Private ruling: deductibility of legal expenses
Published: April 2015
Ruling period: Year ended 30 June 2014
Date scheme commenced: 1 July 2013

Ruling: Q1: Is the settlement payment made by you under a Deed of Release to a former employer a deductible expense? | A1: No. | Q2: Are the associated legal expenses incurred as a result of defending yourself in this matter a deductible expense? | A2: No.

Relevant facts and circumstances: Several years ago you entered into a written employment contract with an employer. Express terms of the contract stated that while you were under this contract, you would: • Act in the employer's best interest • Not act in conflict with the employer's best interest • Not compete with the employer without the employer's consent, or • Not work in any capacity for any other person or organisation without the employer's consent. It was also an express term of this contract that you would not (without the written consent of the employer) at any time during your employment or after the termination of your employment: • Use the employer's confidential information, or • Disclose any of the employer's confidential information to any person, other than to the extent necessary for you to carry out your duties under the contract. Your employment with the employer ended. Subsequent to the cessation of this employment, your former employer took legal action against you claiming that you established a rival business whilst still employed by them and undertook various other actions and used the employer's confidential information to further your business. In summary, as a result of your conduct, your former employer claimed that you breached the following: • Your employment obligations • Confidentiality obligation • Disclosure of conflict obligation • Non-solicitation obligation • Non-compete obligation • Implied obligations • Fiduciary obligations • Equitable obligations of confidence, and • Corporations Act obligations The result of these legal proceedings against you was that a Deed of Settlement and Release was entered into. In this Deed, you agreed, without admission of liability, to pay the employer a sum in full and final settlement. You also incurred legal fees defending yourself in this matter.

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

Reasons for decision: Summary: A claim for a deduction of losses or outgoings falls for consideration under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997). Section 8-1 of the ITAA 1997 states: (1) You can deduct from your assessable income any loss or outgoing to the extent that: a) it is incurred in gaining or producing your assessable income; or b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income. (2) However, you cannot deduct a loss or outgoing under this section to the extent that: a) it is a loss or outgoing of capital, or of a capital nature; or b) it is a loss or outgoing of a private or domestic nature; or c) it is incurred in relation to gaining or producing your exempt income; or d) a provision of this Act prevents you from deducting it. Taxation Determination TD 93/29 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 continues:- 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. Legal expenses are generally deductible if the expenses 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). Similarly, 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 their 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. No significance was placed by the court on the taxpayer's status as an employee. However, in Case W94 89 ATC 792; AAT Case 5376 (1989) 20 ATR 4001 ( Case W94 ), the Administrative Appeals Tribunal (AAT) held that expenditure incurred on legal fees by the taxpayer in defending disciplinary charges of misconduct were not deductible. The activities to which the charges related were not authorised employment duties. The legal expenses were not incurred as a result of the taxpayer defending the manner in which they performed their employment duties, and therefore, were not allowable deductions under section 8-1 of the ITAA 1997. Your case is similar to Case W94 rather than Rowe's case in that the activities to which the claims against you related were not authorised employment duties; therefore, the connection between the gaining of your assessable income and the costs incurred from this legal action and resulting settlement is not apparent. It is also noted that unlike Rowe's case and FC of T v. Day [2008] HCA 53 ( Day's case ) which you referred to in your private ruling application, the legal action took place after you had ceased the relevant employment. In Case 9/2013 [2013] AATA 783, the AAT denied a deduction for legal expenses incurred by a taxpayer in defending activities he had undertaken in the course of carrying out his previous employment. The AAT distinguished Day's case as the taxpayer no longer had an on-going employment relationship with the relevant employer. The AAT stated that the connection between the production of the taxpayer's previous employment income and the legal expenses rose no higher than a mere 'causal connection' and that the authorities make it clear that this is insufficient; something closer and more immediate than a mere causal connection is required for a deduction to be allowable under section 8-1 of the ITAA 1997. Also, your settlement payment and associated legal expenses are considered to be capital in nature. The payment settled the claims made by your former employer which provides an enduring advantage for you, being the elimination of any further liability you may have been subject to under the claims. Accordingly, the full and final settlement payment and the associated legal expenses incurred by you during the year ended 30 June 2014 in relation to the legal action against you by your former employer are not deductible under section 8-1 of the ITAA 1997.