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Ruling

Subject: Employment termination payment and legal expenses

Questions

1. Is the payment made by your client's former employer on termination of your client's employment?

2. Is the payment of legal expenses incurred to secure the termination payment allowable as a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answers

1. Yes.

2. No.

This ruling applies for the following periods:

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 and circumstances

Your client is over 55 years of age.

Your client commenced employment with an entity (Entity 1) during the 2001-02 income year.

During 200X there were various allegations of inappropriate behaviour made against your client which resulted in them being suspended on full pay whilst investigations into the allegations were undertaken.

Your client returned to work for a short period of time before being suspended once again on full pay after more allegations were made against them.

During the 200Y-0X income year your client was informed that they were unable to be placed in a suitable position and were advised that there will be no objection if your client took unpaid leave and commenced work elsewhere.

During the 200Y-0X income year your client commenced employment with another entity (Entity 2).

As a result of a disciplinarily penalty imposed against your client, their employment was terminated during the 200X-0Z income year.

Shortly after, your client lodged an application seeking reinstatement to his former position.

Your client incurred the following legal expenses in relation to this action:

· 2008-09 income year - A

· 2009-10 income year - B

· 2010-11 income year - C

· 2011-12 income year - D

The decision handed down by the relevant state Industrial Relations Commission in response to this application found that the disciplinarily process undertaken in relation to your client's dismissal was unjust and that compensation was the appropriate remedy.

It was further stated that your client's continuing loss for their unjust dismissal was significant and therefore the maximum compensation allowable under the Act was awarded; being six months pay.

Your client received a payment of X during the 2010-11 income year. This amount had tax withheld from it at a rate of 38%.

You have stated that as your client had reached their preservation age at the time the payment was made, the tax withheld should have been at a rate of 15%.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subsection 83-175(1)

Income Tax Assessment Act 1997 Section 83-175.

Income Tax Assessment Act 1997 Paragraph 83-170.

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

Summary

The compensation payment received by your client is an employment termination payment as all the conditions have been satisfied. It is assessable in the year in which it was paid; being the 2010-11 income year. As your client was over the preservation age at the date of payment, the concessional tax rate of 15% applies to the employment termination payment.

You client is not entitled to claim a deduction for legal expenses they incurred because they are considered to be capital in nature.

Detailed reasoning

Employment termination payment

Section 995-1 of the Income Tax Assessment Act 1997 (ITAA 1997) states that:

employment termination payment has the meaning given by section 82-130.

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

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 (discussed below)

The above three conditions need to be satisfied in order for the payment to be treated as an employment termination payment.

Failure to satisfy any of the three conditions will result in the payment not being considered an employment termination payment.

Termination of employment

The phrase 'in consequence of termination of employment' in subparagraph 82-130(a)(i) of the ITAA 1997 above is not defined in the legislation. However, the courts have considered the meaning of the words 'in consequence of' in relation to eligible termination payments (ETPs), the predecessor of employment termination payments.

Of note are the decisions made by the Full High Court in Reseck v. Federal Commissioner of Taxation (1975) 49 ALJR 370; (1975) 6 ALR 642; (1975) 5 ATR 538; (1975) 75 ATC 4213; (1975) 133 CLR 45 (Reseck) and the Full Federal Court in McIntosh v Federal Commissioner of Taxation (1979) 25 ALR 557; (1979) 10 ATR 13; (1979) 45 FLR 279; (1979) 79 ATC 4325 (McIntosh).

Suffice it to say that both Courts views were that for a payment to be made in consequence of the termination of employment it had to follow on as a result or effect of the termination of employment. Additionally, while it is not necessary to show that termination of employment is the sole or dominant cause, a temporal sequence alone would not be sufficient.

The Commissioner in Taxation Ruling TR 2003/13 considered the phrase 'in consequence of' as interpreted by the Courts. In paragraph 5 of TR 2003/13 the Commissioner states:

a payment is made in respect of a taxpayer in consequence of the termination of the employment of the taxpayer if the payment follows as an effect or result of the termination. In other words, but for the termination of employment, the payment would not have been made to the taxpayer.

Your client's employment with Entity 1 was terminated during the 200X-0Z income year as a result of a disciplinarily penalty imposed against your client. The relevant state Industrial Relations Commission later found that the disciplinarily process undertaken in relation to your client's dismissal was unjust and awarded your client the maximum compensation allowable under the Act was awarded. In your client's case this was six months pay and amounted to X.

As such, the payment follows on as an effect or a result of the termination of employment. The payments would not have been made to your client had their employment not been terminated. Therefore the compensation payment was made in consequence of the termination of your client's employment and therefore the requirement pertaining to subparagraph 82-130(1)(a)(i) is satisfied.

Payment received no later than 12 months after the termination

The second requirement under section 82-130 of ITAA 1997 is that the payment be made within12 months of the termination of employment. As your client's compensation payment was received more than 12 months after termination, the payment is called a late termination payment. 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.

The Commissioner has issued a legislative determination (SPR 2007/1) under subsection 82-130(7) of the ITAA 1997 which states that the 12 month rule will not apply where legal action commenced within 12 months of the termination of employment, of which the subject relates to the person's entitlement to the payment and/ or the amount of the person's entitlement.

Legal proceedings regarding the termination were initiated with the relevant state Industrial Relations Commission within 12 months of the termination. As these proceedings related to both your client's entitlement to the compensation payment and the amount, the 12 month rule will not apply pursuant to SPR 2007/1.

Employment termination payment exclusions

Section 82-135 of the ITAA 1997 provides that certain payments are not employment termination payments, including:

· payment for unused annual leave or unused long service leave;

· the tax-free part of a genuine redundancy payment or an early retirement scheme payment; and

· reasonable capital payments for personal injury.

As such, this provision excludes payments or benefits that compensate or reimburses the taxpayer for or in respect of the particular injury. The above circumstances to not apply to the present case and therefore the requirements pertaining to paragraph 82-130(1)(c) are satisfied.

As all of the conditions have been satisfied, the compensation payment for X is considered an employment termination payment and is assessable in the year in which it was paid; being the 2010-11 income year. As your client was over the preservation age at the date of payment, the concessional tax rate of 15% applies to the employment termination payment.

Legal expenses

Section 8-1 of the Income Tax Assessment Act 1997 allows a deduction for a loss or an outgoing to the extent to which it is incurred in gaining or producing assessable income, except where the loss or outgoing is 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 capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature.

It is clear that legal expenses may be deductible where they arise out of litigation concerning a taxpayer's professional conduct.

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. 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.

In your client's case, it may be arguable the legal expenses arose from the day to day conduct of your client's former employment activities.

However, even if your client is able to satisfy the first limb of section 8-1 of the ITAA 1997, it is still necessary to determine whether the legal expenses are capital in nature and so precluded from deduction.

Generally, legal expenses incurred in an unfair dismissal action (seeking reinstatement and/or damages) are of a capital nature. Paragraph 5 of Taxation Determination TD 93/29 provides the Commissioner's view on the deductibility of legal expenses in relation to a wrongful dismissal action and states that if the legal action goes beyond a claim for a revenue item such as wages, and constitutes an action for a breach of the contract of employment, the legal costs would not be deductible because they are capital in nature.

In your client's case, the advantage to be gained in incurring the legal expenses was reinstatement of your client's employment position and/or damages for unfair dismissal.

Accordingly, the legal expenses are not deductible under section 8-1 of the ITAA 1997 as they are capital in nature.