ATO Interpretative Decision

ATO ID 2010/131

Income Tax

Issue

Is the taxpayer entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for legal expenses incurred in seeking entitlements under an employment contract for payment in lieu of notice on termination of employment?

Decision

Yes. The taxpayer is entitled to a deduction under section 8-1 of the ITAA 1997 for legal expenses incurred in seeking entitlements under an employment contract for payment in lieu of notice on termination of employment.

Facts

The taxpayer was employed under an employment contract that provided for 6 months' pay in lieu of notice on termination of employment.

The taxpayer's employment was terminated and the employer refused to make the lump sum payment in lieu of notice provided for under the employment contract. The payment in lieu of notice did not form part of a genuine redundancy payment or early retirement scheme payment in terms of Division 83 of the ITAA 1997.

The taxpayer took legal action and the Court enforced the taxpayer's contractual entitlement to the lump sum payment in lieu of notice of termination and also awarded interest and costs.

The taxpayer incurred legal expenses in relation to this matter.

Reasons for Decision

Broadly, 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 to the extent 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 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.

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

The question of deductibility of legal expenses under section 8-1 of the ITAA 1997 to enforce a contractual entitlement to a lump sum payment in lieu of notice was considered in Romanin v. Commissioner of Taxation [2008] FCA 1532; 2008 ATC 20-055; (2008) 73 ATR 760.

In that case, McKerracher J held, at FCA paragraph 52, in terms of positive limb nexus:

In my view, the requisite connection exists between the outgoing claimed (legal expenses) and the incurrence of assessable income. On this point, I accept Mr Romanin's submission that he pursued proceedings in the Commission to obtain income that was contractually owed to him and that the costs incurred in doing so are deductible under s8-1(1) of the ITAA.

In terms of the negative limbs, McKerracher J held, at FCA paragraph 56, that:

It is true that payment was for a lump sum in lieu of 12 months income (less other income received) but the amount was described in the orders pursuant to the Commission's judgment as remuneration, was computed by reference to his entitlement to income, was set off against other income actually earned and is a financial reward for exertion that would have been carried out had his employment not been (invalidly) terminated. Income is of course received by people and entities in a variety of ways. The payment in a lump sum of the sum which would otherwise be income by way of regular payments, does not of itself, in my view change the character of the payment . [Emphasis added.]

That is, the character of the advantage sought was held to be on revenue rather than capital account.

Therefore, in the circumstances here, the same conclusion follows. That is, the taxpayer's legal expenses in enforcing payment of their contractual entitlement to payment in lieu of notice are outgoings with nexus to assessable income and where the character of the advantage sought is on revenue account. The legal expenses are therefore deductible under section 8-1 of the ITAA 1997.

Year of income:  Year ended 30 June 2010

Legislative References:
Income Tax Assessment Act 1997
   section 8-1

Case References:
Hallstroms Pty Ltd v Federal Commissioner of Taxation
   (1946) 72 CLR 634
   (1946) 3 AITR 436
   (1946) 8 ATD 190

ATO Interpretative Decisions overturned by this decision
ATO ID 2002/656

Keywords
Deductions & expenses
Employment termination
Legal action
Legal expenses
Employment contracts

Siebel/TDMS Reference Number:  1-22GMW3A

Business Line:  Small Business/Individual Taxpayers

Date of publication:  18 June 2010

ISSN: 1445-2782