Edited version of your private ruling

Authorisation Number: 1012434934071

Ruling

Subject: Legal expenses

Question

Are you entitled to a deduction for the legal expenses incurred?

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 an employee.

You signed an employment agreement that had a 'restraint of trade' clause.

You left your employment and started your own business within the same field.

For 12 months during the non-compete period you did not earn income from any former clients of your former employers.

Legal action was taken against you by your former employer, which if successful would have prevented you from carrying out your trade and earning assessable income.

You successfully defended the action and were left with significant legal bills.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Summary

You incurred legal expenses in order to defend your right to continue working in your field. These expenses are capital in nature and are not deductible.

Detailed reasoning

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for a loss or outgoing to the extent that it is incurred in gaining or producing assessable income, except where it is of a capital, private or domestic nature.

 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 (Hallstroms). 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.

 The legal test for distinguishing between capital and revenue outgoings was laid down in Sun Newspapers Ltd and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 1 AITR 403; 5 ATD 87 (Sun Newspapers). Dixon J pointed out that expenditure in establishing, replacing and enlarging the profit-yielding structure itself is capital and is to be contrasted with working or operating expenses. The test laid down in the Sun Newspapers Case involved three elements, although none is in itself decisive:

· the nature of the advantage sought

· the way it is to be used or enjoyed, and

· the means adopted to get it.

In regards to the first two elements, the lasting or recurrent character of the advantage and the expenditure is important. Thus the courts have held that, in the absence of special circumstances, expenditure is capital in nature where it is made with a view to bringing into existence an asset or an advantage (tangible or intangible) for the enduring benefit of the business (British Insulated & Helsby Cables v. Atherton (1926) AC 205).

 The third element involves a consideration of whether the outlay is a periodic one covering the use of the asset or advantage during each period, or whether the outlay is calculated as a single final provision for the future use or enjoyment of the asset or advantage.

In general, legal expenses have been held to be deductible if the expenses have arisen as a consequence of the day to day activities of a business providing that the expenses are not of a capital nature (applying the principles in Sun Newspapers).

 In Case V140 88 ATC 874; AAT Case 4596 (1988) 19 ATR 3859, a solicitor was denied a deduction for expenses incurred in defending certain allegations before the Statutory Committee of the Law Society of New South Wales. The Committee ordered the taxpayer be suspended from practice for a certain period, and to pay the costs of the Law Society. Failure to pay these costs would have resulted in the taxpayer being further suspended from practice until they were paid. It was held that the obligation to pay the Law Society's costs was fundamental to the taxpayer's continuing right to derive his principal source of income through the practice of his profession. That right to earn money was regarded as a profit-yielding subject or as a structural asset. It was held that expenses of defending or acquiring a profit-yielding subject or structural asset are of a capital nature, and that the taxpayer's expenses were not deductible.

In Case X84 90 ATC 609; AAT Case 6528 (1990) 21 ATR 3721, legal expenses were incurred by a medical practitioner in defending certain charges relating to his practice, which subsequently led to deregistration proceedings. The taxpayer argued that failure to defend proceedings against him would have resulted in his deregistration as a medical practitioner thereby depriving him of his sole source of income. It was held that his legal expenses were not deductible because the expenditure was incurred to protect a structural asset, that is, his registration as a medical practitioner, and were therefore of a capital nature. The charges brought were considered to be a serious risk to the taxpayer's right to practise, and that being so, the expenses incurred in defending that right were regarded as capital expenses.

 In your case, you incurred legal expenses in defending the action commenced by your former employer to enforce a restraint of trade clause. You were defending your right to continue working in your field. As discussed in the cases above (Case V140; AAT Case 4596 and Case X84; AAT Case 6258), costs incurred in defending a right to practice a profession or employment are capital in nature, as the right to practice is considered a profit yielding subject or structural asset and the associated expenses are incurred to protect this right.

The advantage that you sought in defending your right to continue working in your field is capital in nature. As the nature of legal expenses follows the nature of the advantage sought, the legal expenses that you incurred in defending the action are also capital in nature. A deduction is therefore not allowable for these legal expenses under section 8-1 of the ITAA 1997.