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Ruling

Subject: Legal expenses

Question:

Can you claim a deduction for legal fees incurred in relation to defending suspension and dismissal from employment?

Answer:

No

This ruling applies for the following period

Year ending 30 June 2012

The scheme commences on

1 July 2011

Relevant facts and circumstances

You were advised by your employer that you were suspended on full pay from your position, pending an investigation of alleged serious misconduct. You were advised on this date you would receive a letter of allegation within a week. You sought legal advice, which advised once a letter of allegation was received, action to defend this was highly recommended.

You were contacted by your employer and advised you would no longer be receiving a letter of allegation but, instead, a letter of intent to terminate employment. This information was passed on to your legal advisor.

You were provided with a Letter of Intent to Terminate Employment, advising you had 24 hours to respond. This letter was passed on to your legal advisor, who advised that this was unfair and unlawful. The letter from them to your employer specifically alleges "unfair dismissal" and "unlawful termination of an employment contract".

Acting on your behalf, your legal advisor sought an extension of time to respond, which was granted with full pay. However, after mediation proceeding, which was the subject of an "unfair dismissal application" with Fair Work Australia, your legal advisor withdrew your claim for unfair dismissal and your employment was officially terminated.

The allegations against you, by your employer, related to transactions pertaining to private matters.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 118-37

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.

In respect to employment, legal expenses are generally deductible, i.e., revenue in nature, when they arise from an employee defending the way they performed their duties (see Federal Commissioner of Taxation v Rowe 31 ATR 392; 95 ATC 4691; Putnin v. Federal Commissioner of Taxation (1991) 27 FCR 508; 91 ATC 4097; (1991) 21 ATR 1245). Legal expense will also be revenue in nature when they are incurred to enforce a contractual entitlement which relates to a right to income, even if it is after employment has ceased.

Legal expenses will generally be capital in nature when they arise from defending the right to practise a profession, implicitly seeking to regain employment or seeking compensation for loss of employment, such as in an action for wrongful dismissal or loss of office (see Scott v. Commissioner of Taxation (1935) 35 SR (NSW) 215; (1935) 52 WN (NSW) 44; (1935) 3 ATD 142; Museth and Federal Commissioner of Taxation [2006] AATA 482; (2006) 62 ATR 1243; (2006) 2006 ATC 2217).

Paragraph 5 of Taxation Determination TD 93/29 states:

…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 where the essential character of the advantage sought relates to an enduring advantage that is of a capital nature, the legal costs would not be deductible. For example, legal expense relating to an action for damages for wrongful dismissal are not deductible.

In the High Court of Australia case of Commissioner of Taxation v Day [2008] HCA 53; 2008 ATC 20-064; (2008) 70 ATR 14 (Day), the Commissioner of Taxation argued the taxpayer's legal expenses arose due to conduct outside the performance of the respondent's duties, which proscribed private misbehaviour, and were therefore not deductible. (As a result of disciplinary procedures, Mr Day, a public servant, was demoted but, on appeal, the relevant disciplinary committee ordered he be transferred to another position instead of being demoted.)

The High Court ruled Shane Day's legal expenses were deductible because the taxpayer's position as an officer subject to the Public Service Act 1922 exposed him to disciplinary procedures within the Service. It its Decision Impact Statement, the Tax Office expressed its view of the High Court decision as follows:

Where legal expenses are incurred by the employee in an ongoing employment relationship the majority's decision clarifies that the requisite connection required by paragraph 8-1(1)(a) of the ITAA 1997 will not only be satisfied where the connection between the outgoing and the income is identified as being incurred to defend the manner of performance of positive duties, or as arising out of the day-to-day activities of employment. The decision establishes that where the connection between the legal expenses and the income is identified as being incurred to answer allegations of breaching negative duties imposed under the terms of the employment this may also be sufficient to satisfy paragraph 8-1(1)(a) of the ITAA 1997.

Of significance was the fact that the legal expenses were incurred in responding to disciplinary action internal to the employment relationship and existing for no other purpose.

Crucial to this view was the fact that the terms of employment exposed the taxpayer as an employee to the employer action, and therefore to the need to incur the legal expenses. The employer brought the action and the legal expenses were incurred in respect of proceedings internal to the employment relationship.

In your case, the arising of your legal expenses is distinguished from the case of Day, in that you were not "obliged" to obtain legal advice and representation, as part of an on-going employment relationship, in order to answer the charges at an internal disciplinary procedure. Further, unlike your case, Mr Day was not terminated from his employment but, instead, demoted and then transferred. In other words, his legal expenses where not incurred in defending wrongful dismissal of a capital nature.

To conclude, you incurred legal expenses in relation to the termination of your employment and alleged wrongful dismissal. Such expenses are capital in nature, as advised in Taxation Determination TD 93/29. It follows your legal expenses are not deductible under section 8-1 of the ITAA 1997.

Further, section 118-37 of the ITAA 1997 prohibits a capital loss for your legal expenses (see paragraph 215 of Taxation Ruling TR 95/35).