Edited version of your written advice

Authorisation Number: 1012852889991

Date of advice: 3 August 2015

Ruling

Subject: Legal expenses and settlement payments.

Question 1

Are the legal fees incurred by you during the financial years ended 30 June 20BB and 20CC deductible against ordinary income under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Should these amounts be included at label D5 of your personal tax return for those years?

Answer

Yes.

Question 3

Is the settlement sum payable by you under Deed of Settlement and Release (1) deductible in the year in which the obligation to pay it is created, being the financial year ended 30 June 20CC?

Answer

Yes.

Question 4

Is the interest component of the settlement sum deductible in each year of accrual prior to the payment actually being made?

Answer

Yes.

Question 5

If the (second) potential settlement sum becomes an obligation, is it deductible in the year this occurs, being the financial year ended 30 June 20EE?

Answer

Yes.

Question 6

Is the amount of the settlement sum received by you from your former employer as determined in the Deed of Settlement and Release (2) to be treated as an assessable recoupment under section 20-20 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 2014

Year ended 30 June 2015

Year ended 30 June 2016

Year ended 30 June 2017

Year ended 30 June 2018

The scheme commenced on:

1 July 20AA

Relevant facts and circumstances

You are a professional practising in a particular field.

You were employed by XX for several years up until 20AA.

You then commenced your own practice, entering into a Deed of Sale with XX to enable you to take a number of existing clients with you into your new practice.

In 20BB, civil proceedings were commenced by a former client of yours when you were employed by XX, against both you and XX for alleged negligent conduct occurring while you were employed by XX.

A Deed of Settlement and Release (1) was entered into during the 20CC income year, finalising these proceedings.

This resulted in your obligation to pay an amount for damages and costs (increasing twofold depending on your future financial position), plus interest on whichever sum you will be obliged to pay, calculated from the date of settlement until date of payment.

The first amount plus interest has been determined to be paid in instalments to the claimant commencing 20DD.

The second amount will be determined as payable or not payable, as a result of meetings to be held in 20EE.

The Deed of Sale you entered into with XX in 20AA included a clause which indemnified you from any loss or outgoing incurred by you as a result of claims made by former clients.

In 20CC, you commenced proceedings against XX for the losses and outgoings you incurred as a result of the proceedings with your former client, being legal costs, expenses and damages, and the settlement sum.

You entered into a Deed of Settlement and Release (2) with XX, citing the indemnity clause of the Deed of Sale, resulting in your receipt of a payment within seven days of execution of the Deed.

You have also incurred legal costs in 20BB and 20CC defending yourself in these proceedings.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 6-10

Income Tax Assessment Act 1997 Section 20-20

Reasons for decision

A claim for a deduction of losses or outgoings falls for consideration under section 8-1 of the ITAA 1997.

Section 8-1 of the ITAA 1997 states:

(1) You can deduct from your assessable income any loss or outgoing to the extent that:

(a) it is incurred in gaining or producing your assessable income; or

(b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

(2) However, you cannot deduct a loss or outgoing under this section to the extent that:

(a) it is a loss or outgoing of capital, or of a capital nature; or

(b) it is a loss or outgoing of a private or domestic nature; or

(c) it is incurred in relation to gaining or producing your exempt income; or

(d) a provision of this Act prevents you from deducting it.

Legal fees and settlement payment

Taxation Determination TD 93/29 states that if an employee incurs legal expenses in recovering wages, the legal expenses are an allowable deduction providing that the legal action relates solely to the recovery of wages. The ruling continues:-

However, if the legal action goes beyond a claim for a revenue item such as wages, and constitutes an action for breach of the contract of employment where the essential character of the advantage sought relates to an enduring advantage that is of a capital nature, the legal costs would not be deductible. For example, legal expense relating to an action for damages for wrongful dismissal are not deductible.

Legal expenses are generally deductible if the expenses arise out of the day to day activities of the taxpayer's business (Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 39 ALR 46; (1932) 2 ATD 169).

In FC of T v. Rowe (1995) 60 FCR 99; (1995) 31 ATR 392; 95 ATC 4691 (Rowe's case), the court accepted that legal expenses incurred in defending the manner in which a taxpayer performed their employment duties were allowable. The activities which produced the taxpayer's income were what exposed them to the liability against which they were defending themselves. No significance was placed by the court on the taxpayer's status as an employee.

In Commissioner of Taxation v Shane Day [2008] HCA 53 (Day's case) the concern was with the deductibility of legal expenses incurred by a public servant in defending charges in respect of conduct which occurred outside the course of the taxpayer's normal day-to-day duties.

The legal expenses were incurred in responding to disciplinary action internal to the employment relationship and existing for no other purpose. Consequently the expenses were held to be deductible.

In contrast, in Case 9/2013 [2013] AATA 783, the AAT denied a deduction for legal expenses incurred by a taxpayer in defending activities he had undertaken in the course of carrying out his previous employment. The AAT distinguished Day's case as the taxpayer no longer had an on-going employment relationship with the relevant employer. The AAT stated that the connection between the production of the taxpayer's previous employment income and the legal expenses rose no higher than a mere 'causal connection' and that the authorities make it clear that this is insufficient; something closer and more immediate than a mere causal connection is required for a deduction to be allowable under section 8-1 of the ITAA 1997.

Although your case is similar to Case 9/2013, in that you are incurring legal and settlement expenses in defending activities you had undertaken in the course of carrying out your previous employment, it is the Commissioner's view that there is more than a mere 'causal connection' between your previous employment income and your legal expenses.

The inclusion of the indemnity clause in the Deed of Sale between yourself and XX suggests your connection with your former employment would likely continue for a period after you left their employ.

It follows that both the legal and settlement costs you have incurred are considered to have a sufficient connection to your income earning activities and are therefore deductible at the time they are incurred under section 8-1 of the ITAA 1997.

Incurred

Generally, a deduction under section 8-1 of the ITAA 1997 is allowable in the income year in which it is incurred.

There is no statutory definition of the term 'incurred' however Taxation Ruling TR 97/7: Income tax: section 8-1 - meaning of 'incurred' - timing of deductions (TR 97/7) sets out the Commissioner's view as to the meaning of 'incurred' for the purposes of section 8-1 of the ITAA 1997. Paragraphs 5 and 6 of TR 97/7 state:

5. As a broad guide, you incur an outgoing at the time you owe a present money debt that you cannot escape. But this broad guide must be read subject to the propositions developed by the courts, which are set out immediately below.

6. The courts have been reluctant to attempt an exhaustive definition of a term such as 'incurred'. The following propositions do not purport to do this, they help to outline the scope of the definition. The following general rules, settled by case law, assist in most cases in defining whether and when a loss or outgoing has been incurred:

(a) a taxpayer need not actually have paid any money to have incurred an outgoing provided the taxpayer is definitively committed in the year of income. Accordingly, a loss or outgoing may be incurred within section 8-1 even though it remains unpaid, provided the taxpayer is 'completely subjected' to the loss or outgoing. That is, subject to the principles set out below, it is not sufficient if the liability is merely contingent or no more than pending, threatened or expected, no matter how certain it is in the year of income that the loss or outgoing will be incurred in the future. It must be a presently existing liability to pay a pecuniary sum;

(b) a taxpayer may have a presently existing liability, even though the liability may be defeasible by others;

(c) a taxpayer may have a presently existing liability, even though the amount of the liability cannot be precisely ascertained, provided it is capable of reasonable estimation (based on probabilities);

(d) whether there is a presently existing liability is a legal question in each case, having regard to the circumstances under which the liability is claimed to arise;

(e) in the case of a payment made in the absence of a presently existing liability (where the money ceases to be the taxpayer's funds) the expense is incurred when the money is paid.

The determination of whether an outgoing is 'incurred' often depends on whether there is a presently existing pecuniary liability, having regard to the terms of the contract, and other arrangements giving rise to that liability.

The key issue in determining whether an outgoing was incurred is whether:

(a) you were definitively committed to, or completely subject to, the discharge of the liability in the future (FC of T v. Citylink Melbourne Ltd [2006] HCA 35 at [125] (Citylink); Coles Myer Finance Ltd v. FC of T 176 CLR 640 at 162), or

(b) your liability was merely 'impending, threatened or expected' (Nilsen Development Laboratories Pty Ltd v. FCT (1981) 144 CLR 616).

In your case, you have entered into a legally binding contract, being the Deed of Settlement and Release ordering you to pay an amount plus interest at a future date.

It is considered that you are definitively committed to, or completely subject to, the discharge of the liability in the future and can be taken to have 'incurred' the relevant amount of interest expenses in each year at the time you are required to calculate and confirm these interest amounts as stated above.

As such, the yearly interest amounts calculated, though not yet paid, will be deductible under section 8-1 of the ITAA 1997 in each relevant year.

It follows that the (first) settlement sum is considered to have been incurred at the time of the creation of the liability within the Deed of Settlement, being the year ended 30 June 20CC.

The (second) settlement sum however, will not be considered to have been incurred until such time as it is created (if that indeed occurs) by the Plaintiff during the 20EE income year as per a clause of the same Deed. This also applies to any interest that may be applicable to the (second) settlement sum, as you are not definitively committed to, or completely subject to, the discharge of that liability until that time, if at all.

Settlement payment received

Ordinary income

Subsection 6-5(2) of the ITAA 1997 provides that the assessable income of an Australian resident includes ordinary income derived directly or indirectly from all sources during the income year.

Ordinary income has generally been held to include three categories, namely, income from rendering personal services, income from property and income from carrying on a business.

Other characteristics of income that have evolved from case law include receipts that:

• are earned

• are expected

• are relied upon, and

• have an element of periodicity, recurrence or regularity.

In your case, you have not earned the settlement sum as it does not payment for services performed. The payment is a one-off payment and thus does not have an element of periodicity, recurrence or regularity.

The contribution is not considered to be ordinary income and is not assessable under section 6-5(2) of the ITAA 1997.

Assessable recoupment

Section 6-10 of the ITAA 1997 provides that amounts that are not ordinary income but are included in assessable income by another provision, are called statutory income.

Assessable recoupments are a form of statutory income.

Subsection 20-20(2) of the ITAA 1997 provides that an amount you have received as a recoupment of a loss or outgoing is an assessable recoupment if:

• you received the amount by way of insurance or indemnity, and

• you can deduct an amount for the loss or outgoing for the current year, or you have deducted or can deduct an amount for it in an earlier income year, under any provision of this Act.

In your case, the settlement sum you received from XX is regarded as being received by way of indemnity as per a clause of the Deed of Sale between you and XX and you are able to claim a deduction for the legal expenses and settlement payment you incurred in an earlier income year.

Accordingly, the settlement sum is considered to be an assessable recoupment and therefore is assessable under section 20-20 of the ITAA 1997.