Edited version of private advice

Authorisation Number: 1052042638366

Date of advice: 3 November 2022

Ruling

Subject: Deductions - legal expenses

Question 1

Are you entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for legal expenses you incurred in defending a claim against your previous employment agreement?

Answer

No.

Question 2

Are the legal expenses you incurred able to be categorised into general advice, administration, and representation costs?

Answer

Not applicable. These expenses are capital in nature and not deductible.

This ruling applies for the following period:

Period ended 30 June 20XX

Period ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You were employed from DDMMYYYY in accordance with an Australian Industrial Award and signed a standard full-time employment agreement dated DDMMYYYY (employment agreement).

Your position title was X Management Supervisor of the X Management Department.

Your responsibilities were extensive and varied, however, you were primarily accountable for the overall management of X, as well as supervising and co-ordinating the X management team to ensure that high quality services were consistently provided to the clients.

As per the Non-Acceptance clause in your employment agreement and Item x of the Reference Schedule, there were four city council areas with restraint conditions in your agreement with your previous employer.

The restraint of trade conditions did not permit you for a period of X months from the termination of your employment, for any reason, within those council areas directly or indirectly, on your own account or on behalf of or in association with others:

(i)    Approach, solicit or attempt to solicit, or entice or endeavour to entice away from the Employer any person, firm or company who was at any time during the X months before the termination of your employment, a client on the books of the Employer

(ii)   Approach, solicit or attempt to solicit, or entice or endeavour to entice or encourage any Employer Representative who was at any time during the X months before the termination of your employment an Employer Representative of the Employer to leave their engagement with the Employer

(iii)  Accept any instructions to perform any work for any person, firm or company who was at any time during the X months before the termination of your employment, a client on the books of the Employer or a sales client of the Employer

(iv)  Accept any employment which would require you to reveal any confidential information of the Employer.

The restraint conditions were not intended to prevent you from working in the areas after termination for any similar business. It was aimed at protecting confidential information of the business including but not limited to customer lists.

In a letter and email to your employer dated DDMMYYYY, you tendered your resignation with the previous employer, citing an unforeseeable change in your family circumstances (resignation).

The resignation indicates you provided the previous employer X weeks notice and you ceased work as an employee of DDMMYYYY. The resignation also indicates you accepted a position as X Manager at a company.

Your final payment date for your wages on your pay slip was DDMMYYYY.

In DDMMYYYY, you were approached by a client of the previous employer

You provided a copy of an agreement between your new employer and the client, effective from DDMMYYYY.

In an email to you and your previous employer dated DDMMYYYY, the client explained the events leading up to you signing a new agreement with them and your new employer.

Your previous employer commenced proceedings in the local District Court against you in DDMMYYYY for damages as they claim the confidentiality and restraint of trade provisions of your employment agreement are valid and enforceable up to and including DDMMYYYY and that you breached those relevant provisions.

The proceedings were commenced without your previous employer having notified you of their intended statement of claim and/or taking reasonable steps to resolve the dispute with you first.

Your previous employer also claimed that before you last day at work, you printed out and retained confidential information from their systems, that you failed to return upon resignation. In their statement of claim, they cited that you therefore breached the Return of Property, and Information Upon Termination Term. They claimed that after your resignation you had attempted to use their confidential information.

You sought legal advice and counsel from a lawyer to defend yourself claim against the claims and incurred legal expenses in the 20XX-XX & 20XX-XX income years of approximately $X. You did not seek reimbursement of your costs from the previous employer and you supplied tax invoices from your lawyer for the legal expenses you incurred.

You are full time salary earner, so do not have professional indemnity insurance.

Your response dated DDMMYYYY proposed without any admission of liability, and solely for the purpose of resolving the dispute, that you would not seek an adverse cost order against your previous employer and provided an undertaking that you will comply with the terms of the employment agreement for the duration of the restraint period, provided that the previous employer discontinued their proceedings against you within 7 days of receiving your signed undertakings; and each party was to bear their own costs.

Your previous employer did not lodge a response against the court orders but lodged a notice of discontinuance in the district court dated DDMMYYYY agreeing to discontinue the whole of the proceedings and the matter was considered finalised.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 subsection 8-1(2)

Reasons for decision

Summary

Your legal expenses to defend a claim against breaching the confidentiality and restraint of trade provisions of your previous employment agreement, were incurred while being employed with your new employer.

The expenses were not incurred in defending the way you performed your previous day to day employment duties as a x management supervisor or your employment duties with you new employer. Therefore, they were not incurred in the course of gaining or producing assessable income.

The advantage sought in defending a claim by your former employer to enforce restraint provisions in your previous employment agreement, is to enable you to continue working in your new employment. The legal expenses incurred are capital in nature. Therefore, the legal expense are not deductible.

Detailed reasoning

Section 8-1 of the ITAA 1997 allows a deduction for all losses or outgoings to the extent to which they are incurred in gaining or producing assessable income or are necessarily incurred in carrying on a business for that purpose. However, where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income they will not be deductible (subsection 8-1(2) of the ITAA 1997).

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 (Hallstrom's 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.

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 (Magna Alloys & Research Pty Ltd v. Federal Commissioner of Taxation 80 ATC 4542; (1980) 11 ATR 276). The action out of which the legal expenses arise 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. (Putnin v. Federal Commissioner of Taxation (1991) 27 FCR 508; 91 ATC 4097; (1991) 21 ATR 1245 and Elberg v. Federal Commissioner of Taxation (1998) 82 FCR 440; 98 ATC 4454; (1998) 38 ATR 623).

However, if the expenses were incurred in protecting the underlying profit yielding structure or assets of the business they are considered to be capital in nature and will not be deductible.

Paragraph five of Taxation Determination TD 93/29 Income tax: if an employee incurs legal expenses recovering wages paid by a dishonoured cheque, are these legal expenses an allowable deduction under subsection 51(1) of the Income Tax Assessment Act 1936? states:

... 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, the legal costs would not be deductible because they are capital in nature.

The courts have held that expenditure incurred in relation to a restraint of trade clause are capital in nature (Kemp v. Federal Commissioner of Taxation (1992) 110 ALR 375; (1992) 24 ATR 75; 92 ATC 4542.

Defending a right to practice a profession or employment is capital in nature, as the right to practice is considered a structural asset and the associated expenses are incurred to protect this right (ATO Interpretative Decision 2004/367; Case V140 88 ATC 874; AAT Case 4596 (1988) 19 ATR 3859 and Case X84 90 ATC 609; AAT Case 6258 (1990) 21 ATR 3721). As the nature of the expense follows the nature of the advantage sought, the expense is also capital in nature.

We considered Taxation Ruling TR 2000/5 Income tax and fringe benefits tax: costs incurred in preparing and administering employee agreements. Paragraph 12 of TR 2000/5recognises that both the employer and employee may incur expenses in setting the conditions for and administering the employee agreement. These costs may include costs associated with settlement of disputes.

Where an employee incurs costs, associated with settlement of disputes arising out of an existing employment agreement, (includes the costs of legal representation), this is as an allowable deduction. Similarly, where the employer incurs costs in the settling of disputes arising out of existing employment agreements, this is an allowable deduction (paragraphs 2 and 4 of TR 2000/5).

However, in your case the dispute did not arise out of an existing employment agreement. The dispute and the expenses incurred relate to your previous employment agreement with your previous employer, and not your existing employment agreement with your current employer. The expenses were incurred after your employment had ceased. TR2000/5 is not applicable to your circumstances.

In your situation the legal action went beyond a claim for a revenue item such as wages owed by the previous employer. The legal action constituted an action for breaches of the previous employment agreement. You incurred legal expenses to defend breaches of confidentiality and restraint provisions of you previous employment agreement. The advantage sought was to enable you to continue your employment with your new employer which is an enduring advantage. The expenses are considered to be capital in nature.

Therefore, you are not entitled to a deduction under section 8-1 of the ITAA 1997 for your legal expenses.