Private ruling: Legal expenses
Published: May 2014
Ruling period: Year ended 30 June 2012 | Year ended 30 June 2013 | Year ended 30 June 2014
Date scheme commenced: 1 July 2011

Ruling: Q1: Are you entitled to a deduction for legal fees you incurred? | A1: Yes

Relevant facts and circumstances: You were employed over a period. Since ceasing employment your ex-employer made a claim against you for damages as a result of you breaching your contractual, fiduciary and statutory obligations in your day-to-day employment. You incurred legal fees to dispute the claims against you. You settled the dispute with your ex-employer. You agreed to return an asset to your ex-employer. Your ex-employer agreed to discontinue the allegations made against you in any Statement of Claim currently filed in the Proceedings or which they intend to file in the Proceedings.

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 any loss or an outgoing to the extent to which it is incurred in gaining or producing assessable income or is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income, except where the loss or outgoing is of a capital, private or domestic nature. 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 or business operations ( Ronpibon Tin NL & Tong Kah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 4 AITR 236; (1949) 8 ATD 431). 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 and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 39 ALR 46; (1932) 2 ATD 169 (the Herald and Weekly Times case )) and the legal action has more than a peripheral connection to the taxpayer's income producing activities ( Magna Alloys and Research Pty Ltd v. Federal Commissioner of Taxation 80 ATC 4542; (1980) 11 ATR 276 ( Magna Alloys )). In Magna Alloys , charges were made against the Directors of the company related to the marketing methods adopted to sell the taxpayer's products. The Full Federal Court unanimously held that the legal expenses were deductible. In his judgment, Brennan J referred to a passage from Charles Moore & Co (WA) Pty Ltd (1956) 95 CLR 344 at 351: Phrases like the phrase 'incidental and relevant' when used in relation to the liability of losses as deductions do not refer to the frequency, expectedness or likelihood of the occurrence of the antecedent risk of their being incurred, but to their nature or character. What matters is their connection with the operations which would gain or produce the assessable income. It was found that the conduct of the Directors which was impugned by the charges was conduct which formed part of the business carried on and that the interests of the company and the Directors were inseparable. Brennan J also found that the expenditure was not of a capital nature: The capital of the business was in no way increased by the expenditure incurred. True it is that the expenditure protected the reputation and goodwill of Magna's business, but the attack which was made arose out of the day-to-day selling activities of the business and it was a business purpose of vindicating the methods by which it was conducted that brings the expenditure within [subsection 51(1) of the Income Tax Assessment Act 1936]. It is clear that legal expenses may be deductible where they arise out of litigation concerning a taxpayer's professional conduct. In the High Court decision in Federal Commissioner of Taxation v. Day [2008] HCA 53; (2008) 70 ATR 14; 2008 ATC 20-064 ( Day's case), Mr Day was charged with breaching the standards of conduct and failing to fulfil his duty as an officer. It was found that the requisite connection with his assessable income was present and that he was exposed to the charges by reason of his office. In your case, it was alleged that you acted in breach of your contractual, fiduciary and statutory duties. As a consequence of the claims, you were required to defend your actions that were normal day-to-day activities undertaken in the course of carrying out your role. Similar to Day's case , the legal expenses you incurred arose out of your conduct in your role. Therefore, the essential character of the legal expenses, arising from the nature of the allegations defended (relating to breaches of specific contractual, fiduciary and statutory duties), is such that the expenses have sufficient connection with the activities that gain or produce assessable income, or were expected to gain or produce assessable income. However, even if a taxpayer is able to satisfy the first positive limb of s 8-1 of the ITAA 1997, as is the case here, it is still necessary to determine whether a loss or outgoing is caught by the negative limb of that section and so precluded from deduction. This possibility of an expense being classified as incurred in gaining assessable income but also private in nature was recognised in Federal Commissioner of Taxation v. Hatchett (1971) 125 CLR 494; 71 ATC 4184; (1971) 2 ATR 557 where Menzies J. stated: It must be a rare case where an outgoing incurred in gaining assessable income is also an outgoing of a private nature. In most cases the categories would seem to be exclusive. There is no issue of the legal expenses being losses or outgoings of a private or domestic nature, or being incurred in relation to the gaining or producing of exempt income or non-assessable non-exempt income. Therefore, you are entitled to a deduction for the legal expenses you incurred under section 8-1 of the ITAA 1997.