Edited version of private advice

Authorisation Number: 1052308097352

Date of advice: 21 October 2024

Ruling

Subject: Deduction - legal expenses

Question 1

Are you entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for legal expenses incurred in reviewing your employment contract and the subsequent new clause in the employment contract?

Answer

Yes.

Question 2

Are you entitled to a deduction under section 8-1 of the ITAA 1997 for legal expenses incurred in establishing your rights in relation to intellectual property developed by you and the subsequent sale of it?

Answer

No.

Question 3

Are you entitled to a deduction under section 8-1 of the ITAA 1997 for legal expenses incurred in drafting a deed of releases in relation to intellectual property developed by you?

Answer

No.

This ruling applies for the following period:

Year ended XX XX 20XX

The scheme commenced on:

XX XX 20XX

Relevant facts and circumstances

In 20XX, you commenced your employment as a XX with your employer.

In early 20XX, you began developing a software product, outside the scope of your employment.

You tested the software with some of the company's customers.

You informed your supervisor of the product, who indicated that the company might claim ownership based on the Intellectual Property (IP) clause in your employment contract.

The original IP clause 12 stated:

12.1. To the extent that you have the legal right to do so, you assign to us all rights and interests you may have in any Intellectual Property produced, invented or conceived by you:

a.    in the course of your employment;

b.    at our direction or request;

c.     in connection with any of our businesses or products or services;

d.    whether alone or jointly with another person, whether or not during business hours, and whether before or after the date of this document,

e.    automatically vests in us. You agree that your remuneration is sufficient consideration for these assignments.

12.2. You must disclose to us any of the Intellectual Property that is the subject of this clause promptly after it is brought into existence.

12.3. You must, at our expense, sign all documents and do all other things reasonably necessary to:

a. enable us or our nominee to register any Intellectual Property anywhere in the world; and

b. effect or perfect the transfer to us, or our nominee, of your rights and interests in any of the Intellectual Property that is the subject of this clause.

12.4. You irrevocably appoint us to be your attorney to do in your name on your behalf any of the things you are required to do under this clause.

12.5. Your obligations under this clause continue after termination of your employment.

As well as some minor grammatical changes and renumbering, the amended IP clause 12 added the following as paragraph (e)

If you are unsure whether any Intellectual Property is covered by clause 12(a) or not, you must inform us to make a determination. Provided that none of the conditions at clause 12(a) arise, such Intellectual Property will not vest in us.

On XX XX 20XX, you contacted Company A for IP legal advice.

On XX XX 20XX, you provided your employment contract to Company A. After waiting on your employer's position on IP ownership.

On XX XX 20XX, Company A sent a letter of fees, and advised that you likely owned the IP.

On XX XX 20XX, you received your first invoice from Company A. It was for $XX ($XX after excluding trademark advice fees).

On XX XX 20XX, you noticed an amended IP clause in the new contract, required for receiving your bonus. Upon noticing this, you contacted Company A to review the new clause.

On XX XX 20XX, you contacted Company A regarding monetising the software. You had customers waiting to purchase the product, but you didn't want to jeopardise your employment.

At this time, you were waiting to hear back from your employer on whether they wanted to work in partnership to sell the software.

On XX XX 20XX, you received an invoice for $XX from Company A for reviewing the new clause.

On XX XX 20XX, you received an invoice for $XX from Company A for advice on monetising software.

On XX XX 20XX, your employer responded, asserting ownership of the IP. You engaged Company A again.

On XX XX 20XX, you received an invoice for $XX from Company A.

On XX XX 20XX- Company A advised you to prepare a Deed of Release. Your employer told you that they would not sign it and provided an email instead. Company A also advised you to amend the new contract. Your employer refused the amended contract. They sent you an invoice for $XX ($XX after excluding deed of release fees).

On XX XX 20XX, you set up two companies:

•         Company B- not trading, holds IP and trademarks.

•         Company C - trading company for the software.

Both companies have commenced sales.

Legal advice provided by Company A

Concerns about the Employment contract

•         The items of costs associated with invoice X and X are in relation to the review of the employment contract and the IP clause within it.

Concerns about the Intellectual Property

•         The e-mail initiating the request under invoice X outlines 4 possibilities for the IP including a concern that the employer may claim full ownership of the IP, the consequences of starting a company to hold the IP and the effect on your employment contract if you volunteered to work for this company. The advice considered each of the above and concluded that your situation is risky.

Drafting email to your employer

•         You were asked to provide something in writing to your employer stating that you created an IP, outlining your intentions for the software, and asserting your position. As per invoice 4, you sought counsel from Company A to assist with the wording of the email to your employer. You amended the email that Company A drafted slightly, and sent your employer an email advising them of your intention to market the IP yourself with it having no association to your employer- subject to any conditions of your employment contract. You were seeking confirmation from your employer that they approve, and won't take any issues with your proposed activities.

•         Your employer responded with an email stating that the ongoing commitment is to ensure that your proposed independent commercialisation activities do not impact on fulfilling your role for them, nor impact the best interests of your employer or its reputation. The employer also stated that "on that basis that ownership may imply responsibility and based on your view that the software is owned by you, to the extent Company B may be considered to own any IP software, Company B assigns any IP related to the software product developed relation to the configuration backup services to you.

•         Your employer stated that given there may be some risk in the connection of a sale of the software to a customer, any proposal to sell the software to a Company B customer must be done with their prior written consent.

•         Company A advised you to provide your employer with a Deed of Release to be signed regarding the IP, which covers the assignment of intellectual property rights; the release and promise from Company B that it won't pursue you for breaches of your employment contract in relation to the commercialisation activities; and any obligations on your part and Company B in relation to Company B's consent proposal.

•         Company A also advised you to make minor amendments to the new clause in your employment contract, in order to ensure that there is no inadvertent transfer of IP in the software to your employer.

Drafting the Deed of Release

•         The e-mail initiating the request under invoice X related to the drafting of the Deed of Release.

•         You provided the Deed of Release to your employer, who confirmed that they would not be signing the document, and re-iterated that what they had stated in their email to you as per above was sufficient.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Summary

The legal expenses you incurred in reviewing the rights of an existing employment contract are allowable deductions under section 8-1 of the ITAA 1997. However, you are not entitled to claim a deduction under section 8-1 of the ITAA 1997 for legal expenses incurred in obtaining a release from your employer on the basis that it does not relate to the gaining or production of income. This means you cannot claim the expenses incurred obtaining legal advice in relation to the ownership of the IP or the expenses incurred in drafting a deed of release.

Expenses incurred to ascertain the ownership of the IP are capital in nature and are not deductible.

If the legal action goes beyond a claim for a revenue item such as wages and constitutes an action for example, breach of the employment contract, 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.

Detailed reasoning

As stated in ATO ID 2002/1081 Legal expenses - to establish rights to intellectual property, 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.

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. 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.

Legal expenses may be of a revenue nature and therefore deductible if they arise out of the day to day activities of the taxpayer's business or income producing activity (Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; [1932] HCA 56; (1932) 2 ATD 169). Where however, expenditure is devoted towards a structural rather than an operational purpose, the expenditure is of a capital nature and the expenses are not deductible (Sun Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; [1938] HCA 73; (1938) 5 ATD 87; (1938) 1 AITR 403).

Outgoings incurred in the preservation of an existing capital asset have been held to be capital in nature (John Fairfax & Sons Pty Limited v. Federal Commissioner of Taxation (1959) 101 CLR 30; [1959] HCA 4; (1959) 7 AITR 346; (1959) 11 ATD 510).

The taxpayer incurred legal expenses in seeking advice to establish their rights in relation to the written materials authored by them. The advantage sought to be obtained by seeking legal advice was to establish their right to the materials. The legal expenses are capital in nature as they relate to the asset rather than the derivation of income from that asset.

Accordingly, as the legal expenses incurred by the taxpayer are of a capital nature, a deduction is not allowable under section 8-1 of the ITAA 1997.

Taxation Ruling 2000/5 Income tax and fringe benefits tax: costs incurred in preparing and administering employee agreements (TR 2000/5), sets out the Commissioner's view on the application of section 8-1 of the ITAA 1997 to costs incurred by employees and employers in preparing and administering employment agreements. Where costs incurred were to resolve a dispute with your employer, you will be entitled to a deduction under section 8-1 of the ITAA 1997 for the cost of representation (paragraph 2 of Taxation Ruling TR 2000/5).

You will not be entitled to claim a deduction under section 8-1 of the ITAA 1997 for expenses incurred in obtaining a release from your employment, on the basis that it does not relate to the gaining or production of income.

Legal expenses

Generally, legal expenses have been held to be deductible if the expenses are directly related to the earning of income.

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 Commissioners view on legal expenses. 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.

However, if the legal action goes beyond a claim for a revenue item such as wages and constitutes an action for example, 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 or a breach of employment contract, are not deductible.

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).

If the advantage to be gained does not have an immediate connection to the duties undertaken to derive income and has more of an enduring and consequently capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature. An amount that is capital in nature will remain capital notwithstanding that it is specifically included in the assessable income of the taxpayer.

Apportionment of expenses

Apportionment is a question of fact and involves a determination of the proportion of the expenditure that is attributable to deductible purposes. The Commissioner believes that the method of apportionment must be fair and reasonable in all the circumstances. Where legal expenses are not broken up into the relevant parts, you will need to calculate the deductible portion.

Paragraph 7 of TD 93/29 discusses the apportionment legal expenses

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.

Application to your circumstances

In your case, the costs you incurred to review your employment contract as well as to review the new IP clause are an allowable deduction under section 8-1 of the ITAA 1997. This is because the expenses relating to legal advice sought are revenue in nature.

However, you will not be able to claim as a deduction the legal expenses incurred in seeking advice regarding the ownership of the IP.

As the legal expenses you have incurred are both revenue and capital in nature, you will need to apportion the legal expenses in a reasonable manner. You should apply the above principles in paragraph 7 of TD 93/29 in undertaking the apportionment.