Edited version of private advice

Authorisation Number: 1051982361616

Date of advice: 8 June 2022

Ruling

Subject: Legal expenses

Question 1

Are all your legal expenses deductible in accordance with section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Are the legal expenses associated with obtaining advice to resolve the dispute with your employer, prior to your termination, deductible in accordance with section 8-1 of the ITAA 1997?

Answer

Yes.

Question 3

Are the legal expenses associated with attempting to obtain payment for unused annual and long service leave deductible in accordance with section 8-1 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You became involved in a dispute with your employer over your working hours, leave and aspects of your remuneration package.

You engaged legal representation to resolve the dispute.

You contend that you were dismissed from your employment on xx/xx/xxxx and that the dismissal was unlawful and unfair. Your employer claims that you resigned from your position.

In a letter dated xx/xx/xxxx from your legal representatives to your employer, you made a number of claims including a lump sum payment equivalent to x months pay, payment for unused annual and long service leave, and a request of a private nature.

Your employer's representative rejected your settlement offer and made a counter offer.

You subsequently lodged an unfair dismissal claim with the Fair Work Commission.

In your unfair dismissal claim you advised you were seeking a payment of compensation for unfair dismissal.

The matter was resolved by way of a Settlement Deed.

You received a settlement amount of $x as a lump sum termination payment amount which was taxed as an Employment Termination Payment as per the deed.

You incurred legal fees.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-10

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 82-130

Reasons for decision

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 where 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, 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 and not deductible.

An employment related dispute may continue for some time and commence while the employee is still employed and continue after termination. What is being sought by the employee may change over time and consequently, the deductibility of their legal expenses may also change.

Legal advice/representation prior to termination

Where legal expenses incurred are associated with settlement of disputes arising out of an existing employment agreement a taxpayer will be entitled to a deduction under section 8-1 of the ITAA 1997 for the cost of representation as per paragraph 2 of Taxation Ruling TR 2000/5 Income tax and fringe benefits tax: costs incurred in preparing and administering employment agreements.

Before the termination of your employment, you first sought legal representation for advice on how to settle the dispute with your employer over your employment conditions. The legal expenses related to this legal advice you sought prior to your termination are considered to be revenue in nature and deductible under section 8-1 of the ITAA 1997.

Legal advice/representation after termination

If a former employee takes legal action seeking unpaid income to which they are contractually entitled such as unpaid wages then the related legal expenses are also revenue in nature and deductible (Taxation Determination TD 93/29 Income tax: if an employee incurs legal expenses 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? (TD 93/29)).

Paragraph five of Taxation Determination TD 93/29 states:

5. However, If the legal action goes beyond a claim for a revenue item such as wages, and constitutes an action for breach of the contract of employment, 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.

A compensation payment made by an employer to a former employee in settlement of an unfair dismissal action is capital in nature. However, it qualifies as an Employment Termination Payment (ETP), as it is considered to be made 'in consequence of the termination of any employment of the taxpayer' (Taxation Ruling IT 2424 Income tax: compensation payments in respect of unlawful acts of discrimination paragraph 24).

ETP's are subject to special tax treatment that may result in some or all of the amounts being included in assessable income (Division 82 of the ITAA 1997). However, the fact that a capital payment is specifically brought to account as assessable income will not change the nature of the payment. An amount that is capital in nature will remain capital notwithstanding that it is specifically included in assessable income.

The example in TD 93/29 is relevant for you to consider:

Example: Andrew B is dismissed by his employer. He consults a solicitor who advises that he is entitled to wages, severance pay and damages for wrongful dismissal. The solicitor sends a letter of demand for payment of $5,000 (wages and severance pay ) and institutes legal proceedings in respect of the wrongful dismissal. Upon receipt of the letter of demand, the employer pays the amount of $5,000, but he decides to defend the action for wrongful dismissal. After 15 months of negotiations, Andrew receives a further $5,000 for wrongful dismissal in an out-of-court settlement. He also receives an account from his solicitor for $3,000, which he pays. The account is not itemised. Andrew includes a deduction of $100 for legal expenses in his return. This amount is acceptable because only one letter was written by the solicitor to recover the wages and severance pay. The balance of $2,900 is not deductible. If the letter of demand had not resulted in payment, and legal proceedings had been instituted which led to a settlement of $5,000 for wages and severance pay, as well as $5,000 for wrongful dismissal, a deduction of $1,500 would be reasonable, the apportionment being based on the size of the revenue amount relative to the capital amount.

Additionally, the following paragraphs in Taxation Ruling TR 2012/8 Income tax and fringe benefits tax: assessability of amounts received to reimburse legal costs incurred in disputes concerning termination of employment (TR 2012/8) are also relevant:

Example 1

8. Alice takes legal action seeking compensation for wrongful dismissal (not including any contractual rights to income) and is successful.

10. The legal costs incurred by Alice will not be deductible under section 8-1 because the advantage sought in the legal action is of a capital nature. This is the case even if the amount awarded in respect of her claim for wrongful dismissal is calculated by reference to lost income.

Example 3

15. Debbie takes legal action against her former employer seeking damages of $170,000 for breach of contract following her dismissal from her senior executive position.

20. The legal costs incurred by Debbie are not deductible under section 8-1 because the advantage sought by the legal action (compensation for loss of employment) is of a capital nature.

38. Legal costs take their quality as an outgoing of capital or revenue nature from the cause or purpose of incurring the expenditure. If the advantage to be gained is of a revenue nature, then the costs incurred in gaining the advantage will also be of a revenue nature.

45. Compensation for loss of employment, such as in an action for wrongful dismissal or loss of office, is a capital receipt (Scott v. Commissioner of Taxation). Legal costs incurred in seeking such compensation are not deductible because the nature of the advantage sought is capital. This is so, even if the amount of compensation awarded is calculated by reference to unpaid salary or lost income, or is assessable as statutory income.

From the point where you were dismissed from your employment, what you were seeking changed. You no longer sought to resolve the dispute over your employment conditions such that you could continue working. What you sought was set out in the letter dated xx/xx/xxxx from your legal representatives, including a matter of a private nature, a lump sum payment equivalent to x months pay and payment for unused annual and long service leave.

A payment for unused annual and long service leave is revenue in nature and therefore the portion of your legal expenses that relate to this claim is deductible.

However, the information provided does not indicate that your claim for x months pay was an income amount that was contractually owed to you. Rather, it is considered to be a claim for a lump sum to compensate you for the manner in which you were dismissed. It is therefore capital in nature and consequently the related legal expenses are not deductible.

The remaining claims made on xx/xx/xxxx were not revenue in nature. Therefore, the legal expenses related to these claims are not deductible.

After your claims made on xx/xx/xxxx were rejected, your legal representatives then lodged an unfair dismissal application with the Fair Work Commission in which you sought payment of compensation for unfair dismissal.

As explained previously, compensation for unfair dismissal is capital in nature even though it is included in assessable income as an ETP. As the compensation payment is capital in nature, the related legal expenses are also capital in nature and not deductible.

As some of your legal expenses related to items which are capital or private in nature, a portion of these legal expenses are also capital or private in nature. Therefore, not all your legal expenses are deductible under section 8-1 of the ITAA 1997.

Apportion of expenses

As discussed above, some of the legal expenses you have incurred are deductible as they are revenue in nature, whilst other legal expenses are not deductible.

Where legal expenses are both deductible and non-deductible, they must be apportioned and only the deductible portion can be claimed. Apportionment must be on a reasonable basis. TD 93/29 states:

Where the solicitor's account is itemised, one reasonable basis for apportionment would be the time spent involving the revenue claim, relative to the time spent on the capital claim. If the solicitor's account is not itemised, a possible basis for apportionment would be either a reasonable costing of the work undertaken by the solicitor in relation to the revenue claim, or, where this is not possible, an apportionment on the basis of the monetary value of the revenue claim relative to the capital claim.

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