute, your entitlement to the severance amount.

You took legal action against the Employer to claim recovery of the balance of the severance amount together with damages for loss of use of the severance amount.

You and the Employer have agreed to resolve the action and to compromise the amount of severance amount due and payable. A Deed of Release (the Deed) was executed in the 2012 income year.

Under the Deed, the Employer will pay to you a gross sum inclusive of costs in satisfaction of the claims in the action.

The Employer will provide to you a pre-payment statement within the meaning and for the purposes of section 82-10E of the Income Tax (Transitional Provisions) Act 1997 to enable payment of a specified sum as a directed termination payment.

In the 2012 income year, the Employer made a directed termination payment to your superannuation fund. The balance was made directly to you.

You incurred legal fees.

The market value of the motor vehicle (MV) provided for your use under the Agreement was included in the settlement amount.

Relevant legislative provisions:

Income Tax Assessment Act 1997 Section 8-1.

Income Tax Assessment Act 1997 Section 995-1.

Income tax Assessment Act 1997 Section 82-130.

Income tax Assessment Act 1997 Section 82-135.

Income tax Assessment Act 1997 Section 82-140.

Income tax Assessment Act 1997 Section 82-145.

Income tax Assessment Act 1997 Section 82-155.

Income Tax (Transitional Provisions) Act 1997 Section 82-10.

Reasons for decision

Employment termination payment (ETP)

An ETP, where the payment is made during the life of a taxpayer, is known as a life benefit termination payment (subsection 82-130(2) of the ITAA 1997).

Section 995-1 of the ITAA 1997 states that employment termination payment has the meaning given by section 82-130.

Subsection 82-130(1) of the ITAA 1997 states:

A payment is an employment termination payment if:

(a) it is received by you:

(i) in consequence of the termination of your employment; or

(ii) after another person's death, in consequence of the termination of the other person's employment; and

(b) it is received no later than 12 months after the termination (but see subsection (4)); and

(c) it is not a payment mentioned in section 82-135.

All of the conditions set out in subsection 82-130(1) of the ITAA 1997 must be satisfied for the payment to be considered an ETP.

(a) payment is made in consequence of the termination of employment

In your case, the payment was made in consequence of your termination of employment. The payment would not have been made had there been no termination of employment. The termination of employment and the payment are all intertwined and connected. If not for the termination of employment, the issue of paying a lump sum would not have arisen.

The payment was therefore made in consequence of the termination of your employment.

(b) payment received more than 12 months after termination

The settlement sum must be received within 12 months of the employee's termination of employment. However, subsection 82-130(4) of the ITAA 1997 provides that the 12 month rule does not apply if a determination under subsection (5) or (7) is made.

Subsection 82-130(7) of the ITAA 1997 provides that the Commissioner may determine, by legislative instrument that the 12 month rule will not apply to a class of payments or a class or recipient. The Commissioner has issued legislative determination SPR 2007/1 which states that the 12 month rule will not apply where:

· legal action commenced within 12 months of the termination; or

· the payment was made by a liquidator, receiver, receiver/manager or trustee in bankruptcy provided they were appointed within 12 months of the termination.

The settlement payment was made more than 12 months after your termination of employment. However, legal action was commenced within 12 months of your termination of employment.

The conditions for the payment to be viewed as a late termination payment are satisfied.

(c) not a payment mentioned in section 82-135 of the ITAA 1997

In your case, the facts show that the payment (an undissected lump sum) did not include any of the payments mentioned in section 82-135 of the ITAA 1997 which would preclude any part of the payment from being an ETP.

Therefore, as all the conditions under subsection 82-130(1) of the ITAA 1997 have been satisfied, the settlement amount made, or to be made, under the Deed is an ETP.

Transitional termination payment

A life benefit termination payment (LBTP) made between 1 July 2007 and 30 June 2012 may be a transitional termination payment under section 82-10 of the Income Tax (Transitional Provisions) Act 1997 (IT(TP)A).

Subsection 82-10(1) of the IT(TP)A states:

This Division applies in relation to a life benefit termination payment received by you on or after 1 July 2007 if:

(a) the payment is received by you because you are entitled to it under a written contract, a law of the Commonwealth, a State, a Territory or another country, an instrument under such a law, a collective agreement within the meaning of the Fair Work (Transitional Provisions and Consequential Amendments) Act 2009 or an AWA within the meaning of that Act; and

(b) the entitlement is provided for under that contract, law, instrument or agreement as in force just before 10 May 2006.

In the current case, you will be entitled, on termination of employment, to a payment, a LBTP, in accordance with your employment contract with the Employer.

Contract in force before 10 May 2006

Paragraph 82-10(1)(b) of the IT(TP)A requires that 'the entitlement is provided for under that contract, law, instrument or agreement as in force just before 10 May 2006'. Furthermore, subsection 82-10(3) provides that the division applies to a payment only to the extent that the contract in force just before 10 May 2006 specifies the amount of the payment, or a way to work out a specific amount of the payment.

You had a written employment contract with the Employer that was in place prior to 10 May 2006.

Your employment was terminated by your resignation. At that time, certain payments were made to you in consequence of that termination of employment.

However, due to the interpretation of an ambiguous clause in your employment contract regarding the entitlement to a payment described as 'Redundancy Pay', you commenced legal action against the Employer. The Employer countered by claiming if you was entitled to the 'Redundancy Pay', then he became disentitled to it or obliged to repay it to the Employer by reason of breach of fiduciary duty and misleading or deceptive conduct.

You and the Employer agreed to resolve the action and to compromise on the amount due and payable. As a result, the Deed was executed.

It is clearly evident that, by signing the Deed, both parties intended that the payment received by you:

· was to be determined by the terms and conditions of the Deed; and

· represented the full and final satisfaction of all claims by you in respect of the contract, the employment and the termination of employment.

Therefore, the payment received by you was not made in relation to 'a contract, law, instrument or agreement as in force just before 10 May 2006'. It was provided for in the Deed which supersedes any prior understanding or agreement.

Therefore, the settlement payment is not a transitional termination payment for the purposes of section 82-10 of the IT(TP)A.

Directed termination payment

A payment is a directed termination payment if an individual chooses within 30 days of receiving a pre payment statement from the payer to direct a transitional termination payment or part of it on the individual's behalf to a complying superannuation plan or to purchase a superannuation annuity.

In this case, as determined above, the payment is not a transitional termination payment and therefore it cannot be a directed termination payment as required under section 82-10F of the IT(TP)A.

As the payment received by you is not a transitional termination payment you cannot rollover the payment into a superannuation fund as a directed termination payment.

Although the payment cannot be rolled over as a directed termination payment you can still make the payment into a superannuation fund as a non--concessional contribution.

It is noted that you had directed that the ETP be paid into his superannuation fund. This amount should be recorded by the trustee of superannuation fund as a non-concessional contribution.

Tax treatment of the settlement payment as an LBTP

An ETP will be comprised of the following components:

· Tax free component - this includes an invalidity segment (if any) and/or a pre-July 83 segment (if any); and

· Taxable component - the amount remaining after deducting the tax free component.

The tax free component is not assessable income and is not exempt income.

The taxable component is included, in full, as assessable income.

You commenced employment with the employer on after 1 July 1981. Accordingly the period of employment to which the settlement payment relates commenced prior to 1 July 1983. Hence, the LBTP contains a pre-July 83 segment within the meaning of section 82-155 of the ITAA 1997. As you resigned from his employment there will not be an invalidity segment within the meaning of section 82-150.

Deductibility of legal expenses

Broadly, 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 to the extent 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. If the advantage to be gained is of a revenue nature, then the expenses incurred in gaining the advantage will also be of a revenue nature.

It follows also that the character of legal expenses is not determined by the success or failure of the legal action.

The question of deductibility of legal expenses under section 8-1 of the ITAA 1997 to enforce a contractual entitlement to a lump sum payment in lieu of notice was considered in Romanin v. Commissioner of Taxation [2008] FCA 1532; 2008 ATC 20-055; (2008) 73 ATR 760.

In that case, McKerracher J held, at FCA paragraph 52, in terms of positive limb nexus:

In my view, the requisite connection exists between the outgoing claimed (legal expenses) and the incurrence of assessable income. On this point, I accept Mr Romanin's submission that he pursued proceedings in the Commission to obtain income that was contractually owed to him and that the costs incurred in doing so are deductible under s8-1(1) of the ITAA.

In terms of the negative limbs, McKerracher J held, at FCA paragraph 56, that:

It is true that payment was for a lump sum in lieu of 12 months income (less other income received) but the amount was described in the orders pursuant to the Commission's judgment as remuneration, was computed by reference to his entitlement to income, was set off against other income actually earned and is a financial reward for exertion that would have been carried out had his employment not been (invalidly) terminated. Income is of course received by people and entities in a variety of ways. The payment in a lump sum of the sum which would otherwise be income by way of regular payments, does not of itself, in my view change the character of the payment.

That is, the character of the advantage sought was held to be on revenue rather than capital account.

Therefore, in your circumstances, the same conclusion follows. That is, your legal expenses in enforcing payment of their contractual entitlement to payment in lieu of notice are outgoings with nexus to assessable income and where the character of the advantage sought is on revenue account.

The legal expenses are therefore deductible under section 8-1 of the ITAA 1997.

Please note that you can only have a deduction to the extent that it relates to assessable income. As you received a tax-free component and a taxable component in your settlement sum, you can only have a deduction in relation to the amount of the taxable component received.