Edited version of private advice

Authorisation Number: 1052363385786

Date of advice: 19 February 2025

Ruling

Subject:Deductions - legal expenses

Question 1

Is the payment of the employer A settlement sum an allowable deduction within the meaning of the Income Tax Assessment Act 1997(ITAA 1997), in the 20XX income year?

Answer 1

No.

Question 2

If the answer to question 1 is no, then does the payment of the employer A settlement sum give rise to a capital loss?

Answer 2

No.

Question 3

Are the employer A legal costs deductible under section 8-1 of the ITAA 1997?

Answer 3

No.

Question 4

If the answer to question 3 is no, then do the employer A legal costs form part of the incidental costs in calculating the capital loss in question 2?

Answer 4

Not applicable as the answer to question 2 is no.

Question 5

Is the receipt of the employer B payment capital proceeds in relation to a capital gains event (CGT) in the 20XX income year?

Answer 5

No.

Question 6

Are the employer B legal costs deductible under section 8-1 of the ITAA 1997?

Answer 6

Yes.

Question 7

If the answer to question 6 is no, then do the employer B legal costs form part of the incidental costs in determining the capital gain from the relevant CGT event?

Answer 7

Not applicable as the answer to question 5 is no.

Question 8

Can the capital gain arising from the employer B payment be set-off or deducted against the capital loss arising from the employer A settlement sum for the 20XX income year?

Answer 8

Not applicable as the answer to question 2 and 5 are both no.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commenced on:

XX XXXX 20XX

Relevant facts and circumstances

From XXXX 20XX to XX XXXX 20XX, you were employed by employer A.

On XX XXXX 20XX, you signed an employment agreement with employer B.

In accordance with your employer B employment agreement your commencement date was XX XXXX 20XX. The delay between you signing the employment agreement and the commencement date was due to you being bound by contractual obligations under the employer A employment agreement in respect to a XX-month non-compete provision that began when you ceased employment with employer A.

After XX XXXX 20XX, employer A undertook an investigation of your IT activity and determined you were in possession of confidential information of employer A material.

On XX XXXX 20XX, employer A commenced proceedings against you in the Federal Court of Australia. The claims brought by employer A were that you breached your employer A Employment Agreement, fiduciary duties, duties of confidence and infringed employer A's copyright and/or contravened sections XX and XX of the Corporations Act.

You incurred legal costs in defending the employer A proceedings.

On XX XXXX 20XX, employer B notified you of their concerns in relation to the ongoing proceeding between employer A and you, namely that you have:

•                     acted contrary to the direction given by employer B in Recital (X) of the Employment Agreement signed XX XXXX 20XX (employer B Employment Agreement) that you comply with the post-employment obligations you owe employer A, and therefore had acted contrary to the representation you made in signing the contract to the effect that you would comply with that direction;

•                     breached the obligation in clause XX of the employer B Employment Agreement that you would not disclose or use for employer B's benefit any trade secret or confidential information of employer A or any other third parties which you may possess; and

•                     committed an act of dishonesty as to a matter related to employer B or its affiliates (clause XX), a breach of the warranty to provide truthful information in clause XX, and a breach of the warranty contained in clause XX.

Employer B based their concerns on:

•                     your downloading of files from employer A's servers onto a personal storage device was not in accordance with employer A's policies;

•                     the files included at least some information that is confidential to employer A;

•                     you did not inform employer B at the material time that you had transferred employer A's confidential information to a personal storage device; and

•                     you were not prepared to swear that you have not breached any of your post-employment obligations set forth in your employer A Employment Agreement.

Employer B maintained its position, that they would not pay your pre-commencement compensation set out in Schedule X to the employer B Employment Agreement while the employer A proceeding remained unresolved.

Employer B communicated their desirability to rescind their offer of employment to you.

In XXXX 20XX, you reached a deed of settlement with employer A (employer A Deed).

Under the employer A Deed, you are required to pay compensation of $XX to employer A in five instalments.

On XX XXXX 20XX, you reached a deed of settlement with employer B (employer B Deed).

The employer B Deed, states that the contract claims mean any or all present and future claims relating to or arising out of or in connection with the employment agreement (including in respect of non-payment of compensation payable prior to the commencement date or upon the termination of the employment agreement).

Under recital x of the employer B Deed, employment is defined as your prospective employment with employer B as contemplated in the employment agreement.

Under recital x of the employer B Deed, the parties agreed that the employment agreement will terminate on the end date and the employment will not commence on the commencement date.

Under the employer B Deed, within XX days of receiving a copy of the Deed, employer B are required to make an Ex-Gratia payment to your bank account.

Under recital X of the employer B Deed, the agreement reached was a full and final settlement.

Under recital X, the employer B Deed is executed without any admission of liability of either party.

Under subclause XX of the employer B Deed, each party will pay its own legal and other costs and expenses of negotiating, preparing, executing and performing its obligations under this deed.

On XX XXXX 20XX, employer B made payment of the ex-gratia payment to you as per the employer B Deed.

On XX XXXX 20XX, your employment agreement with employer B was terminated as per the employer B Deed.

The following documents were provided with respect to the private ruling application and form part of, and are to be read with, the description of the facts and circumstances set out below:

•                     Employer A Employment Agreement.

•                     Employer A Deed.

•                     Employer B Employment Agreement.

•                     Employer B Deed.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 15-2

Income Tax Assessment Act 1997 division 82

Income Tax Assessment Act 1997 division 102

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 subdivision 110-A

Income Tax Assessment Act 1997 section 118-20

Reasons for decision

Question 1

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.

The High Court majority in Commissioner of Taxation v Payne [2001] HCA 3 said it is well established that these words are to be understood as meaning incurred 'in the course of' gaining or producing assessable income, and do not convey the meaning of outgoings incurred 'in connection with' or 'for the purpose' of deriving assessable income.

The majority further stated that the meaning of 'in the course of' gaining or producing income was amplified in Ronpibon Tin NL v Commissioner of Taxation (Cth) [1949] HCA 15 where it was held that:

... to come within the initial part of [section 8-1] it is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income, or if none be produced, would be expected to produce assessable income...

Taxation Ruling 2020/1 Income tax: employees: deductions for work expenses under section 8-1 of the Income Tax Assessment Act 1997 sets out the Commissioner's view on when an employee can deduct a work expense under section 8-1 of the ITAA 1997. For the purposes of this Ruling, 'work expense' means 'a loss or outgoing you incur in producing your salary or wages'.

For the expense to be deductible it but be in gaining or producing assessable income. Paragraphs 16, 22, 23 and 25 of the TR 2020/1 state:

16. For expenses incurred by employees, the fundamental question is whether an expense is incurred in the course of earning employment income. This involves considering the proper scope of the particular taxpayer's work activities to determine if the circumstances of the expense have a sufficiently close connection to earning the employment income.

22. The requirement that expenses be incurred while producing assessable income means that it is not enough to show only that there is some general link or causal connection between expenditure and the production of income. The expenditure must have a sufficiently close connection to performance of the employment duties and activities through which the employee earns income.

23. Accordingly, in some cases, expenditure would be regarded as too remote from the income-earning activities or incurred only as a prerequisite to earning income, and not incurred in the course of producing that income.

25. Other examples of expenditure that would be too remote from the income-earning activity, or incurred at a point too soon to be characterised as incurred in the course of earning assessable income, would be expenses of looking for and securing new employment. This would also be the case for relocation expenses to work in a different city or state. Similarly, education expenses to obtain qualifications for new employment would not be incurred in the course of gaining or producing relevant assessable income.

A deduction cannot be claimed if it is capital or capital in nature. Paragraphs 42 and 43 of TR 2020/1 state:

42. Even if the positive test of section 8-1 is satisfied, an employee cannot claim a deduction for expenditure that is capital, or capital in nature.

43. Broadly, 'capital or capital in nature' refers to expense items that are not regular or recurrent but, rather, are one-off expenditures that can be expected to have an enduring or lasting benefit.

Application to your circumstances

The settlement sum paid to employer A as part of the employer A Deed, is not incurred in gaining or producing assessable income. It is not regular or recurrent but, rather, are one-off expenditures that can be expected to have an enduring or lasting benefit. You are therefore not entitled to a deduction under section 8-1 of the ITAA 1997.

Question 2

Your assessable income includes your net capital gain for the income year (subsection 102-5(1) of the ITAA 1997). You make a capital loss (or gain) as a result of a CGT event happening (section 102-20 of the ITAA 1997).

CGT event C2 happens if your ownership of an intangible CGT asset ends in certain ways, including being released or cancelled (subsection 104-25(1) of the ITAA 1997). The time of the event is when you enter into the contract that results in the asset ending, or if there is no contract, when the asset ends (subsection 104-25(2) of the ITAA 1997).

A CGT asset is any kind of property or a legal or equitable right that is not property (section 108-5 of the ITAA 1997).

In your case, employer A's right to seek compensation is an intangible CGT asset (acquired at the time of the compensable wrong) and their ownership of that asset ended when you entered into the Deed of Settlement and Release with employer A). At that time CGT event C2 happened.

In your case, it was employer A's right to compensation and not your right. Thus, you do not have an intangible CGT asset and are not entitled to the capital loss from the payment made to employer A under the employer A Deed.

Question 3

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).

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) 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 revenue nature, then the expenses incurred in gaining the advantage will also be of a revenue 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).

Furthermore, legal expenses are generally deductible if they arise out of the day to day activities of the taxpayer's business (Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 39 ALR 46; (1932) 2 ATD 169) and the legal action has more than a peripheral connection to the taxpayer's income producing activities (Magna Alloys and Research Pty Ltd v. FC of T (1980) 49 FLR 183; (1980) 11 ATR 276; 80 ATC 4542).

In FC of T v. Day [2008] HCA 53 and FC of T v. Rowe (1995) 31 ATR 392; 95 ATC 4691, the courts 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.

ATA legal expenses.

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 certain 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.

Your legal expenses relate to an action for damages regarding you breaching your employment contract. Therefore, you are not entitled to a deduction under section 8-1 of the ITAA 1997 for your legal expenses associated with the employer A proceedings.

Question 4

Not applicable because it was determined that the employer A settlement sum did not give rise to a capital loss in your hands.

Question 5

Ex-gratia payment

The payment made under the employer B Deed was an ex-gratia payment. The payment represented the non-payment of compensation payable prior to the commencement date or upon the termination of your employment agreement with employer B.

Division 82 of the ITAA 1997 sets out how employment termination payments (ETP) are treated for income tax purposes. Section 82-130 of the ITAA 1997 explains that a payment is considered an ETP if it is received by you in consequence of the termination of your employment and it is received no later than 12 months after that termination. ETPs are typically not considered assessable where you receive them upon cessation of your employment. A payment is an ETP if it satisfies all the requirements in section 82-130 and is not specifically excluded under section 82-135.

Taxation Ruling TR 2003/13 Income tax: employment termination payments (ETP): payments made in consequence of the termination of any employment: meaning of the phrase 'in consequence of' discusses the Commissioner's opinion on the meaning of the phrase 'in consequence of' in the context of the expression 'in consequence of the termination of any employment' as used in Subdivision 82-C of the ITAA 1997. It is relevant in determining a severance payment, such as a 'golden handshake', made in respect of a taxpayer by a former employer of the taxpayer is an employment termination payment under subsection 82-130(1) of the ITAA 1997.

In paragraphs 5, 6 and 30 of TR 2003/13 the Commissioner states:

5.... a payment is received by a taxpayer in consequence of the termination of the taxpayer's employment if the payment 'follows as an effect or result of' the termination. In other words, but for the termination of employment, the payment would not have been received by the taxpayer.

6. The phrase requires a causal connection between the termination and the payment, although the termination need not be the dominant cause of the payment. The question of whether a payment is received in consequence of the termination of employment will be determined by the relevant facts and circumstances of each case.

30. A severance payment that is made in respect of a taxpayer by a former employer after the termination of the taxpayer's employment, such as a golden handshake, is a payment that follows as an effect or result of the termination. Accordingly, the payment is made in consequence of the termination of employment. In such circumstances there is a causal connection between the payment and the termination of employment in that the payment would not have been made to the taxpayer but for the termination of the employment.

In your case, you had signed an employment agreement with employer B, and you were meant to commence employment on XX XXXX 20XX. However, as a result of the employer A proceedings, employer B wanted to terminate your employment under the agreement. You and employer B, agreed on you receiving the ex-gratia payment, in respect of a termination dispute with employer B. The payment was not specifically excluded under section 82-135 of the ITAA 1997. The ETP is considered a life termination payment under subsection 82-130(2) of the ITAA 1997. You were paid the lump sum payment as specified in recital X of the employer B Deed as a 'golden handshake' acknowledging that it was the full and final settlement regarding the termination of your employment agreement.

Based on the Commissioner's views expressed in TR 2003/13, 'in consequence of the termination' requires that termination be a cause, but not necessarily a dominant cause of the payment. As per the facts of your case, the ex-gratia payment you received was connected to your termination. Your termination was the cause of the ex-gratia payment made to you.

Assessable ordinary income

Section 15-2 of the ITAA 1997 outlines allowances and other things provided in respect of employment or services. Section 15-2 states:

(1) Your assessable income includes the value to you of all allowances, gratuities, compensation, benefits, bonuses and premiums *provided to you in respect of, or for or in relation directly or indirectly to, any employment of or services rendered by you (including any service as a member of the Defence Force).

(2) This is so whether the things were *provided in money or in any other form.

The receipt of the ex-gratia payment under the employer B Deed is considered assessable income under section 82-30 and 15-2 of the ITAA 1997. Thus, the payment of the ex-gratia is assessable income.

As the amount is otherwise taxable as assessable income, we do not consider if it is a capital gain from CGT event C2 in this situation under subsection 118-20 of the ITAA 1997.

Question 6

Please see the previous discussion on legal expenses under question 3.

LNW legal expenses.

Taxation Ruling TR 2000/5 Income tax and fringe benefits tax: costs incurred in preparing and administering employee agreements, sets out the Commissioner's view of the application of section 8-1 of the ITAA 1997 to costs incurred by employees and employers in preparing and administering employment agreements. At paragraph 12, it recognises the types of costs that may be incurred in administering an employment agreement, including costs relating to the settlement of disputes.

As the legal costs were incurred in administering your employment agreement with employer B, they are deductible under section 8-1 of the ITAA 1997.

Question 7

Not applicable as we determined the ex-gratia payment is assessable income and not a capital gain.

Question 8

Not applicable because we have determined there was no capital gain or loss from either payment.