Edited version of private advice

Authorisation Number: 5010048400753

Date of advice: 7 February 2018

Ruling

Subject: Deductibility of legal expenses

Question

Are you eligible to claim a deduction for legal expenses incurred with regard to defending undertakings and a Statement of Claim made by your previous employer?

Answer

This ruling applies for the following period

Year ended 30 June 20XX

The scheme commences on

1 July 20XX

Relevant facts and circumstances

You were employed with a company as a salesperson.

You signed a confidentiality agreement at the time of commencing your employment.

The agreement stated that you would not make any disclosure of any of the information made available to you by the employer, or copy confidential material unless it was essential to undertake your daily duties.

It also stated that you would not remove confidential, company property or documents without authorisation, and by signing you agreed not to solicit customers or potential customers of the company after the termination of the agreement post-employment with the company, by making use of company confidential material.

In XXXX you left the company to work for a competitor of your employer. During your time at your new employer your previous employer began legal proceedings in the form of a Request for Undertakings and then a Statement of Claim against you for loss of business, on the basis that you used confidential information obtained during your time with the previous employer to obtain business for your new employer.

The undertakings and actions taken against you have diminished your ability to perform your job for your new employer as well as tarnished your reputation within the industry which affects your ability to perform your job and earn assessable income.

In defence of the actions taken by your previous employer you paid a total of $XXXX in fees to your solicitor. You attempted to recover costs from your previous employer, however upon settlement it was agreed both parties would cover their own costs.

You responded to the request for undertakings by receiving legal advice on the prospects of success, the meaning of confidential information, and the remedies of defending the action, or providing undertakings as to confidential information you had either possessed or destroyed.

Your solicitors advised the plaintiffs of your agreement to provide the undertakings in the belief that this would be an end to the matter, and to avoid further costly court proceedings.

Notwithstanding this, you were then served with a Statement of Claim seeking damages for loss of business, in 20XX.

In 20XX your defence, along with a request for further and better particulars was lodged.

The plaintiffs made an offer to settle in that you would pay an amount in full and final settlement of the claim.

You did not accept the offer, you were advised of the costs associated with pursuing the matter, and instructed your solicitor to proceed with the application for particulars.

You subsequently agreed to a conference with the plaintiffs, which was postponed.

The conference was cancelled. You later attended a conference with legal representation.

You received further advice in regard to legal costs and the possibilities of receiving costs.

The offer which was eventually accepted was that each party walk away, and bear their own costs.

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.

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. 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.

Legal expenses are generally deductible if they arise out of the day to day activities of the taxpayer's business (Herald Weekly Times Pty ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (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) 11 ATR 276; 80 ATC 4542). In Magna Alloys the legal expenses were to satisfy the personal needs of the directors, faced with criminal charges, and were not related to their income producing activities.

However, 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 (Sun Newspapers Ltd v. FC of T (1938) 61CLR 337; 5 ATD 87; (1938) 1 AITR 403).

In FC of T v. Rowe (1995) 60 FCR 99; (1995) 31 ATR 392; 95 ATC 4691 (Rowe's case), the court accepted that legal expenses incurred in defending the manner in which a taxpayer performed his employment duties were allowable. The activities which produced the taxpayer's income were what exposed them to the liability against which they were defending themselves.

You also referred to FC of T v. Day (2008) HCA 53 in your application.

In this case, charges were brought by an employer against the taxpayer. The taxpayer was still employed at the time they incurred the legal expenses. The taxpayer incurred the legal expenses to defend the charges which had been brought against them, which concerned the way in which they performed their work duties. The taxpayer was still regarded to be in an ongoing employment relationship at the time of the legal expenditure.

Your legal expenses are not related directly to your employment duties either at XXXX Pty Ltd, or your current employer, therefore the principles in Day or Rowe do not apply to your circumstances.

Taxation Ruling TR 2000/5 sets out the Commissioner's view of the application of section 8-1 of the ITAA 1997 to costs incurred by employees and employers in preparing and administering employment agreements. Employment agreements are a written, legal and binding confirmation of the employer/employee relationship (paragraph 11 TR 2000/5).

As outlined in TR 2000/5, a deduction is allowed for an employee for costs associated with settlement of disputes arising out of an existing employment agreement including the cost of representation. Your employment agreement with your previous employer was no longer current at the time of the proceedings for which you incurred the legal costs. Therefore your disputes do not arise out of an existing employment agreement.

In your situation, you were defending action taken by your previous employer. The action by your former employer was in relation to the breach of the confidentiality agreement from your previous employment. The action was not prompted or caused as a consequence of the performance of your then current duties.

It is considered your legal expenses were incurred to enable you to continue working in your new employment. They did not relate to the duties of your previous employment or your new employment and therefore, were not incurred in earning your assessable income from either.

Although the claims may relate in part to the period of time you worked with your previous employer, the nexus to your income earning activities with your previous employer is not sufficient.

The legal expenses associated with the alleged activities do not have the necessary connection to your former employment activities. Therefore, these expenses are not deductible under section 8-1 of the ITAA 1997.

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