Edited version of your written advice

Authorisation Number: 1051437281696

Date of advice: 8 October 2018

Ruling

Subject: Legal expenses

Question

Are you entitled to claim a deduction for legal expenses incurred as a result of the legal proceedings against your employer?

Answer

No

This ruling applies for the following period:

For the financial year ended xx/xx/20XX

The scheme commences on:

xx/xx/20XX

Relevant facts and circumstances

You commenced employment in xx/xx/20XX with your company A.

From the Deed of Release, on or about xx/xx/20XX, company B purchased company A’s business and assets.

You were offered fulltime permanent employment with company B in xx/xx/20XX. You commenced employment for company B in xx/xx/20XX.

You continued to work for company A, which had been retained by company B as a separate business unit.

You reported to the General Manager of company A and to the HR Manager of company B.

After company B took over company A, a number of incidents from your HR Manager of company B occurred in which you were subjected to ongoing inappropriate conduct. You were in a state of unease about your employment status which created a risk to your health and safety.

In xx/20XX, you had a discussion with the General Manager about the status of your employment. The General Manager assured you your position was secure.

You raised a complaint against another employee on or about xx/xx/20XX (with company B).

Numerous requests were made to your employer to investigate your complaint of bullying and harassment.

Your employer failed to investigate your complaint fairly and promptly.

You engaged a lawyer as your complaint had not property been investigated and sought a payment to cover your living expenses to enable you to seek other employment.

Your settlement asked for a payment to cover your living expenses to enable you to seek other employment

You followed the advice of your lawyer in terms of approach to the matter.

In a letter dated xx/xx/20XX from your legal representatives to your employer a without prejudice save as to costs offer was made in paragraph 37.

Notwithstanding the matters set out above, employee A is willing to agree terms to end employment with company B, as follows:

(a) employee A’s position will be made redundant on a date to be agreed;

(b) Company B will pay employee x weeks’ notice in lieu, in accordance with the contract of employment;

(c) Company B will pay employee x weeks’ redundancy pay;

(d) Company B will pay employee outstanding annual leave entitlements;

(e) Company B will pay employee x month’s salary on an ex-gratia basis;

(f) Company B will provide employee with a hardcopy, signed State of Service in agreed terms on Company B letterhead;

(g) Company B will nominate Mr Employer as nominated contact person, who will deal with any third party enquiries regarding employee’s employment and provide a verbal, positive reference;

(h) In consideration of the matters above, employee will enter into a Deed of Release and Settlement in suitable terms, releasing Company B from any claims they may have against it in relation to her employment, to the extent possible at law.

Company B engaged legal representatives who responded to the employee’s legal representatives on xx/xx/20XX making a counter offer.

On the advice of your legal advisor, a response was issued on xx/xx/20XX, rejecting the settlement offer and proposing a new settlement terms.

On xx/xx/20XX, Company B’s lawyers, rejected the counter offer made and made a final offer to resolve the matter.

You resigned your employment with Company A effective xx/xx/20XX.

The terms of the offer are detailed in the Deed of Release dated xx/xx/20XX.

There was no dispute with respect to your leave entitlements.

The terms of the Deed of Release discloses in clause x under the heading Settlement the following details regarding your payment:

Settlement Sum $x,xxx

Reimbursement of legal expenses $x,xxx

Three weeks’ pay in lieu of notice $x,xxx

Accrued annual leave $x,xxx

Your payslip for the period xx/xx/20XX to xx/xx/20XX records the following payments:

Ordinary $x,xxx

Reimbursement (Legal Expenses) $x,xxx

Annual Leave Payout $x,xxx

ETP – 3 x Weeks in lieu $x,xxx

ETP $x,xxx

ETP tax $x,xxx

Clause xx under the heading Acknowledgments in the Deed of Release states:

The employee acknowledges and agrees that the agreement recorded in this deed and payments made to the Employee are not an admission of liability or fault by the employer.

You incurred costs of $x,xxx for the legal services provided.

Your employer reimbursed legal expenses of $x,xxx.

You do not have professional indemnity insurance

You have paid the legal expenses in full.

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 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.

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. 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.

Termination payment

Payments made in consequence of termination of employment are treated as employment termination Payments (ETP's) and are subject to special tax treatment that may result in some or the entire amount being included in the taxpayer's assessable 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 the assessable income of the taxpayer.

Taxation Ruling TR 2012/8 Income tax and fringe benefits tax: assessability of amounts received to reimburse legal costs incurred in disputes concerning termination of employment provides examples of this type of arrangement and how legal expenses are treated. Example 4 reads:

Colin commences legal action claiming that the termination of his employment was unlawful. On execution of a Deed of settlement, Colin received an undissected amount including an unspecified amount to cover Colin's legal costs, within 12 months of that termination.

There is a clear connection between the termination of Colin's employment and the undissected payment made under the deed. The lump sum was paid 'in consequence' of termination of employment, within 12 months of that termination and is not covered by the payments mentioned in section 82-135; it is therefore an ETP.

The legal costs incurred by Colin are not deductible because the advantage sought by the legal action (compensation for loss of employment) is of a capital nature.

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

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.

Annual leave

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, is considered ordinary income as it is paid directly as a result of the personal services an employee renders for their employer.

However, unused annual leave 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. 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.

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