Edited version of private advice

Authorisation Number: 1052067094608

Date of advice: 17 January 2023

Ruling

Subject: Deductions - legal expenses

Question

Are you entitled to a deduction for the legal expenses you incurred prior to your resignation?

Answer

Yes.

Question

Are you entitled to a deduction for the legal expenses you incurred after your resignation?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You are a care worker.

Allegations were made against you by a colleague that were characterised by your employer as misconduct/serious misconduct including unlawful physical contact with, or assault of, a person.

These allegations were reported to authorities that oversee your type of employment.

The allegations include:

-               physical and verbal abuse of a person

-               neglect of a person in your care.

It is alleged these incidents occurred in early 20XX.

If the allegations were substantiated, any or some of the following outcomes may have applied:

-               remedial action, counselling, or a warning

-               reassignment from one area of employment to another

-               transfer to a lower classification

-               termination of employment.

You responded to these allegations through a letter sent to your employer in early 20XX in which you denied the allegations.

This matter was referred to the police and you have been charged with assault.

You enlisted the services of a barrister at your own expense.

In late 20XX you negotiated a resignation package with your employer. Your employer sought to terminate you because you contacted a staff member and accessed emails when you were not meant to. This termination did not occur and instead the negotiated resignation took effect.

You have professional indemnity insurance and are in the process of ascertaining what financial support you will receive.

You intend to seek compensation for your legal expenses from the Police Service.

You are to appear at the contested mention hearing in 20XX.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Question 1

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. You can deduct these losses or outgoings except where they 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 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) 3 AITR 436; (1946) 8 ATD 190) (Hallstroms). The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses.

It is also generally accepted that legal expenses will be an allowable deduction if the expenses arise out of the day-to-day activities of the taxpayer and are relevant to the performance of the taxpayer's duties. In Federal Commissioner of Taxation v Day [2008] HCA 53 (Day) the High Court found that employee legal expenses where the legal expenses were incurred in defending the manner in which a taxpayer performed their employment duties could be an allowable deduction.

Application to your circumstances

In your case, your employment required you to have physical and verbal contact with your clients and also to provide appropriate care and management to them. The allegations that were brought against you were a result of an incident where it was alleged inappropriate physical and verbal contact was made and improper care was provided to a client. This occurred while you were carrying out your day-to-day employment activities. Your employer notified you that if the allegations were found to be correct you may be subject to a range of disciplinary actions including termination of your employment.

Until your resignation you remained employed in the position in which the allegations were raised against you. Legal expenses you incurred during this period had a direct relationship with your employment activities, and the manner in which you had performed them.

Therefore, the legal expenses you incurred prior to your resignation are an allowable deduction under section 8-1 of the ITAA 1997. The legal expenses were a consequence of you protecting your income as a result of an incident that occurred while you were performing your income producing activities.

Question 2

For expenses to constitute an allowable deduction under section 8-1 of the ITAA 1997, it must be shown that they were incidental or relevant to the production of the taxpayer's assessable income. 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

Legal expenses are generally deductible if they arise out of the day-to-day income earning activities (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 80 ATC 4542; (1980) 11 ATR 276).

In principle, a taxpayer will not satisfy section 8-1 of the ITAA 1997 merely by demonstrating a causal connection between the expenditure and their income producing activities. It must be shown that there is a closer and more immediate connection. The expenditure must be incurred in the gaining or producing the assessable income (Lunney v. FC of T; (1958) 100 CLR 478). These principles have been affirmed by the High Court in Commissioner of Taxation v Payne [2001] HCA 3.

For example, 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.

When considering whether legal expenses are an allowable deduction, the nature of the expenditure must also be considered (Hallstroms). 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, domestic or private nature, then the expenses incurred in gaining the advantage will also be of a capital, domestic or private nature.

Based on the taxpayer's circumstances in the Day 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'

Therefore, for legal expenses to be an allowable deduction, it is not only necessary for the legal expenses to be incurred as a consequence of the taxpayer performing their day-to-day activities, but regard must also be given to the advantage the taxpayer sought to gain.

Application to your circumstances

In your case, you ceased your employment in late 20XX. From this time, any legal fees you may incur will no longer be pursuant to preserving your position with your employer. While the allegations arose by way of you performing your day-to-day activities, the advantage you are seeking to gain is to disprove those allegations and to avoid reputational damage and any consequences of the criminal charges.

Therefore, there is an insufficient nexus between the legal expenses and your current income earning activities as the allegations only have a connection to your former employment. The advantage you are seeking to gain is not revenue in nature. You are not entitled to a deduction for the legal expenses under section 8-1 of the ITAA 1997.