Private ruling: Deductibility of legal expenses
Date of advice: 21 December 2018
Published: April 2019
Ruling period: Year ended 30 June 20XX to year ended 30 June 20XX.
Date scheme commenced: 1 July 20XX

Ruling: Q1: Can you claim a deduction for the damages and settlement amount you paid as a result of the two disputes with your former employers? | A1: No. | Q2: Can you claim a deduction for the legal fees you paid in relation to the disputes? | A2: No.

Relevant facts and circumstances: You were previously employed by Employer 1. Employer 1 attempted to sue you for breach of contract for soliciting clients within your restraint period stated in your employment contract. You have advised that this did not happen and you strongly denied the allegation. The dispute with Employer 1 was settled out of court for $XX,XXX. Your new employer (Employer 2) paid this $XX,XXX settlement sum with the condition written in to your employment contract that you would repay the $XX,XXX plus interest if you were to leave within X years of employment with Employer 2. Whilst employed by Employer 2 you lodged a claim for worker’s compensation as a result of a workplace incident. Your claim for worker’s compensation was accepted by the insurer. You had intended to return to work after the period of leave, however while on leave Employer 2 started legal action against you and attempted to have you removed from their employment. Employer 2 terminated your employment. The employment termination fell within the X year period of employment with Employer 2 so Employer 2 brought action against you to pay back the $XX,XXX plus interest. You sought legal advice at this time and eventually settled and paid the $XX,XXX plus interest to Employer 2 along with an agreed amount of $XX,XXX for the cost of their legal fees. You incurred $XX,XXX in legal fees in disputing your dismissal by Employer 2.

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

Reasons for decision: Summary: 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. In determining whether a deduction for legal expenses is allowed, 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. Generally, legal expenses incurred in an unfair dismissal action (seeking reinstatement and/or damages) and a breach of contract action are of a capital nature and therefore, not deductible. Paragraph five of Taxation Determination TD 93/29 states: … 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. The courts have held that expenditure incurred in relation to a restraint of trade clause are capital in nature ( Kemp v. Federal Commissioner of Taxation (1992) 110 ALR 375; (1992) 24 ATR 75; 92 ATC 4542; Nicholls v. Commr of IR (NZ) (1965) 14 ATD 52). Generally, the treatment of a settlement sum or damages payment will follow the treatment of the other legal costs incurred in relation to a particular matter. In your case, you incurred expenses in disputing your dismissal by Employer 2. The advantages that may have resulted from incurring the expenses (that is, reinstatement, a receipt of damages, and the avoidance of your liability to pay the $XX,XXX) are benefits of a capital rather than revenue nature. Consequently these expenses are capital in nature. Your payment related to your earlier restraint of trade dispute is also considered to be capital in nature. Therefore, these amounts are not deductible under section 8-1 of the ITAA 1997.