Edited version of your written advice

Authorisation Number: 1012928126090

Date of advice: 16 December 2015

Ruling

Subject: Legal expenses and settlement payment

Question 1

Is the payment received under a deed of release and settlement regarded as ordinary assessable income?

Answer

No.

Question 2

Is the payment received under a deed of release and settlement an employment termination payment in accordance with section 82-130 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 3

Does the payment received under a deed of release and settlement form part of capital proceeds for capital gains tax purposes?

Answer

Yes.

Question 4

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

Answer

No.

Question 5

Do the legal expenses form part of the cost base for capital gains tax purposes?

Answer

Yes.

This ruling applies for the following periods

Year ended 30 June 2015

Year ending 30 June 2016

The scheme commenced on

1 July 2014

Relevant facts

A few years ago you resigned from your previous position having been promised partnership at entity A. You asked for the offer of interim employment if the promise of partnership was put in writing. A written Interim Employment Agreement was executed.

You commenced employment with entity A.

You accepted the employment offer from entity A based on the understanding that entity A would offer you partnership in the firm after 18 months of employment.

Further representations were made to you by the partners of entity A to the effect that you would be made a partner of entity A. You were to earn more income as a partner.

You sold an asset to raise capital for the goodwill component.

You sought some initial legal advice which included assistance with preparing a letter to the partners of entity A reminding them of the representations made and their obligations in connection with that agreement.

You sent the partners a letter referring them to the agreement and to the representations and noting again that you had sold property to raise the capital required. No response was received.

You followed up the letter and requested a response by a given date.

You later received a written reply denying the allegations contained and stating that the partners were not in a position to offer you partnership.

You received a letter from entity A denying that they had offered you partnership and in turn refusing to make you a partner.

You immediately sought legal advice which was on-going for months when you sent a letter of demand to entity A seeking compensation for lost income and drawings as well as losses associated with the sale of your assets that were only sold to raise the fund necessary for partnership.

You would not have joined entity A without the promise of partnership. Further you would not have sold your assets if it were not for the offer of partnership.

You also sought damages for breach of contract, an order declaring the whole of the employment contract void, in particular the restraint of trade clauses, interest on lost earnings and costs.

Your employment with entity A became untenable after they denied that they promised you partnership. You left entity A.

Not having received the demands set out in your letter of demand, you commenced court proceedings in an attempt to obtain compensation for your losses.

A deed of release and settlement was signed to resolve the matters of the court proceedings. The partners agreed to pay you money. There were no specific details in how the amount was calculated.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5.

Income Tax Assessment Act 1997 Section 8-1.

Income Tax Assessment Act 1997 section 82-130.

Income Tax Assessment Act 1997 section 82-135.

Income Tax Assessment Act 1997 section 83-170.

Income Tax Assessment Act 1997 section 83-175.

Income Tax Assessment Act 1997 Section 102-20.

Income Tax Assessment Act 1997 Section 108-5.

Income Tax Assessment Act 1997 Section 104-25.

Reasons for decision

Ordinary income

Subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of an Australian resident includes the ordinary income they derived directly or indirectly from all sources, whether in or out of Australia, 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.

For income tax purposes, an amount paid to compensate for a loss generally acquires the character of that for which it is substituted (Federal Commissioner of Taxation v. Dixon (1952) 86 CLR 540; (1952) 5 AITR 443; 10 ATD 82). Compensation payments which substitute income have been held by the courts to be income under ordinary concepts (Federal Commissioner of Taxation v. Inkster (1989) 24 FCR 53; (1989) 20 ATR 1516; 89 ATC 5142, Tinkler v. FC of T (1979) 10 ATR 411; 79 ATC 4641, and Case Y47 (1991) 22 ATR 3422; 91 ATC 433).

On the other hand, if the compensation is paid for the loss of a capital asset or amount then it will be regarded as a capital receipt and not ordinary income. Damages awarded for past or future loss or impairment of earning capacity is not ordinary income (Groves v. United Pacific Transport Pty Ltd [1965] Qd R 62).

Taxation Determination TD 93/58 Income tax: under what circumstances is the receipt of a lump sum compensation/settlement payment assessable? explains the circumstances in which a lump sum compensation/settlement payment is assessable, and states that such a payment is assessable income:

• if the payment is compensation for loss of income only (even when the basis of the calculation of the lump sum cannot be determined), or

• to the extent that a portion of the lump sum payment is identifiable and quantifiable as income. This will be possible where the parties either expressly or impliedly agree that a certain portion of the payment relates to a loss of an income nature.

In your case, you sought compensation for lost income and drawings as well as other things. However, there is no identifiable portion of your payment that relates to your loss of income. The payment you received is not compensation for loss of income only and it does not relate to services performed. Rather the payment was received on the finalisation of a dispute you had with your previous employer. The payment is a one-off payment and thus does not have an element of recurrence or regularity. Although the payment can be said to be expected, and perhaps relied upon, this expectation does not arise from any personal services performed.

The payment is not regarded as ordinary income and is therefore not assessable under subsection 6-5(2) of the ITAA 1997.

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 and are also included in assessable income.

The other relevant provisions are discussed below.

Employment termination payment

A payment is an employment termination payment (ETP) if it satisfies all the requirements in section 82-130 of ITAA 1997.

Subsection 82-130(1) of the ITAA 1997 states that a payment is an ETP if:

(a) it is received by you:

(i) in consequence of the termination of your employment; or

(ii) after another person's death, in consequence of the termination of the

other person's employment; and

(b) it is received no later than 12 months after the termination (but see

subsection (4)); and

(c) it is not a payment mentioned in section 82-135.

To find that a payment is an ETP, all the conditions in subsection 82-130(1) of the ITAA 1997 must be satisfied. Failure to satisfy any of one the three conditions will result in the payment not being considered an ETP.

Payment is made 'in consequence of the termination of' your employment

The phrase 'in consequence of' is not defined in the ITAA 1997. However, the courts have interpreted the phrase in a number of cases. Whilst the courts have divergent views on the meaning of this phrase, the Commissioner's view on the meaning and application of the 'in consequence of' test are set out in Taxation Ruling TR 2003/13 Income tax: eligible termination payments (ETP): payments made in consequence of the termination of any employment: meaning of the phrase 'in consequence of'.

While TR 2003/13 contains references to repealed provisions, some of which may have been rewritten, the ruling still has effect as both the former provision under the Income Tax Assessment Act 1936 and the current provision under the ITAA 1997 both use the term 'in consequence of' in the same manner.

In paragraphs 5 and 6 of TR 2003/13 the Commissioner states:

5. ...the Commissioner considers that a payment is made in respect of a taxpayer in consequence of the termination of the employment of the taxpayer if the payment 'follows as an effect or result of' the termination. In other words, but for the termination of employment, the payment would not have been made to the taxpayer.

6. The phrase requires a causal connection between the termination and the payment, although the termination need not be the dominant cause of the payment. The question of whether a payment is made in consequence of the termination of employment will be determined by the relevant facts and circumstances of each case.

In this case, you accepted an employment offer from entity A based on the understanding that they would be offered partnership in the firm after 18 months of employment. Entity A denied that this was promised.

You subsequently sent a letter of demand seeking compensation. Having not received the demands set out you commenced court proceedings.

A deed of release and settlement was signed to resolve the matters of the court proceedings. The partners of entity A agreed to pay you an amount of money.

Based on the above, it cannot be said that the payment follows as an effect or result of the termination of your employment with entity A. The payment is a result of your dispute in connection with an agreement that you would be offered partnership in the firm.

In addition, legal action in regards to the matters settled upon was commenced prior to the termination of your employment.

Further, you terminated your employment with entity A as you found their employment untenable after denial of the promise of partnership.

The sequence of events indicates that the payment does not follow as an effect or result of the termination of your employment. It cannot be said that but for the termination of employment, the payment would not have been made to you.

Therefore, the payment is not in consequence of the termination of your employment. Hence, paragraph 82-130(1)(a) of the ITAA 1997 has not been satisfied.

Payment is received no later than 12 months after that termination

In this case, your employment was terminated and the payment will be received within 12 months after the termination.

Payments mentioned in section 82-135 of the ITAA 1997

Section 82-135 of the ITAA 1997 lists certain payments that are not ETPs. The payment is not a payment mentioned in subsection 82-135 of the ITAA 1997.

Conclusion

The payment is not an ETP in accordance section 82-130 of ITAA 1997, as the payment is not in consequence of the termination of your employment.

Capital gains tax provisions

Amounts received as a lump sum are generally capital in nature and are potentially taxable as statutory income under the capital gains tax (CGT) provisions of the ITAA 1997.

You make a capital gain (or loss) as a result of a CGT event happening (section 102-20 of the ITAA 1997).

A CGT asset is any kind of property or a legal or equitable right that is not property (section 108-5 of the ITAA 1997).

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts considers the CGT consequences for compensation payments.

In your case, your right to seek compensation is an intangible CGT asset (acquired at the time of the compensable wrong) and your ownership of that asset ended when you accepted the settlement sum from the partners. At that time CGT event C2 happened (section 104-25 of the ITAA 1997).

The capital proceeds from a CGT event are the total of the money you have received, or are entitled to receive, in respect of the event happening, and the market value of any other property you have received, or are entitled to receive, in respect of the event happening (worked out as at the time of the event) (section 116-20 of the ITAA 1997).

In your case, the capital proceeds will include the settlement payment paid by the partners to you.

As you acquired your right to seek compensation more than 12 months before the CGT event, you are able to apply the 50% general discount to your capital gain.

Allowable deductions

Section 8-1 of the ITAA 1997 allows a deduction for a loss or an outgoing to the extent to which it is incurred in gaining or producing assessable income, except where the loss or outgoing is of a capital, private or domestic nature.

For legal expenses to constitute an allowable deduction, it must be shown that they are incidental or relevant to the production of the taxpayer's assessable income or business operations. Also, in determining whether a deduction for legal expenses is allowable 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. 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 and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 39 ALR 46; (1932) 2 ATD 169 (the Herald and Weekly Times Case)) and the legal action has more than a peripheral connection to the taxpayer's income producing activities (Magna Alloys and Research Pty Ltd v. FC of T 80 ATC 4542; (1980) 11 ATR 276).

In your case, you are employed as a professional; however the legal costs were not incurred in relation to the way you carried on your day to day income earning activities or the performance of your employment duties.

Your legal costs were incurred in relation to you becoming a partner in the business.

Being a partner of the business would provide you with an enduring benefit.

An expense, will usually be capital in nature where it is incurred with the intention to create an asset or advantage of a lasting and enduring nature. (British Insulated & Helsby Cables Ltd v. Atherton (1926) AC 205) The nature of the advantage sought by the taxpayer is therefore relevant.

The enduring benefit test was adopted and expanded by Dixon J in Sun Newspapers Limited v. FC of T (1938) 61 CLR 337 when expenditure is made once, with a view to bringing into existence an asset or advantage for the enduring benefit of the business, and absent of special circumstances leading to the opposite conclusion, this expenditure would be properly classified as capital.

In your case, being a partner would have provided you with lasting advantages. Such advantages and enduring benefits are capital or of a capital nature.

As outlined above, the payment you received is capital in nature. It follows that the expenses incurred in pursuing the action and obtaining the payment are also capital in nature. Consequently, no deduction is allowable under section 8-1 of the ITAA 1997 for the legal expenses you incurred.

Please note that the legal expenses incurred form part of the cost base for CGT purposes (section 110-25 of the ITAA 1997).