Private ruling: Deductibility of Legal Expense
Date of advice: 6 April 2017
Published: September 2017
Ruling period: Income Year ending 30 June 20YY
Date scheme commenced: 01 July 20XX

Ruling: Q1: Are monies paid by the taxpayer under a Deed of Settlement, in order to discontinue legal proceedings commenced by a former employer of X, an allowable deduction under section 8-1 of the of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: No.

Relevant facts and circumstances: This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling. X, entered into an employment contract (first contract) with company A and became a permanent employee at company A. Amongst other things, there was a 'Specific Obligations' clause in the first contract. Several years later, X terminated the employment with company A, and subsequently entered into an employment contract (second contract) with the taxpayer. X was also appointed as one of the directors of the taxpayer, and started to indirectly hold some shares of the taxpayer. Company A commenced legal proceedings against X for breach of the first contract; taxpayer was also added as a defendant in the legal proceedings. Sometime later, a Deed of Settlement between the taxpayer, company A and X was executed. The three parties agreed to discontinue the legal proceedings and settle the dispute on the terms set out in the Deed. The Deed required the defendants pay a settlement sum to company A within a certain time frame upon execution of the Deed; after-which the legal proceedings will be discontinued by the relevant parties. There was no admission of liability by the defendants in relation to the dispute in the legal proceedings. There was consensus between X and the taxpayer, that the taxpayer pay any costs arising from any dispute with company A concerning any breach of the first contract. The taxpayer paid the settlement sum to company A upon execution of the Deed, with a view of completely dispensing itself of any liability under the Deed.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 8-1

Reasons for decision: Summary: On the facts, the legal proceedings went beyond a claim for a revenue item. The claim constituted two parts, an action for breach of the first contract and an action to involve, aid and abet the breach. The existence of an oral agreement between X and the taxpayer indicates that, taxpayer was prepared for and not opposed to the breach. In making the payment, the essential character of advantage sought by taxpayer was the use of X's services and expertise free of any liability, with a view of possibly enlarging the profitability of its business. The object and effect of the payment was to enable taxpayer to obtain the potentially substantial and lasting advantage of being in a promising business position to secure and retain the services of a highly valued director/employee, X. This is for an undefined period of time until X terminates the employment and directorship with taxpayer. The payment of the settlement sum was made by taxpayer once and for all. Once it was paid, it was agreed by the parties to discontinue the legal proceedings and settle the dispute based on the terms of the Deed; it is not expected to recur in future. For the nature of the taxpayer's business, entering into employment agreements may form part of the business activities, however that does not unavoidably result in the business being exposed to legal disputes with and/or claims by former employers of its current employees on recurrent basis. The expenditure is of non-recurrent nature. In considering nature of the business and its income-producing activities, purpose of producing income for a business of the nature does not establish sufficient degree of connection with original cause of the legal claim. The monies paid by the taxpayer are capital in nature and not an allowable deduction under section 8-1 of the ITAA 1997.