Edited version of private advice

Authorisation Number: 1051781855895

Date of advice: 03 December 2020

Ruling

Subject: Legal expenses

Question

Are you entitled to a full deduction for all the legal expenses you incurred?

Answer

No

Question

Are you entitled to a partial deduction for the legal expenses you incurred?

Answer

Yes

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You commenced employment in your chosen industry in 20XX.

In or around 20XX, your manager at Company X conducted a performance appraisal. A dispute arose between you and your manager regarding the performance appraisal.

Mediation occurred 20XX, to resolve this dispute where outcomes were meant to have been achieved; this did not occur.

For several months other incidents occurred with your manager, which led you to lodge a formal workplace harassment complaint in 20XX.

After lodging the formal complaint, you were then subjected to a code of conduct complaint by another employee. You defended this claim.

You engaged the services of an industrial relations (IR) lawyer who provided you with employment advice and dispute resolution advice.

It became apparent that there was no future for you working at Company X and you through your lawyer put forward a separation proposal to Company X which included an amount made up of certain payments.

The Deed of Settlement and Release was executed in 20XX and you received $XX,XXX.

You incurred $XX,XXX in legal expenses.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Summary

Expenditure incurred in earning assessable income is deductible except to the extent it is private or capital in nature.

The dispute with Company X essentially involved a disagreement between you and your manager concerning your performance and workplace incidents between the two of you. You believe a complaint against your workplace conduct was retaliation against the complaint you made against your manager's conduct. The portion of your legal expenses that relate to you initially seeking advice from your IR lawyer on how to resolve these issues in order to remain in your employment with Company X are deductible. This is because you were defending the way in which you undertook your employment duties so that you could continue earning income from your current employment and this advantage that was sought is not considered to be capital in nature.

However, once you decided that there was no future for you working for Company X and instead sought to receive payments from them, then the deductibility of the legal expenses you incurred from that point onwards depends on the nature of the payments you were seeking, that is, whether the payments sought were revenue or capital in nature.

For example, payments for contractually entitled salary in lieu of notice and unused annual leave are amounts of a revenue nature rather than of a capital nature. Therefore, the portion of your legal expenses that were incurred in attempting to obtain these payments are deductible.

However, a redundancy type payment is a capital payment. Therefore, the portion of your legal expenses that were incurred in seeking payment of an amount in recognition of your years of service is considered to be expenditure of a capital nature. Consequently, this portion of your legal expenses is not deductible.

You will need to apportion the legal expenses in a reasonable manner.

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. If the advantage to be gained is of a capital nature, then the expenses incurred in gaining this advantage will also be of a capital nature.

The courts, on a number of occasions, have determined legal expenses to be an allowable deduction if the expenses arise out of the day to day income producing activities of the taxpayer (The Herald and Weekly Times Ltd v. FC of T (1932) 48 CLR 113). The action out of which the legal expense arises has to have more than a peripheral connection to the taxpayer's business or income earning activities. The expense may arise out of litigation concerning the taxpayer's professional conduct (Magna Alloys and Research Pty Ltd v. FC of T (1980) 11 ATR 276; 80 ATC 4542; Putnin v. FC of T (1991) 21 ATR 1245; 91 ATC 4097).

When legal action is undertaken to obtain a payment, then the deductibility of the legal expenses depends on whether the payment sought is revenue in nature, such as unpaid wages, or whether the payment sought is capital in nature, such as a redundancy type payment or compensation for unfair dismissal.

This principle is confirmed in Taxation Determination TD 93/29 which states that if an employee incurs legal expenses in recovering wages, the legal expenses are an allowable deduction providing that the legal action relates solely to the recovery of wages. The ruling continues: -

5. However, 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, are not deductible.

6. There will often be occasions where the legal expenses are incurred in relation to proceedings that relate both to accounts that are revenue in nature as well as amounts which are capital in nature. For example, many proceedings in relation to wrongful dismissal will also involve the recovery of unpaid salary or wages. In these circumstances '....there must be some fair and reasonable assessment of the extent of the relation of the outlay to assessable income' (Ronpibon Tin N.L. v. FC of T (1949) 78 CLR 47 at 59).

Generally, legal expenses incurred in an unfair dismissal action (seeking reinstatement and/or damages) are of a capital nature and therefore, not deductible.

When legal expenses are incurred in relation to proceedings that relate both to claims that are revenue in nature as well as those of a capital nature, there must be some fair and reasonable apportionment of the extent of the relation of the outlay to the revenue claim.

TD 93/29 paragraph 7 discusses the apportionment of legal expenses.

7. Where the solicitors 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 solicitors 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 revenue claim relative to the capital claim.

Application to your circumstances

In your case, you were involved in a disagreement with your manager concerning your performance and there were workplace incidents between the two of you. Also, you were later the subject of a complaint over workplace conduct which you believe was unfounded. You obtained legal advice through an IR lawyer initially to resolve these issues so you could continue your employment.

However, when it became clear that there was no future for you working for Company X, you accepted your IR lawyer's advice to offer them a separation proposal. Under the proposal you sought an amount made up of certain payments.

Initially you were seeking to defend the manner in which you undertook your employment duties in order to continue your employment. The advantage sought at this stage was not capital in nature and therefore this portion of your legal expenses is deductible.

Once you determined that you could no longer continue working for Company X and instead sought to obtain certain payments, the deductibility of your subsequent legal expenses is determined by the nature of those payments you were seeking. As stated previously, the nature of legal expenses follows the nature of the advantage sought in incurring the legal expenses. Therefore, if you are seeking a capital payment then the advantage you are seeking is capital in nature and consequently the legal expenses incurred in trying to obtain that capital payment are not deductible.

For example, payments for contractually entitled salary in lieu of notice and unused annual leave are revenue in nature and therefore, legal expenses incurred in seeking those payments are also revenue in nature and deductible.

However, a redundancy type payment such as payment on termination for recognition of years of service is a capital payment. Therefore, legal expenses incurred in seeking this type of payment are also capital in nature and consequently not deductible.

As the legal expenses you have incurred are both revenue and capital in nature, you will need to apportion the legal expenses in a reasonable manner. You will need to apply the principles in paragraph 7 of TD 93/29 in undertaking the apportionment.

Note: Some capital payments such as capital gains or a golden handshake termination payment are included in assessable income by specific provisions in the ITAA 1997. Although capital payments may be included in assessable income, this does not mean they are no longer capital in nature or that expenses incurred in obtaining those payments are not capital in nature. That is, expenses incurred in seeking a capital payment are capital in nature and therefore not deductible under section 8-1 of the ITAA 1997 and the fact that some, or all, of the capital payment may be included in assessable income does not change that outcome.