Private ruling: Deductibility of legal fees
Date of advice: 28 February 2016
Published: August 2017
Ruling period: Year ended 30 June 2016 | Year ended 30 June 2017
Date scheme commenced: 1 July 2015

Ruling: A3: No.

Relevant facts and circumstances: You were issued with correspondence from your employer, calling on you to show cause as to why you should not be disciplined in line with the Public Service Act 2008 in response to alleged contraventions of the Code of Conduct for the Queensland Public Service. You responded via your legal representative. You were suspended from your duties on full pay. You were issued with correspondence from your employer advising that the allegation made against you were, on the balance of probabilities, substantiated. The letter advised you were liable for discipline under section 187(1)(f) of the Public Service Act 2008 on the grounds that you contravened, without reasonable excuse, a standard of conduct applying to you under an approved code of conduct under the Public Sector Ethics Act 1994 . The letter called on you to show cause as to why a disciplinary penalty should not be imposed. You instigated defamation actions against your employer and members of the public in relation to comments or inferences made by them regarding your reputation, good name and character. You lodged an employee grievance with your employer, relating to the decision to conduct an investigation and discipline process in relation to your conduct. Your legal representatives further responded to your employer, in support of your grievance. You filed an injunction with the Relevant Industrial Relations Commission (RIRC) against your employer. You were issued with correspondence from your employer responding to your grievance. Your grievance was upheld on all matters with a recommendation that the original findings, as made to you in correspondence, be set aside. You returned to your duties and instructed for the injunction to be withdrawn. You pursued your employer for compensation, via WorkCover in relation to personal injury, wrong or illness caused by their investigation and disciplinary matters.

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

Reasons for decision: Detailed Reasoning - Deductibility of legal fees: 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 losses or outgoings are of a capital, private or domestic nature. 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. 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. When the principal reason for incurring the legal expenses is defending the actions of the taxpayer in carrying out their employment duties through which they gain or produce assessable income, such expenses are characterised as being of a revenue nature and are deductible ( Inglis v. FC of T 87 ATC 2037; and Case V116 88 ATC 737; AAT Case 4502 (1988) 19 ATR 3703) | Detailed Reasoning - Question 1: In FC of T v. Rowe (1995) 31 ATR 392; 95 ATC 4691, 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 Commissioner of Taxation v Day [2008] HCA 53, 2008 ATC 20-064, (2008) 70 ATR 14 ( Day's case), the High Court considered the deductibility of legal expenses incurred by a public servant in defending charges in respect of conduct which occurred outside the course of the taxpayer's normal day-to-day duties. It was established that the taxpayer's position as an officer subject to the Public Service Act 1922 obliged him to observe standards of conduct extending beyond those in the performance of the tasks associated with his office and exposed him to disciplinary procedures within the Service which might have consequences for the retention of his office or salary. In the circumstances of Day's case the majority of the High Court had regard to the nature of the employment, the terms and conditions of the employment and the tasks performed and duties to be observed under the employment. Of significance was the fact that the legal expenses were incurred in responding to disciplinary action internal to the employment relationship and existing for no other purpose. It was the terms of employment that exposed the taxpayer as an employee to the employer action, and therefore to the need to incur the legal expenses. It was also held that the expenses were not of a private nature, because they were incurred in connection with the taxpayer's position as a public servant and were not unconnected to his service like some fines and penalties are. Your case is similar to that of Day's case, in that you incurred legal expenses in responding to disciplinary action internal to your employment under the Code of Conduct for the Queensland Public Service . Therefore, the expenses you incurred in relation to the disciplinary matters are deductible under section 8-1 of the ITAA 1997. | Detailed Reasoning - Question 2: In Federal Commissioner of Taxation v. Sydney Refractive Surgery Centre Pty Ltd [2008] FCAFC 190; 2008 ATC 20-081; (2008) 73 ATR 28 the Full Federal Court held that an award of damages for defamation received by a company for defamation was not held to be assessable income in. This was because the damages were awarded for the harm caused to its business reputation, and not for lost profits (even though they were calculated by reference to lost profits) because an award of damages for injury to reputation is not assessable income. In that case, the Court held that the damage was to the corporation's reputation which is part of what enables it to earn money. An injury to that reputation diminishes its capacity to earn because it reduces the corporation's ability to induce others to do business with it. The Court said that an award of damages for that injury is therefore no different from an award for the loss of an arm or any other injury impairing earning capacity, which is capital in nature. Similarly, taking into consideration your circumstances, the alleged damage was to your reputation, good name and character, which is part of what, enables you to earn money. Any legal expenses incurred to help restore your professional reputation are not deductible as they are considered to provide an enduring advantage. The advantage sought is the restoration of a capital asset, that is, your means of producing income. As such, the character of the associated legal expenses in relation to your defamation maters is considered to be capital in nature and the expenses are not deductible under section 8-1 of the ITAA 1997. | Detailed Reasoning - Question 3: The deductibility of expenses can also depend on whether the claims would have resulted in amounts classified as assessable income. An amount paid to compensate for loss generally acquires the character of that for which it is substituted ( Federal Commissioner of Taxation v. Dixon (1952) 86 CLR 540; (1952) 5 AITR 443; (1952) 10 ATD 82). Lump sum damages awarded for a personal injury, wrong or illness suffered, which is not direct compensation for loss of income, will usually be capital in nature. In your case, the payment you sought was compensation for the personal injury and wrong you felt during the investigation and disciplinary matters bought about by your employer. No part of the payment you sought related to the loss of income or payment of outstanding salary or wages owed to you. Therefore, the payment you sought and received is capital in nature and not deductible under section 8-1 of the ITAA 1997.

Subject: Deductibility of legal fees: Question 1 - Can you deduct the cost of legal fees incurred when responding to code of conduct investigations and disciplinary action taken by your employer in relation the manner in which you carried out your duties? | Question 2 - Can you deduct the cost of legal fees incurred when instigating defamation action against your employer and members of the public in relation to comments or inferences made by them regarding your reputation, good name and character? | Question 3 - Can you deduct the cost of legal fees incurred in pursuing compensation, for damages sustained during the code of conduct investigations and disciplinary action, via WorkCover?