Edited version of your written advice

Authorisation Number: 1051334032355

Date of advice: 21 February 2018

Ruling

Subject: Legal expenses-unpaid wages and redundancy

Question 1

Are you entitled to a deduction for legal expenses incurred to recover unpaid wages, a salary bonus and leave?

Answer

Yes

Question 2

Are you entitled to a deduction for legal expenses incurred in pursuing payment of your redundancy entitlements?

Answer

No.

This ruling applies for the following period

Income year ended 30 June 20XX

The scheme commenced on

1 July 20XX

Relevant facts and circumstances

You were made redundant and signed a deed of release.

You took legal advice and prior to signing the deed of release you instructed your legal representative to check it.

Your legal representative identified that your payment was incorrect and also requested that the reference to certain restrictions on further employment be removed from the deed.

As a result of this, your payment increased, and you were released from the employment restrictions.

The payments which changed due to the legal action were payment in lieu of notice, accrued leave, redundancy payment, and a The Key Performance Indicator (KPI) bonus.

The legal action was subsequently settled. You received increased unpaid pay and redundancy payments. KPI amount is taxable with your pay, and counts as additional pay received.

You have provided a copy of your final deed of settlement with details of the new payments, as well as invoices and receipts to show that you have paid the legal costs incurred.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subsection 6-5

Income Tax Assessment Act 1997 Section 6-10

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Summary

You are entitled to a deduction for the legal expenses you incurred in relation to the recovery of your salary, bonus and leave as it is accepted these expenses were incurred in producing your assessable income.

However, you are not entitled to a deduction for the legal expenses that you incurred in relation to your redundancy entitlements as these expenses were not incurred in producing your assessable income. The advantage you were seeking in incurring the legal expenses is considered to be an advantage of a capital nature. As the nature or character of legal expenses follows the advantage that is sought to be gained by incurring the expenses, the expenses you have incurred are considered to be of a capital nature and are not deductible.

Detailed reasoning

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, or relate to the earning of exempt income.

In determining whether a deduction for legal expenses is allowed, 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.

It also follows that the character of legal expenses is not determined by the success or failure of the legal action.

Unpaid wages, leave and bonus

Subsection 6-5(2) of the ITAA 1997 provides that the assessable income of an Australian resident includes ordinary income derived directly or indirectly from all sources during the year. Salary and wages, including leave payments, is considered ordinary income as it is paid directly as a result of personal services an employee renders for their employer.

Taxation Determination TD 93/29 states that where legal expenses are incurred in pursuing an amount of assessable income which is owed, such as salary and wages, those legal expenses are directly incurred in the process of deriving assessable income and therefore deductible.

Similarly, legal expenses incurred in recovering unpaid bonuses and accrued leave are generally allowable as they sufficiently relate to gaining or producing assessable income and are therefore deductible under section 8-1 of the ITAA 1997.

In Romanin v. FC of T 2008 ATC 20-055; [2008] FCA 1532; 73 ATR 760 (Romanin) the court considered the deductibility of legal expenses incurred by the taxpayer for proceedings at the Industrial Relations Commission. In the proceedings, the taxpayer argued that an employment contract existed where they were entitled to 12 months’ notice, or a payment in lieu of this notice. The employer had denied such a contract existed and had given seven days’ notice.

The proceedings found in favour of the taxpayer and the employer was ordered to pay them the total value of the employment package for the period of 12 months less any salary and other earnings that they had earned in alternative employment during the 12 months following the termination of his employment.

The legal expenses were found not to be capital in nature because the character of the advantage which the taxpayer sought in bringing the proceedings was on revenue account, namely receipt of his contractual entitlement to salary he would have received had he been given 12 months’ notice.

Legal expenses incurred to recover income payments were at issue in Romanin - that is, salary that would have been derived during the notice of termination period, had it been given - will be deductible, even if the receipt was paid as a lump sum and subject to assessment as an employment termination payment.

The cost of legal expenses to recover from an employer a payment in lieu of a termination notice period is deductible. Because the payment is a substitute for regular payments of income which otherwise would have been received, legal expenses incurred to recover the payment is deductible under section 8-1 of the ITAA 1997.

Therefore the portion of legal expenses that relate to your unpaid wages, accrued leave, KPI bonus and notice payment are an allowable deduction.

Redundancy component

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.

Taxation Determination TD 93/29 states:

If the legal action goes beyond a claim for a revenue item such as wages, and constitutes an action for breach of the contract of employment where the essential character of the advantage sought relates to an enduring advantage that is of a capital nature, the legal costs would not be deductible. For example, legal expense relating to an action for damages for wrongful dismissal is not deductible.

Although your legal expenses do not relate to damages for wrongful dismissal, they relate to your redundancy payment in addition to salary and wages. A redundancy payment, being compensation for the loss of the expectation of continuity of service, is a payment that is capital in nature. Such a payment is made to compensate the taxpayer for the loss of their employment position and is regarded as a capital payment (Case Y24 91 ATC 268; AAT Case 6942 (1991) 22 ATR 3184).

Redundancy payments are treated as employment termination payments and subject to special tax treatment that may result in some or the entire amount being included in your income. However 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.

Therefore as a redundancy payment is capital in nature, the legal expenses incurred in obtaining a better redundancy payment will also be capital in nature.

Further information - Apportionment

As your legal expenses are incurred in relation to proceedings that relate to both deductible and non-deductible components, a reasonable apportionment is required to determine the portion of the legal expenses that are deductible.

TD 93/29 states that:

Where the solicitor’s account is itemised, one reasonable basis for apportionment would

be the time spent involving the revenue claim, relative to the time spent on the capital

claim. If the solicitor’s account is not itemised, a possible basis for apportionment would

be either a reasonable costing of the work undertaken by the solicitor in relation to the

revenue claim, or, where this is not possible, an apportionment on the basis of the

monetary value of the claim relative to the capital claim.

You should apply the above principles in determining the portion of the legal expense that relate to the claims for unpaid leave and wages, as well as the redundancy payment.