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Ruling
Subject: Legal expenses
Question
Are you entitled to claim a deduction for legal expenses incurred to defend yourself in a breach of contract action?
Answer
No
This ruling applies for the following periods:
Year ended 30 June 2012
The scheme commences on:
1 July 2011
Relevant facts and circumstances
You were employed an employee.
Your employment contract had a "non-compete" clause, stating you could not provide services to any of your employer's clients for twelve months after terminating employment.
You subsequently left your employment and started your own business in the same field. You earned income from clients of your former employer.
Your former employer launched legal action to enforce the "non-compete" clause.
You incurred legal expenses in defending your right to continue your business.
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 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.
For legal expenses to constitute an allowable deduction, it must be shown that they were incidental or relevant to the production of your 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).
The expenditure must therefore 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).
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.
In your situation, you were defending action taken by your previous employer to enforce a "non-compete" clause which prevented you from engaging with your former employer's clients after you had left their employment.
Your legal expenses were incurred due to you breaching the terms of your employment contract. They did not relate to the duties of your previous employment, nor did they occur in the course of the day to day activities of your new business and therefore, were not incurred in earning your assessable income from either.
The legal expenses incurred to defend the breach of contract action are therefore not deductible.