Legal costs paid under a settlement deed held to be assessable income

On 4 June 2015, as part of the Australian Taxation Office’s test case litigation program, the Administrative Appeals Tribunal held that legal costs in the amount of $500,350.33 paid by the ACT Government to a taxpayer under a deed of settlement and release constituted an assessable recoupment under section 20-20 of the Income Tax Assessment Act 1997 (Cth).

This finding was despite the ACT Government at all times referring to the payment as an ex-gratia one, such payment falling outside the bounds of section 20-20 and, therefore, not constituting assessable income.

This decision of the AAT comes at the end of acrimonious litigation waged by the taxpayer against the ACT Government, and will no doubt raise the ire of the taxpayer. More concerning, however, is the adverse impact on litigants who fail to understand when their settlement deed may invoke the application of section 20-20, and fail to factor the cost of a tax liability into their settlement negotiations.

The case is as follows.

Falk and Commissioner of Taxation [2015] AATA 392 — the facts

The taxpayer, Dr Falk, was a senior clinician at The Canberra Hospital operated by ACT Health under the auspices of the ACT Government. In May 2006 Dr Falk was summarily dismissed from his employment at the Hospital, whereupon he commenced proceedings in the (former) Australian Industrial Relations Commission seeking reinstatement.

The proceedings were vigorously defended by ACT Health, causing Dr Falk to incur significant legal costs. Dr Falk claimed his legal costs as a deduction against his assessable income in the relevant income tax years over the course of the proceedings.

In November 2007 the AIRC ordered Dr Falk be reinstated to his position at the Hospital, and delivered a judgment scathing of the Hospital’s management team. In light of the AIRC’s findings, Dr Falk filed an application in the AIRC within time for his costs. Thereafter, settlement negotiations ensued between the parties on the issue of Dr Falk’s costs.

At the end of May 2008 the ACT Government, on behalf of ACT Health, agreed to pay Dr Falk the amount of $500,350.33 for his legal costs. The offer to pay was subject to two conditions, the first being that Dr Falk withdraw his application for costs and the second that he provide a release to the Government.

The payment was determined by the ACT Government to be an act of grace payment under section 130(1) of the Financial Management Act 1996 (ACT) because there was no legal liability at that stage for the ACT Government to pay any costs to Dr Falk.

Dr Falk accepted the Government’s offer in September 2008 and disclosed the payment amount in his income tax return for the year ended 30 June 2009. The Commissioner assessed the payment as income subject to tax and Dr Falk objected.

The question before the AAT

Section 20-20(2) of the ITAA 1997 provides that an assessable recoupment is a payment in respect of a loss or outgoing where the payment is by way of insurance or indemnity and the loss or outgoing was deductible

Section 20-25(1) provides that a recoupment of a loss or outgoing is any kind of recoupment, reimbursement, refund, insurance, indemnity or recovery however described in respect of the loss or outgoing.

The question for the AAT was whether the payment to Dr Falk was ‘by way of indemnity’.

The AAT’s findings

The AAT confirmed there ‘is no general principle that an amount received as compensation for, or reimbursement of, a deductible expense is assessable income’. The payment to Dr Falk would only be assessable if it fell within a particular category of statutory income.

Turning to the meaning of ‘indemnity’, the AAT referred to the reasoning of Deputy President Deutsch in Re Batchelor and Commissioner of Taxation [2013] AATA 93 who said that the meaning of indemnity is ‘protection against, hurt, damage or loss; or compensation for loss or damage sustained’. Importantly, Re Batchelor found that the word indemnity was capable of encompassing past loss.

The AAT then looked at the character of the payment to Dr Falk, namely whether the payment was in the character of an indemnity versus an ex-gratia payment. Relying again on the reasoning in Batchelor, the AAT said that an ex-gratia payment is not one ‘apt to be regarded as indemnification of a loss or outgoing’ and that ‘it is a payment made for reasons otherwise than on account of a legal liability’.

The AAT said it was not inherently implausible that the ACT Government had paid Dr Falk without having the least regard to the question of the Territory’s legal liability for costs, but Dr Falk did not call evidence to prove the Territory’s motivation for the payment

The AAT concluded that the character of the payment was consistent with an indemnity for the Government’s legal liability to Dr Falk, and that the ACT Government’s reference to the payment being ex-gratia was only to comply with its internal procedures.

The message

For a party on the receiving end of settlement funds, this case confirms that care must be taken when framing a settlement offer and drafting the accompanying deed that unintended or unfunded tax obligations do not arise.

For more information contact:

Greg Brackenreg — Partner — Dispute Resolution Team
(02) 6279 4409
greg.brackenreg@mvlawyers.com.au

Bernice Ellis — Senior Associate — Dispute Resolution Team
(02) 6279 4385
bernice.ellis@mvlawyers.com.au

Giang Tan — Associate — Corporate & Commercial Team
(02) 6279 4425
giang.tan@mvlawyers.com.au