Edited version of private advice

Authorisation Number: 1052297406143

Date of advice: 4 October 2024

Ruling

Subject: Legal expenses

Question 1

Are legal expenses incurred for advice on the terms of your existing employment contract including changes to duties, incentives and reporting lines, deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Are legal expenses incurred for advice on negotiating measures to retain your existing role deductible under the ITAA 1997?

Answer

Yes.

Question 3

Are legal expenses incurred for advice on reviewing the terms of an equity plan (EP), including the restrictive covenants, vesting criteria, whether you should sign and including the impact this would have if you were to subsequently be made redundant, deductible under section 8-1 of the ITAA 1997?

Answer

No.

Question 4

Are legal expenses incurred for advice on whether the employer would be a breach or repudiation of your employment contract because of the new role and whether, your position would be considered redundant deductible under section 8-1 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ending 30 June 20XX

The scheme commenced on:

XX X 20XX

Relevant facts and circumstances

You have been employed in Role A with a Company A since XX X 20XX.

In 20XX, you renegotiated your employment contract, changing the reporting line.

You are a member of the executive team reporting to the Chief Executive Officer (CEO).

Recently, Company A has initiated a restructuring, which has significant implications for your role and reporting lines.

Your current agreement replaces and supersedes the terms of your existing employment agreement dated XX X 20XX and as varied by the variation letter dated XX X 20XX with effect from the date of this agreement.

Your employment with Company A will be regarded as a period of continuous service which commenced on XX X 20XX.

Your employment agreement dated XX XX 20XX details, your responsibilities, reporting line, duties, remuneration, incentive plan, leave, conditions, and other terms.

Restructuring and Recruitment

You are currently in the Executive team at Company A and you report into the CEO. In the restructure, it is proposed that the new role (Role B), overlaps some of your current responsibilities. Role B would be in the executive team and report into the CEO.

You are concerned this new role significantly overlaps with your current responsibilities and would potentially replace your position.

Currently, Company A has engaged the Recruitment Firm to advertise for Role B.

On legal advice you applied for the Role B on XX X 20XX.

It is unclear at present what would happen to your role if you applied for and did not get Role B.

Company A maintains the position that they would consider whether you could either retain your existing role and report into Role B (which would mean you would step down from the executive team and this would reduce your status in the organisation) or whether they would make you redundant.

You sought legal advice to understand your options and rights. Company A has indicated you may be able to stay in your current role and report into the new role.

Financial Impact of Changes

At present because the recruitment process for the new role is ongoing and is not expected to conclude until the XX X 20XX, there is no immediate financial impact until after the recruitment process has concluded.

At which point, a number of things could happen which would impact you which would impact you financially, you could be re-deployed to a different role, or you could be made redundant or Company A might come up with other options. If you were to be made redundant you would no longer be a participant of the Equity Plan (EP) and you would lose access to a potential significant financial benefit.

Equity Plan

On XX X 20XX you were informed by the Company A CEO that you would be invited to participate in the EP and share allocation. The EP is designed to run for several years, has complex vesting criteria.

The EP presents the possibility of a significant financial benefit. However, it is highly complex, and contains significant restrictive covenants.

Terms of invitation

This invitation of shares is offered subject to receipt of final approvals from the board.

Upon receipt by the company of duly completed and executed participant documents, the company will issue the shares referred to in this invitation letter to you as soon as practicable.

Based on legal advice you signed the EP agreements and required documents by the due date with the intention to proceed.

Remuneration Principles

The remuneration structure has been developed so your in-year compensation structure will not materially change versus the current structure, but the invitation to participate in the EP will provide a significant upside and offer a material wealth creation opportunity.

Legal Concerns

The proposed restructuring and external recruitment prompted several legal concerns, including:

•         authority to change duties and reporting lines

•         negotiation of Role Retention and EP

•         impact of incentives and other benefits.

Engagement with Lawyers

Due to the complexity of these legal issues and their potential impact on your employment conditions, benefits and remuneration, you have engaged Lawyers for expert legal advice. The engagement is ongoing.

The specific legal services provided include:

•         contract evaluation

•         legal rights and negotiation strategy:

•         documentation and communication:

•         assistance in drafting correspondence and documentation to communicate my position and negotiate terms with Company A.

Invoices for Legal Expenses

On XX X 20XX you were issued with an invoice payable of $X,XXX.

You have attached copies of all invoices detailing the legal expenses incurred during the relevant period, including the dates they were incurred. The latest fee estimate is that work will cost $XX,000 (however, you anticipate this may be higher).

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

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.

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 allowable 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) 8 ATD 190; (1946) 3 AITR 436). 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.

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

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 TDstates that if an employee incurs legal expense in recovering wages, the legal expenses are an allowable deduction provided 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, on a number of occasions, have determined legal expenses to be an allowable deduction if the expenses arise out of the day-to-day activities of the taxpayer's business or income earning activities. 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.

Taxation Determination TD 2024/7 Income tax: deductions for financial advice fees paid by individuals who are not carrying on an investment business, discusses legal expenses incurred in obtaining financial advice and concept of an enduring or lasting benefit.

Capital or of a capital nature

TD 2024/7 under paragraphs 26, 27 and 28 states as follows:

26. Even if the amount is incurred in gaining or producing the individual's assessable income, a deduction is not available if the amount is capital or of a capital nature.

27. In determining whether an expense is capital or of a capital nature, it is necessary to consider the advantage that is sought from incurring the expense, the manner in which that advantage is to be used and whether the means of its acquisition is a once-and-for all expense for the acquisition of something of enduring advantage or a periodical outlay to cover the use and enjoyment of something for periods commensurate with those payments.

28. Fees for financial advice on a new investment are not deductible under section 8-1 because the amount is considered to be capital or of a capital nature. This is because the expenditure is incidental to the cost of acquiring the income-producing investment. However, the expenditure may qualify as an incidental cost of the acquisition of the asset and for capital gains tax purposes, it may be included in the cost base of the asset under subsection 110-25(3) and section 110-35.

Even if an expense is considered to be incurred in gaining or producing assessable income, it will be excluded from being deductible under section 8-1 of the ITAA 1997 if it is private or capital in nature. Legal expenses are capital or private 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).

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 2000/5 recognises 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).

Application to your circumstances

Question 1 and 2 - Legal expenses incurred in obtaining advice regarding your existing employment.

You incurred legal expenses to advice on the terms of my existing employment contract including changes to duties, incentives and reporting lines. It is considered that your expenses were incurred to preserve your employment and were incidental and relevant to the production of your assessable income. Therefore, we consider that TR 2000/5 is applicable in your circumstance and the relevant costs incurred to dispute your employer's compliance with the agreement are deductible.

Question 3 - Equity Plan

Even if an expense is incurred in gaining or producing assessable income, it will be excluded from being deductible under section 8-1 of the ITAA 1997 if it is private or capital in nature. 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. Expenditure is capital in nature where it is made with a view to bring into existence an asset or advantage that is of an enduring benefit. Capital expenditure is characterised by the fact that it is usually a one-off payment and establishes, replaces or enlarges an income producing asset.

While we acknowledge the successful vesting and potential upside for your participation in the EP is significant, the type of benefit sought would be characterised as capital rather than revenue. The value of shares and possible future dividends as well as interest likely to result from your participation are an enduring benefit and therefore considered capital. Consequently, the legal expenses incurred in advising you to proceed with the Management Equity Plan and the covenants it imposes would not be deductible under section 8-1 of the ITAA 1997.

Question 4 - Impact of the creation of the new role on your existing employment

TR 2000/5 at paragraph 12 provides 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. Therefore, legal expenses associated with determining the impact of the new position and restructure on your current employment conditions and contract are considered deductible under section 8-1 of the ITAA 1997.

Apportionment

The use of the phrase 'to the extent that' in section 8-1 of the ITAA 1997 contemplates apportionment between the following:

•         expenses incurred in gaining or producing your assessable income of a non-capital nature, or necessarily incurred in carrying on your business for the purpose of gaining or producing assessable income that is ordinary income or statutory income of a non-capital nature); and

•         expenses that are of a capital, private or domestic nature, or incurred in relation to gaining or producing your exempt income or your NANE income, or for which you are entitled to a specific deduction or disallowed a deduction.

In determining the extent of your entitlement to deduction for your expenses under section 8-1 of the ITAA 1997, you can use any apportionment method that is fair and reasonable in your circumstances.

As you incurred legal expenses in seeking payments of both a capital and revenue nature, you will have to apportion your legal expenses to calculate the deduction you are entitled to. The apportionment must be on a reasonable basis.

TD 93/29 states that if the solicitor's account is itemised and you can determine from it, how much of the legal expenses relate to the revenue claim then this is a reasonable basis for apportionment. However, if you are not able to determine from the account, how much relates to the revenue claim, then an apportionment on the basis of the monetary value of the revenue claim relative to the capital claim would be reasonable.