Edited version of private advice

Authorisation Number: 1052093526806

Date of advice: 9 March 2023

Ruling

Subject: Work related expenses - legal expenses

Question

Can a tax deduction be claimed for legal costs incurred in relation to a dispute over alleged breaches of an employment contract?

Answer

No.

This private ruling applies for the following periods:

Year ended 30 June 20XX

Year ending 30 June 20XX

The scheme commences on:

13 May 20XX

Relevant facts and circumstances

The taxpayer was employed by a previous employer A under an employment agreement signed at the beginning of employment.

The taxpayer resigned from employment with the previous employer A on XX/XX/20XX.

Shortly after, the taxpayer was employed with employer B operating in the same industry from XX/XX/20XX to XX/XX/20XX. A copy of the job offer was provided.

The taxpayer then commenced employment with employer C also operating within the same industry, on XX/XX/20XX.

After employment ended with previous employer A, employer A commenced legal proceedings against the taxpayer claiming the taxpayer was in breach of the Deed of Restraint entered into as part of the employment agreement and breached confidentiality provisions in the employment agreement.

Previous employer A's legal representative provided a letter that stated the taxpayer had breached their employment agreement entered into at the beginning of employment. The letter indicated the taxpayer breached restraint obligations pursuant to the Deed of Restraint and the taxpayer took confidential information for the benefit of a competing business to solicit clients.

The taxpayer engaged legal services to respond to the claim.

The taxpayer incurred legal costs defending the alleged breach of the employment contract.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

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

Reasons for decision

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).

Several significant court decisions have determined that for an expense to be an allowable deduction:

•         it must have the essential character of an outgoing incurred in gaining assessable income or, in other words, of an income-producing expense (Lunney v. FC of T; (1958) 100 CLR 478 (Lunney's case)),

•         there must be a nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income (Ronpibon Tin NL v. FC of T, (1949) 78 CLR 47), and

•         it is necessary to determine the connection between the particular outgoing and the operations or activities by which the taxpayer most directly gains or produces his or her assessable income (Charles Moore Co (WA) Pty Ltd v. FC of T, (1956) 95 CLR 344; FC of T v. Hatchett, 71 ATC 4184).

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 have determined legal expenses are generally an allowable deduction if:

•         the expenses 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 (the Herald and Weekly Times Case)).

•         the action out of which the legal expenses arise has more than a peripheral connection to the taxpayer's business or income earning activities (Magna Alloys & Research Pty Ltd v. Federal Commissioner of Taxation 80 ATC 4542; (1980) 11 ATR 276).

•         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).

It also follows, that the character of legal expenses is not determined by the success or failure of the legal action.

Taxation Ruling TR 2012/8 Income tax and fringe benefits tax: assessability of amounts received to reimburse legal costs incurred in disputes concerning termination of employment states at paragraph 40:

Where the legal costs are incurred to enforce a contractual entitlement which relates to a right to income, even if they were incurred after employment has ceased, the taxpayer will be entitled to a deduction under section 8-1.

However, if the advantage to be gained by incurring the expenses does not have an immediate connection to the derivation of income and is more capital in nature, then expenses incurred will also be of a capital nature.

Taxation Determination TD 93/29 Income tax: if an employee incurs legal expense recovering wages paid by a dishonoured cheque, are these legal expenses an allowable deduction under section 8-1 of the Income Tax Assessment Act 1997? outlines the Commissioner's view on legal expenses and how they are viewed. The ruling states that if an employee incurs legal expense 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 expenses 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 amounts 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. F C of T (1949) 78 CLR 47 at 59).

7. Where the solicitor's 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 solicitor's account is not itemised, a possible basis for apportionment would be either 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.

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 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).

Application to the taxpayer's circumstances

The taxpayer incurred legal expenses from taking legal action in defending a claim for allegedly breaching the confidentiality and restraint of trade provisions of their previous employment agreement with employer A. The legal expenses were incurred whilst being employed with employer C.

The dispute did not arise to enforce a contractual agreement relating to right to income such as an action to recover unpaid wages, unused annual leave and unused long service leave owed. Therefore TR 2012/8 does not apply.

TR 2000/5 is not applicable because the dispute did not arise out of a current employment agreement being an agreement with employer C. The legal expenses related to the previous employment agreement with previous employer A and were incurred after the taxpayer's employment had ceased.

The legal expenses were not incurred in defending the way the taxpayer performs their day-to-day employment duties. The legal expenses arose from the alleged personal conduct of the taxpayer (being employed in a competing start up business within the restraint area and restraint period and taking and using confidential information for the benefit of the competing business). Thus, it cannot be said the legal expenses were incurred in gaining or producing assessable income.

The legal action constituted an action for breaches of the previous employment contract. The advantage sought was to enable the taxpayer to continue their employment with their new employer which is an enduring advantage. The expenses are capital in nature.

To be deductible under section 8-1 of the ITAA 1997, the expense must be incurred in gaining or producing assessable income and not be capital or private in nature. Therefore, the taxpayer is not entitled to a deduction under section 8-1 of the ITAA 1997 for their legal expenses.