Edited version of private advice

Authorisation Number: 1052374721583

Date of advice: 19 March 2025

Ruling

Subject: Deductions - legal expenses

Question 1

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

Answer 1

Yes.

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ending 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

You were a partner with XXXX from XX 20XX.

On DD MM 20YY a XX XX was lodged against you and your spouse by your spouse's former employer in the XXXX.

You undertook legal action for XXXX against the XXXX and to defend yourself against the allegations and validate your compliance with the mandatory requirements of the XXXX in order to carry on your activity as a partner of XXXX through which you generate your income.

On DD MM 20YY you and your spouse engaged a law firm to deal with the XX XX.

On DD DD 20YY you and your spouse engaged a law firm to represent you in the pending court case.

On DD MM 20YY a statement of claim was filed by your spouse's employer which was against both you and your spouse.

The case was first reported by XX media on DD MM 20YY, followed by other outlets.

On DD MM 20YY you met with two senior partners. You were placed on directed leave effective immediately. Your clients were reassigned to other partners and you were prohibited from contacting clients or colleagues and directed not to comment on media reports. The partner's view was that the adverse media could potentially damage XXXX's reputation, and under their partnership agreement, your inclusion in the filed action and subsequent media coverage had the potential to cause an adverse impact to brand, reputation or clients, and its standing with any government, professional or regulatory body.

On DD MM 20YY you requested XXXX against the XXXX. A XX XX was filed in the XX XX.

The defence on behalf of yourself and your spouse was filed on DD MM 202YY.

You met with counsel and solicitors on DD MM 20YY where it was expressed that due to the court action you may experience problems maintaining accreditation and it was reiterated there were concerns about the impact on the reputation of the firm, it's clients and external regulators.

On DD MM 20YY your legal representation engaged an XX XX.

On DD MM 20YY your legal representation engaged a XX XX.

On DD MM 20YY you were issued a notice of mandatory retirement of your partnership. You successfully appealed and the notice was withdrawn.

On DD MM 20YY you filed evidence with the XX XX.

On DD MM 20XX the XX XX dismissed the case in its entirety.

You were on directed leave from DD MM 20YY until DD MM 20YY. During this time, you were not employed by any other organisation and you continued to receive income from XXXX.

On DD MM 20YY you voluntarily retired as a partner, effective from DD MM 20YY.

In total, between XX 20YY and XX 20YY you incurred apportioned legal expenses of $XXXXXX.

Relevant legislative provisions

Income Tax Assessment Act 1997, section 8-1

Reasons for decision

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 essential character of the advantage sought in undertaking the proceedings determines whether the expenses are on revenue or capital account.

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. Federal Commissioner of Taxation [1932] HCA 56. 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. Federal Commissioner of Taxation [1980] 80 ATC 4542; Putnin v. Federal Commissioner of Taxation [1991] 27 FCR 508.

When the principal reason for incurring the legal expenses is defending the actions of the taxpayer in carrying out their income earning 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). That is, for legal expenses to be an allowable deduction under section 8-1, it must be shown they are incidental or relevant to the income earning activity.

Sums paid in defending or settling tortious actions are generally deductible if liability for the alleged tort or other wrongful action arose out of, or in connection with, the carrying on of the income-earning activities, and the particular tort alleged represents that kind of casualty, mischance or misfortune which is a natural or recognised incident of the income-earning activities (C of T (NSW) v Ash [1938] 61 CLR 263.

The leading authority in this area is Herald & Weekly Times Ltd v FC of T [1932] 48 CLR 113. In that case, the taxpayer, the proprietor and publisher of an evening newspaper, claimed outgoings (for legal advice, defence costs and damages awarded) in connection with libels the newspaper had published. The Full High Court allowed the deduction since, firstly, publishing the newspaper was both the source of income and the cause of liability and, secondly, the risk of libel was a regular and almost unavoidable incident or inherent risk of publishing.

In Federal Commissioner of Taxation v Day [2008] HC 53, legal expenses were incurred with respect to charges against an officer of the public service. Consideration was given to the context and position of such an officer holds, the extend of the duty owed by the officer and the legislative provision for the enforcement and regulation of such duty. The taxpayer's duties as an officer of the public service, and the possible consequences to him of internal disciplinary proceedings and action with respect to the continuation or termination of his service, formed part of what was productive of his assessable income in that capacity. The occasion of the legal expenses was to be found in his position as an officer and it followed that the expenses were property allowable as deductions.

In your case, the newspaper reporting was considered damaging to your role. The partners considered the reporting a reputational risk and placed you on immediate directed leave.

On the facts presented, the legal expenses incurred by you were in relation to defending your position and source of income as a partner of XXXX and are therefore not an outgoing of a private or domestic nature. You incurred the legal expenses as a result of the threat of action and were incurred in respect of defending your working relationship. The consequences of action taken, if proven, would have affected the existence of your working relationship and ability to gain income as a partner.

The terms of your partnership agreement oblige you to observe certain standards of conduct and the incurring of the expenditure by you to defend a charge because it may result in your mandatory retirement demonstrates the necessary connection to your income earning in order to continue your partnership. The requisite connection required by paragraph 8-1(1)(a) of the ITAA 1997 will be satisfied where the connection between the outgoing and the income is identified as being incurred to defend the manner of performance of positive duties. The connection between the legal expense and your income is identified as being incurred to answer allegations that breach the terms imposed by your partnership agreement. Therefore, the legal expenses incurred in resisting civil legal action will be deductible.

As your legal expenses affect both your spouse and you, the legal expenses only partially related to your income earning activities. Taxation Determination TD 93/29 paragraph 7 discusses the apportionment of legal expenses and that where a solicitor's account is not itemised, a possible basis for apportionment would be either a reasonable cost of the work undertaken by the solicitor, or on the basis of the monetary value of the claim.