Edited version of your private ruling

Authorisation Number: 1012470930819

Ruling

Subject: Legal expenses

Question 1

Are you entitled to a deduction for the legal expenses incurred to get legal advice regarding your employment contract with Company A?

Answer

Yes.

Question 2

Are you entitled to a deduction for the legal expenses incurred defending a restraint of trade clause?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 2012

Year ended 30 June 2013

The scheme commences on:

1 July 2011

Relevant facts and circumstances

You were employed with Company A

You were contemplating changing employers.

Your employment contract contained a restraint of trade clause stated that you could not work within the industry for 12 months.

You sought legal counsel regarding your employment contract.

Based on the legal advice you changed jobs and became employed by Company B.

Company A pursued you legally believing you breached the restraint of trade clause.

Company B initially covered your legal expenses but then withdrew support and you started to incur expenses.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Summary

The legal expenses incurred to review your employment contract have a sufficient connection to your income earning activities and are therefore an allowable deduction.

The legal expenses incurred to defend the restraint of trade clause are not deductible as they are capital in nature.

Detailed reasoning

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, 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 (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.

Legal expenses are generally deductible if they arise out of the day to day activities of the taxpayer's business (Herald Weekly Times Pty ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 2 ATD 169) and the legal action has more than a peripheral connection to the taxpayer's income producing activities (Manga Alloys and Research Pty Ltd v. FC of T (1980) 11 ATR 276; 80 ATC 4542).

Taxation Ruling TR 2000/5 examines the deductibility of costs incurred in preparing and administering employment agreements. The ruling states that certain costs incurred by an employee are an allowable deduction, those costs being:

· costs of drawing up an employment agreement with an existing employer

· costs of settling disputes arising from an existing employment agreement

· costs of changing conditions of an existing employment agreement

· costs of renewing or extending a fixed term agreement where there is a provision allowing for renewal or extension

Where expenditure is incurred for the purpose of securing an enduring benefit, rather than a revenue purpose, the expenditure is capital in nature and is not deductible (Sun Newspapers Ltd v. FC of T (1938) 61CLR 337; 5 ATD 87; (1938) 1 AITR 403).

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, while you were employed with Company A you incurred legal expenses to discuss and review the conditions of your existing employment contract. It is accepted that you incurred these expenses in administrating your employment agreement. Therefore, you are entitled to a deduction for these expenses.

Additionally, you incurred legal expenses in defending the action commenced by Company A to enforce a restraint of trade clause. You were defending your right to continue working in your field. 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.