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Ruling

Subject: Legal expenses

Question 1

Are you entitled to a deduction for legal expenses incurred in defending claims made against you by your previous employer?

Answers

No

Question 2

Are you entitled to a deduction for a settlement payment and advisory fees?

Answers

No

Question 3

Are you entitled to a capital loss for legal expenses, settlement payment and advisory fees?

Answers

No

This ruling applies for the following periods:

Year ended 30 June 2012

Year ending 30 June 2013

The scheme commences on:

1 July 2011

Relevant facts

You were an employee of entity A.

You signed a contract of employment at the time of commencing your employment.

Your employment contract included a restraint of trade clause limiting your ability to provide services should you cease employment with entity A, to clients of entity A that you have provided services to whilst employed by entity A.

You later accepted employment with entity B, a client of entity A. At the same time you commenced work as a part-time employee with entity C.

Entity B was a significant client of your previous employer entity A. You completed work for entity B when working with entity A.

Entity B terminated their services with entity A and engaged entity C to do their work.

You were entitled to receive as bonus income, a percentage of all amounts collected from entity B by entity C as an entitlement arising from a contract of employment with entity C for introducing a client.

Entity A took legal action against you for breach of your employment contract. The contract contained a clause that purported to give the employer a right to liquidated damages under a restraint of trade clause.

You provided services post-employment to entity B whom you had previously provided the same services whilst employed with your previous employer entity A. This was a breach of the restraint of trade clause included in your previous employment contract.

The principal of entity B gave you assurances of financial support as the change of arrangements was initiated by the principal. No financial support was provided due to certain circumstances when the matter went to court.

You were order to pay:

· Liquidated damages

· Interest and

· Costs of the appellant

You did not have sufficient funds to meet the financial commitment and engaged assistance to negotiate a settlement or to arrange bankruptcy.

A settlement was later paid in full.

You used your own resources and borrowed a shortfall amount to make the payment.

You incurred the following costs:

§ Legal fees

§ Settlement payment

§ Advisory fees

You have since obtained employment with another firm.

Relevant legislative provisions

Income tax Assessment Act 1997 Section 8-1

Income tax Assessment Act 1997 Section 102-20

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.

A number of significant court decisions have determined that for an expense to be an allowable deduction:

§ it must have the essential character of an outgoing incurred in gaining assessable income or, in other words, of an income-producing expense (Lunney v. FC of T; (1958) 100 CLR 478), 

§ there must be a nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income (Ronpibon Tin NL v. FC of T, (1949) 78 CLR 47), and

§ it is necessary to determine the connection between the particular outgoing and the operations or activities by which the taxpayer most directly gains or produces his or her assessable income (Charles Moore Co (WA) Pty Ltd v. FC of T, (1956) 95 CLR 344; FC of T v. Hatchett, 71 ATC 4184).

For legal expenses to constitute an allowable deduction, it must be shown that they are incidental or relevant to the production of the taxpayer's assessable income. Also, in determining whether a deduction for legal expenses is allowable 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.

Legal expenses are generally deductible if they arise out of the day to day activities of the taxpayer's business (Herald Weekly Times Pty ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 2 ATD 169) and the legal action has more than a peripheral connection to the taxpayer's income producing activities (Manga Alloys and Research Pty Ltd v. FC of T (1980) 11 ATR 276; 80 ATC 4542).

However, where the expenditure is incurred for the purpose of securing an enduring benefit, rather than a revenue purpose, the expenditure is capital in nature and is not deductible (Sun Newspapers Ltd v. FC of T (1938) 61CLR 337; 5 ATD 87; (1938) 1 AITR 403).

In FC of T v. Rowe (1995) 60 FCR 99; (1995) 31 ATR 392; 95 ATC 4691 (Rowe's case), the court accepted that legal expenses incurred in defending the manner in which a taxpayer performed his employment duties were allowable. The activities which produced the taxpayer's income were what exposed them to the liability against which they were defending themselves.

The expenditure must be related to the production of assessable income and not incurred at a point too soon to be deductible (FC of T v. Maddalena (1971) 45 ALJR 426; 2 ATR 541; 71 ATC 4161).

Taxation Ruling TR 2000/5 sets out the Commissioner's view of the application of section 8-1 of the ITAA 1997 to costs incurred by employees and employers in preparing and administering employment agreements. Employment agreements are a written, legal and binding confirmation of the employer/employee relationship (paragraph 11 TR 2000/5).

As outlined in TR 2000/5, a deduction is allowed for an employee for costs associated with settlement of disputes arising out of an existing employment agreement including the cost of representation. Your employment agreement with your previous employer is no longer current. Therefore your disputes do not arise out of an existing employment agreement.

In your situation, you were defending action taken by your previous employer. The action by your former employer was to enforce a restraint of trade clause in your previous employment agreement. The action was not prompted or caused as a consequence of the performance of your then current duties.

It is considered your legal expenses were incurred to enable you to continue working in your new employment. They did not relate to the duties of your previous employment or your new employment and therefore, not incurred in earning your assessable income from either.

Although the claims may relate in part to the period of time you worked with your previous employer, the nexus to your income earning activities with your previous employer is not sufficient.

You have argued that you were settling a dispute regarding your employment agreement. However, as stated above, the employment agreement is now terminated and the character of the legal expenses follows the advantage which is sought.

In addition, the legal expenses associated with the breaches of contract do not have the necessary connection to your former employment activities. Therefore, these expenses are not deductible under section 8-1 of the ITAA 1997.

Settlement payment and advisory fees

Generally, the treatment of a settlement sum or damages payment will follow the treatment of other legal costs incurred in relation to a particular matter.

You undertook activities which resulted in a breach of your employment contract with your previous employer. The activities to which the breach related were not employment duties and did not arise as a consequence of the performance of your duties from which you derived assessable income.

As discussed above, the legal expenses you incurred in defending this action are not deductible. Accordingly, the settlement payment paid by you to your previous employer is also not an allowable deduction under section 8-1 of the ITAA as it was not incurred in gaining or producing your assessable income.

Similarly, the advisory fees incurred in negotiating the settlement are not an allowable deduction under section 8-1 of the ITAA 1997.

Capital losses

Under section 102-20 of the ITAA 1997 you make a capital gain or capital loss as a result of a capital gains tax (CGT) event.

CGT events are the different types of transactions or events involving a CGT asset.

A CGT asset is:

·         any kind of property; or

·         a legal or equitable right that is not property.

In your case, you do not hold a contractual right or any other relevant CGT asset.

Therefore the CGT provisions do not apply and you are not entitled to a capital loss for the legal expenses, settlement payment or advisory fees.