Edited version of private advice

Authorisation Number: 1051908412534

Date of advice: 20 October 2021

Ruling

Subject:Deductions - legal expenses

Question 1:

Are you entitled to claim a deduction for the legal expenses incurred prior to your employment being terminated under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer:

Yes.

Question 2:

Are you entitled to claim deductions for the legal expenses incurred after your employment was terminated under section 8-1 of the ITAA 1997?

Answer:

No.

This ruling applies for the following period

Income year ending 30 June 20XX.

The scheme commences on

1 July 20XX.

Relevant facts and circumstances

Several allegations were made against you while you were employed by Organisation X.

You were suspended and Organisation X sent you a 'Notice of suspension' outlining that you had been suspended from duty on normal remuneration less any amount earned from alternative employment during the suspension period, taking effect immediately on the receipt of the letter, which would remain in place until the investigations were completed or until otherwise determined.

You engaged the services of a legal firm, Company A, to assist you in relation to this matter during your period of suspension.

You participated in interviews with the workplace investigators during your period of suspension.

You were sent a 'Show Cause Notice' by Organisation X in which you were invited to provide a response as to why you should not be subject to disciplinary action in relation to the following allegations against you which included that:

•         XXXX

•         XXXX; and

•         XXXX.

You provided a response after a short period of time.

Organisation X informed you that you were suspended from duty on normal remuneration.

Organisation X informed you that several of the allegations made against you had been substantiated, advising that the proposed disciplinary action was the termination of your employment. It was confirmed that your suspension from duty on normal remuneration would continue until the following month.

You provided a response to Organisation X's intention to terminate your employment.

The suspension of your employment was extended on several occasions to provide you with the opportunity to respond to Organisation X's intention to terminate your employment during the period taken to finalise the disciplinary process, with you receiving normal remuneration during your suspension.

You provided additional submissions to Organisation X in relation to this issue.

Organisation X sent you a letter outlining that that several allegations had been substantiated and your employment was being terminated effective immediately from the date of the receipt of the letter. You had a specified period to make an application for reinstatement in the relevant state's Industrial Relations Commission (IRC) and that you would be paid an amount in lieu of notice, together with any outstanding leave accruals, in accordance with your industrial entitlement.

Your employment with Organisation X was terminated.

You had incurred legal expenses prior to the termination of your employment in relation to services provided by Company A in relation to responding to the allegations made against you.

During the period you were suspended from your employment you received your normal wages.

You received a payment from Organisation X in relation to the period your employment had been terminated which included amounts relating to payment in lieu of notice and unused annual leave.

You continued to use the services of Company A following the termination of your employment, incurring legal fees after your employment had ended and filed a form (the Application) with the IRC which indicated that you were seeking the following:

•         Reinstatement in your former position and remuneration lost between the date the dismissal took effect and the date of reinstatement, or re-employment in another position that Organisation X had available, and the Commission considered suitable.

•         However, if the Commission considers reinstatement would be impracticable, you sought that the Commission make an order that Organisation X pay you an amount of compensation the Commission considered appropriate.

You commenced employment with a new employer several months after your employment with Organisation X had ended, in a lesser paid position.

You attended a conciliation before an Industrial Commissioner during which the income you had lost since the termination of your employment until you obtained your new employment was discussed.

Organisation X and you agreed to settle the Application and you signed a Deed of Settlement with the IRC between Organisation X and you which included that you would be paid a specified amount that was the equivalent to a specified period of salary, less applicable tax to be taxed as an employment termination payment (ETP), being the Settlement amount, with the payment to be made on or after a specified date.

You received a payment notice from Organisation X which indicated that the Settlement amount was a severance ETP.

You received the settlement payment from Organisation X.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Deductions for legal expenses

Section 8-1 of the 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.

Subsection 6-5(2) of the ITAA 1997 provides that the assessable income of an Australian resident includes ordinary income derived directly or indirectly from all sources during the year. Salary and wages, including leave payments, is considered ordinary income as it is paid directly as a result of personal services an employee renders for their employer.

To be deductible in a particular year under section 8-1 of the ITAA 1997, a loss or outgoing must generally have been 'incurred' in that year. 'Incurred' is not defined in the Act and in general terms, an outgoing is incurred at the time a taxpayer owes a present money debt that the taxpayer cannot escape. The courts have been reluctant to attempt an exhaustive definition of incurred, but they have developed a series of guidelines that can be used in assisting to determine whether an item has been incurred in a current year.

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),

•         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 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 incurred in an unfair dismissal action, such as seeking reinstatement after termination and/or damages, are of a capital nature and therefore, not deductible. Alternatively, if the advantage being sought is of a revenue nature, such as unpaid wages, then the legal expenses will be of revenue nature.

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) 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 (1980) 49 FLR 183; (1980) 11 ATR 276; 80 ATC 4542).

Similarly, in FC of T v. Day [2008] HCA 53 and FC of T v. Rowe (1995) 31 ATR 392; 95 ATC 4691, the courts accepted that legal expenses incurred in defending the manner in which a taxpayer performed his employment duties were allowable. No significance was placed by the court on the taxpayer's status as an employee.

Taxation Determination TD 93/29 outlines that 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, such as legal expenses relating to an action for damages for wrongful dismissal are not deductible.

The Courts, Boards and Tribunals have consistently held that the legal expenses incurred by taxpayers in defending themselves against dismissal from their employment are of a capital nature unless they are defending the way they carry out their day-to-day employment duties. This is because:

•         the legal expenses can be regarded as having been incurred once and for all; and

•         the advantage sought to be gained is the preservation of the taxpayer's employment.

In Case L26 79 ATC 126, a majority of the Board of Review No. 1 held that legal expenses incurred by a schoolteacher in appealing to a statutory board against her dismissal were not deductible.

Legal expenses are generally deductible by employees and former employees if they arise out of:

•         recovering unpaid wages, unused annual leave and unused long service leave in accordance with the principles contained in Taxation Determination TD 93/29

•         instituting proceedings and settling disputes arising out of employment agreements, such as to enforce a contractual entitlement (Romanin v FCT (2008) 73 ATR 760)

•         preventing redundancy or dismissal. In FC of T v. Rowe (1995) 31 ATR 392; 95 ATC 4691, 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; and

•         defending the manner in which employment duties are performed: (Inglis and FCT 87 STC 2037).

In contrast, legal expenses incurred in seeking compensation for loss of employment, such as in an action for wrongful dismissal, are not deductible. It is irrelevant if any amount awarded to the employee is calculated by reference to unpaid salary or lost income. As outlined at paragraph 5 of TD 93/29, legal expense relating to an action for damages for wrongful dismissal are not deductible as the claim is of a capital nature.

Allegations were made against you by Organisation X and your employment was later terminated. You incurred legal expenses while you were still employed and continued seeking legal assistance after your employment was terminated.

We have considered your eligibility to claim deductions in relation to the legal expenses you incurred as follows:

Legal expenses incurred prior to the termination of your employment

In this case, allegations were made against you by Organisation X in relation to XXXX, XXXX and XXXX with Organisation X and your other employment outside of your employment with them.

You incurred the legal expenses in relation to providing responses to the allegations and defending the manner in which you performed your employment duties while you were still employed by Organisation X from which you earned your assessable income, to avoid possible termination of your employment.

Therefore, it is viewed that you can claim a deduction for any legal expenses you incurred prior to the termination of your employment with Organisation X.

Legal expenses incurred after your employment was terminated

In your case, you incurred legal expenses after your employment was terminated by Organisation X and you had filed the Application with the IRC in which you indicated that you were seeking either reinstatement to your former position or to be re-employed in another position with Organisation X, or if neither of those then that the Commission make an order to pay you an amount of compensation.

Based on what you were seeking in relation to the Application it is viewed that the objective you were seeking was of a capital nature being your re-employment in your old position or a new position with your former employer, or an amount of compensation, which are all capital in nature.

You entered into a Deed of Settlement which outlined that you would be paid an amount the equivalent to a specified period of salary, less applicable tax to be taxed as an employment termination payment, being the Settlement amount.

Organisation X identified the Settlement amount as being a Severance ETP in the payment notice for the period covering the date the Deed of Settlement was entered into.

While the settlement amount was calculated as being the equivalent of a specified period of salary, and your salary had been used as a basis to calculate the amount, nothing has been provided to support that the amount related to your day-to-day employment duties and was not an ETP.

Therefore, as the Settlement amount is viewed as being an ETP, it will retain its character as a capital receipt that is providing you with an enduring advantage. Accordingly, you cannot claim any deductions in relation to legal expenses incurred after your employment was terminated under section 8-1 of the ITAA 1997.