Australia: More Deductions For Employee Legal Costs

In Commissioner of Taxation v Day [2008] HCA 53, the High Court has ruled that an employee was entitled to claim a deduction for the legal expenses incurred in defending disciplinary charges. The charges led to his demotion but could have resulted in his termination.

The High Court decided that the taxpayer's duties as a public officer and the possible consequences of internal disciplinary proceedings formed part of what was productive of his assessable income. This case reflects a recent judicial trend to increasingly allow tax claims for legal expenses incurred to protect an employee's income. Given the increasing number of terminations and redundancies in the current economic environment, the High Court's decision may mean that some employees are more willing to take on their employers in Court.

The taxpayer, Shane Day, was a senior compliance officer with the Australian Customs Service. He incurred legal expenses of $37,077 in defending two separate charges of improper conduct as an officer of the Public Service. The taxpayer claimed the legal expenses as a deduction in his 2001-02 tax return. The claim was disallowed by the Commissioner of Taxation.

The charges

The first incident of improper conduct related to a breach of the Customs Code of Ethics and Conduct in 1998. The taxpayer was suspended from duty for presenting his Customs identification card to a Court Clerk in order to obtain information about a warrant to search his workstation. An internal investigation found that it was improper for the taxpayer to have represented that his visit to the Court was for official purposes.

The second incident related to seven charges of improper conduct in 1999 including the taxpayer's involvement in a false claim for a diesel fuel rebate and the use of a work vehicle for a non-work related purpose. For these charges, the taxpayer was suspended without pay.

The claim

The taxpayer sought to claim his legal expenses for defending the charges as a deduction under the relevant income tax legislation. A taxpayer can generally deduct from their assessable income 'any loss or outgoing to the extent that it is incurred in gaining or producing' assessable income.

After the Commissioner's disallowance of the claim, the taxpayer appealed to the Federal Court. Justice Emmett held that the legal expenses were not deductible. A majority of the Full Federal Court overturned Justice Emmett's decision by finding that the expenses were in fact deductible. The Commissioner appealed to the High Court. Justices Gummow, Hayne, Heydon and Kiefel delivered the majority judgment. Justice Kirby dissented.

The Commissioner of Taxation's arguments

The Commissioner of Taxation argued that legal expenses are deductible when incurred in connection with, or incidental to, the taxpayer's business.

However, the Commissioner argued that since the taxpayer's expenses were incurred in defending conduct outside the scope of his duties, the expenses could not have been incurred "in" or "in the course of" gaining or producing assessable under the relevant income tax legislation.

Furthermore, while the Commissioner accepted that the taxpayer was under an obligation not to engage in improper conduct, the Commissioner argued that this obligation was not an activity that was relevant to the production of the taxpayer's income.

The High Court's decision

The taxpayer's legal expenses were allowable as deductions on the basis that the taxpayer's duties as an officer of the Public Service required him to observe standards of conduct that extended beyond the normal standards required in the performance of tasks associated with his office. Furthermore, the taxpayer was subjected to disciplinary action that could have led to the termination of his employment. Therefore, the High Court concluded that what was productive of the taxpayer's income must be understood given the particular circumstances of this case, including the nature of the employment and the duties it imposes on an employee.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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