Court costs could be deductible

It is often hard to figure out whether legal expenses are deductible for tax purposes or not.

This is because it might be difficult to determine whether those expenses have been incurred in the gaining or production of assessable income, or have been necessarily incurred in carrying on a business for the purpose of gaining or producing such income.

Even if they were so incurred, they might not be deductible because they are of a capital nature.

This difficulty is illustrated by the High Court decision in Federal Commissioner of Taxation versus Day (High Court, 12 November 2008).

Shane Day was employed as a senior compliance officer with the Australian Customs Service, and was charged under the Public Service Act 1992 with failure to fulfill his duty as an officer of the public service.

It was claimed that Day had improperly used his customs identification card; that he improperly supported another officer’s claim for a diesel fuel rebate; that he improperly used a work vehicle; and that he had improperly sought to conceal his absences from work.

Day incurred legal fees in defending himself against those charges and claimed deductions for those legal fees.

At first instance (Federal Court, 30 May 2006) Justice Emmett held that the legal expenses were not deductible because the conduct of the subject of the charges comprised acts unconnected to duties to be performed by Day in the course of him earning assessable income.

However, the majority of the Full Federal Court (21 December 2007) reversed that decision; the tax office was granted leave to appeal from that decision to the High Court.

The High Court dismissed that appeal. It reached its decision based on its understanding of the Public Service act.

The court said that Day’s position as an officer, subject to that act, obliged him to observe standards of conduct extending beyond those associated with his office, and exposed him to disciplinary procedures within the service which might have consequences for the retention of his office or salary (but I would imagine that all employees face similar restrictions).

The court said: “What was productive of [Day’s] income by way of salary is to be found in all the incidents of his office in the service to which the act referred, including his obligation to observe standards of conduct, breach of which might entail disciplinary charges.

“[Day’s] outgoings, by way of legal expenses, followed upon the bringing of the charges with respect to his conduct, or misconduct, as an officer. He was exposed to those charges and consequential expenses, by reason of his office. The charges cannot be considered as remote from his office, in the way that private conduct giving rise to criminal or other sanctions may be.”

Justice Kirby dissented. I have sympathy for his view that there was no relevant connection between Day’s assessable income and the legal expenses. Rather, Justice Kirby felt that the only connection was that of defending and protecting an income stream.

Presumably the tax office will attempt to limit the decision to public servants who are subject to the Public Service Act 1992, and certainly the High Court’s decision could be limited to that act.

But it would be illogical to do so. While public servants are subject to the act, employees generally are subject to specific industrial legislation, awards and the general law. They too have an “obligation to observe standards of conduct”, breaches of which, while perhaps not entailing disciplinary charges, would certainly hinder their production of assessable income.

All taxpayers should be able to take comfort from the High Court decision, knowing that if they are accused of a breach of their conditions of employment they should be able to claim a tax deduction for legal expenses incurred in defending themselves against any such accusation.

This article first appeared in CPA Australia’s magazine, In the Black