Edited version of private advice

Authorisation Number: 1051979408022

Date of advice: 25 May 2022

Ruling

Subject: Deductibility of legal expenses and employment termination payment

Question 1

Are the legal expenses incurred in your claim against your previous employer an allowable deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Is the lump sum payment made to you by your former employer an Eligible Termination Payment (ETP) under section 82-130 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following periods:

Year ending 30 June 20XX

Year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You were employed on a full time basis by your previous employer for approximately 14 years.

You were engaged under the original contract at the beginning of your employment, that contract contained oral and implied terms.

You contract was amended around 7 years into your employment period.

The new contract was also partly oral and partly written, it contained implied terms. The oral terms included a conversation in which you said to your employer that you were dissatisfied with your remuneration, you said you wanted an amount on top of your annual salary to secure your employment for the next 10 years.

The new contract consisted of a letter from your previous employer containing the following contractual terms:

•         The period of the contract would be for 10 years from 1 July 20XX to 30 June 20XX

•         You would receive a golden handshake payment of an amount (plus tax) paid over the next ten years instead of one lump sum payment.

The calculation of the payment was worked out in the contract.

You assert it was an oral or implied term of the new contract that the period of the contract and the payments set out in the contract were in respect of your work for the company.

Your employment was terminated, you were paid five weeks termination payment.

You sought legal advice with the intention to pursue a claim for breach of contract and wrongful dismissal against your previous employer.

You commenced legal proceedings against your previous employer and incurred legal expenses.

The parties signed a Deed of Settlement and Release, agreeing to the payment of a specified amount within 28 days.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997section 82-130

Income Tax Assessment Act 1997 subsection 82-130(1)

Income Tax Assessment Act 1997 subsection 82-130(4)

Income Tax Assessment Act 1997 subsection 82-130(5)

Income Tax Assessment Act 1997 section 82-135

Reasons for decision

Question 1

Deductibility of 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, or relate to the earning of exempt income.

In determining '...whether expenditure has the character of a capital or revenue payment... the advantage for which the expenditure was incurred must be identified and the manner in which it "is to be relied upon or enjoyed" must be considered...' (Magna Alloys & Research Pty Ltd v. Federal Commissioner of Taxation 80 ATC 4542 at 4548; 11 ATR 276 at 283). The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses, that is, whether the legal expenses are incurred for a capital or a revenue purpose.

Taxation Determination TD 93/29 Income tax: if an employee incurs legal expense recovering wages paid by a dishonoured cheque, are these legal expenses an allowable deduction under section 8-1 of the Income Tax Assessment Act 1997? articulates the Commissioners view on legal expenses and how they are viewed. The rulings states that if an employee incurs legal expense in recovering wages, the legal expenses are an allowable deduction providing that the legal action relates solely to the recovery of wages. TD 93/29 goes on to state:

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 expenses relating to an action for damages for wrongful dismissal, are not deductible.

In your case, the legal expenses were incurred in your action against your former employer for breach of contract and wrongful dismissal. The amount you were seeking to recover is calculated based off the future payments owed under the contract. The essential character you were seeking to recover under the contract is capital in nature as relates to an enduring advantage and does not relate to salary or wages owed for services already performed.

The deductibility of your 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. Compensation for loss of employment such as wrongful dismissal, is a capital receipt. It is irrelevant if any amount awarded to a claimant is calculated by reference to unpaid or lost income. Legal costs incurred in seeking such compensation are not deductible because the nature of the advantage sought is capital. Therefore, the legal expenses are capital in nature and are not a deductible expense.

Question 2

Employment Termination Payment

A payment is an ETP if it satisfies all the requirements in section 82-130 of ITAA 1997 and is not specifically excluded under section 82-135 of the ITAA 1997.

Subsection 82-130(1) of the ITAA 1997 states:

A payment is an employment termination payment if:

(a) it is received by you:

(i) in consequence of the termination of your employment; or

(ii) after another person's death, in consequence of the termination of the other person's employment; and

(b) it is received no later than 12 months after the termination (but see subsection (4)); and

(c) it is not a payment mentioned in section 82-135.

Taxation Ruling TR 2003/13 Income tax: eligible termination payments (ETP): payments made in consequence of the termination of any employment: meaning of the phrase 'in consequence of' (TR 2003/13) sets out the Commissioner's views on when a payment is made 'in consequence of' termination of employment. Paragraphs 5 and 6 of TR 2003/13 state:

5....the Commissioner considers that a payment is received by a taxpayer in consequence of the termination of the taxpayer's employment if the payment 'follows as an effect or result of' the termination. In other words, but for the termination of employment, the payment would not have been received by the taxpayer.

6. The phrase requires a causal connection between the termination and the payment, although the termination need not be the dominant cause of the payment.

The first requirement is that the payment was received by you, in consequence of the termination of your employment.

You were employed by your former employer for approximately 14 years, then your employment was terminated.

You then commenced legal proceedings against your former employer.

The result of these legal proceedings led to a settlement where you agreed to receive a payment.

The payment was made 'in consequence of' the termination of your employment. There is a causal connection between your termination and the payment. In other words, but for the termination of your employment, this payment would not have been made to you.

Therefore, the payment was made in consequence of the termination of employment as defined in subparagraph 82-130(1)(a)(i) of the ITAA 1997. The first requirement is satisfied.

The second requirement is that the payment was received no later than 12 months after the termination of employment.

Your employment was terminated.

The payment was made to you more than 12 months after your termination, during the following income year

The second requirement has not been satisfied - the payment was not made to you within 12 months of your termination.

However, subsection 82-130(4) states as follows:

Paragraph (1)(b) does not apply to you if:

(a) you are covered by a determination under subsection (5) or (7); or

Subsection 82-130(5) states:

The Commissioner may determine, in writing, that paragraph (1)(b) does not apply to you if the Commissioner considers the time between the employment termination and the payment to be reasonable, having regard to the following:

(a) the circumstances of the employment termination, including any dispute in relation to the termination;

(b) the circumstances of the payment;

(c) the circumstances of the person making the payment;

(d) any other relevant circumstances.

The payment was made to you under a Deed of Settlement and Release, following legal proceedings initiated by you.

The undertaking of legal proceedings inevitably necessitates a delay in any payment being made. Paragraph (1)(b) does not apply to you as supported by determination made under paragraph 5 of Legislative instrument; ETP 2018/1. Accordingly, the second requirement is satisfied.

Finally, consideration needs to be given to whether this payment is specifically excluded under section 82-135 of the ITAA 1997.

Section 82-135 provides that the following payments are not employment termination payments:

a)  A superannuation benefit;

b)  A payment of a pension or an annuity (whether or not the payment is a superannuation benefit); and

c)   An unused annual leave payment;

d)  An unused long service leave payment;

e)  The part of a genuine redundancy payment or an early retirement scheme payment worked out under section 83-170;

f)    A payment to which Subdivision 83-D (Foreign Termination Payments) applies;

g)  A payment that is an advance or a loan to you on terms and conditions that would apply if you and the payer were dealing at arm's length;

h)  A payment that is deemed to be a dividend under this Act;

i)    A capital payment for, on in respect of, personal injury to you so far as the payment is reasonable having regard to the nature of the personal injury and its likely effect on your capacity to derive income from personal exertion (within the meaning of the definition of income derived from personal exertion in subsection 6(1) of the Income Tax Assessment Act 1936);

j)    A capital payment for, or in respect of, a legally enforceable contract in restraint of trade by you so far as the payment is reasonable having regard to the nature and extent of the restraint;

k)   A payment:

i)    Received by you, or to which you are entitled, as the result of the commutation of a pension payable from a constitutionally protected fund; and

ii)   Wholly applied in paying any superannuation contributions surcharge (as defined in section 37 of the Superannuation Contributions Tax (Members of Constitutionally Protected Superannuation Funds) Assessment and Collection Act 1997);

l)    A payment:

i)    received by you, or to which you are entitled, as the result of the commutation of a pension payable by a superannuation provider (within the meaning of the Superannuation Contributions Tax (Assessment and Collection) Act 1997); and

ii)   wholly applied in paying any superannuation contributions surcharge (as defined in section 43 of that Act);

m) an amount included in your assessable income under Division 83A of this Act (which deals with employee share schemes).

You have provided no information to suggest that the payment you received from your former employer, meets any of the above criteria under section 82-135 of the ITAA 1997.

Therefore, the payment is an Eligible Termination Payment under section 82-130 of the ITAA 1997.

Further information

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.