Edited version of private advice

Authorisation Number: 1051843854449

Date of advice: 10 June 2021

Ruling

Subject: Legal expenses

Question 1

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

Answer

No.

Question 2

Are you entitled to a partial deduction for the legal expenses 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

In a meeting with your employer you were notified that your team would be undergoing a restructure and that your salary package benefits would decrease without any decrease in your responsibilities or role.

You were told that if you did not agree with the decrease in salary package benefits the next discussion would be one of redundancy.

The next morning your employer attempted to undertake a disciplinary process against you which you believe was done in order to circumvent your right to a redundancy payment by raising allegations and accusations which you state are false and had never been raised with you previously. You strongly denied the allegations and accusations.

You sought legal advice on the matter.

Your lawyers wrote to your employer stating: 'The obvious motivation for these baseless allegations was to engage clause X.X of the employment contract in order to circumvent XXX's severance pay liability.' They also advised that you were willing to enter into mediation to resolve the matter.

You did not receive any response to the letters so on XX/XX/XXXX you lodged a general protections application with the Fair Work Commission which stated that the outcome you were seeking was:

1.            Mutual release;

2.            Damages;

3.            Compensation; and

4.            Penalties.

The matter was finalised on XX/XX/XXXX when you and your employer entered into a deed of release under which you accepted a redundancy payment.

You have stated that your legal expenses were incurred 'purely to protect my right to a redundancy payment, and therefore for the purposes of gaining assessable income (redundancy) which the company sought to save on, at a challenging economic period for them.'

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) allows a deduction for a loss or an outgoing to the extent to which it is incurred in gaining or producing assessable income, except where the loss or outgoing is of a capital, private or domestic nature.

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 or business operations. 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.

Legal expenses are generally deductible if they arise out of the day to day activities of the taxpayer's business or employment duties (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). However, even where the legal expenses are connected to a taxpayer's day to day income earning activities, they will not be deductible if the purpose of incurring the expenses is to obtain a capital payment. As the advantage sought is of a capital nature, the expenses are also capital in nature and therefore excluded from being deductible under section 8-1 of the ITAA 1997.

In FC of T v. Rowe (1995) 31 ATR 392; 95 ATC 4691 (Rowe's case), the taxpayer, an employee, was suspended from normal duties and was required to show cause why he should not be dismissed after several complaints were made against him. A statutory inquiry subsequently cleared him of any charges of misconduct or neglect. The court accepted that the legal expenses incurred by the taxpayer in defending the manner in which he performed his duties, in order to defend the threat of dismissal, were allowable. Since the inquiry was concerned with the day to day aspects of the taxpayer's employment, it was concluded that his costs of representation before the inquiry were incurred by him in gaining assessable income. In Rowe's case, the taxpayer was not attempting to obtain a capital payment.

A redundancy payment, being compensation for the loss of the expectation of continuity of service, is a payment that is capital in nature. The payment is made to compensate the taxpayer for the loss of their employment position (Case Y24 91 ATC 268; AAT Case 6942 (1991) 22 ATR 3184).

Redundancy payments are treated as employment termination payments and subject to special tax treatment that may result in some or all of the 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 and any expenses incurred in relation to the capital payment will not be deductible as the expenses are capital in nature.

You have stated that your employer made baseless allegations against you in order to avoid having to pay you a redundancy payment.

You have also stated that the legal expenses you incurred were purely to protect your right to a redundancy payment. If that was the case, then none of your legal expenses would be deductible as all the expenses would be capital in nature. As stated previously, even though a capital payment may be subject to tax, it remains capital in nature and any expenses incurred in relation to the payment are also capital in nature and consequently not deductible.

However, despite your statement that all your legal expenses related to your redundancy payment, we accept that when you initially consulted with your lawyers, you would have received advice on all your options concerning the allegations made against you by your employer about your conduct at work, including the possibility that you could continue working for them. These initial legal expenses incurred in receiving advice about your employment situation are deductible as they were incurred as a consequence of your day-to-day activities as an employee from which you derived assessable income and at that time, were not being incurred in relation to a capital payment.

However, once you decided that you could no longer work for your employer and you sought to protect your entitlement to a redundancy payment then any further legal expenses are capital in nature and not deductible. It is noted that in your general protections application with the Fair Work Commission the first outcome sought was mutual release. Continued employment on mutually agreed terms was not an outcome that was sought.

Therefore, it is clear that, at the latest, by the time you made your general protections application you had decided you could no longer work for your employer and you were seeking to protect your redundancy payment. Consequently, at the least, any legal expenses incurred in preparing the general protections application and subsequent to that, are capital in nature and not deductible given the focus had become to receive a redundancy payment.

Having regard to the advice provided above, you should use the chronologically itemised invoice from your lawyers to determine the amount of your legal expenses that is deductible.