Edited version of private advice

Authorisation Number: 1051993552847

Date of advice: 20 June 2022

Ruling

Subject: Work related expenses - legal expenses

Question

Will the legal expenses the Taxpayer incurred be deductible under section 8-1 of the Income Tax Assessment Act 1997?

Answer

No.

This private ruling applies for the following period:

Year ended 30 June 20XX

Year ended 30 June 20XX

The scheme commences on:

X April 20XX

Relevant facts and circumstances

The Taxpayer commenced working with Company X on or around January 20XX as an independent contractor.

On or around April 20XX the Taxpayer commenced working as a part-time employee with Company X then as a full time employee.

There is no written employment contract.

On XX May 20XX, the Taxpayer was provided a letter from Company X. The letter indicates the notice was issued because it was believed the Taxpayer committed fraud. The letter requested the Taxpayer to respond in writing by XX May 20XX. The letter also states termination will immediately follow unless a satisfactory response is provided.

The Taxpayer provided a written response dated XX May 20XX refuting the claims made of fraudulent behaviour.

The Taxpayer' s employment was terminated on X June 20XX.

The Taxpayer engaged the services of a legal professional and incurred legal costs with invoices totalling $XX,XXX,XX in the income year ending 30 June 20XX and $XXX.XX in the income year ended 30 June 20XX.

The Taxpayer lodged a general protections application involving dismissal on X June 20XX in the Fair Work Commission (FWC) against Company X and the Director (the FWC proceedings). In summary, the outcome the Taxpayer was seeking by lodging the application was:

•         Immediate stop to further comments about the Taxpayer. The Taxpayer's reputation has been damaged by notifying suppliers about the Taxpayer's termination and to stop threatening the Taxpayer with spreading accusations of fraud to professional bodies and elsewhere until this application is resolved

•         Compensation for a maximum of $XXX,XXX.XX for time lost working with Company X plus an amount for retraining should the applicant not be able to continue as a full time occupation X

•         Apology for harm caused in the dismissal and loss of reputation in the form of a Statement of Regret

•         Statement of Service regarding the work done

•         A non-disparagement agreement as part of a Deed of Settlement or otherwise

•         An order as to costs under section 611 and Section 375B of the Fair Work Act 2009 (Cth) if the matter goes to a hearing and the Taxpayer incurs costs because of unreasonable negotiations and unwilling to negotiate a resolution of this matter

The Taxpayer lodged a claim under the Fair Work Act 2009 (Cth) in the Federal Circuit Court of Australia against Company X and the Director (the FCC proceedings).

Parties attended mediation on XX March 20XX.

On XX June 20XX, the Taxpayer offered to settle privately before a two-day trial later in the year. In summary the Taxpayer is prepared to waive an entitlement to damages for hurt and humiliation, penalties and interest on damages in consideration for payment of $XX,XXX.XX characterised as 'damages, interest and costs'. Any consequential Deed of Settlement will incorporate:

1.    A full mutual release clause

2.    A mutual non-disparagement clause

3.    A mutual confidentiality clause

4.    That the exchange of the executed deed take place within 7 days from the date the first party executes the deed

5.    The Taxpayer to file and serve a notice of discontinuance within 14 days of receiving the payment.

On XX June 20XX, Company X and Director rejected the Taxpayer's offer to settle and made an offer in the interests of the matter being resolved without the need for a hearing and provided a notice of offer to compromise.

In summary, the form provides Company X and Director will pay the Taxpayer $X and will allow the Taxpayer to discontinue the proceedings on the basis that there be no order as to costs.

The Taxpayer voluntarily ceased proceedings and the Taxpayer lodged a Notice of Discontinuance in the Federal Circuit Court of Australia on X July 20XX to the FCC proceedings.

The Taxpayer has paid the legal expenses.

The Taxpayer is not seeking to recover costs.

The taxpayer does not have professional indemnity insurance.

Relevant legislative provisions

Income Tax Assessment Act 1997, section 8-1

Reasons for decision

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 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 (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).

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) 8 ATD 190; (1946) 3 AITR 436). 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.

It also follows, that the character of legal expenses is not determined by the success or failure of the legal action.

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? outlines the Commissioner's view on legal expenses and how they are viewed. The ruling 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. The ruling continues:

Paragraph 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.

Paragraph 6. There will often be occasions where the legal expenses are incurred in relation to proceedings that relate both to amounts that are revenue in nature as well as amounts which are capital in nature. For example, many proceedings in relation to wrongful dismissal will also involve the recovery of unpaid salary or wages. In these circumstances'...there must be some fair and reasonable assessment of the extent of the relation of the outlay to assessable income' (Ronpibon Tin N.L. v. F C of T (1949) 78 CLR 47 at 59).

Paragraph 7. Where the solicitor's account is itemised, one reasonable basis for apportionment would be the time spent involving the revenue claim, relative to the time spent on the capital claim. If the solicitor's account is not itemised, a possible basis for apportionment would be either costing of the work undertaken by the solicitor in relation to the revenue claim, or, where this is not possible, an apportionment on the basis of the monetary value of the revenue claim relative to the capital claim.

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. The action out of which the legal expense arises has to have more than a peripheral connection to the taxpayer's business or income earning activities. The expense may arise out of litigation concerning the taxpayer's professional conduct.

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).

However, there must be an evident connection between the expenditure in instituting the proceedings and the taxpayer's earning activities. Legal expenses are also capital or private in nature where the legal action taken is to protect the taxpayer's personal good name and reputation (Case U102 87 ATC 621; AAT Case 72 (1987) 18 ATR 3515). The taxpayer's legal expenses were not sufficiently connected with the income earning activities of the taxpayer and were essentially private or capital in nature and character. The need for them arose out of the taxpayer's reaction to what they saw as damage to their credit and reputation.

Application to the Taxpayer's circumstances

The deductibility of taxpayers legal expenses is determined by the nature of those payments they were seeking. As stated previously, the nature or character of the legal expenses follows the nature of the advantage sought in incurring the legal expenses.

The Taxpayer participated in the Scheme. The Taxpayer's former employer accused the Taxpayer of committing fraud in relation to the Scheme. The Taxpayer's employment was subsequently terminated.

The legal expenses incurred by the Taxpayer arose from taking legal action defending unfair dismissal from the former employer. The outcome the Taxpayer sought was to protect reputation, seek compensation for loss of future work with the former employer and retraining.

Compensation for loss of employment, such as wrongful dismissal is a capital receipt. Legal costs incurred in seeking such compensation are not deductible because the nature of the advantage sought is capital. The Taxpayer was also seeking compensation for retraining purposes which is considered private in nature. Both capital and private expenses are not deductible under section 8-1 of the ITAA 1997.

To be deductible under section 8-1 of the ITAA 1997, the expense must be incurred in gaining or producing assessable income and not be capital or private in nature.

The legal expenses incurred by the Taxpayer arose from the personal conduct of the Taxpayer participating in the Scheme. They did not arise from the performance of the Taxpayer's work duties as occupation X from which assessable income is derived. The legal expenses were not incidental or relevant to gaining of the Taxpayer's assessable income. Therefore, the legal expenses are not deductible under section 8-1 of the ITAA 1997.

Based on the information provided it cannot be determined any portion of the legal expenses incurred are revenue in nature. Such as, an action to recover unpaid wages, unused annual leave and unused long service leave. As the legal expenses incurred are not revenue in nature, the Taxpayer will not be entitled to a partial deduction and will not need to apportion the legal expenses.