Edited version of your written advice

Authorisation Number: 1012988182803

Date of advice: 22 March 2016

Ruling

Subject: Lump sum and expenses

Question 1

Is your back payment assessable in the relevant financial year?

Answer

Yes.

Question 2

Is your back payment regarded as eligible income for the purposes of calculating your lump sum in arrears tax offset?

Answer

Yes.

Question 3

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

Answer

Yes.

Question 4

Are you entitled to a deduction for your bank charges, study costs and medical expenses incurred?

Answer

No.

This ruling applies for the following periods

Year ended 30 June 2014

Year ended 30 June 2015

Year ended 30 June 2016

The scheme commenced on

1 July 20XX

Relevant facts

Your employer made a considerable error and has underpaid you for several years.

You received a back pay in the relevant financial year.

You incurred legal fees in relation to the above. You engaged the services of your lawyer in 20XX and 20XX when your employer stopped paying you and refused to pay back pay on what they owed. The legal battle went on for many months.

You also incurred the following expenses:

• bank charges,

• study costs,

• out of pocket medical expenses, and

• Medicare.

Your lawyer advised you to take out a bank loan to pay for your living expenses while your employer refused to pay you. The bank charges related to the interest paid and loan fees. These bank charges were incurred in the relevant years.

You started studying in 20XX and continued your studies in 20XX and 20XX. You started the course to further your career, however that changed in 20XX and 20XX and you were then studying under doctor's advice.

Due to your employer's actions you became very ill and incurred medical expenses.

None of the expenses were reimbursed.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5.

Income Tax Assessment Act 1997 Section 8-1.

Income Tax Assessment Act 1936 Section 159ZR.

Reasons for decision

Assessable 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 derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

Taxation Ruling TR 98/1 Income tax: determination of income; receipts versus earnings considers the appropriate method of determining when income is derived under subsection 6-5(2) of the ITAA 1997 where income is earned in one tax year but received in another. Paragraph 42 of TR 98/1 states that salary and wages or other employment remuneration is assessable on a receipts basis. This is irrespective of whether that income relates to a past or future income period. Therefore, a lump sum amount of assessable income in arrears will be included in your assessable income in the year in which it is received.  

In your case, you received a payment in the relevant financial year in respect of income that you earned in previous years. Under section 6-5 of the ITAA 1997 the amount should be included in your assessable income for the relevant financial year, as the income was received in that year. 

As the receipt of a lump sum in arrears can give rise to excessive taxation liability in the year of receipt there is legislative provision that in specified circumstances a lump sum in arrears tax offset is available.  

Lump sum in arrears tax offset

Section 159ZRA of the Income Tax Assessment Act 1936 (ITAA 1936) provides a lump sum payment in arrears tax offset where:

• the assessable income of the taxpayer of a year of income includes an eligible lump sum (or sums), and

• the total arrears amount is not less than 10% of the amount (if any) remaining after deducting the total arrears amount from the normal taxable income of the current year.

An eligible lump sum' is defined as a lump sum payment of eligible income received on or after 1 July 1986 that is included in the assessable income of the taxpayer and accrued, in whole or in part, in an earlier year or years of income (subsection 159ZR(1) of the ITAA 1936). 

Under subsection 159ZR(1) of the ITAA 1936 the definition of 'eligible income' includes salary or wages to the extent to which they accrued during a period ending more than 12 months before the date on which they were paid. 

The salary and wages that you received in the relevant financial year related to income you earned in prior years. Therefore your salary and wages back payment is regarded as 'eligible income'. 

Accordingly, you may be entitled to a lump sum payment in arrears tax offset under section 159ZRA of the ITAA 1936.

Legal expenses 

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. 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.

In Tax Determination TD 93/29 Income tax: if an employee incurs legal expenses recovering wages paid by a dishonoured cheque, are these legal expenses an allowable deduction under section 8-1 of the Income Tax Assessment Act 1997? the Commissioner states that legal expenses incurred by an employee in recovering unpaid wages are deductible under section 8-1 of the ITAA 1997, as the expenses are directly incurred in the process of deriving assessable income.

In your case, you incurred legal expenses in relation to unpaid wages from your employer. As your legal expenses directly relates to your assessable income, a deduction is allowable under section 8-1 of the ITAA 1997.

The expenses are deductible in the year you paid for your legal costs.

Bank charges

Generally, interest expenses incurred for income producing purposes are deductible under section 8-1 of the ITAA 1997, to the extent that it is not capital, private or domestic in nature. The essential character of the expense is a question of fact to be determined by reference to all the circumstances.

Taxation Ruling TR 95/25 Income tax: deductions for interest under section 8-1 of the Income Tax Assessment Act 1997 following FC of T v. Roberts; FC of T v. Smith provides the Commissioner's view regarding the deductibility of interest expenses. As outlined in TR 95/25, there must be a sufficient connection between the interest expense and the activities which produce assessable income. TR 95/25 specifies that to determine whether the associated interest expenses are deductible, regard must be given to all the circumstances including the purpose of the borrowing and the use to which the borrowed funds are put.

The 'use' test, established in the High Court case Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, (1926) 32 ALR 339 is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion. The interest incurred will generally be deductible to the extent that the borrowed funds are used to produce assessable income. That is, it is generally accepted that interest incurred on funds borrowed to acquire an income producing asset is an allowable deduction. However, where the new funds are used for private purposes, no deduction is allowed.

In your case you incurred interest expenses in relation to a bank loan used to pay your living expenses. We acknowledge your specific circumstances and that your employer was refusing to pay you, however living expenses are regarded as private in nature and not directly related to the earning of your assessable income. Therefore the associated interest expenses and loan fees are not an allowable deduction under section 8-1 of the ITAA 1997.

Study expenses

The deductibility of self-education expenses falls for consideration under section 8-1 of the ITAA 1997. Therefore, in considering whether you are entitled to a deduction for your study costs, it is necessary to consider whether the expenses were incurred in the course of gaining or producing your assessable income.

Taxation Ruling TR 98/9 Income tax: deductibility of self-education expenses incurred by an employee or a person in business discusses the circumstances under which self-education expenses are allowable as a deduction. A deduction is allowable for self-education expenses if a taxpayer's current income earning activities are based on the exercise of a skill or some specific knowledge and the subject of the self-education enables the taxpayer to maintain or improve that skill or knowledge (Federal Commissioner of Taxation v. Finn (1961) 106 CLR 60, (1961) 12 ATD 348).

However, no deduction is allowable for self-education expenses if the study is to enable a taxpayer to get employment, to obtain new employment or to open up a new income-earning activity (whether in business or in the taxpayer's current employment). The expenses are incurred at a point too soon to be regarded as incurred in gaining or producing assessable income. They are incurred in getting, not in doing, the work which produces the income (High Court decision in FC of T v. Maddalena 71 ATC 4161; (1971) 2 ATR 541 (Maddalena's case)).

In your case, your study costs were not incurred in the course of earning your assessable income. Rather the study was designed to help you get work in the future. That is, your self-education expenses were not incurred in the course of any actual income earning activity. There is no direct connection between your self-education expenses and your assessable income.

In accordance with TR 98/9, your study costs were incurred at a point too soon to be regarded as incurred in gaining or producing your assessable income. Therefore, the expenses are not deductible under section 8-1 of the ITAA 1997.

Your personal circumstances are acknowledged, however, the legislation does not allow a deduction for your study costs in your situation.

Medical expenses

Generally medical expenses have no direct connection to the gaining or producing of assessable income. The expense relates to a personal medical condition and is private in nature. There is insufficient connection to the gaining or production of assessable income for a deduction to be allowed.

Taxation Ruling IT 2217 Income tax deductions: medical appliances, discusses income tax deductions in respect of medical appliances and various case decisions in relation to medical expenses. In Case Ql7 83 ATC 62, a farmer was denied the cost of a hearing aid which he claimed was an essential tool in carrying on his business. The Board found that the sole purpose of the hearing aid was to aid the taxpayer in overcoming his personal disability in order that he could earn his assessable income. The Board concluded that, although the taxpayer might be unable to earn his assessable income without the aid of the relevant appliance, the outlay on the appliance was not incurred in gaining assessable income or carrying on a business for that purpose, but rather was incurred to help overcome an unfortunate disability suffered by the taxpayer.

In your situation, it is acknowledged that the actions of your employer caused difficulties and illness. However, expenditure on medical expenses is not deductible, even though the expenditure had a causal connection with the earning of income. The expenditure is inherently of a private or domestic nature and not incurred in gaining or producing your assessable income. Therefore no deduction is allowable under section 8-1 of the ITAA 1997 for your medical or Medicare expenses.