Edited version of private advice

Authorisation Number: 1052353795667

Date of advice: 29 January 2025

Ruling

Subject: Deductions - legal expenses

Question

Are you entitled to claim a deduction in respect of the legal and settlement expenses you incurred as an employee under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

Since the income tax year ended 30 June 20XX, you were employed by a company (the company) and related corporate entities.

Your role was as the XXXX, and you were the most senior person working at the company. You were not a shareholder of the company.

The unrelated owner of the business was suffering from a medical condition, restricting their ability to carry out company officer duties.

As part of your employment with the company, you were required to act as the XXXXX.

On or about XX XX 20XX, the company became insolvent.

On XX XX 20XX, an administrator was appointed to the company.

On XX XX 20XX, the administrator was appointed as liquidator to the company.

On the appointment of the administrator and liquidator, your employment with the company ceased.

On XX XX 20XX, the liquidator issued a Letter of Demand to you and an associate, as XXXX of the company. You were pursued as the XXXX for the company, for insolvent trading. The Letter of Demand requested repayment of a debt due to the company, pursuant to section 588G and 588M of the Corporations Act 2001.

You engaged a lawyer (the lawyer).

On XX XX 20XX, the lawyer responded to the Letter of Demand, stating that you reject the allegations against you and denied any liability owing to the company or to the liquidator.

On XX XX 20XX, the Liquidator filed a claim in the Supreme Court (the Court) and commenced proceedings against you and a second XXXX, seeking, among other things, orders for compensation under section 588M of the Corporations Act 2001, for loss or damage suffered by the company due to insolvent trading.

In XX XX 20XX, you filed your defence in the Court, disputing the insolvent trading claim.

On XX XX 20XX, Consent Orders were granted by the Court to dismiss the proceedings. A Deed of Settlement and Release was signed to settle the proceedings. You agreed to pay the company and the liquidator in full and final satisfaction of the proceedings.

In the income tax year ending 30 June 20XX, you made a settlement payment to the company amounting to $XXX,XXX. The settlement was made with two instalments, being:

•                     $XX,XXX on XX XX 20XX

•                     $XX,XXX on XX XX 20XX.

You were not employed by the company when you paid the settlement amount.

You incurred legal fees totalling $XX,XXX, to defend the claim against you.

You do not have professional indemnity insurance.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Section 8-1 of the ITAA 1997 allows for a deduction of all losses and outgoings to the extent 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 non-assessable income.

A number of 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

•                     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. Hatchett71 ATC 4184).

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. Federal Commissioner of Taxation (1946); 72 CLR 634; [1946] HCA 34; (1946) 3 AITR 436; (1956) 8 ATD 190). The nature or character of the legal expenses follows the advantage that is ought to be gained by incurring the expenses. If the advantage sought to be gained is of a capital nature, then then expenses incurred in gaining the advantage would also be of a capital nature.

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. The action of out of which the legal expenses arise 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.

In FC of T v. Rowe (1995) 60 FCR 99; (1995) 31 ATR 392; 95 ATC 4691, the court accept 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.

However, there must be an evident connection between the expenditure in instituting the proceedings and the taxpayer's earning activities. Legal expenses are capital or private in nature where the legal action is taken to protect the taxpayer's good name and reputation (Case U102 87 ATC 621; AAT case 72 (1987) 18 ATR 3515).

Company expenses met by director or shareholder

The fundamental requirement to allow the deduction of legal expenses, is that there must be a sufficient nexus between a particular expense and the assessable income such that the expense is incidental and relevant to the gaining of assessable income.

Paragraph 217 of Taxation Ruling 1999/10 Income tax and fringe benefits tax: Members of Parliament - allowances, reimbursements, donations and gifts, benefits, deductions and recoupments refers to Case N9 81 ATC 56; 24 CTBR (NS) Case 81, where the Board of Review disallowed a claim for legal expenses by a director of a number of companies. He was defending himself on charges under the Companies Act that would affect his future appointment as a director. The deduction was disallowed as it was a private and capital nature. The action did not occur as a matter of course in the gaining or producing of his assessable income.

The courts have consistently held that a deduction is not allowable by a director where they pay company expenses, as the expenses are not incurred in gaining or producing assessable income in their capacity as a director. Such expenses are incurred by the taxpayer in earning assessable income of the company, rather than assessable income of the taxpayer (Federal Commissioner of Taxation v. Munro [1926] HCA 28; (1926) 38 CLR 153).

Legal expenses incurred in gaining or producing assessable income in the capacity as the XXXX

Outgoings can be characterised by reference to the legal rights the taxpayer obtains from incurring them. In the ordinary case of a payment under a contract, the legal and substantial nature of the outgoing will commonly be determined by what was gained in return.

To be deductible under section 8-1 of the ITAA 1997, there must be a sufficient nexus between the loss or outgoing and the production of assessable income. You must be able to establish the link between the outgoing and your income producing activities so that the outgoing is direct, relevant and incidental to gaining or producing your assessable income. The circumstances leading to your settlement of the proceedings, were not inherent in your day to day role as a XXXX managing the business activities of the Company.

You incurred legal expenses in full and final settlement of proceedings brought against you; the expenses incurred prevented the Liquidator from taking any further action against you and prevented any further investigation into your involvement as a XXXX and the claims made against you for insolvent trading.

In Duncan v Federal Commissioner of Taxation 2020 ATC 10-544 (Duncan), the Court determined that the costs of settlement of legal action against a company director for trading while insolvent were not deductible, the advantage sought was unrelated to maintaining employment. The payment and legal expenses incurred were not in gaining or producing assessable income or necessarily incurred in carrying on the taxpayer's business. The payment was a capital outgoing directed to defending the capital of the taxpayer's business or an outgoing of a private nature directed at protecting the taxpayer's name and reputation.

Expenses incurred to protect your professional reputation and your ability to practice in future, are incurred to seek an outcome of an enduring advantage and are capital in nature.

Application to your circumstances

Legal proceedings were commenced against you when you were named as a defendant in a matter as an associate of another defendant, as XXXX of a company.

In XX 20XX the proceedings filed in Court sought, amongst other things, orders for compensation under section 588M of the Corporations Act 2001, for loss or damage suffered by the company due to insolvent trading.

In XX 20XX, you settled out of Court, agreeing to pay the plaintiff company and liquidator a settlement amount to dismiss the claims against you. The legal expenses incurred by you, relate to these proceedings.

In your case, the legal expenses incurred are not deductible under section 8-1 of the ITAA 1997, as the advantage sought was to avoid further litigation. The outgoing was to protect and preserve your reputation as a XXXX of a company, and your capacity to earn income as such in the future. The lasting nature of the advantage and the means adopted to secure it (with the agreement to make a one-off settlement payment) point to the outgoing of legal expenses as being capital in nature. The evidence establishes that if the payment had not been made, the liquidator may have proceeded with the legal action brought against you. The payment you made was to avoid any further investigation into your actions as a XXXX of the company and any legal proceedings which might follow from it.

Consequently, no deduction is allowable for the legal expenses you incurred. The advantage sought was capital in nature, your legal expenses follow the advantage sought and you cannot claim a deduction under section 8-1 of the ITAA 1997.