Private ruling: Legal expenses
Date of advice: 6 September 2017
Published: December 2017
Ruling period: Year ended 30 June 2016 | Year ending 30 June 2017
Date scheme commenced: 1 July 2015

Ruling: Question and answer | Are you entitled to a deduction for legal expenses incurred in defending claims made against you by your previous employer? | No.


Relevant legislative provisions: Income tax Assessment Act 1997 Section 8-1 | Income tax Assessment Act 1997 Section 102-20

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. A number of significant court decisions have determined that for an expense to be an allowable deduction: ● it must have the essential character of an outgoing incurred in gaining assessable income or, in other words, of an income-producing expense ( Lunney v. FC of T ; (1958) 100 CLR 478), ● there must be a nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income ( Ronpibon Tin NL v. FC of T , (1949) 78 CLR 47), and ● it is necessary to determine the connection between the particular outgoing and the operations or activities by which the taxpayer most directly gains or produces his or her assessable income ( Charles Moore Co (WA) Pty Ltd v. FC of T , (1956) 95 CLR 344; FC of T v. Hatchett , 71 ATC 4184). 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. 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 Weekly Times Pty ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 2 ATD 169) and the legal action has more than a peripheral connection to the taxpayer’s income producing activities ( Manga Alloys and Research Pty Ltd v. FC of T (1980) 11 ATR 276; 80 ATC 4542). However, where the expenditure is incurred for the purpose of securing an enduring benefit, rather than a revenue purpose, the expenditure is capital in nature and is not deductible ( Sun Newspapers Ltd v. FC of T (1938) 61CLR 337; 5 ATD 87; (1938) 1 AITR 403). 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 his 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. The expenditure must be related to the production of assessable income and not incurred at a point too soon to be deductible ( FC of T v. Maddalena (1971) 45 ALJR 426; 2 ATR 541; 71 ATC 4161). Taxation Ruling TR 2000/5 sets out the Commissioner's view of the application of section 8-1 of the ITAA 1997 to costs incurred by employees and employers in preparing and administering employment agreements. Employment agreements are a written, legal and binding confirmation of the employer/employee relationship (paragraph 11 TR 2000/5). As outlined in TR 2000/5, a deduction is allowed for an employee for costs associated with settlement of disputes arising out of an existing employment agreement including the cost of representation. Your employment agreement with your previous employer is no longer current. Therefore your disputes do not arise out of an existing employment agreement. In your situation, you were defending action taken by your previous employer. The action by your former employer was in relation to the breach of the restrictive covenant clause in your previous employment agreement. The action was not prompted or caused as a consequence of the performance of your then current duties. It is considered your legal expenses were incurred to enable you to continue working in your new business. They did not relate to the duties of your previous employment or your new business and therefore, not incurred in earning your assessable income from either. Although the claims may relate in part to the period of time you worked with your previous employer, the nexus to your income earning activities with your previous employer is not sufficient. The legal expenses associated with the alleged breaches of contract do not have the necessary connection to your former employment activities. Therefore, these expenses are not deductible under section 8-1 of the ITAA 1997.

Relevant facts: You were employed with your former employer for a number of years. | You signed a contract of employment at the time of commencing your employment. | Your employment contract contained a restrictive covenant clause. | You resigned from your former employment in the 2016 income year. | You commenced working in your own business. | A number of weeks after you resigned you received correspondence from your former employer which alleged that you had breached the terms of your employment contract. | You sought legal advice and incurred costs of $XX, XX.XX.