Edited version of your written advice

Authorisation Number: 1051204634407

Date of advice: 5 May 2017

Ruling

Subject: Employment termination payment and legal expenses

Question 1

Is any part of the payment made to you in settlement of legal proceedings brought against the Employer, an employment termination payment in accordance with section 82-130 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Are you entitled to a deduction for legal expenses you incurred from legal proceedings brought against the Employer?

Answer

No.

This ruling applies for the following periods:

Year ending 30 June 201X

The scheme commences on:

1 July 201X

Relevant facts and circumstances

You commenced employment with the Employer in 200X.

In 201X, you were terminated, with immediate effect, by the Employer.

You commenced legal proceedings in the relevant court alleging breach of contract in relation to termination without notice.

You and the Employer agreed to settle their dispute under a Deed of Release (the Deed).

The terms of the Deed include the following:

● In consideration of you agreeing to discontinue the proceedings, the Employer will pay within 21 days of receiving the Deed signed by you:

● An amount to your lawyers, representing a portion of the amount for the claim plus a contribution for your legal costs

You undertook to declare the claim component of the payment, which is not related to legal costs, to the ATO and to pay any taxation liability associated with the payment.

You indemnified the Employer in relation to any taxation liability arising out of the payment, including any penalties imposed in the future by the ATO for the underpayment of taxation liability.

You agreed that in accepting the payment they release and forever discharge the Employer from all claims, demands, actions and proceedings relating to their employment.

Upon receipt of the payment, you forthwith lodged a Notice of Discontinuance with the Court.

You stated they lodged the Notice of Discontinuance, after the Deed was signed by both parties, in 201X.

You incurred legal expenses over the contribution you received for legal costs from proceedings with the Employer.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 82-130

Income Tax Assessment Act 1997 subsection 82 130(1)

Income Tax Assessment Act 1997 subsection 82 130(4)

Income Tax Assessment Act 1997 subsection 82 130(7)

Income Tax Assessment Act 1997 Section 82-135

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 10-5

Reasons for decision

Summary

The amount paid to you in regards to the claim is an employment termination payment (ETP) as defined in section 82-130 of the ITAA 1997.

Detailed reasoning

Employment termination payments

In accordance with subsection 82-130(1) of the ITAA 1997, 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 be an ETP, a payment must satisfy all the conditions in subsection 82-130(1) of the ITAA 1997. Failure to satisfy any one of the conditions under subsection 82-130(1) will result in the payment not being treated as an ETP.

Payment received in 'consequence of' the termination

The phrase 'in consequence of' is not defined in the ITAA 1997. However, the courts have interpreted the phrase in a number of cases. Taking into account the courts decisions on the meaning of the 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' (TR 2003/13).

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. ... 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.

Relevantly, at paragraph 31 of TR 2003/13, the Commissioner considers payments made to settle wrongful dismissal and states:

It is clear from the decision in Le Grand, that when a payment is made to settle a claim brought by a taxpayer for wrongful dismissal or claims of a similar nature that arise as a result of an employer terminating the employment of the taxpayer, the payment will have a sufficient causal connection with the termination of the taxpayer's employment. The payment will be taken to have been made in consequence of the termination of employment because it would not have been made but for the termination.

The payment was made to you to settle a dispute that arose as a result of the termination of your employment. Had it not been for the termination of employment, there would have been no dispute and the payment to settle the dispute would not have been paid to you.

Based on the above, we consider that the payment was made to you in consequence of the termination of their employment.

Payment received within 12 months of termination

Your employment was terminated in 201X. The Deed states that the payment will be made to you within 21 days of you signing the Deed. The Deed was signed in 201X.

Therefore, as the payment was made more than 12 months after the termination date this condition is not satisfied.

However, subsection 82-130(4) of the ITAA 1997 provides that paragraph 82-130(1)(b) of the ITAA 1997 does not apply if a person is covered by a determination under subsection 82-130(7) of the ITAA 1997.

Determination under section 82-130(7) of the ITAA 1997

In accordance with subsection 82-130(7) of the ITAA 1997, the Commissioner can make a legislative determination that paragraph 82-170(1)(b) does not apply to either or both of the following:

(a) a class of payments;

(b) a class of recipients of payments.

To that effect, the Commissioner has issued a legislative instrument SPR 2007-1 - Employment Termination Payments (12 month rule) (SPR 2007-1) which further expands on paragraph 82-130(1)(b) of the ITAA 1997. It states at paragraph 4:

Paragraph 82-130(1)(b) of the ITAA 1997 does not apply to a late termination payment if the payment is received more than 12 months after the termination of a person's employment because:

(a) legal action was commenced within 12 months of the termination of employment, of which the subject is either or both:

(i) the person's entitlement to the payment;

(ii) the amount of the person's entitlement; or …

In this case, you commenced legal proceedings in 201X, which is within the 12 months after your employment was terminated.

Therefore, the determination made under 82-130(7) of the ITAA 1997 applies to your circumstances and provides an exemption from paragraph 82-130(1)(b) of the ITAA 1997.

Payment is not a payment mentioned under section 82-135 of the ITAA 1997

Section 82-135 of the ITAA 1997 lists certain payments that are not ETPs.

The amount awarded to you is not included in the list, therefore this condition is satisfied.

Consequently, the amount paid to you in regards to the claim is an ETP as defined in section 82-130 of the ITAA 1997.

Deductibility of legal expenses

Section 8-1 of the ITAA 1997 allows a deduction for a loss or outgoing to the extent that it is incurred in gaining or producing assessable income and is not of a capital, private or domestic nature.

To determine whether legal expenses are deductible under section 8-1 of the ITAA 1997 it is necessary to consider the nature or character of the expenses.

Section 10-5 of ITAA 1997 includes an ETP as assessable income. The fact that a capital payment is specifically brought to account as assessable income will not change the nature of the payment. An amount that is capital in nature will remain capital notwithstanding that it is specifically included in your assessable income.

Paragraph 5 of Taxation 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?, provides the deductibility of legal expenses incurred in relation to a wrongful dismissal action. This paragraph states that the expenses:

● will be deductible to the extent to which they relate to a claim for items of a revenue nature such as unpaid salary of wages; but

● will not be deductible to the extent to which they relate to a claim for items of a capital nature such as damages.

Compensation in an unfair dismissal action is equivalent to damages in a wrongful dismissal action.

Paragraph 24 of Taxation Ruling IT 2424 provides a compensation payment made by an employer to a former employee in settlement of an unfair dismissal action qualifies as an ETP, as it is considered to be made 'in consequence of the termination of any employment of the taxpayer'. For this reason an ETP is capital in nature.

The character of legal expenses is determined by the character of the advantage which is sought to be gained by incurring in the expenses (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 3 AITR 436; (1946) 8 ATD 190). If the advantage sought to be gained is of a capital nature then the legal expenses will also be of a capital nature.

The character of legal expenses is not determined by the success or failure of the legal action (Case B31 70 ATC 147; (1970) 15 CTBR (NS) Case 93).

In your case, your settlement with the Employer resulted in you receiving an ETP. This is a capital payment.

In your case, according to the deed of release, your legal expenses were reimbursed by the Employer, with a contribution for your legal costs. You incurred actual legal expenses greater than the contribution paid by the Employer.

However, the redundancy payment you received is capital in nature and consequently the legal expenses incurred in obtaining your redundancy payment are also capital in nature.

Therefore, no deduction is allowable under section 8-1 of the ITAA 1997 for your legal expenses you incurred in the proceedings with the Employer.