Edited version of private advice

Authorisation Number: 1052249996678

Date of advice: 3 July 2024

Ruling

Subject: Legal expenses

Question

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

Answer

No.

This ruling applies for the following period

Year ending 30 June 20XX.

The scheme commenced on:

1 July 20XX.

Relevant facts and circumstances

You were employed by as the Manager.

You ceased employment with the company.

Legal correspondence in relation to the matter

Your previous employer wrote to you regarding your previous role, detailing the following concerns:

On the specified date, the alterations of the equipment whilst under your management.

Further transactions were completed under an unspecified licence on numerous occasions.

On the specified date, the equipment was disposed of under an unauthorised licence for no sale price.

The disposal of the equipment coincided with the installation of the new equipment. Standard practice was to dispose of the equipment to the company installing the new product, which did not occur.

On the specified date, further equipment was disposed of for no consideration, sign off under an unauthorised licence.

They could not locate any invoices for the disposal of the equipment that was collected. The equipment alone had a resale value of $XXXXX which they did not receive any payment for the disposals.

You notified staff members the equipment was in storage.

On the specified date, they contacted the person to clarify the disposals, they provided the following information in relation to receiving the equipment:

•         They previously met you; this was the first time they worked with you. They collected the equipment for no consideration, an invoice was not provided and no other services were provided in lieu of payment, the equipment had been sold.

After they reviewed the reports, the disposal of the equipment was authorised and signed by an employee. However, the employee was relieved of their duties at the time of the events and did not authorise the disposals.

They asked a series of questions in relation to the events and requested a response by the specified date. If you did not provide a response, they advised they may take the matter further including issuing proceedings and reporting to the relevant authorities.

Negotiations

Between the specified dates negotiations took place between your legal representative and your previous employer representative via written statements surrounding the following matters:

Your legal representative

Standard practice to dispose of the old equipment to the installing company, they would have received nil consideration and no monetary benefit.

To resolve the dispute without further legal action and reporting the matter to the relevant authorities, you were willing to return the equipment, through a professional.

You anticipated the procure the delivery of the equipment within 14 days of the parties entering a deed of settlement and release. They can nominate a third party to inspect the condition of the equipment and reject the equipment and you will be given an opportunity to procure further equipment.

Negotiated the payable amount to the previous employer for disposing of the equipment without authorisation if they could not be returned with like for like equipment satisfactory to their requirements.

Payment by you for the previous employers incurred legal expenses in relation to the matter.

Previous employer's legal representative

You have not provided information of the whereabouts of the equipment that were collected from the premises.

They were concerned with your ability to source replacement equipment as they were not aware if the equipment can be sourced by you, if you held an existing contract, to the extent they would be like for like equipment and to their knowledge you were not a licenced dealer.

They remained concerned with the steps undertaken by you to dispose of the equipment, that you were not acting in their best interest, no money had been received them, especially when the value of the equipment was enhanced by way of conversions just prior to disposal.

If you were unable to the deliver the equipment, by the specified dates, they provided the monetary outcomes required to pay them in relation to the disposal of the machines and legal expenses incurred by them in relation to the matter.

Negotiations around pursuing legal proceedings and reporting to the relevant authorities due to not acting in their best interest when you were an employee.

Deed of settlement

On the specified date, a Deed of Settlement and Release (The Deed) was entered between you and your previous employer on the following terms:

You have ceased employment with the club on the specified date.

You have both agreed without admissions, to settle the issue arising out of the alleged conduct and your employment with the previous employer on the terms outlined in the deed.

The agreed settlement obligations for you are as follows:

•         By the specified date, the return of the equipment to the previous employer, with the outlined specifications, substantially similar, or in better condition than the disposed machines.

•         The previous employer may nominate a third party to inspect the condition of the equipment, if they are not reasonably satisfied, they can reject the equipment and you will be given an opportunity to procure further equipment under the specified clauses.

•         If you are unable to deliver the equipment in accordance with the specified clause by the specified date, you must pay the outstanding amount, or part thereof on a pro rata basis.

•         If you return one or more of the equipment you must pay the required amount to the previous employer by the earlier of satisfying the specified deed clauses or the specified date in respect of the previous employer's legal costs.

•         You agreed to be released and discharged from all past, present or future claims (known or unknown) arising from or related in any way to the alleged conduct and your employment in respect of the disposal of the machines and your former employment.

•         You agreed to indemnify the previous employer and related bodies and agreed to keep them indemnified in relation to any claims you have had, or but for this deed may have had, against any of them including associated costs.

Your employment duties

You confirmed that you never received the position description for your role with your full time employment contract.

Legal expenses and settlement expenses paid by you.

•         Your legal expenses $XXXX

•         Your previous employer's legal expenses $XXXX

•         The machines returned to your previous employer $XXXX

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Question

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

Answer

No.

Summary

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. Legal costs take their quality as an outgoing of capital or revenue in nature from the advantage sought in incurring the expenditure.

In your circumstance your legal expenses and cost for replacement equipment were not incurred in defending the way you performed your day to day employment duties. The legal expenses and replacement equipment expenses were in relation to you converting the equipment owned by your employer the disposing of the equipment to a party not known to your employer. You then later disposed of the equipment for no consideration on monetary value under an unauthorised licence. Therefore, they were not incurred in the furtherance of gaining or producing your assessable income and as stated by your employer you were not acting in their best interest at the time of the disposals.

Furthermore, the expenses are capital in nature as they relate to you being released and discharged from all claims against you and the repayment of the equipment to the club which were disposed under an unauthorised licence. Therefore, the legal expenses and cost for replacement equipment is not considered deductible under 8-1 of the ITAA 1997.

Detailed reasoning

Section 8-1 of the 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).

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 expenses 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).

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, at paragraph 40 states:

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.

An example of a situation to which paragraph 40 of TR 2012/8 would apply is where a former employee sues their former employer for a performance bonus, they claim that they were entitled to under their employment contract but which was never paid.

Application to your situation

You ceased employment. After your employment ceased your previous employer's legal representative notified you in a written statement, they were reviewing the disposal of the equipment and your association with these transactions.

You contend that your employment duties involved negotiating buying agreements of new games and equipment including the disposal of the equipment. Although you were not able to provide a copy of your employment duties, you contend that the alleged conduct relates to the manner in which you disposed of the equipment.

We acknowledge that there is a connection between your former employment (even in the absence of a formal duty statement), 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 payment for the equipment that were disposed to an individual not known to your employer under an unauthorised licence were not incurred in the performance of your day to day employment duties while you were employed. Your previous employer in a legal statement to you confirmed these actions were not in their best interest. Further the employment contract you provided stated at you also have general duties to act in their best interests at all times. Consequently, your actions and the expenses do not demonstrate they have sufficiently close connection to the performance of your employment duties. Therefore, as there is not a direct connection with your employment you cannot claim a deduction under 8-1 of the ITAA 1997.

In any case, even if your contentious regarding your duties and conduct are accepted, that the expenses were considered to be incurred in the course of earning your assessable income, 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 and in so doing, 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 your previous employer to indemnify yourself against any future legal actions imposed by the relevant regulatory bodies in relation to your former employment which is another enduring advantage which was sought and expenses incurred in relation to.

In summary, you are not entitled to a deduction under section 8-1 of the ITAA 1997 for your legal expenses and payment for the equipment 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.