Assessability of recoupment of legal costs

Is the payment the taxpayer received for legal costs under a settlement agreement an assessable recoupment which results in an amount being included in assessable income under Subdivision 20-A of the Income Tax Assessment Act 1997 (ITAA 1997)?

No. The payment the taxpayer received for legal costs under a settlement agreement is not an assessable recoupment which results in an amount being included in assessable income under Subdivision 20-A of the ITAA 1997.

The taxpayer brought a civil action against a former employer for unpaid employee entitlements comprising wages and annual leave.

The taxpayer incurred legal costs in relation to this civil action. A portion of these legal costs was an allowable deduction under section 8-1 of the ITAA 1997.

The taxpayer was successful in their action and received a settlement amount comprising: • ordinary income, • a capital amount exempt from taxation under the Capital Gains Tax (CGT) provisions of the ITAA 1997, and • legal costs.

The legal costs were awarded to the taxpayer as part of the settlement to cover their legal costs incurred in bringing the civil action.

The amount received for legal costs does not have the characteristics of income according to ordinary concepts and is therefore not ordinary income.

Section 6-10 of the ITAA 1997 provides that a taxpayer's assessable income includes statutory income amounts that are not ordinary income but are included in assessable income by another provision.

Section 10-5 of the ITAA 1997 lists provisions about assessable income. Included in the list is Subdivision 20-A of the ITAA 1997 which deals with amounts received by way of a recoupment for deductible losses or outgoings.

A recoupment of a loss or outgoing is defined in paragraph 20-25(1)(a) of the ITAA 1997 to include any kind of recoupment, reimbursement, refund, insurance, indemnity or recovery, however described.

The payment received by the taxpayer for legal costs would be a 'recoupment' within the meaning of paragraph 20-25(1)(a) of the ITAA 1997.

Subsection 20-20(2) of the ITAA 1997 provides that an amount received as a recoupment of a loss or outgoing will be an 'assessable recoupment' if the amount is received by way of insurance or indemnity, and the loss or outgoing is deductible either in the current income year, or in an earlier income year.

The term 'indemnity' is not defined in the ITAA 1997 and it is therefore necessary to look at the case law which deals with the definition of the term.

The courts have held in considering the former paragraph 26(j) of the Income Tax Assessment Act 1936 (ITAA 1936), a previous recoupment law, that 'by way of...indemnity' includes payments which are not made pursuant to a contract of indemnity, particularly compensation paid under a statute, and awards of damages. Goldsbrough Mort & Co Ltd v. FC of 76 ATC 4343 (1976) 6 ATR 580, Federal Commissioner of Taxation v. Wade (1951) 84 CLR 105; 9 ATD 337; (1951) AITR 214 and Robert v. Collier's Bulk Liquid Transport Pty Ltd (1959) 33 VLR 280.

In Commercial Banking Company of Sydney Ltd v. FC of T 83 ATC 4208; (1983)14 ATR 142;, Hunt J in considering the operation of paragraph 26(j) of the ITAA 1936, was of the view that indemnity or indemnify contemplated an obligation to make good, or to compensate for, a loss which may happen in the future, whether by contract or otherwise and that it was difficult to comprehend the notion of an indemnity in respect of a loss which had already been incurred.

In this case the payment the taxpayer received was for legal expenses already incurred in the recovery of unpaid wages and annual leave. There was no obligation for the payment to be made to the taxpayer under any contract, statute, common law duty of care or otherwise prior to the costs being incurred. The payment is therefore different in nature to the payments considered by the courts to be an indemnity under the former paragraph 26 (j) of the ITAA 1936 and is not an assessable recoupment under subsection 20-20(2) of the ITAA 1997.

Where an amount is not received by way of insurance or indemnity, subsection 20-20(3) of the ITAA 1997 provides that the amount can only be an assessable recoupment if the loss or outgoing is deductible in the current or an earlier income year under a provision listed in section 20-30 of the ITAA 1997.

The legal costs received by the taxpayer represented a recoupment of legal expenses incurred in bringing the civil action against their former employer. The legal expenses incurred by the taxpayer are not deductible under one of the provisions listed in section 20-30 of the ITAA 1997. Therefore the amount is not an assessable recoupment under subsection 20-20(3) of the ITAA 1997.

Accordingly, the amount the taxpayer received for legal costs is not an assessable recoupment within Subdivision 20-A of the ITAA 1997 and will not be included as assessable income.