Private ruling: Deductibility of legal expenses
Date of advice: 16 September 2015
Published: September 2015
Ruling period: Year ended 30 June 2015 | Year ending 30 June 2016
Date scheme commenced: 1 July 20XX

Ruling: Q1: Is your payment of your employer's legal costs that were awarded against you an allowable deduction? | A1: No.

Relevant facts and circumstances: You were injured while performing your duties. It was the view of your general practitioner and specialists that you were no longer fit for work and should be medically discharged from employment. Due to issues surrounding your application for medical discharge you were assigned a solicitor by a body representing employees to manage a potential discharge from your employer. After consultation between your solicitor and your employer, your employee file was reviewed under your medical discharge application. After consideration of your employee file your employer decided not to medically discharge you. Upon what you believe to be poor advice from your solicitor, your matter proceeded to the Court. Your initial proceedings were undertaken in order to be medically discharged. The summons that had initially been prepared for court was significantly altered changing your request for discharge to a request for a permanently modified position with your employer. You requested a permanently modified position when it appeared you would not be able to obtain a medical discharge and the resulting entitlements because you wanted to ensure your continued employment with your current employer. The change in your summons was undertaken by your solicitor only days prior to your hearing date. On your hearing date your case was dismissed due to insufficient time to hear the matter based on the changes to the summons and the defence not being permitted reasonable time to consider the changes. When your case was dismissed the judge ruled that you were to pay the legal costs that your employer incurred in relation to the proceedings that you had brought against them.

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. Costs awarded against a taxpayer are considered to form part of the taxpayer's overall legal costs in relation to an action and the same deductibility principles concerning legal expenses generally, apply. In determining whether a deduction for legal expenses is allowed under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered ( Hallstroms Pty Ltd v. FC 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. For example, if the advantage to be gained is of a capital nature, such as an enduring benefit, then the expenses incurred in gaining the advantage will also be of a capital nature. Therefore, to determine the deductibility of legal expenses, it is necessary to consider the reason for which the expenses were incurred. Where legal expenses arise as a consequence of the day to day activities of an employee's work or of a business, the object of the expenditure is devoted towards a revenue end and the legal expenses are deductible ( Herald & Weekly Times v. Federal Commissioner of Taxation (1932) 48 CLR 113; 2 ATD 169). However, where the expenditure is devoted towards a structural rather than an operational purpose, that is, the expenditure relates to the income earning asset, the expenditure is of a capital nature and the expenses are not deductible ( Sun Newspapers Ltd v. FC of T (1938) 61 CLR 337; 5 ATD 87; (1938) 1 AITR 403). In FC of T v. Rowe (1995) 31 ATR 392; 95 ATC 4691 ( Rowes's case ) , the taxpayer, an employee, was suspended from normal duties and was required to show cause why he should not be dismissed after several complaints were made against him. A statutory inquiry subsequently cleared him of any charges of misconduct or neglect. The court accepted that the legal expenses incurred by the taxpayer in defending the manner in which he performed his duties, in order to defend the threat of dismissal, were allowable. Since the inquiry was concerned with the day to day aspects of the taxpayer's employment, it was concluded that his costs of representation before the inquiry were incurred by him in gaining assessable income. In a High Court decision in Commissioner of Taxation v. Day [2008] HCA 53 ( Day's case ), Mr Day was charged with breaching the standards of conduct and failing to fulfil his duty as an officer. He was suspended without pay. 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. The main factor in the above cases is that the legal action was taken by the employee to defend the way that they undertook their day to day duties. The fact they keep their employment is a mere by product of the litigation process. Where legal action is undertaken to obtain a payment, then the deductibility of the legal expenses depends on whether the payment sought is revenue in nature, such as unpaid wages or capital in nature, such as an employment termination payment. | Detailed Reasoning - Your circumstances: In your case you took legal action initially in order to obtain a medical discharge and the resulting entitlements. These entitlements are considered to be capital payments rather than ordinary income. Therefore, the legal expenses related to your attempt to obtain a medical discharge and the resulting entitlements are capital in nature and not deductible. Your legal action was altered to change your request for a medical discharge to a request for a permanently modified position. An expense will be capital in nature if it is to obtain an enduring benefit or to modify an income earning asset. A permanently modified position would have been a modification to your income earning asset being your employment position. Also, you requested a permanently modified position to protect your continued employment which is an enduring benefit. Therefore we consider that the legal expenses related to the altered request are capital in nature and consequently not deductible. Your case cannot be compared to Rowes's case and Day's case as the reason for your legal proceedings was initially to obtain a medical discharge to gain capital entitlements and then to enable you to keep your employment by gaining a permanently modified position; you were not defending how you were performing the duties for which you were originally employed. In short, you were attempting to obtain capital payments and then to modify and protect your income producing asset, your job, which has an enduring advantage making the action capital in nature not revenue. | Summary: Both aspects of your legal action are considered to be capital in nature. Therefore, the costs awarded against you with respect to your legal action are also capital in nature and not deductible.