Edited version of private advice

Authorisation Number: 1052222794130

Date of advice: 7 March 2024

Ruling

Subject: Deductions - legal expenses and settlement sum

Question

Are you entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for your legal expenses and settlement sum?

Answer

No.

This ruling applies for the following periods:

For the income year ended 30 June 20YY

For the income year ended 30 June 20YY

The scheme commenced on:

1 July 20YY

Relevant facts and circumstances

In MMYYYY you commenced employment in a X position with X (your former employer - the company), a specialist firm in the relevant industry.

You had specific employment duties included management and oversight of various functions.

You became concerned with issues regarding safety and compliance with other regulations.

You raised these issues with your employer and sought to resolve or rectify several of these matters directly with them.

You wanted to resolve these matters so that it did not impact on your then current employment, or as stated in your private ruling application, future employment prospects in the relevant professional industry in which you work.

You received unsatisfactory responses from the employer, so you reported the matters to the regulatory bodies (relevant authorities) as a compliance breach.

On DDMMYYYY, you resigned from the company and provided the relevant notice period with your last day of employment planned for DDMMYYYY.

You contend that your reason for resigning was the company's failure to take action to resolve the identified issues. However, the company disputes this, stating that you resigned due to frustration dealing with fellow employees of the company.

You were notified on DDMMYYYY that as most of your responsibilities had been handed over to other staff, you would not be required to attend the workplace or perform any duties on DD & DDMMYYYY.

You were also advised that as that was your last day in the office, you should ensure that before you left for the day, you handed over your work laptop and any digital or hard copies of any of the company's confidential documentation or records.

On the evening of DDMMYYYY, you downloaded a substantial amount of the company's information from your work laptop.

Your explanation for doing so was that based on advice you received from the regulatory bodies, you were to retain documents that may be used as evidence in the course of any investigations. However, the company's lawyer rejects this suggestion.

Your explanation for downloading a substantial amount of information that was unrelated to your concerns was that you did not have time to select individual documents; rather, you had to download all the information on your work laptop.

In response to a request from one of the regulatory bodies, shortly after your termination you provided them with company documentation in relation to your safety concerns.

Under the terms of your employment contract with the company dated DDMMYYYY, it stated that in the course of your employment you were strictly prohibited from disclosing confidential information and intellectual property of the company. The information was made available to you for the sole purpose of enabling you to perform your job, and you were not allowed to use any of it for your own purposes, or disclose it, or make it known, or allow it to be made known, to any person, except as authorised by the company. You were also not permitted to remove company property (including by sending by electronic means) without permission.

Your employment agreement also stated that intellectual property shall be owned by the company and may not be used, forwarded or given to external parties, without the explicit written consent of the company director.

These obligations under your employment contract with the company, in respect of the confidential information, continued to apply after the termination of your employment.

Several months after your employment ended, the company and their solicitors contacted you stating that they had serious concerns that you had retained their confidential information and demanded that you identify and return any of their documents that remained in your possession.

You rejected their demands. You neither confirmed nor denied that you had retained company information.

The company wrote to you several more times seeking the return of their information. They also put you on notice that they would be seeking costs from you if they had to incur further expenses to recover their confidential information.

The company engaged an IT specialist firm which provided a forensic report confirming that on DDMMYYYY you had downloaded large numbers of company documents from your work computer.

The company provided you with a copy of the forensic report and put you on notice that if the property was not returned, they would make an urgent court application to require you to deliver up all the digital or hard copies of any of their documents in your possession that belonged to them.

You refused to return the information.

After the company commenced court action against you, you ultimately agreed to return the company's information shortly before the proceeding was to be heard.

The company sought an order against you for their costs including the expense of obtaining the forensic report and of the court action.

Without admission of liability, you and the former employer entered into a Deed of Release dated DDMMYYYY and settled with you agreeing to pay them a settlement sum of $X for their costs.

You stated in the additional information provided with your private ruling application, that to safeguard your standing in the relevant industry and with the regulatory bodies, and to protect your future employability, you took precautions in the settlement deed with the company by inserting clause X(x) to indemnify yourself against any possible future fines or penalties.

Your legal expenses and settlement sum expenses totalled $X.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Summary

Your legal expenses and settlement sum were not incurred in defending the way you performed your day to day employment duties while you were still employed with your former employer. The litigation arose as a direct result of your conduct after your employment had ceased, being your retention of your former employer's confidential information, and therefore the expenses were not incurred in the course of gaining or producing your assessable income from the company.

Additionally, the expenses are considered to be capital in nature as they also relate to an advantage sought in defending or protecting your future employment prospects in the relevant industry and your intention to maintain a good standing reputation with the regulatory bodies. Therefore, the legal expenses and settlement sum are not deductible.

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 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.

A deduction for legal expenses by an employee depends on the particular facts of a case. 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 allowed under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered (Hallstroms Pty Ltd v. FC 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.

When the principal reason for incurring the legal expenses is defending the actions of the taxpayer in carrying out their employment duties through which they gain or produce assessable income, such expenses are characterised as being of a revenue nature and are deductible (Inglis v. FC of T 87 ATC 2037; and Case V116 88 ATC 737; AAT Case 4502 (1988) 19 ATR 3703).

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).

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.

Paragraph 5 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:

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.

In addition, if the expenses were incurred in protecting the taxpayer's underlying profit yielding structure or assets of a business they are considered to be capital in nature and will not be deductible. In addition, legal expenses are also capital in nature where the legal action taken is to protect the taxpayer's personal good name and reputation (Case U102 87 ATC 621; AAT Case 72 (1987) 18 ATR 3515).

Application to your situation

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 the settlement of disputes and representation.

Where an employee incurs costs associated with settlement of disputes arising out of an existing employment agreement 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).

However, in your case the dispute did not arise out of an existing employment agreement when the expenses were incurred. The dispute and the expenses incurred relate to your conduct after your previous employment agreement with the company ended. Although the confidentiality obligations in your previous employment agreement continued to apply after your employment ended, there was no longer a current employment agreement in relation to existing employment and consequently TR 2000/5 is not applicable to your circumstances.

We also considered the ATO Interpretive Decision you quoted in your private ruling application, ATO ID 2001/549 Income Tax: Legal Expenses - Defamation Action.However, the difference in your case is that you are not an existing employee incurring the legal expenses. The taxpayer in that decision was incurring the expenses to defend the way they were carrying out their existing duties with their current employer.

We acknowledge that there is a connection between your former employment with the company and your legal and settlement expenses in that if you had never had that employment, you would not have incurred those expenses. However, the High Court in Commissioner of Taxation v Payne [2001] HCA 3 found that for expenses to be considered 'incurred in the course of producing assessable income', it is not enough to show that these is some general link or causal connection between the expenditure and the production of income. The expenditure must have a sufficiently close connection to the performance of the employment duties and activities through which the employee earns income.

Your legal expenses and settlement sum were not incurred in the performance of your employment duties in the day to day course of gaining or producing your assessable income while you were employed with the company. The legal action related to alleged breaches to your previous employment agreement with the company, that is, the Confidentiality obligation, the Removal prohibition, and the Obligation to return property clauses, obligations that legally continued to apply after the termination of your employment. The litigation arose as a result of your personal conduct after your employment ceased, in that you failed to return the confidential information and documentation in your possession, custody or control that was the property of your former employer. Consequently, the expenses were not incurred in the course of earning your assessable income from the company.

In any case, even if the expenses were considered to be incurred in the course of earning your assessable income from the company, they are excluded from being deductible under section 8-1 of the ITAA 1997 because they are capital in nature. They are capital in nature as they were incurred to provide the enduring advantage of protecting your personal reputation in the relevant industry and in so doing, maintaining your employability in the industry, protecting your future employment prospects with other employers and continuing a good standing with the regulatory bodies. You also had a specific clause included in the settlement deed with the company to indemnify yourself against any future fines imposed by the regulatory bodies in relation to your former employment which is another enduring advantage obtained.

In summary, you are not entitled to a deduction under section 8-1 of the ITAA 1997 for your legal expenses and settlement sum as they were incurred as a result of your conduct after your employment ended rather than in the course of earning your employment income. Also, the expenses are considered to be capital in nature.