Are legal expenses incurred in defending legal proceedings initiated by a former employer tax deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?
No. This ruling applies for the following periods : Year ended 30 June 20XX Year ended 30 June 20XX The scheme commenced on: XX XXXX 20XX
On XX XXXX 20XX, you commenced employment at employer A. You were originally employed as general manager but were demoted to sales director. Your duties and responsibilities included managing sales strategy, key customer relationships, new business development, and revenue growth initiatives. You also led a small sales team and worked closely with the production and operations departments to align customer requirements with delivery capability. On XX XXXX 20XX, you resigned from employer A. On XX XXXX 20XX, you commenced employment with your employer B. On XX XXXX 20XX, employer A initiated proceedings against you in the court for breaching your employment related duties and confidentiality (the allegations). The allegations made against you, were that you breached clauses XX and XX of your employment contract with employer A.
Clause XX was confidentiality clause, where employer A asserted you breached this clause by engaging in conversations to seek employment with a competitor while employed at employer A and by downloading confidential information to your personal devices (while still employed at employer A) and providing them to the employer B. Employer A further asserted that your conduct had influenced the employer B's decision to discontinue merger discussions that were taking place between the two companies before you joined, and employer A sought damages for the alleged loss arising from this supposed breach. You formally denied the claims in their entirety and defended yourself. Clause XX was a non-compete clause, where employer A asserted you breached this clause by joining the alleged competitor employer B. You asserted you did not breach clause XX because employer B was not a direct competitor and that you worked in an unrelated role and department. Employer A sought injunctive relief that, if successful, would have prevented you from commencing or continuing your new employment. On XX XXXX 20XX, you engaged legal representation to defend the allegations.
On XX XXXX 20XX, the Supreme Court issued consent orders (the order). The terms of the order were: • The proceedings against you were dismissed. • No order as to costs; each party bore their own costs. The consent orders were made by consent, without admission of liability by either party. You incurred approximately $XX over the course of the proceedings. The expenses were incurred during the 20XX income year.
Income Tax Assessment Act 1997 section 8-1
Summary Your legal expenses relate to an action for damages regarding you breaching your employment contract. Therefore, you are not entitled to a deduction under section 8-1 of the ITAA 1997 for your legal expenses associated with your proceedings. Detailed reasoning 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. The High Court majority in Commissioner of Taxation v Payne [2001] HCA 3 said it is well established that these words are to be understood as meaning incurred 'in the course of' gaining or producing assessable income, and do not convey the meaning of outgoings incurred 'in connection with' or 'for the purpose' of deriving assessable income. A deduction for legal expenses by an employee depends on the particular facts of a case. 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] HCA 15; (1949) 4 AITR 236; (1949) 8 ATD 431). 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 revenue nature, then the expenses incurred in gaining the advantage will also be of a revenue 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). Furthermore, 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) 39 ALR 46; (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) 49 FLR 183; (1980) 11 ATR 276; 80 ATC 4542). In FC of T v. Day [2008] HCA 53 and FC of T v. Rowe (1995) 31 ATR 392; 95 ATC 4691, the courts accepted that legal expenses incurred in defending the manner in which a taxpayer performed his employment duties were allowable. No significance was placed by the court on the taxpayer's status as an employee. Taxation Determination TD 93/29 Income tax: if an employee incurs legal expense recovering wages paid by a dishonoured cheque, are these legal expenses an allowable deduction under Income Tax Assessment Act 1997 section 8-1? outlines the Commissioners view on certain legal expenses. The ruling states that if an employee incurs legal expense in recovering wages, the legal expenses are an allowable deduction providing that the legal action relates solely to the recovery of wages.
However, if the legal action goes beyond a claim for a revenue item such as wages and constitutes an action for example, breach of the contract of employment, where the essential character of the advantage sought relates to an enduring advantage that is of a capital nature, the legal costs would not be deductible. Legal expenses relating to an action for damages for wrongful dismissal or a breach of employment contract, are not deductible. Application to your circumstances. Your legal expenses relate to an action for damages regarding you breaching your employment contract, where the essential character of the advantage sought relates to an enduring advantage that is of a capital nature. Therefore, you are not entitled to a deduction under section 8-1 of the ITAA 1997 for your legal expenses associated with your proceedings.