Edited version of private advice

Authorisation Number: 1052059274709

Date of advice: 21 November 2022

Ruling

Subject: Legal expenses

Question 1

Are you entitled to a full deduction for all the legal expenses you incurred?

Answer

No.

Question 2

Are you entitled to a partial deduction for the legal expenses you incurred?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Since 20XX, you were employed under a written contract of employment which set out that your role is a full-time position.

After you returned from leave, you were told your full-time role had changed to a part-time role with different duties.

You sought legal advice in relation to this change in your employment conditions.

Your lawyer contacted your employer.

You later decided that you did not want to take up the part-time role and another full-time role was not available in the organisation.

In a letter dated XX/XX/20XX your lawyer advised your employer that you considered it was in the interests of both parties to formally cease the employment relationship and that you that you were prepared to resolve the dispute.

However, you sought certain payments to settle the matter including a payment in lieu of notice equivalent to X weeks' salary; payment for unused leave and leave loading; and an 'ex gratia payment' equivalent to XX months' salary.

You and your employer entered into a settlement deed. As part of the settlement, you resigned and received the payments that you had sought.

The 'ex gratia payment' was taxed as an Employment Termination Payment.

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, 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 this 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 income producing activities of the taxpayer (The Herald and Weekly Times Ltd v. FC of T (1932) 48 CLR 113). 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 (Magna Alloys and Research Pty Ltd v. FC of T (1980) 11 ATR 276; 80 ATC 4542; Putnin v. FC of T (1991) 21 ATR 1245; 91 ATC 4097).

Taxation Ruling TR 2005Income tax and fringe benefits tax: costs incurred in preparing and administering employment agreements, states that costs associated with attempting to settle a dispute arising out of an existing employment agreement including the cost of representation are deductible

When legal action is undertaken to obtain a payment, then the deductibility of the legal expenses depends on whether the payment sought is revenue in nature, such as unpaid wages, or whether the payment sought is capital in nature, such as a redundancy type payment or compensation for unfair dismissal.

This principle is confirmed in Taxation Determination TD 93/29 which states that if an employee incurs legal expenses 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:

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 expense relating to an action for damages for wrongful dismissal, are not deductible.

6. There will often be occasions where the legal expenses are incurred in relation to proceedings that relate both to accounts 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. FC of T (1949) 78 CLR 47 at 59).

Generally, legal expenses incurred in an unfair dismissal action (seeking reinstatement and/or damages) are of a capital nature and therefore, not deductible.

When legal expenses are incurred in relation to proceedings 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.

TD 93/29 paragraph 7 discusses the apportionment of legal expenses:

7. 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.

Application to your circumstances

In your case you returned from leave to find out that your position had changed from a full-time position to a part-time position. Your employment contract states that your role is a full-time position.

You initially attempted to maintain your full-time status with your employer by seeking legal advice. You obtained legal advice initially to resolve these issues so you could continue your employment.

However, when it became clear that there was no possibility for you to remain as a full-time employee you decided that you wanted to leave the organisation. Your lawyer then notified your employer that you proposed to settle the matter. Under the proposal you sought a number of different payments.

Initially you obtained legal advice to help resolve a dispute with your employer related to your employment agreement as it states that your employment position is full-time whereas your employer was trying to change the position to part-time. The expenses incurred for this initial legal advice are deductible as per TR 2000/5.

Once you determined that you could no longer continue working for your employer and instead sought to obtain certain payments, the deductibility of your subsequent legal expenses is determined by the nature of those payments you were seeking. As stated previously, the nature of legal expenses follows the nature of the advantage sought in incurring the legal expenses. Therefore, if you are seeking a capital payment then the advantage you are seeking is capital in nature and consequently the legal expenses incurred in trying to obtain that capital payment are not deductible.

For example, payments for contractually entitled salary in lieu of notice and unused annual leave are revenue in nature and therefore, legal expenses incurred in seeking those payments are also revenue in nature and deductible.

However, a redundancy type payment such as an ex gratia payment is a capital payment. Therefore, legal expenses incurred in seeking this type of payment are also capital in nature and consequently not deductible. We note that you have argued that the ex gratia payment is not a redundancy payment. Even if it is not a redundancy payment, we consider it to be capital in nature as it is one-off lump sum payment that is not a back payment of accrued revenue payments owed.

As the legal expenses you have incurred are both revenue and capital in nature, you will need to apportion the legal expenses in a reasonable manner. You will need to apply the principles in paragraph 7 of TD 93/29 in undertaking the apportionment.

Note: Some capital payments such as capital gains or a golden handshake termination payment are included in assessable income by specific provisions in the ITAA 1997. Although capital payments may be included in assessable income, this does not mean they are no longer capital in nature or that expenses incurred in obtaining those payments are not capital in nature. That is, expenses incurred in seeking a capital payment are capital in nature and therefore not deductible under section 8-1 of the ITAA 1997 and the fact that some, or all, of the capital payment may be included in assessable income does not change that outcome.