Edited version of your written advice

Authorisation Number: 1051431961920

Date of advice: 15 October 2018

Ruling

Subject: Income Tax Deductions – Legal Expenses

Question 1

Are you entitled to a deduction for legal expenses incurred seeking advice on defending your employment?

Answer

Yes

Question 2

Are you entitled to a deduction for legal expenses incurred in relation to negotiating a suitable termination package and preparing your Deed of Release?

Answer

No

This ruling applies for the following period:

For the financial year ended 30 June 2018

The scheme commences on:

1 July 2017

Relevant facts and circumstances

You were employed.

Your role involved acting in a management capacity on a day to day basis running a specific department until you took leave.

On return from leave you were not working in the same department.

Your role had been filled permanently whilst you were on leave.

Your base pay was unaltered. Your bonus after leave however was much less than prior to taking leave.

You were issued a formal warning that you sought to defend.

You followed the advice of Lawyers in terms of approach to the matter.

A letter was issued by your Lawyers to your employer in relation to negotiating an exit from your employment which was followed up with a confidential agreement.

You have provided relevant clauses of your agreement which detail the obligations of the parties.

You resigned from your employment subject to a settlement deal.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 6-10

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 (Lunney’s case)),

● 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. FC of T, (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. FC of T, (1956) 95 CLR 344; FC of T v. Hatchett, 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 (the Herald and Weekly Times Case)) and the legal action has more than a peripheral connection to the taxpayer's income producing activities (Magna Alloys and Research Pty Ltd v. FC of T 80 ATC 4542; (1980) 11 ATR 276).

In FC of T 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.

Taxation Ruling TR 2000/5 Income tax and fringe benefits tax: costs incurred in preparing and administering employment agreements states that expenses incurred by an employee to settle a dispute with their current employer over their employment conditions are incurred in earning assessable income and are therefore generally deductible.

Workplace allegations

You incurred legal expenses in relation to seeking advice on your employment situation in responding to issues raised by your employer.

The associated legal expenses in seeking advice about your current employment situation and possible ways to restore or improve your day to day working conditions were a consequence of defending your rights under your current employment situation. It is considered that this portion of your legal expenses was a consequence of your day to day activities as an employee from which you derived assessable income. Therefore the associated legal expenses incurred are deductible under section 8-1 of the ITAA 1997.

Ex-gratia payment

In your case, you incurred a portion of the legal expenses negotiating a suitable termination package, seeking to obtain the ex-gratia payment. Legal expenses incurred in negotiating a termination package do not sufficiently relate to your day to day employment duties. Although the ex-gratia payment may be included in your assessable income, the ex-gratia payment retains its character as a capital receipt.

Under the terms of the agreement, the employer agreed, without admission of liability, to make an ex-gratia payment to you and you agreed to release the employer from all claims and liability arising out of or in connection with the employment and the cessation of your employment.

It follows, even if the claims by you amount to discrimination, there is no evidence to indicate that any part of the payment was calculated with regard to the nature and extent of your discrimination.

The ex-gratia payment is a single un-dissected lump sum payment which bears no relation to a capital payment for, or in respect of, the events that occurred to you.

Further, there is nothing to indicate that any part of the Provisions of benefits sum has been calculated with regard to your likely loss of income producing capacity. Rather, the payment was simply made in full resolution of claims arising from or in relation to the dispute, the employment, the termination and any act or omission of the employer during your employment.

Accordingly, it is considered that the ex-gratia payment was made to settle all matters and claims arising out of, or in connection with, your employment and for the cessation of your employment. The payment was not made in respect of any discrimination.

The fact that a capital payment is specifically brought to account as assessable income will not change the nature of the payment. That is, an amount that is capital in nature will remain capital notwithstanding that it is specifically included as assessable income.

The legal expenses that you incurred in relation to the negotiation of your lump sum termination payment are also capital in nature as they are considered to provide an enduring advantage and are therefore not deductible under section 8-1 of the ITAA 1997.

Bonus and annual leave payment

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

However, your bonus payment and unused annual leave (although acquired through personal services and thus characterised as ordinary income) are considered to be forms of statutory income under section 6-10 of the ITAA 1997. There is no indication that there was a dispute over your unused leave entitlements or bonus payment. Rather it appears you would simply have received those entitlements after you agreed to resign as part of your settlement and therefore no portion of your legal expenses were incurred in relation to those entitlements.

In view of the facts provided it is considered that the payment of the bonus (a percentage of pro-rated salary) was not in consequence of your termination of employment as it represents a bonus earned by you on their performance up to the date of their termination of employment.

Accordingly, the legal expenses incurred in gaining your annual leave and bonus payments are not deductible under section 8-1 of the ITAA 1997. 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.

Apportionment of expenses

As outlined above, your legal costs relate partly to deductible legal action and partly to non-deductible legal action. Therefore only the relevant portion of the associated legal expenses is an allowable deduction.

The portion of the legal costs incurred in relation to your employment duties are considered to be sufficiently connected to your assessable income and deductible. However, the portion that relates to the termination package and Deed of Release are capital in nature and no deduction is allowed for these associated legal expenses.

You will need to apportion the expenses using a reasonable basis. Apportionment is a question of fact and involves a determination of the proportion of the expenditure that is attributable to deductible purposes. The Commissioner believes that the method of apportionment must be fair and reasonable in all the circumstances.