Edited version of private advice

Authorisation Number: 1052012185194

Date of advice: 3 August 2022

Ruling

Subject: Legal expenses

Question 1

Are the legal expenses you incurred in transitioning to another firm (including your clients), deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

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 held the position of principal lawyer at your previous employer, the legal branch of a financial planning firm.

You decided to leave your former employer when you became aware meetings were being held without their legal principal (yourself) in attendance. This also included the firm incurring debts without your prior knowledge.

You decided to leave the firm in order to protect yourself from the potential liabilities from activities you had not been party to or had occurred without your knowledge.

You were hired by a commercial law firm.

You engaged a legal firm to assist in all communication concerning your departure as director and cessation of employment at the firm. This included ensuring you were fulfilling your professional obligations as the outgoing principal of the legal incorporated practice.

A meeting was held with the owner and yourself in which the following was discussed:

•         your replacement at the firm.

•         you were transferring from the firm to a new legal practice.

•         communication to your clients that at the new legal practice you would have greater legal resources and be able to offer broader legal services.

•         communication to your clients that you were departing on positive terms and the relationship between you and the firm would continue.

•         the clients were welcome to

o   leave their safe custody records with the firm.

o   authorise their safe custody records to be transferred with you to the new legal practice.

o   collect their safe custody records.

•         you would complete as many of the current matters as possible prior to your departure.

•         you would take to the new legal practice, all current matters incapable of being completed prior to your departure

•         the owner acknowledged that you introduced a significant number of clients to the firm and that those clients would transfer with you to the new legal practice.

•         the owner was not familiar with the individual clients you introduced and has requested that the list be shared with the other directors for comment.

•         the firm may discontinue use of its practice management software including its Safe Custody Register. The software subscription would continue until a decision is taken to retain it or migrate to another software product.

•         it would be prudent for back-up copies of the client data to be kept in both soft copy and hard copy format.

You obtained the legal opinion that the matters covered in the meeting would unlikely be binding on the firm because the meeting may not constitute a proper meeting of all impacted parties.

Your lawyers provided you an estimated cost of the legal fees.

You have been invoiced by your lawyers for part of the 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.

In determining whether a deduction for legal expenses is allowed under section 8-1 of the ITAA 1997, the nature of the expenses must be considered (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 3 AITR 436; (1946) 8 ATD 190).

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.

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).

Application to your situation

A deduction for legal expenses by an employee depends on the particular facts of any case. To be deductible the occasion of the expenditure must be found in what is productive in the gaining of assessable income by the employee. Legal expenses are generally only deductible if they arise out of the day to day activities of the taxpayer. If for example the expenses are incurred to dispute the receipt of income contractually owed under an employment contract, then the expenses are on revenue account and allowable as a deduction.

While it is understood the legal expenses did relate to an obligation you felt you had to both your former employer and your clients during your transition to another firm, the expenses would not have resulted but for your decision to leave your former employer.

The occasion of the expenditure is found in your decision to change firms and not in what is productive in the gaining of assessable income. As the legal expenses were not incurred in the course of gaining or producing your assessable income in your day to day activities, nor were they seeking an advantage of a revenue nature, they are not deductible under section 8-1 of the ITAA 1997.