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Edited version of your private ruling
Authorisation Number: 1012454773469
Ruling
Subject: Legal expenses
Question
Are the legal fees you incurred deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?
Answer
No
This ruling applies for the following periods
Year ended 30 June 2011
Year ended 30 June 2012
The scheme commenced on
1 July 2010
Relevant facts and circumstances
You are an employee.
A third party commenced legal action against you.
You also commenced legal proceedings.
You incurred legal expenses.
Relevant legislative provisions
Income Tax Assessment Act 1997 Section 8-1
Reasons for decision
Summary
You are not entitled to claim a deduction for the legal expenses you have incurred on the basis that it was not incurred in gaining or producing your assessable income. We also consider that it is precluded from deduction on the basis that it is capital or private in nature.
Detailed reasoning
Section 8-1 of the 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.
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). The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses.
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 a taxpayer's business or employment (Magna Alloys and Research Pty Ltd v. FC of T (1980) 49 FLR 183; (1980) 11 ATR 276; 80 ATC 4542).
Where legal expenses are defensive and not voluntary, the correct approach to the characterisation of the expenditure is the objective approach taken by the High Court in Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 2 ATD 169.
In the High Court decision in Federal Commissioner of Taxation v. Day [2008] HCA 53; (2008) 70 ATR 14; 2008 ATC 20-064 (Days case), Mr Day was charged with breaching the standards of conduct and failing to fulfil his duty as a Customs Officer. It was found that the requisite connection with his assessable income was present and that he was exposed to the charges by reason of his office.
The Full Federal Court said that the deductibility of an expense required a requisite connection, which might be indirect or direct. It also said the deductibility of the expense incurred by the taxpayer depended on the determination of what was productive of assessable income, which could take into account the positive and negative duties to be performed or observed by the taxpayer. It further said the deductibility also depended upon the employment and the duties imposed on the taxpayer which arose from his occupation.
The Court noted that the Public Service Act imposed an obligation to observe standards of conduct, breach of which might entail disciplinary charges. Therefore, it found that a requisite connection between the legal expenses incurred by the taxpayer and the deriving of his assessable income existed. It held that the legal expenses were allowable deductions and could not be viewed as private or domestic in nature.
Contrary to Days case, the legal expenses you incurred arose out of your involvement with another entity and was not directly or indirectly related to income derived, or expected to be derived, from your employment position. In Day's case the dispute arose because of his employment but in your case the action arose because of your involvement with the other entity.
Therefore, the legal fees you incurred are considered to be too remote from the earning of your assessable income to be entitled to a deduction for the amount of the legal expenses under section 8-1 of the ITAA 1997.
Potential consequences are incidental.
Even if you were able to satisfy the first positive limb of s 8-1 of the ITAA 1997, which we consider is not satisfied, it is still necessary to determine whether a loss or outgoing is caught by the negative limb of that section and so precluded from deduction.
For example, if the expenses were incurred in protecting the underlying profit yielding structure of the income-earning activity they are considered to be capital in nature and will not be deductible.
The circumstances demonstrate that your objectives were fundamentally directed toward preserving a capital asset. Accordingly, the legal expenses are of a capital nature.
The legal expenses may also be precluded from deduction on the basis that they may be considered private expenditure and did not arise from the performance of your duties from which you derived assessable income.
The legal expenses are accordingly not deductible under section 8-1 of the ITAA 1997.