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Ruling

Subject: Legal expenses

Questions:

1. Is the portion of the legal expenses incurred in defending allegations of maladministration in relation to your employment duties an allowable deduction?

Answer:

Yes.

2. Is the portion of the legal expenses incurred in securing share and option entitlements from your previous employer included in the cost base of the shares and options received?

Answer:

Yes.

This ruling applies for the following period

Year ended 30 June 2012

The scheme commenced on

1 July 2011

Relevant facts

You were employed by the employer for several years under an employment agreement.

During the relevant financial year, the employer raised a number of allegations of misconduct against you and others and advised that they intended to conduct an investigation into those matters.

The allegations related to maladministration of your employment duties.

The investigation was to be conduct by forensic accountants.

You engaged your solicitor, who then demanded the employer provide you with copies of all the documents necessary to respond to the allegations.

Additional information was also sought in relation to your share and option entitlements which were due to vest shortly.

Your solicitors negotiated an extension of time to allow you and your solicitors to prepare.

Soon after the investigation, your solicitor's received an e-mail copy of the employer's preliminary findings and proposed outcome, including taking disciplinary action against you and terminating your employment contract. However, before making a final decision, you were invited to place any matter that you considered relevant before the employer for consideration.

Your solicitors advised that you wished to take the opportunity to respond, which you did. Ultimately, your employment was terminated.

Your solicitors sought advice in relation to taking further legal action to obtain an injunction to prevent the employer from terminating your employment and thereby jeopardising your share and option entitlements.

In the end, your solicitors successfully negotiated an agreement with the employer that they would honour their share and option obligations.

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 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.

The courts on a number of occasions have determined legal expenses to be an allowable deduction if the expenses arise out of the day to day activities of the taxpayer's business. The action out of which the legal expense arises has to have more than a peripheral connection to the taxpayer's business and the expense may arise out of litigation concerning the taxpayer's professional conduct.  

In FC of T v. Rowe (1995) 31 ATR 392; 95 ATC 4691 the taxpayer, an employee, was suspended from normal duties and was required to show cause why he should not be dismissed after several complaints were made against him. A statutory inquiry subsequently cleared him of any charges of misconduct or neglect. The court accepted that the legal expenses incurred by the taxpayer in defending the manner in which he performed his duties, in order to defend the threat of dismissal, were allowable. Since the inquiry was concerned with the day to day aspects of the taxpayer's employment, it was concluded that his costs of representation before the inquiry were incurred by him in gaining assessable income. No significance was placed on the taxpayer's status as an employee.

In your case, you incurred legal expenses in order to defend allegations of maladministration in relation to activities undertaken as part of your day to day activities. These expenses are considered to have been incurred in gaining your assessable income and are an allowable deduction under section 8-1 of the ITAA 1997. However, you also incurred legal expenses in order to secure share and option entitlements on your termination.

In Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 3 AITR 436; (1946) 8 ATD 190, the Court established that in determining whether a deduction is allowable under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered. The nature or character of the legal expenses follows the advantage which is sought to be gained by incurring the expenses. Dixon J stated at CLR 647 that:  

...legal expenses...take the quality of an outgoing of a capital nature or of an outgoing on account of revenue from the cause or purposes of incurring the expenditure. We are, therefore, remitted to a consideration of the object in view when the legal proceedings were undertaken, or of the situation which impelled the taxpayer to undertake them.  

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.

In your case, you have incurred legal expenses for dual purposes. Firstly, in order to defend your actions and secondly to receive a share and option allocation. While the advantage sought in defending your actions was of a revenue nature, the share and option allocation was of a capital nature.

As the nature or character of legal expenses follows the advantage that is sought to be gained by incurring the expenses, a portion of the expenses you have incurred are considered to be of a capital nature and are not deductible under section 8-1 of the ITAA 1997. Therefore, any deduction will need to be apportioned to reflect the dual purpose of the expenses incurred.  

Capital gains tax

The cost base of a capital gains tax (CGT) asset consists of five elements:

· The first element, being the acquisition costs, is the total of the money paid, or required to be paid, in respect of the acquisition. 

· The second element is the incidental costs that the taxpayer incurs in acquiring the asset of which relate to a CGT event that happens in relation to the asset.

· The third element is costs of ownership, including both capital and non-capital costs.

· The fourth element is capital costs associated with increasing or preserving the value of your asset, or installing or moving the asset.

· The fifth element is capital expenditure incurred by a taxpayer in establishing, preserving or defending their title to an asset, or right over an asset.

As discussed above, a portion of the legal expenses you incurred were capital in nature. The fifth element of the cost base of a CGT asset includes capital expenditure incurred in establishing, preserving or defending title to an asset.

In your case, the portion of the legal expenses incurred in securing your share and option allocation will be included in the fifth element of the cost base when calculating any capital gain from their sale.

Apportionment of expenses

TD 93/29 discusses the apportionment of legal expenses.

Where legal expenses are incurred in relation to proceedings that relate both to amounts that are revenue in nature as well as amounts which are capital in nature, there must be some fair and reasonable assessment of the extent of the relation of the outlay to assessable income.

Where the solicitors account is itemised, one reasonable basis for apportionment would be the time spent involving the revenue claim, relative to the time spent on the capital claim.

If the solicitors account is not itemised, a possible basis for apportionment would be either a reasonable costing of the work undertaken by the solicitor in relation to the revenue claim, or, where this is not possible, an apportionment on the basis of the monetary value of the revenue claim relative to the capital claim.