Edited version of private advice

Authorisation Number: 1052200676453

Date of advice: 8 December 2023

Ruling

Subject: Legal expenses and settlement costs

Question

Are you entitled to a deduction for any portion of your legal expenses or settlement costs?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ended 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

You were employed as an educator several years ago.

You resigned after an investigation into your conduct.

Later, the relevant education authority decided to cancel your registration as an educator after a formal hearing found that you were guilty of serious misconduct in relation to a student.

More than a decade later, a claim for damages was made against you by the former student.

You filed a defence to the proceedings.

A settlement was reached in which you agreed to pay a settlement amount.

The deed of release indemnified you from all further action arising out of or connected with or in relation to the claim.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1.

Reasons for decision

Summary

The legal expenses and settlement costs incurred by you in defending and settling the misconduct claim are not deductible as they arose from your personal conduct rather than from the performance of your employment duties.

Detailed reasoning

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for all losses and outgoings to the extent that 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.

For legal expenses to constitute an allowable deduction, it must be shown that they were incidental or relevant to the production of the taxpayer's assessable income, (Ronpibon Tin NL & Tong Kah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; [1949] HCA 15; (1949) 4 AITR 236; (1949) 8 ATD 431).

Also, 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] HCA 34; (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.

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] HCA 56; (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] FCA 150; (1980) 11 ATR 276; 80 ATC 4542).

Similarly, in FC of T v. Rowe (1995) 60 FCR 99; (1995) 31 ATR 392; 95 ATC 4691, the court accepted that legal expenses incurred in defending the manner in which a taxpayer performed his employment duties were allowable. No significance was placed by the court on the taxpayer's status as an employee.

In Case U102 87 ATC 621; AAT Case 72 (1987) 18 ATR 3515 the taxpayer took defamation action against comments made with regard to the management of a trust fund of which he was a trustee. It was found that the expenses were not incidental to the proper execution of the office of trustee but rather were to maintain the taxpayer's personal reputation.

In Case W94 89 ATC 792; AAT Case 5376 (1989) 20 ATR 4001 the taxpayer, a public servant incurred legal fees in defending and then appealing against disciplinary charges of improper conduct resulting from his compulsive gambling. It was found that the expenses incurred where not incidental or relevant to the gaining of the taxpayer's assessable income. It was the conduct of the taxpayer through his compulsive gambling which led to the charges which, in turn, led to him incurring legal costs. The expenses incurred were not incidental or relevant to the gaining of the taxpayer's assessable income.

Generally, the treatment of a settlement sum or damages payment will follow the treatment of the other legal costs incurred in relation to a particular matter.

The legal expenses and settlement costs incurred by you in defending and settling the misconduct claim arose from your personal conduct. They did not arise from the performance of your duties from which you derived assessable income. Therefore, the legal fees and settlement costs incurred by you are not an allowable deduction under section 8-1 of the ITAA 1997.