Edited version of private advice

Authorisation Number: 1051608667831

Date of advice: 14 November 2019

Ruling

Subject: Deductibility of legal expenses

Question

Are legal costs incurred in relation to your dispute with your former employer deductible?

Answer

No

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commences on:

01 July 20XX

Relevant facts and circumstances

Your employment agreement with your previous employer included a confidentiality clause and post-employment restraint clause.

Subsequently you commenced employment with another entity that had a division that is a competitor of your former employer.

You received a letter from a legal firm representing your former employer, a copy of which was sent to your current employer. The letter alleged you had breached your contract, specifically the confidentiality clause by copying confidential and commercially sensitive information and the post-employment restraint clause by working with a direct competitor.

You engaged a legal firm to represent you, incurring expenses in defending these accusations.

You signed a Schedule of Undertaking for the benefit of your former employer that you will comply with the confidentiality and post-employment restraint obligations set out in your employment contract with your former employer and that you will provide one of your USB devices so it can be audited.

Your former employer has not taken any further action.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Summary

It is considered that your legal expenses in relation to defending the claims against you were incurred to enable you to continue working in your new employment. They did not relate to the duties of your previous employment or your new employment and therefore, were not incurred in the course of earning your assessable income from either. Also, defending a right to practice a profession or employment is capital in nature, as the right is considered a structural asset and the expenses were incurred to protect this right. Consequently, your legal expenses are not deductible.

Detailed reasoning

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. The costs associated with employment arrangements, and in particular legal expenses associated with settling disputes of the arrangements, may be deductible.

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.

Legal expenses are generally deductible if they arise out of the day to day income earning activities (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).

If the advantage to be gained does not have an immediate connection to the duties undertaken to derive income and has more of an enduring and consequently capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature.

The information provided by you indicated you were defending accusations of breach of contract in relation to confidentiality and restraint of trade.

Below these two matters are addressed independently.

Breach of Confidentiality

Taxation Determination TD 93/29 examines the deductibility of legal expenses in certain situations and states:

If the legal action goes beyond a claim for a revenue item such as wages, and constitutes an action for a 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.

Taxation Ruling TR 2012/8, at paragraph 40 states:

40. Where the legal costs are incurred to enforce a contractual entitlement which relates to a right to income, even if they were incurred after employment has ceased, the taxpayer will be entitled to a deduction under section 8-1.

An example of a situation to which paragraph 40 of TR 2012/8 would apply is where a former employee sues their former employer for a performance bonus they claim that they were entitled to under their employment contract but which was never paid.

In your situation you were defending a claim by your former employer in relation to breach of confidentiality. The claim made was that before returning your company laptop on finishing your employment, you copied confidential information belonging to your former employer without authorisation. This is not considered defense of the manner in which you conducted your usual day to day employment activities and was not in relation to the ordinary earning of income or the carrying out of your day to day income producing duties. Therefore, it is considered that your legal expenses incurred to defend the claim brought against you for breach of confidentiality was not incurred in earning assessable income and consequently are not deductible.

Restraint of Trade

Defending a right to practice a profession or employment is capital in nature, as the right to practice is considered a structural asset and the associated expenses are incurred to protect this right (ATO Interpretative Decision 2004/367; Case V140 88 ATC 874; AAT Case 4596 (1988) 19 ATR 3859 and Case X84 90 ATC 609; AAT Case 6258 (1990) 21 ATR 3721). As the nature of the expense follows the nature of the advantage sought, the expense is also capital in nature.

In your situation, you were defending a claim made by your former employer in trying to enforce a restraint of trade clause in your employment contract. You were defending your right to work for your new employer rather than the manner in which you undertook the duties of your former employment. The advantage sought was to be able to continue your employment with your new employer which is an enduring benefit and consequently capital in nature. As the legal expenses you incurred to defend a claim brought against you for breaching a restraint of trade clause are capital in nature, they are not deductible.