Edited version of private advice

Authorisation Number: 1051814955268

Date of advice: 15 March 2021

Ruling

Subject: Legal expenses

Question 1

Are you entitled to a deduction for legal expenses incurred in relation to the alleged bullying and harassment matters that arose from your position?

Answer

Yes.

Question 2

Are you entitled to a deduction for legal expenses incurred in relation to maintaining and defending your position?

Answer

No.

Question 3

Are you entitled to a deduction for legal expenses incurred in relation to your public reputation?

Answer

No.

This ruling applies for the following period:

Year ended 30 June 2019

The scheme commenced on:

1 July 2018

Relevant facts

During the xxxx income year to the 2018-19 income year you had a position.

In your application and in response to requests for further information you have stated:

•         As a result of your role, you were subjected to various prosecutions by your employer and colleagues.

•         Claims were made against you relating to allegations that your written communications constituted bullying and harassment of them via their interpretation of that term.

•         The claims against you were in response to your written correspondence in the performance of your duties.

•         The complainants wanted to force you to quit or be forced from your role.

On xxxx an application for an order to stop bullying was made under section xxx of the relevant act by another employee. They allege bullying conduct by you. You allege bullying conduct by this employee and other employees.

As the complaints fell outside the jurisdictions of the relevant acts, the associated investigations, hearings and matters were dropped.

A mediation process was instigated to settle differences in the xxxx income year.

In the xxxx income years entity A (and related individuals) instigated various actions with a view to dislodging you from your position.

Most of the actions required you to obtain legal advice or representation to defend yourself or represent yourself.

You incurred legal expenses in relation to the above in the xxxx income year.

You state the purpose for incurring the legal expenses was to maintain your position and defend your position and public reputation.

You do not have legal indemnity insurance and your expenses have not been and will not be covered by any other means. The legal costs have been at your own personal expense.

You have not sought, and cannot seek, to recover costs from the other parties.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

Legal expenses

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, or a provision of the ITAA 1997 prevents it.

A number of significant 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) (Lunney's case),

•   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. Hatchett, 71 ATC 4184).

For legal expenses to constitute an allowable deduction, it must be shown that they are incidental or relevant to the production of the taxpayer's assessable income or business operations. Also, 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) 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.

The following guidelines for determining whether a loss or outgoing is of a capital nature have been set down by the High Court in Sun Newspapers Ltd. and Associated Newspapers Ltd. v. Federal Commissioner of Taxation (1938) 5 ATD 23; 5 ATD 87; 61 CLR 337:

•   the expenditure is related to the business structure itself, that is, the establishment, replacement or enlargement of the profit yielding structure rather than the money earning process, or

•   the nature of the advantage has lasting and enduring benefit, or

•   the payment is 'once and for all' for the future use of the asset or advantage rather than being recurrent and ongoing.

That is, where the expenditure is incurred for the purpose of securing an enduring benefit, rather than a revenue purpose, the expenditure is capital in nature and is not deductible.

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) 7 AITR 346; (1959) 11 ATD 510).

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 (the Herald and Weekly Times case)) 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 80 ATC 4542; (1980) 11 ATR 276). It follows, that expenditure will be deductible in earning assessable income if the subject of the claim is something that might ordinarily be expected to occur in carrying out the income earning activities.

In Case U102 87 ATC 621 the taxpayer was a secretary-manager of a large sporting club. Comments about the management of the trust funds were made on television that were defamatory in nature in respect to the trustees. The trustees commenced proceedings for damages for defamation. The Administrative Appeals Tribunal (AAT) held that a deduction for the legal expenses incurred was not allowable. It was found that the events which gave rise to the expenses incurred were not regarded as what is normally expected of a secretary-manager of a club in the course of producing assessable income. The expenses were considered private in nature as the need for them arose out of the taxpayer's reaction to what he saw as a slur upon his personal good name and reputation. Alternatively, it was stated that the expenditure was capital in nature as it was incurred in an endeavour to retain and restore his position as a leading figure in the sports management industry and with it a standing sufficient to pursue his own interest away from the club in the future.

The character of legal expenses is not determined by the success or failure of the legal action (No. 3 Board of Review Case B31, 70 ATC 148).

It is a long-standing principle that a taxpayer does not satisfy section 8-1 of the ITAA 1997 merely by demonstrating some casual connection between the expenditure and the derivation of income. What must be shown is a closer and more immediate connection. The expenditure must be incurred in gaining or producing your assessable income (Lunney's case). These principles have been affirmed by the High Court in Commissioner of Taxation v Payne [2001] HCA 3.

Although your situation differs from the above cases, the principles are relevant.

Bullying and harassment

In your case, you incurred expenses in relation to defending the allegations of bullying and harassment that arose from your position.

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).

Similarly, in FC of T v. Rowe (1995) 60 FCR 99; (1995) 31 ATR 392; 95 ATC 4691, the court accepted that legal expenses incurred in defending the manner in which a taxpayer performed his employment duties were allowable.

It is considered that the disputes concerning the alleged bullying and harassment matters during your time in the position are sufficiently connected to your income earning activities and are not capital or private in nature. Therefore, the portion of your legal expenses incurred in relation to the alleged bullying and harassment is an allowable deduction.

Defending your position and reputation

Taxation Determination TD 93/29 states:

If the legal action goes beyond a claim for a revenue item such as wages, and constitutes an action for a 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 because they are capital in nature. For example, legal expenses relating to an action for damages for wrongful dismissal are not deductible.

The Courts, Boards and Tribunals have consistently held that the legal expenses incurred by taxpayers in defending themselves against dismissal from their employment or seeking to regain employment following dismissal are of a capital nature and not deductible unless they are defending the way they carry out their day to day employment duties. This is because:

•   the legal expenses can be regarded as having been incurred once and for all, and

•   the advantage sought to be gained is the preservation of the taxpayer's employment.

Legal expenses incurred in preserving your position and to help restore your reputation are not deductible as they are considered to provide an enduring advantage and are therefore capital in nature. The advantage sought is the restoration of a capital asset, that is, your means of producing income. As such, the character of the legal expenses is considered to be capital in nature and the expenses are not deductible under section 8-1 of the ITAA 1997 (Case Y24 91 ATC 268; AAT Case 6942 (1991) 22 ATR 3184).

Protecting your reputation and position will assist you to derive assessable income in the future and does not have the necessary connection with your current assessable income. Furthermore, the associated expenses would be characterised as being of a capital nature. Therefore, you are not entitled to a deduction under section 8-1 for the ITAA 1997 for the legal expenses incurred in relation to defending your position and your reputation.

Apportionment of expenses

As your legal expenses are not fully deductible, you will need to apportion the expenses using a reasonable basis. 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 by your solicitor, you will need to calculate the deductible portion.

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