Edited version of your written advice

Authorisation Number: 1013023684265

Date of advice: 25 May 2016

Ruling

Subject: Legal expenses

Question

Can you claim a deduction for the legal expenses you incurred in the relevant income years?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 20YY

Year ended 30 June 20ZZ

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

You had criminal charges brought against you.

The alleged incident occurred at a function outside work hours.

The function was not held on work premises.

You were off-duty at the time of the alleged incident.

If convicted, you would not have been able to continue your employment.

You were found not guilty on all accounts and acquitted of the charges.

You incurred legal expenses defending these charges.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

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.

The courts on a number of occasions have determined legal expenses to be an allowable deduction if the expenses arise out of the day to day activities of the taxpayer's business. The action out of which the legal expense arises has to have more than a peripheral connection to the taxpayer's income earning activities or professional conduct.  

In Case W94 89 ATC 792; AAT Case 5376 (1989) 20 ATR 4001, the Administrative Appeals Tribunal held that expenditure incurred on legal fees in circumstances where the conduct of the taxpayer was not related to their income earning activities, was not 'incidental and relevant' to the gaining or production of the taxpayer's assessable income.

Similarly, in FC of T v. Rowe (1995) 60 FCR 99; (1995) 31 ATR 392; 95 ATC 4691, 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 the more recent High Court decision, Federal Commissioner of Taxation v. Day [2008] HCA 53; (2008) 70 ATR 14; 2008 ATC 20-064, Mr Day was charged with breaching the standards of conduct and failing to fulfil his duty as an officer. It was found that the requisite connection with his assessable income was present and that he was exposed to the charges by reason of his office. The majority approach in this case was that an expense will satisfy the test outlined in paragraph 8-1(1)(a) of the ITAA 1997 if the occasion of the expense is found in whatever is productive of actual or expected income. They indicated that a broad approach should be taken in determining what activities produced the actual or expected assessable income, and that it is not only the day to day tasks performed by the employee that gain or produce this income.

In your case, the legal expenses were not incurred as a result of you defending the manner in which you performed your employment duties but rather in respect of defending your personal conduct. Although you ultimately could have been terminated from your employment as a result of your alleged actions, this was an indirect consequence of and not the purpose for the legal action.

Several cases have examined the deductibility of expenses incurred in defending charges that may have resulted in the loss of a taxpayer's professional registration and right to practise. One of these cases is Putnin v. Federal Commission of Taxation (1991) 27 FCR 508; 21 ATR 1245; 91 ATC 4097 (Putnin's Case) where the taxpayer, an accountant and a registered trustee in bankruptcy, sought a deduction for legal costs he incurred in defending criminal charges. The taxpayer administered a bankrupt's estate without obtaining an assignment of a director's share, which was subsequently dealt with by the debtor. The taxpayer was charged for conspiring with the debtor and another to defraud the Commonwealth (by some means involving the dealing with the share), and upon that charge he was committed for trial. The taxpayer was acquitted of the charges following a ruling that he had no case to answer. 

On allowing the taxpayers appeal the Federal Court stated:

In the argument presented to this court, great emphasis was laid on the possibility that the taxpayer might, if he had been convicted, have incurred professional censure and cancellation of his registration as a trustee in bankruptcy or as an official liquidator. As a result, his partnership might have been dissolved. But these were all indirect consequences that might or might not have happened. They were neither the object of the prosecution, nor could it be said they would inevitably have followed upon its success.  

The ATO view is that where legal expenses are incurred in defending a taxpayer's actions or conduct arising from their income earning activities (Putnin's Case), the expenditure will, generally, be deductible under section 8-1 of the ITAA 1997. In each case the nature of the alleged misconduct, the scope of a taxpayer's income earning activities and other existing circumstances, will determine whether the legal expenses are a deductible expense. Only legal expenses relating to the defence of actions performed in the natural course of a taxpayer's business activities are allowable deductions. The direct object of the expenditure is an important consideration in determining deductibility. For example, in the above case the deductibility of the expenditure was not affected by the potential consequences arising from prosecution or the desire to protect the taxpayer's professional reputation. These indirect consequences were not the object of the legal action taken against the taxpayer.

In your case, although your potential removal from your employment might have been an indirect consequence of any conviction, it was not the object of the legal action taken against you. The object of the action was your defence against criminal charges brought against you that were outside the scope of your employment duties.

As the legal expenses were not incurred in relation to any authorised employment duties and did not relate to actions undertaken for the purpose of earning your assessable income, it follows that your legal expenses are private and domestic in nature and are not deductible under section 8-1 of the ITAA 1997.