Edited version of your private ruling

Authorisation Number: 1012457301518

Ruling

Subject: Employee restrictive covenant

Question

Are you eligible to claim a deduction for amounts paid to your former employer and for associated legal expenses in relation to a deed of release ensuring a restraint of trade would not be implemented by your former employer?

Answer

No

This ruling applies for the following period

Year ended 30 June 2011

The scheme commences on

1 July 20XX

Relevant facts and circumstances

You negotiated a contract for services with an agency to provide services to a client company for a term on a contract rate to the contractor.

A subsequent period of contract was arranged for a further period. However, you requested a rate rise as you were not agreeable to providing services at a lesser than market rate. So certain verbal commitments were made that you wished to continue only on the condition that a rate rise would be re-negotiated at the next available opportunity. During the second contract extension, you realised that certain assurances given verbally by the agency were not kept, at which point you believed the original contract was null and void. Thus you proceeded to obtain work through a new agency, with the same client company.

The original agency became aware of your change of work circumstances and commenced legal action, suing you under the original written contract for "Breach of Contract and thus Loss of Income", stipulating that under the relevant clauses of the said contract that, during the period of contract or any time within X months of the termination of the contract, you will not, without prior written consent of the agency, accept any offer of employment or engagement with client company.

As a result of legal action, you sought legal advice as to your rights and to challenge whether or not you had to pay the agency, who claimed under the signed contract they suffered a loss of income.

After taking legal advice, it was agreed, in light of the possibility the application of the 'Restrictive Covenant' and higher costs being awarded to the agency, you agreed to signing a Deed of Release in favour of the agency, representing its loss of income as set out in the Deed.

In addition you paid legal expenses.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Section 104-35

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Section 110-25

Income Tax Assessment Act 1997 Section 110-40

Income Tax Assessment Act 1997 Section 110-35

Income Tax Assessment Act 1997 Section 110-55

Reasons for decision

Legal expenses

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent that they are incurred in gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature.

Legal expenses can be characterised as an outgoing on revenue account or an outgoing of a capital nature depending on the cause or purpose for which the legal expenses were incurred (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 3 AITR 436; 8 ATD 190).

Restrictive covenants

Taxation Ruling TR 95/3, in being about the CGT implications of restrictive covenants, confirms restrictive covenants are CGT assets. Paragraph 35 of the ruling includes a contract of employment stipulating exclusive service by the employee as an example of a restrictive covenant.

The Explanatory Memorandum to the Taxation Laws Amendment Act (No 4) 1992 (the EM) also confirms that rights under a contract of personal services are CGT assets. It states:

Not all things often referred to as "rights" will be assets for CGT purposes. To be an asset, a right must be recognised and protected by law - a court of law or equity will assist in enforcing it. Personal liberties and freedoms, such as the freedom to work or trade or to play amateur sport, are not legal or equitable rights and accordingly will not be assets for CGT purposes.

A form of property is generally regarded as something that is capable of assignment or transmission. The amendment will make it clear that an option, a debt, a chose in action or a right will not need to be forms of property if they are to be assets for CGT purposes. They will be assets even if they are not assignable or transmissible.

Accordingly, a legal right of a personal character which is not capable of assignment, such as the rights under a contract of personal services, will be an asset. Other examples might include the rights of a party to a restrictive covenant or exclusive trade tie agreement, and the rights of a sporting club under an agreement that a sportsperson play for that club. [Emphasis added]

In clarifying the 'two-sided' nature or 'dual acquisition' of such a restrictive covenant, the EM states:

In relation to the person creating the asset…the person creating the asset will be taken to acquire the asset and to commence to own it.

In relation to the person in whom the asset is vested on its creation…the person in whom the asset is vested on its creation will be taken to have acquired the asset from the person who created it and to commence to own it.

More recently, paragraph 3.67 of the Explanatory Memorandum to the Taxation Laws Amendment Bill (No. 5) 2002, in relation to the business capital expenditure provisions in section 40-880 of the ITAA 1997, made reference to the recommendations of the Review of Business Taxation. Pages 213-280 of the Review of Business Taxation, A Platform for Consultation , Discussion Paper 2 Volume I, February 1999, at paragraph 8.1 on page 217, specifically listed restrictive covenants as an example of a right, that is capital in nature.

CGT tax treatment of restrictive covenants

Section 108-5 of the ITAA 1997 states a right to enforce a contractual obligation is a CGT asset.

CGT event D1 under section 104-35 of the ITAA 1997 happens when a contractual right is created.

CGT event C2 under section 104-25 of the ITAA 1997 happens when the ownership of an intangible CGT asset ends by cancellation, surrender, release or similar endings.

Subsection 104-25(3) of the ITAA 1997 states you make a capital gain if the capital proceeds from CGT event C2 are more than the asset's cost base or you make a capital loss if those capital proceeds are less than the asset's reduced cost base.

Section 100-40 of the ITAA 1997 states for the purpose of working out a CGT loss, costs are called the reduced cost base of the asset. Section 110-55 of the ITAA 1997 states all of the elements (except the third one) of the reduced cost base of a CGT asset are the same as those for the cost base under section 110-25 of the ITAA 1997.

Section 110-35 of the ITAA 1997 lists the categories of incidental costs that relate to a CGT event. The first category includes remuneration for the services of a legal adviser. The tenth category is termination or other similar fees incurred as a direct result of your ownership of a CGT asset ending.

Termination fees and other similar fees, such as exit fees, are contractual fees imposed by one party on the other as a result of the second party breaking a contract. For example, in the context of the irrigation industry, a termination fee is typically any fee or charge payable to an operator for either terminating access or surrendering a water delivery right.

Application of law in your case

In your case, your employment contract which stipulated exclusive service by you during its term was a restrictive covenant and thus a CGT asset. Being capital in nature, a deduction is not allowed under section 8-1 of the ITAA 1997 for your payment and your related legal expenses.

The creation of your restrictive covenant was a CGT event D1 under section 104-35 and its termination was a CGT event C2 under section 104-25 of the ITAA 1997. Your compensation payment and your associate legal expenses were eligible incidental costs under section 110-35 of the ITAA 1997 in relation to the termination of your CGT asset, to be included in its CGT cost base.

As explained in the EM, as your payment to your former employer was to terminate your obligations and rights under the restrictive asset, it was not a payment to acquire personal liberties and freedoms, such as the freedom to work or trade. That your payment was made to your former employer, rather than to a new employer, shows it was not incurred in relation to earning any new income from a new employer.