Private ruling: Deduction of legal costs and settlement amounts
Date of advice: 30 June 2017
Published: October 2017
Ruling period: Year ended 30 June 2016 | Year ended 30 June 2017
Date scheme commenced: 1 July 2015

Ruling: Q1: Are the portion of legal expenses incurred by you in defending a breach of contract claim bought against you by your former employer deductible? | A1: Yes | Q2: Are the portion of settlement costs incurred by you in complying with the deed of settlement with your former employer deductible? | A2: Yes

Relevant facts and circumstances: You work in the XYZ industry. You are the director of a small business (company A). You had completed some short contracts for an unrelated entity (company B) and were offered a job with them, which you accepted and entered into an employment contract for. You still undertook freelance work with company A for your existing clients while employed with company B. You resigned from company B and performed a handover with written documents and team meetings to discuss on hand projects. Company B alleged through their lawyers that you deleted items from your email account with them in order to disrupt their business and claimed damages due to breach of contract. You engaged barristers to refute the claims. Company B filed a claim against you, as first defendant, and company A, as second defendant, in court for alleged damages and loss. You and company B filed a defence in court denying any breach of duty of fidelity and good faith. A pre-trial hearing saw a trial booked. A deed of settlement was negotiated between Company B, you and company A with you and/or company A to pay an amount to Company B as full and final settlement of the proceedings.

Relevant legislative provisions: Section 8-1 of the Income Tax Assessment Act 1997

Reasons for decision: Summary: Section 8-1 of the Income Tax Assessment Act 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 under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered ( Hallstroms Pty Ltd v. FC 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 courts, on a number of occasions, have determined legal expenses to be an allowable deduction if the expenses arise out of the day to day income producing activities of the taxpayer ( The Herald and Weekly Times Ltd v. FC of T (1932) 48 CLR 113). The action out of which the legal expense arises has to have more than a peripheral connection to the taxpayer's business or income earning activities. The expense may arise out of litigation concerning the taxpayer's professional conduct ( Magna Alloys and Research Pty Ltd v. FC of T (1980) 11 ATR 276; 80 ATC 4542; Putnin v. FC of T (1991) 21 ATR 1245; 91 ATC 4097). 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). Your legal expenses are not considered to be private in nature as they were related to an issue that arose while carrying out your employment position. That is, the legal action arose as a result of your employment. The Commissioner considers that the treatment of a settlement sum payment will follow the treatment of other legal costs incurred in relation to a particular matter. Accordingly, the legal expenses you incurred and the settlement sum you paid have the requisite connection to your income earning activities and you are entitled to a deduction for these expenses under section 8-1 of the ITAA 1997.