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:
“(1) You can deduct from your assessable income any loss or outgoing to the extent that:
• it is incurred in gaining or producing your assessable income; or
• it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.
(2) However, you cannot deduct a loss or outgoing under this section to the extent that:
• it is a loss or outgoing of capital, or a capital nature; or
• it is a loss or outgoing of a private or domestic nature;…
(3) A loss or outgoing that you can deduct under this section is called a general deduction.”
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.
The most common obstacle to claiming an allowable deduction for legal expenses is that the expense is of a capital nature.
Summary of recent case law
Legal costs incurred in gaining or producing income under sub-s 8(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, i.e. the expenditure must be ‘incidental and relevant’ to that end.
Legal costs incurred in defending misconduct charges
The High Court affirmed in 2008 a broad interpretation of s 8-1(1) in Commissioner of Taxation v Shane Day (‘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.
Legal costs incurred in claiming damages for breach of contract
Romanin v Commissioner of Taxation was another comparatively 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. This was despite the fact that Mr. Romanin sought a lump sum payment and it related to an amount owing under the contract.
Management fees incurred by professional sportsman
In Spriggs v Commissioner of Taxation and Riddell v Commissioner of Taxation  HCA 22, the issue of deductibility of professional costs came before the High Court. The costs in question were management fees rather than legal costs, but the case is nevertheless instructive.
Spriggs was an Australian Rules football player and Riddell was a professional rugby league player. Each of them claimed the cost of management fees as a deduction pursuant to section 8 (1) of the Act quoted above.
The Commissioner of Taxation refused to allow the deductions and they both objected to the decisions. Their objections were disallowed by the Commissioner and they appealed to the Federal Court of Australia which allowed the deductions. The Commissioner then appealed to the Full Court of the Federal Court which unanimously upheld the appeal by the Commissioner. Spriggs and Riddell (“players”) both appealed to the High Court of Australia and their appeals were heard together on the basis that there were no significant distinguishing features between their cases.
The players argued that they both had playing and nonplaying income, with the latter derived from sponsorships and endorsements etc. and that the management fees were incurred in order to gain their income from their businesses as professional sportsmen. They argued that their playing contracts were not solely contracts of employment, as they contained terms which enabled them to turn their sporting prowess into money. It was also argued on their behalf that the management fees were not solely for negotiating the playing contracts, but for all the services provided by the managers.
The High Court substantially agreed with this submission and held that the management fees were an allowable deduction. This was principally because the players were engaged in a business before the fees were incurred which had both a playing and nonplaying component. In addition, the contracts under which they were engaged envisaged their right to enter into commercial arrangements to make the most of their celebrity status.
The Court noted that section 8 –1 (1) is available to taxpayers who are both employees and also to those who earn income from a business. However, the Court stated:
“The answer may be different from that which would apply if the (players) were not conducting businesses, but were no more than employees.” (Paragraph 57).
The Court went on to quote with approval Maddalena (1971) 45 ALJ . The High Court stated:
“This distinction was recognised in Maddalena where Menzies J, with whom the rest of the Court agreed, said:
“Had the taxpayer claimed as a deduction the expenses of changing from one job to another as an employee electrician his outlay would not have been an allowable deduction. The expenditure would have been incurred in getting, not in doing, work as an employee. It would come at a point too soon to be properly regarded as incurred in gaining assessable income. Nor would the expenditure have been an outgoing in carrying on a business. There is a difference of first importance for present purposes between an electrician who seeks work as an employee and an electrician who seeks contracts to do work as a principal. In the former case the electrician would not have a business; in the latter he would. In the latter, therefore, what he spent to obtain contracts to do electrical work would be properly regarded as an outgoing of his business. There is, however, a clear distinction between the two cases.” (at 426 and 427)
Although the High Court stated that section 8 –1 (1) (a) “does not, in terms, refer to the carrying on of a business”, in considering deductibility under that provision, it may be “useful and necessary” to consider whether the taxpayer is actually carrying on a business. This is because, according to the Court, carrying on a business is one of the ways in which income can be earned. The Court then went on to say (section 57) that while section 8 –1 (1) (a) is “available both to a taxpayer who earns income as an employee and also to a taxpayer who earns income from a business”, nevertheless the outcome may well be very different “from that which would apply if the appellants were not conducting businesses, but were no more than employees.”
In rejecting the Commissioner’s arguments, the High Court held that the football players’ nonplaying activities constituted a business and that it was possible to obtain and perform an employment contract as part of and during the course of running a business. (Section 65)
The outcome of this decision was clearly coloured by the fact that the players were held to be in the business of commercially exploiting their sporting prowess. For most executives, this will not be a factor at play in their relationship with their employers. The decision is nevertheless useful in demonstrating how the courts will approach the interpretation of section 8.
ATO interpretative rulings
The capital/income distinction – are the costs nonetheless disallowed under sub-s 8 (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 – not deductible
Legal costs incurred in seeking improved redundancy payment – not deductible
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 payment was included in the taxpayer’s assessable income was held not to change the capital nature of the payment.
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 – not deductible
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 – deductible
Legal costs incurred claiming lump sum termination payment in lieu of notice – deductible
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.
Subsequently there was the Federal Court decision in Romanin noted above.
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, and was calculated by reference to Mr. Romanin’s income. The deduction was accordingly allowed.
On 12th May 2010 the ATO produced a further interpretive decision (ID 2010/131) which overturned the earlier decision set out in 2002/656.
In this decision, the taxpayer was employed under an employment contract that provided for six months’ pay in lieu of notice on termination of employment. The taxpayer was terminated, but the employer refused to make the payment. The taxpayer commenced proceedings to enforce the contractual promise to pay the lump sum payment in lieu of notice and was successful.
The ATO reached the conclusion that the taxpayer was entitled to the deduction. In arriving at that decision, reference was made to Romanin’s case and the ATO quoted with approval that part of the judgement that said that the payment of a lump sum which would otherwise have been made by regular payments had the contract not been (invalidly) terminated, doesn’t change the character of the payment. In other words, it remains a payment in the nature of income and not of capital.
Whether expenses are deductible doesn’t depend on successful outcome
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.
Other examples of revenue-related expenses
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
The main ruling regarding employment contracts is Taxation Ruling TR 2000/5. Under this Ruling, the following costs are deductible:
• Costs incurred in amending an existing employment agreement are deductible, provided the existing agreement allows for such changes. However, costs associated with securing an employment agreement with a new employer are not deductible to the employee.
• Costs incurred in settling disputes arising out of employment agreements are deductible for both employers and employees.
• Costs of amending existing terms and conditions of employment with the same employer.
• Costs of renewing or extending a contract of employment that has a fixed term.
Special provisions relating to deductibility of legal expenses – not relevant in employment context
The Income Tax Assessment Act 1997 makes special provision for the deductibility of certain legal expenses. These however relate to the discharge of mortgages, the borrowing of money, the preparation of leases and the preparation of income tax returns. These provisions are therefore not relevant in resolving questions of deductibility of legal expenses in an employment context.
Conclusion – Obtain advice from a qualified taxation practitioner
The question of whether legal costs incurred in an employment context are deductible is not necessarily straightforward. The categorisation of the expense as to whether it is income or of a capital/private nature is critical and the legal costs in question need to be seen in light of the Australian Taxation Office’s interpretive decisions. With respect to those legal costs incurred regarding employment agreements, Taxation Ruling 2000/5 is of considerable assistance.
This article is general in nature. Prior to making any claim for legal expenses that depends on the application of general principles, you should first obtain taxation advice from a qualified taxation practitioner and perhaps even a private ruling from the Australian Taxation Office.
The information you obtain at this site is not, nor is it intended to be, legal advice. You should consult a lawyer for individual advice regarding your own situation.