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Are legal expenses associated with an out of court settlement for breach of an employee service agreement deductible under section 8-1 of the Income Tax Assessment Act 1997 ('ITAA 1997')?

No. Legal expenses associated with an out of court settlement for breach of an employee service agreement are not deductible under section 8-1 of the ITAA 1997.

The taxpayer was employed by a firm of consultants under an employee service agreement.

One of the terms of the agreement was that if the taxpayer left the employment and took clients with them, the taxpayer would reimburse the employer.

The taxpayer resigned from their employment.

Some clients of the former employer followed the taxpayer into the taxpayer's own business.

The taxpayer's former employer sued for breach of contract for failure by the taxpayer to pay reimbursement under the terms of the employee service agreement.

The taxpayer incurred legal expenses in relation to the legal action which eventually resulted in an out of court settlement.

The out of court payment settled in full any claims made by the former employer in relation to the clients.

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent that they are incurred in gaining or producing assessable income, or necessarily incurred in carrying on a business for the purpose of 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.

For legal expenses to constitute an allowable deduction, it must be shown that they were incidental or relevant to the production of the taxpayer's assessable income, ( 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.

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) 2 ATD 169) and the legal action has more than a peripheral connection to the taxpayer's income producing activities ( Magna Alloys and Research Pty Ltd v. FC of T (1980) 11 ATR 276; 80 ATC 4542).

Similarly, in FC of T v. Rowe (1995) 60 FCR 99; (1995) 31 ATR 392; 95 ATC 4691, 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. No significance was placed by the court on the taxpayer's status as an employee.

In this case the taxpayer incurred legal expenses in relation to activities they had undertaken which resulted in a breach of the employment agreement they had with their previous employer. The activities to which the breach related were not employment duties and did not arise as a consequence of the performance of the taxpayer's duties from which they derived assessable income.

The out of court payment settled in full any claims made by the former employer in relation to the clients. It thereby allowed the taxpayer to continue to derive assessable income in the course of their recently established business from the clients at issue. The out of court settlement brought into existence an asset or an advantage (tangible or intangible) for the enduring benefit of their business. The legal expenses associated with the settlement are therefore capital in nature (British Insulated & Helsby Cables v. Atherton (1926) AC 205).

The legal expenses associated with the out of court settlement for breach of contract do not have the necessary connection to the taxpayers former employment activities. In addition, the legal expenses are capital in nature. Therefore, the legal expenses are not deductible under section 8-1 of the ITAA 1997.