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Authorisation Number: 1051269872416

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Date of advice: 16 August 2017

Ruling

Subject: Legal fees and compensation payment

Question 1

Is a deduction allowed under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for legal fees incurred in defending a claim for a breach of employment contract with a previous employer?

Answer

No

Question 2

Is a deduction allowed under section 8-1 of the ITAA 1997 for amounts paid in compensation as directed by the courts in relation to the abovementioned legal matter?

Answer

No

This ruling applies for the following periods:

01/07/201x to 30/06/201z

The scheme commences on:

01/07/201x

Relevant facts and circumstances

The taxpayer was employed for several years before the taxpayer was made redundant.

The taxpayer received notification from the previous employer via a solicitor stating that the taxpayer had breached the employment contract with respect to restraint of trade.

A lawyer was employed who sent a letter to the previous employer denying the claim and agreeing to honour the employment contract.

Despite the agreement the previous employer pursued the matter through the Supreme Court.

A solicitor was retained by the taxpayer however due to large legal costs it was agreed to accept the restraint of trade.

The matter was settled and the taxpayer was required to pay damages.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Question 1

Summary

A deduction is not allowable for legal fees incurred in defending a breach of employment contract with a previous employer.

Detailed reasoning

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 were incidental or relevant to the production of your assessable income (Ronpibon Tin N.L.Tongkah Compound N.L. v. Federal Commissioner of Taxation (1949) 78 CLR 47; [1949] HCA 15; (1949) 8 ATD 431; (1949) 4 AITR 236).

The expenditure must therefore be related to the production of assessable income and not incurred at a point too soon to be deductible (FC of T v. Maddalena 71 ATC 4161; (1971) 2 ATR 541).

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) 8 ATD 190; (1946) 3 AITR 436). The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses.

In the taxpayer’s situation, they were defending action taken by a previous employer to prevent them from working for a competitor.

It is considered that the legal expenses did not relate to the duties of the previous or future employment and therefore were not incurred in gaining or producing assessable income. The legal expenses resulted from a contractual dispute in relation to subsequent employment in the context of a restraint of trade.

Defending a right to practice a profession or employment is capital in nature as the ‘right’ is considered a structural asset as established in Case V140 88 ATC 874; and AAT Case 4596 (1988) 19 ATR 3859. As the nature of the expense follows the nature of the advantage sought, the expense is also capital in nature.

The taxpayer is therefore not entitled to a deduction for legal expenses incurred to defend the employment contract clause regarding restraint of trade.

Question 2

Summary

A deduction is not allowable for the settlement paid with respect to the breach of employment contract.

Detailed reasoning

The Supreme Court ordered the taxpayer to pay damages for breaching a contract between themselves and their previous employer subsequent to the termination of that employment. The settlement was incurred in relation to a restraint of trade in which the taxpayer was unable to engage in employment in their industry or any related industry for a period of six months.

The settlement was not incurred in carrying out employment duties for the previous or subsequent employers.

The expenditure incurred on paying the settlement also did not arise as a consequence of the performance of the duties from which the taxpayer derived assessable income.

Although the legal expenses and settlement amount may have been incurred for the purpose of deriving employment income it does not necessarily follow that they were incurred in the course of gaining or producing that income.

The settlement amount and the legal expenses associated with the settlement are capital in nature (British Insulated & Helsby Cables v. Atherton (1926) AC 205). Therefore, the settlement amount and the associated legal expenses are not deductible under section 8-1 of the ITAA 1997.