Deductibility of Legal Expenses

Will your legal expenses be deductible?

 

The answer to this question is not as straightforward as it may seem.

Deductibility of Legal Expenses under General Principles

Normally, the legal principles which determine the deductibility of expenses also apply to the question of legal costs.

Section 8-1 of the Income Tax Assessment Act 1997 is the key provision which relates to general deductions. This states:

 

The effect of s 8-1 is to allow the taxpayer to deduct all losses and outgoings incurred in gaining or producing assessable income or which were necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However, a taxpayer cannot deduct a loss or outgoing if it is of a capital, private or domestic nature.

Are the legal costs incurred in gaining or producing income under sub-s (1)?

For expenditure to be an outgoing incurred in (i.e. ‘in the course of’) gaining or producing assessable income there must exist the requisite connection between it and the earning of income, that is, the expenditure must be ‘incidental and relevant’ to that end.

The High Court has recently affirmed a broad interpretation of s 8-1(1) in Day. That case concerned a public service employee charged with misconduct, who was ultimately able to deduct legal costs incurred in defending those charges, as they were sufficiently connected to his employment. However, the Court also noted that it is not possible to make a formula that can be applied in the circumstances of every case.

Romanin was another recent case concerning the deductibility of legal fees incurred as a result of an employment dispute. In that case, the taxpayer was CEO and General Manager of a company and was dismissed with only seven days notice, despite being contractually entitled to 12 months notice or payment in lieu thereof. The Federal Court applied the Full Federal Court’s earlier decision in Day, finding that Mr. Romanin’s legal costs were deductible, as there was a sufficient nexus between the legal expenses and the receipt of income.

The Capital/Income Distinction - are the costs nonetheless disallowed under sub-s (2)?

The Australian Tax Office has produced a number of "Interpretative Decisions" in an endeavour to throw light on how this section is applied in individual cases. Set out below is a brief summary of some of these decisions.

Legal Expenses of a Capital Nature

Interpretative Decision (ID 2002/657) is of particular interest.

This decision examines the question of whether legal expenses that were incurred in seeking a better redundancy package were deductible.

In the facts of that case, the taxpayer had been made redundant and the employer had made a severance proposal which the taxpayer considered to be unfair. The taxpayer instructed a solicitor to successfully negotiate an improved severance package and in the process incurred legal costs.

The ATO disallowed the deduction. In arriving at its decision, the Department held that a redundancy payment is compensation for the loss of expectation of continuing employment and therefore of a capital nature. In the words of the decision:

"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."

The fact that the redundancy payments were included in the taxpayer's assessable income was held not to change the capital nature of the payment.

Similarly, in Interpretative Decision ID 2002/656, the ATO disallowed a deduction of legal expenses arising out of an unsuccessful attempt to sue for a lump sum termination payment. The ATO considered that a lump sum payment in lieu of notice is a capital amount paid as compensation for the loss of the ability to produce income.

These cases may be contrasted with the abovementioned Federal Court decision in Romanin. The facts in Romanin were substantially similar to ID 2002/656, although Mr. Romanin was successful in his legal action. However, McKerracher J was of the opinion that the mere fact of the money being received as a lump sum rather than as a series of regular payments did not alter the character of the payment, which was described as remuneration in the judgment of the NSW IR Commission, was calculated by reference to Mr. Romanin’s income and was set off by income he was able to earn during the 12 months. The deduction was accordingly allowed.

Other examples of legal fees which have been held to be of a capital nature and therefore non-deductible include:

• costs incurred by a public servant relating to disciplinary proceedings arising from his gambling activities;
• an employee’s costs of defending an allegation of sexual harassment at work (Interpretative Decision ID 2002/664); and
• costs incurred in defending the right to practice a profession (Interpretative decision ID 2004/367).

Legal Expenses of a Private Nature

Costs incurred in defending family Court proceedings are an example of legal fees which have been held to be of a private nature and, therefore, not deductible.

Legal Expenses of a Revenue Nature

In determining whether the costs of legal proceedings are deductible, it is irrelevant whether the taxpayer is successful in those proceedings. In determining into which category the expense falls, the Tax Office looks to the purpose for incurring the expense.

Examples of revenue-related (and therefore deductible) expenses include:

• Costs of proceedings brought by a public servant against her employer to protect work conditions were allowed in circumstances where her actual employment was not under threat (Inglis);
• Schokker’s Case, in which legal expenses incurred by an employee to prevent termination of an existing employment contract were held to be deductible. The termination in this instance was based on the employee's conduct.
  
  If the expense relates to activities by which the taxpayer earns his or her income, legal costs are generally deductible.

Costs Relating to Employment Agreements

According to Taxation Ruling TR 2000/5, costs associated with securing an employment agreement with a new employer are not deductible to the employee. However, costs incurred in amending an existing agreement are deductible, provided the existing agreement allows for such changes. Costs incurred in settling disputes arising out of employment agreements are deductible for both employers and employees.

Special Provisions relating to Deductibility of Legal Expenses

The Income Tax Assessment Act 1997 makes special provision for the deductibility of certain legal expenses. These include the discharge of mortgages, the borrowing of money, the preparation of leases and the preparation of an income tax return.

Most executives who seek our advice normally do so in the context of:

• an actual or threatened dispute with their employer regarding their performance or conduct; or
• some aspect of their employment agreement, for example, confidentiality clauses/post employment restraints; or
• entering into a written contract of employment and needing advice on the terms and conditions of the contract.

The special provisions are not relevant in the above circumstances in determining whether legal costs are deductible.

Obtain Tax Accounting Advice

Determining whether a particular legal expense is deductible or not depends on which line of the capital /income dichotomy the expense falls and on the application of various income tax rulings and interpretative decisions. Prior to making any claim for legal expenses that depends on the application of general principles, you should first obtain tax accounting advice and perhaps even a private ruling from the Australian Tax Office.