Understanding the Nature of Legal Fees for Tax Purposes
The deductibility of legal fees hinges on the nature or character of the expense. This determination is guided by the benefit that is sought through incurring the expense.
- Capital vs. Operational Purpose:
- Legal fees incurred to create an asset or secure an enduring benefit are considered capital expenditures. These are not deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997), as established in the Sun Newspaper Ltd case (1938). For instance, John purchased a property and incurred legal fees to secure the title deed. Since this legal expense aims to create an asset with an enduring benefit, it is considered a capital expense and is not deductible.
- Conversely, legal fees incurred for operational purposes may be deductible. For example, John, a contractor, sued a client to recover unpaid wages for work completed. Since the sole purpose of the legal action is to recover assessable income, the related legal fees and costs should be deductible.
- Employment-Related Legal Fees:
- Lost Wages: If the sole purpose of the legal action is to recover unpaid wages, bonus, contract payment, or leave payments that are assessable to the client, then the legal fees and related costs should be deductible. For instance, John lost his employment unfairly, and his employer didn’t pay his annual leave and long service leave. He sued his employer for unfair dismissal to retrieve his annual leave and long service leave. Since the purpose of the legal action is to recover assessable income, the legal fees should be deductible.
- Reinstatement: If an employee incurs legal fees after termination and one of the purposes is to seek reinstatement to their former position, these expenses are generally of a capital nature. According to the Australian Taxation Office (ATO), such fees are not deductible because they aim to secure an enduring benefit (i.e., reinstatement of employment). For instance, if John also sought reinstatement to his job as part of the legal action, the legal fees related to seeking reinstatement would be considered capital expenses and thus not deductible. For further guidance, refer to paragraph 5 of Taxation Determination TD 93/29.
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