Edited version of private advice

Authorisation Number: 1051996123097

Date of advice: 14 July 2022

Ruling

Subject: Deductibility of legal expenses

Issue 1: Deductibility of legal fees incurred relation to an employment dispute

Question 1

Can the Taxpayer deduct the legal expenses that he incurred in relation to their employment dispute under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Summary

No.

Question 2

If the Commissioner answers no to Question 1 of Issue 1, can the Taxpayer deduct the legal expenses in relation to the "First Phase of Work" under section 8-1 of ITAA 1997?

Summary

Yes, to the extent that the legal expenses incurred in relation to the First Phase of Work relate to the bullying claims, that proportion of the expenses is deductible to the Taxpayer under section 8-1 of the ITAA 1997.

Issue 2: Is the Termination Payment an employment termination payment

Question 1

Is the Termination Payment an "employment termination payment" (ETP) under section 82-130 of the ITAA 1997?

Summary

Yes. The Termination Payment made by the Employer to the Taxpayer is an ETP as defined in section 82-130 of the ITAA 1997.

This ruling applies for the following period:

The year ended 30 June 20XX

The scheme commences on:

10 January 20XX

Relevant facts and circumstances

1.         The Taxpayer was employed by the Employer throughout the period they incurred the legal expenses.

2.         Whilst employed, the Taxpayer also undertook income-earning activities that were outside of this employment ("Outside Services") and the employer had not raised any objections to him continuing to undertake this work prior to the Taxpayer taking legal action in relation to this employment.

3.         The Employer underwent a realignment process, including consultation with employees prior to the new structure being approved and coming into effect.

4.         As a result of the realignment process the Taxpayer was informed that they would be transferred into a new role when the new structure came into effect.

5.         The Taxpayer refused the transfer to the new role, as it was the Taxpayer's view that they had reasonable grounds to refuse as it involved a substantial increase in responsibilities, duties and accountabilities for the Taxpayer, relative to their former role.

6.         The Employer was satisfied that the Taxpayer had the required skills, knowledge and experience to undertake the new role and the responsibilities and requirements of former role, and the new role were significantly similar and therefore directed that they will be required to transfer to the new role.

7.         After the Taxpayer informed the Employer of their decision to refuse the transfer, they were advised that there would be a conflict of interest between the new role and their Outside Services. Thus, if they wished to continue their employment they would have to cease undertaking the Outside Services.

8.         The Taxpayer no longer occupied their original position, it was effectively abolished when the transfer became effective.

9.         The Taxpayer received a directive to occupy the new role.

10.      The Taxpayer was on leave for at least part of the period from the transfer taking effect and when their employment was terminated.

11.      On XX XXX XXXX, the Taxpayer commenced obtaining legal advice in relation to their employment dispute with the Employer. The Taxpayer advises the legal expenses were incurred on legal work comprised of 2 phases:

(a)  advising and acting for the Taxpayer in relation to the workplace issues ("First Phase of Work"), including their bullying claim; and

(b)  acting for the Taxpayer in negotiation of the termination of their employment and payment of the 'eligible termination payment'

12.      The Lawyers developed strategies to put to the Taxpayer in the best position possible to institute proceedings that have sound prospects and thereby allow them to negotiate a better exit package.

13.      Subsequently, on XX XXX XXXX, the Taxpayer instituted proceeding against their Employer for bullying, seeking to have the threat of dismissal removed, permit them to undertake their Outside Services whilst continuing their employment, and to allow them to return to their former role.

14.      At a conference held on XX XXX XXXX, it became apparent that the Employer would not permit the Taxpayer to their former role.

15.      While the Taxpayer did not agree with the Employer's assessment of the new role decided not to continue to pursue this matter, and in order to settle the dispute the emphasis shifted to negotiating a financial settlement in connection with the termination of their employment.

16.      The Taxpayer and Employer settled the dispute. Under the Deed of the Settlement executed the Taxpayer agreed to resign in return for the Employer paying them their unpaid wages and leave entitlements, a payment for the termination of the employment and amount in relation to the Taxpayer's legal expenses.

17.      The Employer made all the required payments under the Settlement Deed within XX months of the Taxpayer's resignation.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Subsection 8-1(1)

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Paragraph 8-1(1)(a)

Income Tax Assessment Act 1997 Paragraph 8-1(1)(b)

Income Tax Assessment Act 1997 Subsection 8-1(2)(a)

Income Tax Assessment Act 1997 Section 82-130

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

Income Tax Assessment Act 1997 Subparagraph 82-130(1)(a)(i)

Income Tax Assessment Act 1997 Section 82-135

Income Tax Assessment Act 1997 Subsection 83-170(1)

Income Tax Assessment Act 1997 Subsection 83-175(1)

Reasons for decision

Issue 1: Deductibility of legal expenses

18.      There are no provisions in the Income Tax Assessment Act 1936 (ITAA 1936) or the ITAA 1997 that specifically govern the deductibility of legal expenses incurred by employees. The deductibility of these expenses is governed by the general deduction provisions in section 8-1 of the ITAA 1997.

19.      Section 8-1 of the ITAA 1997 states:

8-1(1) You can deduct from your assessable income any loss or outgoing to the extent that:

(a)       It is incurred in gaining or producing your assessable income; or

(b)       It is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

8-1(2) However, you cannot deduct a loss or outgoing from your assessable income under this section to the extent that:

(a)       it is a loss or outgoing of capital or of a capital nature; or

(b)       it is a loss or outgoing of a private or domestic nature; or

(c)       it is incurred in relation to the gaining or producing of your exempt income or your non-assessable non-exempt income; or

(d)       a provision of this Act prevents you from deducting it.

20.      In order to satisfy subsection 8-1(1) of the ITAA 1997 there must be a sufficient nexus between an outgoing and the income producing activities or business of the Taxpayer.

21.      The High Court in Ronpibon Tin NL & Tong Kah Compound NL v Federal Commissioner of Taxation (1949) 78 CLR 47 held that the required nexus will be established where the loss or outgoing is 'incidental and relevant' to the income producing activities of the Taxpayer. A loss or outgoing will be considered 'incidental and relevant' to the income producing activities of a Taxpayer where the occasion of the outgoing is found in whatever is productive of actual or expected income.[1]

22.      In determining whether a deduction for legal expenses is allowed, 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.

23.      Legal expenses are generally deductible if they arise out of the day-to-day activities of the Taxpayer's business or employment duties (Herald Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 39 ALR 46; (1932) 2 ATD 169 ("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).

24.      There are various reasons why an employee may incur legal expenses which may include re-employment, preventing redundancy or dismissal and preparing or varying employment contracts.

25.      In Museth v FC of T 2006 ATC 2217, the Taxpayer, a police officer who had been suspended and then removed from the Police Service in May 2002, following a Police Integrity Commission inquiry. The Taxpayer incurred legal expenses in seeking a review of the removal order. Subsequently, the parties reached an agreement, and the Taxpayer was re-employed at a lower rank from March 2003. The AAT held that the legal expenses were, in effect, re-employment expenses; they were not incurred in relation to the Taxpayer's conduct of his day-to-day duties.

26.      In Inglis & Anor v FC of T 87 ATC 2037, the first applicant was, at the time when the legal expenses were incurred, employed as a permanent officer of the Commonwealth Public Service. The first applicant had been made subject to new procedures which in her view placed unwarranted and special restrictions upon her. The first applicant thus pursued legal action because she was of the view that she faced a loss of status, and a lot of indignities as a result of the change to her position within the Commonwealth Public Service. In addition, she was also facing the chance of any promotion being blocked.

27.      The first applicant was held to be entitled to a deduction in relation to the legal expenses (even though the incurring of the legal expenses were considered unwise and ill-judged), as the legal proceedings related to "the day to day situation of the first applicant in her work", and thus the expenses had the necessary connection to the first applicant gaining or producing her assessable income and was not of a capital, private or domestic nature.

28.      In Federal Commissioner of Taxation v Day [2008] HCA 53 ("Day's Case") a leading High Court authority in relation to the deductibility of employee legal expenses where the legal expenses were incurred in defending the manner in which a Taxpayer performed their employment duties were allowable.

29.      In Day's Case, an employee incurred legal expenses in defending charges that arose from his role as a public servant. The majority judgement in Day recognised the following principles:

(a)  In the circumstances of that case, the legal expenses were deductible because 'he was exposed to those charges and consequential expenses, by reason of his office' and it was necessary for the Taxpayer to incur the legal expenses 'to preserve his position'

(b)       What is essential for an expense to be deductible, is a 'determination of what is productive of assessable income' and the fact that relevant matters could result in dismissal was a relevant factor to be taken into account'

(c)       The possible consequences of internal disciplinary proceeds and action with respect to the continuation or termination of service formed part of what was productive of his assessable income

30.      The Commissioner's view in relation to deductibility of expenses incurred by employees in preparing and administering employment contracts under section 8-1 of the ITAA 1997 is set out in Taxation Ruling TR 2000/5 Income tax and fringe benefits tax: costs incurred in preparing and administering employment agreements (TR 2000/5). In particular, example 8 in TR 2000/5 outlines a situation involving costs associated with altering the employee's responsibilities with their current employer. The employee's costs are deductible as the employee did not find a new job, they merely obtained a prospective change in employment with their current employer.

31.      In the Taxpayer's case, the dispute arose when their Employer, completed a realignment process and sought to transfer them to a new position with effect on XX XXXX XXX. The Taxpayer refused the transfer on the basis that it was their belief that the new role involved a substantial increase in responsibilities, duties, and accountabilities relative to their original position.

32.      As the Taxpayer refused the transfer and the Employer was not satisfied that the Taxpayer had reasonable grounds for refusing the transfer, the transfer to the new role came into effect and the Employer had the power to terminate the Taxpayer's employment.

33.      The Taxpayer commenced obtaining legal advice while they were still employed by their Employer, on the basis that their employment was in jeopardy with the threat of dismissal if they did not occupy the new role. The Taxpayer thus had following purposes for incurring the legal expenses:

•                seeking to be able to return to their original position

•                seeking to have bullying claims upheld in relation to being able to continue undertaking their outside employment work while continuing to perform their employment duties, and in relation to the threat of termination of their employment as a result of declining to transfer to the new role ("Bulling Claims")

•                In the event they would not be returned to their original position, they were seeking to maximise the financial settlement received as a result of the termination of their employment.

34.      However, after the conference, it became clear that their Employer was not open to reinstating the position and after taking legal advice decided not to continue seeking this outcome.

35.      The Taxpayer's circumstances may be contrasted with Museth v FC of T 2006 ATC 2217 and Day's case, in that the Taxpayer remained employed with the Employer throughout the period he incurred legal expenses.

36.      The legal expenses incurred in seeking to return to original position are incidental and relevant to the gaining or producing assessable income from the Employer. However, the original position had already been abolished under the realignment process at the time of engaging their lawyers, and any expenditure incurred in seeking to be permitted to undertake that role again is thus capital in nature, and not deductible.

37.      The legal expenses incurred as a result of declining the transfer to the new role and the Bullying Claims, regarding the threat of termination of the employment and Outsider Services are incidental and relevant to the gaining or producing assessable income from their employment with the Employer, and not capital in nature. This is consistent with Inglis & Anor v FC of T 87 ATC 2037.

38.      Generally, legal expenses incurred in an unfair dismissal action (seeking reinstatement after termination and/or damages) are of a capital nature and therefore not deductible. The Taxpayer remained employed by the Employer to XX XXX XXXX. However, the legal expenses incurred in connection with maximising the financial outcome in relation to the termination of the Taxpayer's employment are capital in nature and not deductible under section 8-1 of the ITAA 1997.

39.      Once the Taxpayer decided not to continue pursuing the Bullying Claim as a result of the views expressed by their Employer and the legal advice as to their prospects for success if they continued, the advantage sought became solely obtaining a 'golden handshake' type payment for terminating their employment with the Employer.

40.      A payment, being compensation for the loss of the expectation of continuity of a service contact, is a payment that is not of an income nature. Such a payment is made to compensate the Taxpayer for the loss of their employment position and is regarded as a capital payment (Case Y24 91 ATC 268; AAT Case 6942 (1991) 22 ATR 3184), which applied with favour Lloyd v. Brassey (1969) 1 All ER 382).

41.      Such 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 your 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 Taxpayer's assessable income.

42.      The legal expenses incurred in connection with maximising the financial outcome in relation to the termination of the Taxpayer's employment are therefore capital in nature and not deductible under section 8-1 of the ITAA 1997.

43.      The Commissioner does not agree with the Taxpayer's assertion that the capital exclusion adds little to the test of deductibility once the outgoing or loss incurred has been found to have a connection with the gaining or producing of the Taxpayer's assessable income. Sun Newspapers Ltd & Associated Newspapers Ltd v FC of T (1938) 5 ATD 87 ; (1938) 61 CLR 337 is the leading authority of the test of whether a loss or outgoing is of a capital nature which has been followed consistently by the Australian courts. The test requires an enquiry as to whether the expenditure relates to the structure within which the profits are earned or whether it relates to the process of earning it.

44.      The Taxpayer referred to FC of T v Riverside Road Lodge Pty Ltd (In Liq) 90 ATC 4567, which considered the then subsection 51(1) of the ITAA 1936 (replaced by section 8-1) to assert that the "capital exclusion" in paragraph 8-1(2)(a) does not apply to the Taxpayer. It is our view that consideration of the second positive limb in paragraph 8-1(1)(b) does not assist in applying the "capital exclusion". Further, this case may be distinguished from the Taxpayer's circumstances as it considered the deductibility of interest expenses incurred by the Taxpayer on funds borrowed to finance the purchase of land and the construction of a motel which it operated first as legal owner, and then as a tenant.

45.      The Taxpayer also assert that Spriggs v FC of T; and Riddell v FC of T [2009] HCA 22 ("Spriggs' Case") supports the view that the whole of the Taxpayer 's legal expenses are not capital in nature.

46.      The High Court in Spriggs' Case found that management fees paid by professional a sportsperson to a manger for negotiating a new playing contract were deductible under section 8-1 of the ITAA 1997 as the management fees were incurred because the Taxpayer was engaged in the business of commercially exploiting their sporting prowess and associated celebrity for a limited period, and the income for his employment contract formed part of the income of that business. Further the playing contracts were revenue in nature, being short-term and subject to renewal.

47.      The Taxpayer's circumstances can be contrasted with those in Spriggs' Case in that the legal expenses incurred by the Taxpayer are incurred in part to maximise the payment they may receive in the event of termination of their permanent employment.

48.      Accordingly, in relation to Question 1 of Issue 1 above, the legal expenses the Taxpayer incurred in their dispute with the Employer are not as a whole deductible under section 8-1 of the ITAA 1997.

Apportionment of expenses

49.      When legal expenses are incurred in relation to matters that relate both to claims that are revenue in nature as well as those of a capital nature, there must be some fair and reasonable apportionment of the extent of the relation of the outlay to the revenue claim.

50.      Apportionment is a question of fact and involves a determination of the expenditure that is attributable to deductible purposes. The Commissioner believes that the method of apportionment must be fair and reasonable in all the circumstances.

51.      Paragraph 7 of TD 93/29 discusses the apportionment of legal expenses:

Where the solicitors 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 solicitors account is not itemised, a possible basis for apportionment would be either a reasonable 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.

52.      Accordingly, the legal expenses incurred by the Taxpayer must be apportioned between the deductible and non-deductible matters using a reasonable basis.

53.      It is emphasised that the invoices for legal expenses indicate that there is not a point in time up to which only the bullying claims were pursued by the Taxpayer, i.e. a number of claims were being pursued concurrently, and thus it is not merely a case of apportioning the expenses incurred before and after a given point in time.

54.      Accordingly, in relation to Question 2 of Issue 1, to the extent that the legal expenses incurred during the First Phase of Work are in relation to the Bullying Claims, these legal expenses are deductible under section 8-1 of the ITAA 1997.

Issue 2: Is the Termination Payment an employment termination payment

Question 1

Is the Termination Payment an 'employment termination payment' ("ETP") under section 82-130 of the ITAA 1997?

Summary

Yes. The Termination Payment made by Employer to the Taxpayer is an ETP as defined in section 82-130 of the ITAA 1997.

Detailed reasoning

55.  Subsection 82-130(1) of the ITAA 1997 provides a payment is an employment termination payment ("ETP") 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 that termination (but see subsection (4)); and

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

56.  An ETP does not include any of the following payments, as specified in section 82-135:

(a)       a superannuation benefit (as defined in section 307-5). This covers a lump sum or income stream from a superannuation fund;

(b)       pension or annuity payments (irrespective of whether they are superannuation benefits) (see section 27H of ITAA 1936);

(c)       unused annual leave payments or unused long service leave payments;

(d)       the tax-free part of a genuine redundancy payment or early retirement scheme payment. The balance of such a payment will be an ETP if it satisfies the requirements;

(e)       foreign termination payments covered by Subdivision 83-D;

(f)        a payment made by a company or trust to one of its CGT concession stakeholders under the small business retirement exemption rules;

(g)       an advance or loan on arm's length terms and conditions;

(h)       a payment that is a deemed dividend;

(i)         a capital payment for or in respect of personal injury, so far as the payment is reasonable having regard to the nature of the injury and its likely effect on the person's capacity to derive income from personal exertion (see further below)

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

(k)       an amount received in commutation of a pension and wholly applied to pay a superannuation contribution surcharge liability; or

(l)         an amount included in assessable income under the employee share scheme) rules in Division 83A of the ITAA 1997.

57.  Clause 2.1.3 of the Settlement Deed states:

Pay the Applicant the gross amount of $XX,XXX (being an amount equivalent to X months wages) less applicable tax, to be taxed as an employment termination payment, to be paid between XX XXXX XXXX and XX XXXX XXXX into the bank account into which the Applicant's wages were previously paid.

58.  To determine if the Termination Payment constitutes an ETP, all the conditions in section 82-130 of the ITAA 1997 must be satisfied.

In consequence of termination of employment

59.  The first condition requires that the payment received by the employee is in consequence of the termination of their employment.

60.  In the Taxpayer's case there was a 'termination of employment' as they agreed to resign from their employment as part of the Settlement.

61.  The next issue is to determine whether the payment was made was 'in consequence of'' the termination of your employment.

62.  The phrase 'in consequence of your employment' is not defined in the ITAA 1997. However, the phrase appears in the former provisions of the ITAA 1936 in relation to eligible termination payments and have been interpreted by the courts in that context.

63.  The Commissioner's view on the meaning application of the phrase 'in consequence of', in relation to eligible termination payments, is set out in Taxation Ruling TR 2003/13 Income tax: eligible termination payments (ETP): payments made in consequence of the termination of any employment: meaning of the phase 'in consequence of' and is equally relevant to employment termination payments as defined in Division 82 of the ITAA 1997.

64.  Paragraph 5 of TR 2003/13 the Commissioner states:

... 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.

65.  In the Taxpayer's case, they agreed to resign their employment in return the Employer making the payment under the Settlement.

66.  While agreement to settle the dispute is the direct cause of the Termination Payment being made. The payment was only made because the Taxpayer agreed to terminate their employment.

67.  Accordingly, the first requirement under subparagraph 82-130(1)(a)(i) of the ITAA 1997 is satisfied in relation to the Termination Payment made.

Payment received no later than 12 months after termination

68.  For a payment to be an employment termination payment, paragraph 82-130(1)(b) of the ITAA 1997 specifies that the payment must be received within twelve months of the employee's termination of employment.

69.  As shown in the facts, the Taxpayer agreed to terminate their employment with effect from 29 June 2021, when the settlement agreement was executed, and Employer made the payment on within 12 months of termination of the Taxpayer's employment.

70.  Accordingly, as the payment was made with 12 months of the termination of the Taxpayer's employment, the requirement in paragraph 82-130(1)(b) of the ITAA 1997 is satisfied.

A payment mentioned in section 82-135 of the ITAA 1997

71.  As previously mentioned, section 82-135 of the ITAA 1997 excludes certain payments from being ETP's. These payments include:

(a)       a payment for unused annual leave

(b)       a payment for unused long service leave

72.  In the Taxpayer's case, they received a number of payments under the Settlement with their Employer. It should be noted that the payments were made for unpaid salary and leave entitlements and consequently these payments are either not in relation to the termination of employment or are payments specifically mentioned in section 82-135 of the ITAA 1997.

73.  The Termination Payment will only be a payment mentioned in section 82-135 of the ITAA 1997 if either in whole or part it is a genuine redundancy payment as defined in subsection 83-175(1) of the ITAA 1997.

74.  A genuine redundancy payment is so much of the payment that is received by the employee who is dismissed from employment because the employee's position is genuinely redundant.

75.  The key responsibilities, duties and accountabilities of the New Role includes all the key responsibilities, duties and accountabilities of the original position.

76.  Further the Employer determined that the responsibilities and requirements of the was to be done by an employee with the same job classification level as the Taxpayer when he has been employed in the original position.

77.  The realignment process undertaken did not result in the original position becoming redundant and consequently, no part of the Termination Payment was made because the employee's position is genuinely redundant.

78.  Therefore, the Termination Payment made as part of the Settlement is not a payment of a type specified in Section 82-135 of the ITAA 1997.

79.  Accordingly, the Termination Payment made to the Taxpayer is an ETP as defined in section 82-130 of the ITAA 1997.

[1] Federal Commissioner of Taxation v Payne (2001) 202 CLR 93, at p100 para 11.