Edited version of private advice

Authorisation Number: 1051984075119

Date of advice: 14 June 2022

Ruling

Subject: Legal expenses

Question 1

Are you entitled to a deduction for the settlement payment?

Answer

No.

Question 2

Are you entitled to a deduction for legal expenses?

Answer

No.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You were employed by Employer Z in a specialist postion.

You held the relevant accreditation by the Employer:

a)    on a temporary basis, for several months;

b)    on a fixed term basis for 1 year;

c)    on a further fixed term basis for several years.

Your employment ended after several years with Employer Z.

A couple of years prior to the end of your employment, a client commenced proceedings in the Supreme Court against you and your employer for damages relating to a personal injury they suffered.

The client made personal injury claims.

In the year after your employment finished, Employer Z filed a third-party claim against you within the proceedings for an amount equal to the amount the Court may find the Employer Z is liable to pay to the client.

In the following year, the client amended their Statement of Claim to claim a specified amount of damages.

You were working under an undiagnosed, and untreated, health impairment at the time of the transgression, and that health impairment was directly causative of the transgression.

Your health impairment has since been diagnosed and treated, such that you are at very low risk of a further transgression.

You received legal advice confirming that:

the likelihood of finding a liability against you was significant. If the Court found that you were wholly liable, being that the Employer had no liability, you would be liable to pay the full amount of damages as assessed by the Court, plus costs;

a)    if the Court had found that you were jointly liable with the Employer, you may still have been liable to pay the full amount of damages as assessed by the Court as the Employer had filed a cross claim against you seeking indemnity or contribution from you. In that situation, you would also have been liable to pay for the Employer's costs;

b)    it was likely that you may not have been able to satisfy the amount of any likely judgment against you; and

c)    in those circumstances, it would have been available to the client and the Employer to seek to enforce any judgment against you, including by serving a bankruptcy notice upon you and ultimately seek a sequestration order against you- in effect declaring you bankrupt.

The transgression was not covered by your professional indemnity insurance.

In the following year, the parties attended a mediation as ordered by the Court, which resulted in the parties reaching a confidential settlement, without any admission of liability.

The parties signed a Deed of Release.

As per the Deed of Release the parties agreed that:

a)    You and the Employer will pay to the client a sum in full and final satisfaction of all claims the client has against you and the Employer. The client was to file a notice of discontinuance for the proceedings after receiving payment;

b)    You and the Employer will pay to the client a sum in full satisfaction of the costs and outlays with respect to the proceedings;

c)    the client indemnifies both you and the Employer against all claims which have arisen or may arise in the future;

d)    You and the Employer release and discharge each other from all claims which they have now or may have in the future;

e)    the obligations of payment are several and not joint;

f)     You and the Employer enter into the Deed of Release with an express denial of liability by each of them, and the Deed of Release acts as a bar against any current or future claims;

g)    the terms of the Deed of Release are confidential;

h)    the parties must not make any adverse statements, publicly or otherwise, about the other in respect of or in any way connected to the claims.

You and the Employer also reached a separate agreement regarding the individual contributions to the payments required pursuant to the Deed of Release.

The agreement limited your liability, which is an amount you could afford without the risk of bankruptcy (Settlement Payment).

The Settlement Payment was paid to the client in satisfaction of your obligations under the Deed of Release.

You also incurred legal fees in relation to the proceedings (Legal Costs).

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 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.

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).

Settlement payment

You were required to pay a settlement payment as per the deed of release.

You have referenced the case of Hallstroms (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 3 AITR 436; (1946) 8 ATD 190) to argue that the settlement payment is an allowable deduction.

Hallstroms was about legal expenses disputing a patent extension on refrigerators, there were no settlement costs involved in this case. Hallstroms demonstrates the principle that the character of legal expenses will follow the nature of the advantage being sought.

In your case the purpose of the settlement agreement was to gain an enduring advantage, that is to protect your reputation so you could continue to practice in your profession. The settlement was negotiated and paid several years after you had ceased employment with the Employer. The advantage sought is of a capital nature.

The transgression was not part of your employment or professional duties.

The settlement payment is therefore both capital and private in nature and does not have the relevant connection with your employment, and is therefore not deductible under section 8-1 of the ITAA 1997.

Legal expenses

In determining whether a deduction for legal expenses is allowed under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered (Hallstroms). 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, domestic or private nature, then the expenses incurred in gaining the advantage will also be of a capital, domestic or private 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 activities of the taxpayer's business or employment. In FC of T v Rowe (1995) 31 ATR 392; 95 ATC 4691, an employee incurred legal expenses in defending the manner in which he performed his employment duties. The court accepted that such expenses were allowable and no significance was placed on the taxpayer's status as an employee.

The general principle is that a deduction is allowed where the legal expense has arisen as a consequence of the day to day activities of the business or employment whether or not the expenses are common or recurring (Herald and Weekly Times v FC of T 48 CLR 113; 2 ATD 169, Putnin v FC of T 91 ATC 4097; 21 ATR 1245).

As you discussed in your application, Commissioner of Taxation v. Day [2008] HCA 53 (Day's case) was concerned with legal expenses. The majority approach in this case was that an expense will satisfy the test outlined in paragraph 8-1(1)(a) of the ITAA 1997 if the occasion of the expense is found in whatever is productive of actual or expected income. They indicated that a broad approach should be taken in determining what activities produced the actual or expected assessable income, and that it is not only the day to day tasks performed by the employee that gain or produce this income.

Your situation can be distinguished from Day's case because the occasion of the legal expenses you incurred is not found in activities related to the production of your actual or expected assessable income.

Your legal expenses did not relate to charges brought against you by your employer as in Day's case. The act of engaging a lawyer cannot be said to relate to the production of your actual or expected assessable income, therefore, the decision in Day's case is not applicable to your situation.

Your income earning activities with the employer ceased and the employer did not bring their claim against you until the following year.

Therefore, you were not defending the action to keep your job.

Your case differs from Day in this regard.

The following paragraphs from Re Duncan and Federal Commissioner of Taxation 2020 ATC 10-544 are instructive in distinguishing your case from Day's case:

47. The argument is flawed. In Day, the employee was seeking to maintain his employment by defending the charges. In this case, the Applicant was not. He incurred the Outgoing after his employment ended. It is implicit in the Applicant's argument that the directorships were required as part of his employment and that the directorships ended when his employment ended. His employment was productive of income. If his directorships continued after his employment ceased, they were not productive of income. The connection found in Day between the expenditure and employment productive of income, is not found in this case. ...

52. The "connection" between the expenditure and that which produces assessable income has to be determined. Their Honours were referring to ongoing operations, not to past operations. There is not the necessary connection in this case for the reasons set out at [47] above.

53. There was a causal connection between the Outgoing and the derivation of income (before 28 June 2016). However, as was said in Day, more is necessary, "something closer and more immediate".

The occasion of the outgoing for legal expenses was not your income producing activities with the Employer. The expenses were incurred to protect your professional reputation and your ability to practice in the future. They were incurred seeking an outcome of an enduring advantage and were capital in nature.

The legal expenses are therefore not deductible as they do not have the relevant connection with your employment, they are capital in nature, and they arose in relation to a private matter.