Edited version of your written advice

Authorisation Number: 1013098485705

Date of advice: 27 September 2016

Ruling

Subject: Deductibility of legal expenses

Question

Are you entitled to a deduction for the legal costs incurred?

Answer

Yes

This ruling applies for the following period:

Year ended 30 June 2016

The scheme commences on:

1 July 2015

Relevant facts and circumstances

You are an employee.

During your duties as an employee you were charged with an offence that resulted from activities of your employment.

You were subsequently suspended from your duties.

You were required to appear in court to defend the charges.

You incurred legal expenses during the relevant period, of which you paid yourself.

You were found not guilty of the charge.

If the verdict had been guilty you may have faced jail time and loss of your employment.

You are currently still suspended from duties until you are advised you may return to work.

You are suspended on pay.

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 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.

A number of significant court decisions have determined that for an expense to be an allowable deduction:

• it must have the essential character of an outgoing incurred in gaining assessable income or, in other words, of an income-producing expense (Lunney v. FC of T; (1958) 100 CLR 478), 

• there must be a nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income (Ronpibon Tin NL v. Federal Commissioner of Taxation (1949) 78 CLR 47), and

• it is necessary to determine the connection between the particular outgoing and the operations or activities by which the taxpayer most directly gains or produces his or her assessable income (Charles Moore Co (WA) Pty Ltd v. Federal Commissioner of Taxation (1956) 95 CLR 344; Federal Commissioner of Taxation v. Hatchett 1(971) 125 CLR; 71 ATC 4184).

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.

Legal expenses are generally deductible if they arise out of the day to day income earning activities of the taxpayer (Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 39 ALR 46; (1932) 2 ATD 169) and the legal action has more than a peripheral connection to the taxpayer's income producing activities (Magna Alloys and Research Pty Ltd v. Federal Commissioner of Taxation 80 ATC 4542; (1980) 11 ATR 276).

In Federal Commissioner of Taxation v. Rowe (1995) 31 ATR 392; 95 ATC 4691, the taxpayer, an employee, was suspended from normal duties and was required to show cause why he should not be dismissed after several complaints were made against him. A statutory inquiry subsequently cleared him of any charges of misconduct or neglect. The court accepted that the legal expenses incurred by the taxpayer in defending the manner in which he performed his duties, in order to defend the threat of dismissal, were allowable. Since the inquiry was concerned with the day to day aspects of the taxpayer's employment, it was concluded that his costs of representation before the inquiry were incurred by him in gaining assessable income.

When the principal reason for incurring the legal expenses is defending the actions of the taxpayer in carrying out their employment duties through which they gain or produce assessable income, such expenses are characterised as being of a revenue nature and are deductible (Inglis v. Federal Commissioner of Taxation 87 ATC 2037; and Case V116 88 ATC 737; AAT Case 4502 (1988) 19 ATR 3703).

In a High Court decision in Federal Commissioner of Taxation v. Day (2008) HCA 53, (Day's case), Mr Day was an officer of the Australian Customs Service who was charged with breaching the standards of conduct and failing to fulfil his duty as an officer. He was suspended without pay. He incurred legal expenses to defend himself against the charges. 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.

As highlighted in Days case, to establish the necessary connection to the employment or service which is productive of income, much will depend upon what is entailed in the employment and duties of the employee. Whether expenses are incurred in gaining or producing assessable income looks to the scope of the operations or activities and the relevance to any legal expenses incurred. The scope of a taxpayer's employment is a question of fact and degree.

The majority approach in Day's 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. It was 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.

The significant factors affecting the decision in this case included the fact that the legal expenses were incurred in responding to action internal to the employment relationship and existed for no other purpose. The taxpayer in Days case was exposed to the action by reason of his employment and the consequences of the action only affected his employment.

Your case can be compared to Days case. As an employee you incurred legal expenses in undertaking legal action to defend yourself against a charge that resulted from the activities of your employment. You were required to defend the way in which you performed your duties.

In accordance with Day's case, your legal expenses are not considered to be private in nature as they were related to an issue that arose while carrying out your employment position. That is, the legal action arose as a result of your employment.

Accordingly, the legal expenses you incurred have the requisite connection to your income earning activities and you are entitled to a deduction for these expenses under section 8-1 of the ITAA 1997.