Edited version of private advice

Authorisation Number: 1051819881467

Date of advice: 30 June 2021

Ruling

Subject: Legal expenses

Question

Are you entitled to a deduction for legal expenses incurred in defending your professional registration?

Answer

No.

This ruling applies for the following period periods:

Year ended 30 June XXXX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Background

You are a registered health professional and have been variously employed in your profession.

The Regulation Agency is the charged with the administration of and compliance by health practitioners with the Regulation Law. The Regulation Agency therefore supervises the ongoing registration (and deregistration) of health practitioners.

Having the relevant current registration is a prerequisite to working as a health practitioner.

Employer A

On XXXX 20XX you were, per employer A's letter of that date, informed that they had instigated a formal investigation because it suspected that you had, in the course of your employment with employer A:

• Engaged in improper conduct including unsolicited physical contact with a number of employer A's female employees and at no time was such contact invited;
• Acted improperly at an employer Christmas Function by engaging in a conduct including but not limited to unsolicited physical contact of a sexual nature; and
• On one occasion whilst on duty, unnecessarily conducted a visual examination of a young intoxicated female patient's genitalia.

In your email to the ATO dated XXXX 20XX, you confirmed that as from XXXX 20XX, you were suspended from duty by employer A with pay including your rolled-in-rate allowance. By XXXX 20XX, you remained suspended from the employer A duty while awaiting further investigation, with base pay only as the rolled-in rate allowance had been cut off by XXXX 20XX.

The Regulation Agency

By a letter dated XXXX 20XX, the Regulation Agency informed you that it had received a notification concerning your conduct while in the employer A and required you to provide details of your employment pursuant to your registration as a health practitioner.

On XX XXXX 20XX the Regulation Agency wrote to you proposing to suspend your registration as a health practitioner. It did so on the basis of what the Regulation Agency described as a reasonable belief that, because of your conduct and/or performance, you pose a serious risk to persons. The Regulation Agency indicated there were objective circumstances that support a reasonable belief that you conducted a visual genital examination in circumstances when there was no clinical justification for the examination, and that it was improper.

In that letter, the Regulation Agency also noted that concerns have been raised by several individuals about your conduct towards your colleagues and others. The employer A is in the process of investigating these concerns (along with allegations in relation to a patient) which include allegations of unsolicited physical contact with a number of employer A's female employees and acting improperly at an employer Christmas function. The Regulation Agency was concerned that such alleged conduct might be long-standing and that you utilise your position to engage in improper conduct towards others.

Your lawyers

Given the events described above, you approached your lawyers for legal advice on XXXX 20XX. Your lawyers immediately engaged with the Regulation Agency.

By an agreement between the Regulation Agency and your lawyers, you provided an undertaking not to practise in circumstances were the Regulation Agency indicated it would not move to suspend your professional registration.

As a result of that undertaking, you were required to resign from your part-time casual employment with employer B.

By a letter dated XXXX 20XX the Regulation Agency informed you that it had decided to refer the matter for investigation.

Your lawyers took extensive instructions in a form of detailed statements from you over the ensuing months and engaged in lengthy communication with the Regulation Agency regarding the investigation.

Per letter dated XXXX 20XX the Regulation Agency informed you that the issues being considered as part of the investigation were as follows:

1. Whether you conducted a visual examination of the genitalia of an intoxicated patient without a clinical justification; and

2. Whether you maintained inappropriate and sexualised professional boundaries with colleagues (the Regulation Agency issues)

Your lawyers further variously corresponded with the Regulation Agency in relation to the investigation. They provided a detailed response to the Regulation Agency issues in a letter addressed to the investigator, dated XXXX 20XX. You have provided a copy of this letter.

Over the balance of the XXXX financial year, your lawyers continued to correspond with the Regulation Agency in relation to the investigation, which as at the end of that financial year, was (and still is) ongoing.

As at the date hereof both the Regulation Agency investigation and employer A disciplinary processes are ongoing. It is not presently known when they will be concluded.

Summary of the subject matters of legal advice and representation which produced the expenses which gave rise to the fees in relation to which a deduction is sought

The Regulation Agency received a report from employer A upon the basis of which it determined to initiate an investigation. The issues under investigation are whether you, in the course or your employment

(1) conducted an examination of a patient which was inappropriate and unnecessary; and

(2) was over-familiar with you work colleagues.

The fees

All tax invoices for legal expenses from your lawyers refer to their professional charges inclusive of attending upon you in conference, taking your Statement, drafting and reviewing all written communication between you and the Regulation Agency in relation to the issues which affect your registration as a health practitioner.

The 'undertaking not to practise' while the matter was still under investigation had a similar effect to a suspension of your professional registration. This is because you cannot practise while there is still ongoing investigation on the matter. You confirmed in your email of XX XXXX 20XX that it's still ongoing as of that date.

Relevant legislative provisions

Income tax Assessment Act 1997 Section 8-1

Reasons for decision

Summary

You are not entitled to claim a deduction for legal expenses incurred in defending your professional registration.

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, or a provision of the ITAA 1997 prevents it.

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.

The following guidelines for determining whether a loss or outgoing is of a capital nature have been set down by the High Court in Sun Newspapers Ltd. and Associated Newspapers Ltd. v. Federal Commissioner of Taxation (1938) 5 ATD 23; 5 ATD 87; 61 CLR 337:

• the expenditure is related to the business structure itself, that is, the establishment, replacement or enlargement of the profit yielding structure rather than the money earning process, or
• the nature of the advantage has lasting and enduring benefit, or
• the payment is 'once and for all' for the future use of the asset or advantage rather than being recurrent and ongoing.

That is, where the expenditure is incurred for the purpose of securing an enduring benefit, rather than a revenue purpose, the expenditure is capital in nature and is not deductible.

Outgoings incurred in the preservation of an existing capital asset have been held to be capital in nature (John Fairfax & Sons Pty Limited v. Federal Commissioner of Taxation (1959) 101 CLR 30; (1959) 7 AITR 346; (1959) 11 ATD 510).

Legal expenses are generally deductible if they arise out of the day to day activities of the taxpayer's business (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). It follows, that expenditure will be deductible in earning assessable income if the subject of the claim is something that might ordinarily be expected to occur in carrying out the income earning activities.

In Case U102 87 ATC 621 the taxpayer was a secretary-manager of a large sporting club. Comments about the management of the trust funds were made on television that were defamatory in nature in respect to the trustees. The trustees commenced proceedings for damages for defamation. The Administrative Appeals Tribunal (AAT) held that a deduction for the legal expenses incurred was not allowable. It was found that the events which gave rise to the expenses incurred were not regarded as what is normally expected of a secretary-manager of a club in the course of producing assessable income. The expenses were considered private in nature as the need for them arose out of the taxpayer's reaction to what he saw as a slur upon his personal good name and reputation. Alternatively, it was stated that the expenditure was capital in nature as it was incurred in an endeavour to retain and restore his position as a leading figure in the sports management industry and with it a standing sufficient to pursue his own interest away from the club in the future.

The character of legal expenses is not determined by the success or failure of the legal action (No. 3 Board of Review Case B31, 70 ATC 148).

It is a long-standing principle that a taxpayer does not satisfy section 8-1 of the ITAA 1997 merely by demonstrating some casual connection between the expenditure and the derivation of income. What must be shown is a closer and more immediate connection. The expenditure must be incurred in gaining or producing your assessable income (Lunney's case). These principles have been affirmed by the High Court in Commissioner of Taxation v Payne [2001] HCA 3.

In Commissioner of Taxation v Day [2008] HCA 53 (Day's case), a majority of the High Court held that the legal expenses were incurred by the taxpayer in the course of gaining or producing his assessable income and therefore that paragraph 8-1(1)(a) of the ITAA 1997 was satisfied. The majority also held that the expenses were not of a private nature, because they were incurred in connection with the taxpayer's position as a public servant and were not unconnected to his service like some fines and penalties are.

Kirby J held that the taxpayer had not incurred the legal expenses in gaining or producing his assessable income. The matters giving rise to the expenditure lacked the requisite temporal or other connection with gaining or producing his assessable income. Alternatively, the expenditure was a loss or outgoing of a private nature and therefore excluded from deductibility.

The ATO view on the Day's case decision is expressed in the Decision Impact Statement where relevantly, it states:

The decision does not lay down any rule for the deduction of legal expenses by an employee beyond the requirement that the occasion for the expenses must be found in what is productive of the assessable income of the employee, which will turn on consideration of the scope of the taxpayer's employment which is a question of fact and degree.

Application to your circumstances

For several years you have earned assessable income in the form of salary and allowances as a health practitioner. Having the relevant current registration is a prerequisite to working in a health practitioner role.

On XX XXXX 20XX you were informed by your employer that they had instigated a formal investigation because they suspected that you had, during your employment, engaged in improper conduct.

The Regulation Agency then informed you they would be investigating the charges brought against you by your employer.

You agreed to cease to practise as a health practitioner rather than be suspended by the Regulation Agency. You continue to receive base salary from employer A.

For an expense to be an allowable deduction it must be a loss or outgoing incurred in gaining assessable income, that is, an income-producing expense. In this case, the relevant assessable income is the base salary you received from your employer.

The losses or outgoings were the payment of legal fees in disputing charges in relation to your conduct as a health practitioner. The charges do not relate to your employment. However, you have had to resign from your casual position in a hospital because of the investigation.

The legal expenses did not arise out of the day to day activities of your employment as a health practitioner but occurred after you had been informed by the Regulation Agency that they were investigating you for suspected misconduct. You incurred the legal expenses to defend the retention of your registration as a health practitioner. You require this registration because without it you cannot continue to work in that capacity. As such you are defending your legal right to practise as a health practitioner.

In other words, you incurred the legal expenses for the purpose of defending the retention of your registration as a health practitioner in order to continue deriving assessable income. The legal expenses were not incurred in the course of gaining or producing assessable income as required in paragraph 8-1(1)(a) of the ITAA 1997.

Legal expenses incurred in preserving your position and to help restore your reputation are not deductible as they are considered to provide an enduring advantage and are therefore capital in nature. The advantage sought is the restoration of a capital asset, that is, your means of producing income. As such, the character of the legal expenses is considered to be capital in nature and the expenses are not deductible under paragraph 8-1(2)(a) of the ITAA 1997 (Case Y24 91 ATC 268; AAT Case 6942 (1991) 22 ATR 3184).

Protecting your reputation and position will assist you to continue to derive assessable income in the future as you are then able to retain your registration as a health practitioner. However, it does not have the necessary connection with your current assessable income. As such, the associated legal expenses would be characterised as being of a capital nature. Therefore, you are not entitled to a deduction under paragraph 8-1(2)(a) of the ITAA 1997 for the legal expenses incurred in defending your position and your reputation in order to retain your registration.

Alternatively, the payment for legal representation to defend personal conduct would be characterised as being private in nature. You incurred the legal expenses in defending yourself against allegations of misconduct. Therefore, you're also not entitled to a deduction under paragraph 8-1(2)(b) of the ITAA 1997.