Edited version of private advice

Authorisation Number: 1052150195689

Date of advice: 1 August 2023

Ruling

Subject: Legal expenses

Question 1

Are you entitled to claim a full deduction for the legal expenses (the Legal Expenses) incurred in the relevant income year under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Are you entitled to claim a partial deduction for the Legal Expenses incurred in the 2023 income year under section 8-1 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 2023

The scheme commenced on:

1 July 2022

Relevant facts and circumstances

You were employed by Employer Z for seven years.

In the relevant year, your employment ended after discussions with your employer.

You engaged lawyers in response to a show cause request from the employer as to why your employment should not be terminated in circumstances where you were also informed that you may be issued with a formal warning, placed on a performance improvement plan, or have the queries raised dismissed all together.

After your lawyers advised that the employer breached various laws in the action they proposed, a mutual separation was proposed and ultimately agreed to in an effort to save costs and court action.

These events occurred over a few months.

The settlement deed stated the payment was for several different elements:

•         the settlement sum, being an amount equal to 12 months' pay, to be paid as an Eligible Termination Payment (ETP)

•         the superannuation contribution

•         the notice pay

•         the annual leave pay

•         the long service leave pay.

The terms of the deed were agreed to, with respect to a resignation taking effect in the following month. The final copy of the deed was fully signed during that month. Payments in relation to the deed were not transacted for several weeks later.

You incurred a specified amount of legal fees.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Deductions for legal expenses

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for a loss or an outgoing to the extent to which it is incurred in gaining or producing assessable income, except where the loss or outgoing is of a capital, private or domestic nature.

Subsection 6-5(2) of the ITAA 1997 provides that the assessable income of an Australian resident includes ordinary income derived directly or indirectly from all sources during the year. Salary and wages, including leave payments, is considered ordinary income as it is paid directly as a result of personal services an employee renders for their employer.

To be deductible in a particular year under section 8-1 of the ITAA 1997, a loss or outgoing must generally have been 'incurred' in that year. 'Incurred' is not defined in the Act and in general terms, an outgoing is incurred at the time a taxpayer owes a present money debt that the taxpayer cannot escape. The courts have been reluctant to attempt an exhaustive definition of incurred, but they have developed a series of guidelines that can be used in assisting to determine whether an item has been incurred in a current year.

The guiding principles from case law and Taxation Rulings 94/26 and TR 97/7 are as follows.

A liability will be a loss or outgoing 'incurred' under section 8-1 of the ITAA 1997 even though it remains unpaid, provided the taxpayer is 'definitively committed' or has 'completely subjected' itself to the liability (FC of T v James Flood Pty Ltd (1953) 10 ATD 240 at p 244; (1953) 88 CLR 492 at p 506).

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),

•         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.

Generally, legal expenses incurred in an unfair dismissal action, such as seeking reinstatement after termination and/or damages, are of a capital nature and therefore, not deductible. Alternatively, if the advantage being sought is of a revenue nature, such as unpaid wages, then the legal expenses will be of revenue nature.

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

This principle is confirmed in Taxation Determination TD 93/29 which states that if an employee incurs legal expenses in recovering wages, the legal expenses are an allowable deduction providing that the legal action relates solely to the recovery of wages. The ruling includes the following paragraphs:

2. Salary or wage income is only assessable when it has been derived, and salary or wages are generally derived when paid. ...

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 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 expense relating to an action for damages for wrongful dismissal are not deductible.

6. There will often be occasions where the legal expenses are incurred in relation to proceedings that relate both to amounts that are revenue in nature as well as amounts which are capital in nature. For example, many proceedings in relation to wrongful dismissal will also involve the recovery of unpaid salary or wages. In these circumstances '... there must be some fair and reasonable assessment of the extent of the relation of the outlay to assessable income' (Ronpibon Tin N.L. v. FC of T (1949) 78 CLR 47 at 59).

6A. A deduction for legal expenses by an employee depends on the particular facts of any case. To be deductible the occasion of the expenditure must be found in what is productive in the gaining of assessable income by the employee. If expenses are incurred to dispute the receipt of income contractually owed under an employment contract, then the expenses are on revenue account and allowable as a deduction.

7. 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.

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).

Similarly, 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.

Legal expenses are generally deductible by employees and former employees if they arise out of:

•         recovering unpaid wages, unused annual leave, and unused long service leave in accordance with the principles contained in Taxation Determination TD 93/29

•         instituting proceedings and settling disputes arising out of employment agreements, such as to enforce a contractual entitlement (Romanin v FCT (2008) 73 ATR 760)

•         preventing redundancy or dismissal. In FC of T v. Rowe (1995) 31 ATR 392; 95 ATC 4691, the taxpayer, an employee, was suspended from normal duties and was required to show cause why he should not be dismissed after several complaints were made against him. A statutory inquiry subsequently cleared him of any charges of misconduct or neglect. The court accepted that the legal expenses incurred by the taxpayer in defending the manner in which he performed his duties, in order to defend the threat of dismissal, were allowable. Since the inquiry was concerned with the day to day aspects of the taxpayer's employment, it was concluded that his costs of representation before the inquiry were incurred by him in gaining assessable income; and

•         defending the manner in which employment duties are performed: (Inglis and FC of T 80 ATC 4001)

In contrast, legal expenses incurred in seeking compensation for loss of employment, such as in an action for wrongful dismissal, are not deductible. It is irrelevant if any amount awarded to the employee is calculated by reference to unpaid salary or lost income. As outlined at paragraph 5 of TD 93/29, legal expense relating to an action for damages for wrongful dismissal are not deductible as the claim is of a capital nature.

Taxation Ruling 2012/8 (TR 2012/8) at paragraph 45 considers compensation for loss of employment.

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.

Examples 3 and 4 in TR 2012/8 are similar to your circumstances and illustrate the principles.

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. (Due to her circumstances, Debbie only has access to common law remedies.)

16. Debbie provides her former employer with her solicitor's bill of costs which show that she has incurred $30,000 in legal costs pursuing the claim. The claim is settled within 12 months after termination. Correspondence between the parties indicates that the parties have agreed to settle for the sum of $120,000 in relation to her dismissal claim and that Debbie's former employer has agreed to pay $20,000, being two thirds of her legal costs shown in the bill.

17. Debbie receives an amount of $140,000 on execution of a Deed of settlement.

18. The $120,000 was received 'in consequence' of termination of employment, within 12 months of that termination and is not covered by the payments mentioned in section 82-135; it is therefore an ETP.

19. However, the $20,000 although paid in relation to legal action concerning termination of employment is paid to indemnify Debbie for the cost of pursuing the litigation. It is not received in consequence of termination of employment and is not an ETP. Nor is the $20,000 an assessable recoupment or assessable as ordinary income.

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.

Example 4

21. Colin commences legal action claiming that the termination of his employment was unlawful. On execution of a Deed of settlement, Colin received an undissected amount including an unspecified amount to cover Colin's legal costs, within 12 months of that termination.

22. There is a clear connection between the termination of Colin's employment and the undissected payment made under the deed. The lump sum was paid 'in consequence' of termination of employment, within 12 months of that termination and is not covered by the payments mentioned in section 82-135; it is therefore an ETP.

23. The legal costs incurred by Colin are not deductible because the advantage sought by the legal action (compensation for loss of employment) is of a capital nature.

Application to your situation

Your employer made allegations against you in relation to your performance in your employment role with them which resulted in you addressing this dispute with them and seeking legal advice to assist you with the dispute.

You and your employer entered into a mutual separation agreement.

You incurred expenses in relation to engaging the services of a legal firm to act on your behalf.

As outlined above, legal expenses take the nature of the benefit being sought.

Based on the information provided not all of the legal expenses you incurred were incurred in relation to you seeking benefits that are solely of a revenue nature.

The ETP payment is capital in nature.

You will only be eligible to claim deductions for the legal expenses which relate to benefits/relief that is revenue in nature.

Therefore, you will need to review the benefit being sought in relation to the legal expenses and apportion them in accordance to the nature of the benefit and claim a deduction for those that are attributable to benefits of a revenue nature.

As outlined above, TD 93/29 provides some guidance on how to apportion the legal expenses.

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