Maurice Blackburn

The tax deductibility of employment-related legal expenses is a complicated and changing area. This is especially the case in relation to legal costs incurred in the preparation and administration of employment contracts.

Income Tax Assessment Act 1997

Whether an expense incurred by an employee is tax deductible is generally decided by reference to section 8-1 of the Income Tax Assessment Act 1997 ("ITAA").

This section provides that 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 producing assessable income.

However, you cannot deduct a loss or outgoing to the extent that:

• it is of capital, or a capital nature, or

• it is of a private or domestic nature.

Commissioner of Taxation's Ruling

The Commissioner of Taxation's ("the Commissioner") main ruling in relation to employment contracts is Taxation Ruling 2000/5 ("the Ruling") which provides that the following costs incurred by an employee are allowable deductions:

• costs of drawing up an employment agreement with an existing employer to replace an award, or in accordance with the existing agreement
• costs associated with the settlement of disputes arising out of an existing employment agreement
• costs of changing the conditions of an existing employment agreement with the same employer (providing the existing agreement allows for changes) including a variation, renegotiation or upon a promotion, and
• costs of renewing or extending a fixed term employment agreement, provided the existing agreement provides for this renewal or extension.

In the Ruling the Commissioner highlights that where an employee is entering into new employment a deduction is not allowable for expenses incurred, as it is considered to be incurred at a point "too soon" to be incurred in the production of assessable income and further it is a "capital expense".

Two recent cases

The Commissioner's defeat in two recent relevant court cases may be seen to expand the circumstances in which legal costs may be deductible where the Commissioner formerly had ruled and argued that they were not.  In light of these recent cases, the Commissioner is reviewing a variety of previous rulings and determinations.    

Expense is incurred in gaining or producing assessable income

Court cases have established that in order to be deductible, there must be a sufficient connection between the expense incurred and what is itself productive of the assessable income.

Romanin's case

In the 2008 decision in Romanin v Commissioner of Taxation ("Romanin's Case") the Federal Court held that legal expenses incurred in pursuing proceedings in the Industrial Relations Commission of NSW for pay in lieu of notice were tax deductible. Mr Romanin was found to have a contractual entitlement to 12 months' notice (or pay in lieu) and he was dismissed with seven days notice.

The Commissioner argued that such legal expenses were of a capital nature because the "advantage sought" was a lump sum by way of relief for termination of his employment.

However, McKerracher J held that even though the amount sought was a lump sum and even though it related to an amount owing on the termination of the contract, the legal costs incurred by Mr Romanin in doing so were deductible and that deduction was not denied as being capital or of a capital nature.

Romanin's Case extends the circumstances where legal costs incurred by an employee will be deductible.  Each case should be carefully considered on its merits having regard to the decision and the action the Commissioner takes in relation to the existing rulings.

Day's case

The 2008 High Court decision in Commissioner of Taxation v Shane Day ("Day's Case") held that a Commonwealth Customs Officer who incurred legal expenses in defending disciplinary charges under the Public Service Act 1922 ("PSA") could lawfully claim the legal expenses as a tax deduction.

The majority of the High Court held in Day's Case that the legal costs incurred by Mr Day were deductible as they were incurred in the course of gaining or producing his assessable income and were not of a private or domestic nature.  The Court explained that the question to be answered is whether the occasion of the outgoing was "found in" what was productive of actual or expected income.

In this case, Mr Day's position as an officer subject to the PSA obliged him to observe standards of conduct extending beyond those in performance of the tasks associated with his office and the charges were not "remote from his office" as might be the case in defending a criminal charge for "private conduct".

The Court noted that incurring of expenditure by an employee to defend a charge because it may result in dismissal may not itself be sufficient in every case to establish the necessary connection to the employment which is productive of the income and much will depend upon what was entailed in the employment and the duties which it imposes upon the employee.

The Commissioner in his Decision Impact Statement states "where employment or service is conducted on terms that standards of conduct be observed in a taxpayer's personal life on pain of dismissal or reduction in salary, legal expenses incurred in resisting civil disciplinary or legal action will be deductible."

The implications of this case are to expand the types of circumstances where legal costs may be deductible in cases where an employee takes action to defend against charges that might impact on their continued employment.

The expense must not be of capital or of a capital nature, or of a private or domestic nature.

Section 8-1(2) ITAA provides that a loss or outgoing will not be deductible to the extent that it is capital or of a capital nature, or it is of a private or domestic nature.