Edited version of private advice

Authorisation Number: 1051524724484

Date of advice: 5 June 2019

Ruling

Subject: Legal expenses

Question 1

Are you entitled to a deduction for legal fees of $X,XXX associated with taking legal action against your employer in relation to your employment contract?

Answer

Yes

Question 2

Are you entitled to a deduction for legal fees of $XX,XXX associated with taking legal action in relation to the return of shares to a related entity?

Answer

No

This ruling applies for the following period:

Year ended 30 June 2018

The scheme commences on:

1 July 2017

Relevant facts and circumstances

You are the director of Company A where shares were issued to the following entities in the following percentages:

Shareholder A- XXXX Ordinary shares (XX%)

Shareholder B- XXXX Ordinary shares (XX%)

Shareholder C- XXXX Ordinary shares (XX%)

Shareholder B is the corporate trustee for Trust A where your spouse is the sole director and shareholder. The trust deed of the Trust A lists your spouse as the named beneficiary with a general clause of eligible beneficiaries including spouse of the named beneficiary.

Shareholder B as trustee for Trust A owned XX% of the shares in Company A. Company B entered in to an agreement with Shareholder B to purchase the XX% of shares in return for ordinary shares in Company C which is the holding company of the group that includes Company B. A binding term agreement was executed. The term sheet also included an employment contract for you which was executed.

The share Sale and Subscription Agreement was executed for the sale of shares in Company A and the acquisition of shares in the buying entity (Company C), however, a share certificate was not issued.

The Executive Chairman of Company B informed you in a meeting that Company A is no longer a strategic fit and wishes to pass 100% of its shares in Company A back to Shareholder B.

Company C threatened to wind up Company A in the event you and Shareholder B declined the offer. At this point you and Shareholder B sought legal advice and appointed lawyers.

In a letter dated XX/XX/XXXX you were advised that Company B had 'recently become aware of a number of matters that, if established, could amount to serious misconduct by you in the course of your duties.' You were forced to take 'special leave' (with pay) pending an investigation. An investigator was to be appointed and you were to be given the opportunity to respond.

Through legal intervention, you and your lawyer forced Company C to issue the share certificate.

The shares were issued to Shareholder B.

An investigation into your potential serious misconduct had not commenced and an investigator had not been appointed. You and your lawyer sought the enforcement of the employment contract terms and the payout of the remaining X years of the Y year contract.

The company countered with the transfer of the original business back to Shareholder B with no consideration. Through a series of meetings, no agreement was reached between the two parties.

On the basis that the company would form a constructive dismissal case against you, you resigned your position.

Neither an investigation nor an investigator have been advised and no matters have been documented to you that would potentially lead to a dismissal.

The company intends to wind up Company A and legal advice suggests that any post-employment restraints would disappear on the wind up of the original business.

You lodged a small claims submission as Company B did not pay your final payment which included salary, leave benefits and expense reimbursements.

You incurred legal expenses of $X,XXX in relation to your employment contract.

Legal expenses of $XX,XXX were also incurred with respect to the legal action in relation to the return of shares to Shareholder B.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that a loss or an outgoing is an allowable deduction if it is incurred in producing assessable income or in carrying on a business for the production of assessable income unless that loss or outgoing is capital or of a private or domestic nature.

In determining whether a deduction for legal expenses is allowed 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.

In FC of T v. Rowe (1995) 31 ATR 392; 95 ATC 4691, an employee incurred legal expenses in defending the manner in which he performed his employment duties. The court accepted that such expenses were allowable and no significance was placed on the taxpayer's status as an employee.

Accordingly, for legal expenses to be deductible, you have to be able to show that it was the very act of performing the prescribed or authorised activities of your employment that exposed you to the legal expenses. If it is something other than employment duties that exposed you to the legal expenses, the necessary nexus with the earning of assessable income cannot be established and the expenses are not allowable.

In the High Court decision in Federal Commissioner of Taxation v. Day [2008] HCA 53; (2008) 70 ATR 14; 2008 ATC 20-064 (Day's case), the taxpayer was charged with breaching the standards of conduct and failing to fulfil his duty as a Customs Officer. It was found that the requisite connection with his assessable income was present and that he was exposed to the charges by reason of his office, including the obligation to observe standards of conduct, breach of which might entail disciplinary charges.

It held that the legal expenses were allowable deductions and could not be viewed as private or domestic in nature.

Similar to Day's case, the legal expenses of $X,XXX you incurred arose because of your employment and were directly related to income derived, or expected to be derived, from your employment position.

You incurred legal expenses in defending yourself against a claim made against you in regards to the performance of your employment duties. The legal expenses are directly related to the performance of your duties from which you earned your assessable income. Therefore the legal fees are deductible under section 8-1 of the ITAA 1997.

However, the expenses of $XX,XXX incurred for the legal action in relation to the return of shares to Shareholder B are not deductible. That matter is to do with the ownership of the business and consequently is capital rather than revenue in nature. As these legal expenses are capital in nature they are not deductible under section 8-1 of the ITAA 1997. In any case, even if these legal expenses were not considered to be capital in nature, they were incurred in relation to shares that were never owned by you. Rather, the shares had been owned by Shareholder B and were proposed to be returned to them. Although you were an eligible beneficiary of the discretionary trust which Shareholder B is the trustee of, this does not mean that the shares were an income earning asset of yours. That is, these legal expenses related to an income earning asset of another entity. Consequently, you would not be entitled to a deduction for these expenses even if they were not considered to be capital in nature.