Explanatory Memorandum(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)
Chapter 2 - Regulation Impact Statement for the Taxation Treatment of Software
1. The Government announced on 12 May 1998, as part of the 1998-99 Budget, several measures concerning the taxation treatment of Y2K compliance expenditure and software expenditure.
2. The measures largely involved amending the tax law to include depreciation provisions in respect of expenditure incurred in acquiring, developing or commissioning software. In addition, the Government also proposed other measures to ensure that adequate provision is made for the taxation treatment of Y2K expenditure incurred by businesses up to 31 December 1999 seeking to establish Y2K compliance.
3. The depreciation amendments are in response to the withdrawal of Taxation Ruling IT 26 (IT 26) by the Commissioner of Taxation. Under this ruling software expenditure which was not integral to the computer hardware was immediately deductible. Following the withdrawal of the ruling, some software expenditure would be written off for tax purposes over 25 years. The depreciation amendments will improve the equity of the taxation system by better aligning the true economic life of the asset to the income it generates. The Y2K amendments will address uncertainty concerning the treatment of millennium bug expenses and ensure that taxation arrangements are consistent with the Governments desire to encourage business to achieve Y2K compliance. Taken together, the proposed amendments for software are broadly more generous than those applying in comparable overseas jurisdictions.
4. Three options were considered for the implementation of these Budget measures:
- applying differential write-off rates which closely match the economic life of individual software assets;
- applying a 2 year write-off rate for software with appropriate balancing adjustments; and
- amortising software and computer hardware at the same rate (ie. 3.7 years). This would generalise the write-off rate currently applied to software that is integral to a computer (such as operating software) to all software. While computers have an effective life of five years, the write-off rate under accelerated depreciation is 3.7 years.
5. The following design features were proposed for all of the above options.
- To reduce taxpayer compliance costs, expenditure on software which does not exceed $300 would continue to be immediately deductible.
- To fairly treat taxpayers who have pre-existing commitments to purchase software, the new arrangements will apply to expenditure incurred in relation to contracts entered into to acquire or modify software after 10 am legal time in the Australian Capital Territory on 11 May 1998 the time of withdrawal of IT 26. They will also apply to expenditures on specifically commissioned and in-house development of software commenced after this date. Expenditures on in-house development, or commissioned software commenced up to announcement will continue to be immediately deductible until 30 June 1999.
- To reduce the risk of the arrangements penalising very short lived software:
- taxpayers who cease to use software will be allowed an immediate deduction of its written down value at that time; and
- where expenditure is incurred on commissioned software or software developed in-house and that software is subsequently abandoned and never used, the expenditure will be deductible at the time of abandonment.
To ensure consistency with other policy objectives, software expenditure that currently receives a more favourable treatment (such as the R & D concession) will be excluded from the proposed arrangements.
6. The proposed measures will largely impact on business software users. In the 1995-96 income year, over $2 billion was spent on software consultancy services while a further $1.2 billion was spent on packaged software. However, only part of these expenditures would have been undertaken by the commercial sector. Also, these figures do not include expenditure on 'in-house' development of software which constitutes a substantial part of software development activities.
7. Manufacturers, producers and developers of software will be unaffected by these proposed amendments in relation to trading stock.
8. The revenue impact has been estimated on the basis of the withdrawal of IT 26. This withdrawal provided an environment where expenditure on software would generally not be depreciated, or, at best, depreciated over 25 years. Consequently, the implementation options involve a substantial reduction in Government revenue.
9. The cost to revenue of option (b) and the Y2K measure has been estimated as: $30m in 1998-99; $205m in 1999-00; $295m in 2000-01; and $520m in 2001-02.
10. The nature of compliance costs for depreciation of software is similar to that for all other capital expenditures namely increasing taxpayers compliance costs marginally as taxpayers will need to keep records of the acquisition and development costs of software as well as deductions claimed in respect of that software until at least 5 years after the deduction is claimed.
11. In terms of the impact on compliance costs:
- option (a), which allows expenditure to be written off over the effective life, would have the highest compliance costs due to the requirement for taxpayers to identify the classes of software based on effective life and to depreciate them at different rates. This high compliance cost is the unavoidable down-side to the benefits of option (a) in terms of efficient resource allocation.
- option (b), which allows expenditure to be written off over 2 years, would have lower taxpayer compliance costs than option (a). Option (b) also reduces the time over which depreciation calculations must be made.
- option (c), which allows expenditure to be written off over 3.7 years, would have similar levels of compliance costs as option (b). The compliance costs may be marginally less under option (c) than option (b) as hardware and software will be depreciated at the same rate. However, this reduction is offset through the 2 year write-off period under option (b).
12. In common with the impact of many other taxation provisions, compliance costs are likely to be most onerous for smaller businesses without dedicated accounting personnel. While compliance costs for small and large business may be roughly equivalent in terms of accounting hours used, these hours may be more costly for a small business when viewed as percentage of turnover. The proposed $300 threshold (up to which expenditures on software can be deducted as incurred) has the advantage of reducing compliance costs for small one-off purchases of software.
13. Option (a) would require the ATO to rule on the characteristics of various software assets and to administer different write-off periods for these assets. As well as one-off costs, such as issuing guidelines on the classification of different types of software, the ATO would have significant ongoing costs in the form of audit activities to ensure taxpayers were amortising different software expenditures at the appropriate rate. These costs could be significant.
14. Options (b) and (c) provide a general write-off rate over 2 and 3.7 years respectively. This would substantially lower ongoing auditing costs for the ATO compared to option (a).
15. All options will substantially reduce the taxation burden on business users of software in comparison to no policy response being made to the withdrawal of IT 26.
16. The greatest reduction in taxation burden will occur under option (b) (2 year write off). Option (c) would involve a proportionately lesser reduction in taxation burden, reflecting the 3.7 year write off. The reduction in taxation burden would be expected to be lowest under option (a), assuming the average effective life of the larger software applications is greater than 5 years.
17. All options would better align the taxation life of software assets with the economic life of those assets.
18. Option (a) would be associated with a high degree of economic efficiency. This is because, under ideal conditions, this option would involve the assignment of the taxation life of a software asset to closely match the economic life of that asset.
19. Option (b) allows for less discrimination between software assets on the basis of their effective life than option (a). As such, the resource allocation benefits would be lower than for option (a).
20. Option (c) also allows for less discrimination between software assets than option (a).
21. The measures being implemented are as announced in Treasurers Press Release No. 52. of 1998 with modifications including the introduction of a software pooling choice. Since the announcement on 12 May 1998, there has been extensive consultation in the form of discussions and seminars on administrative and legislative issues with relevant industry, professional bodies and individuals. The pooling method was developed as a consequence of this consultation and is designed to reduce the compliance costs taxpayers will otherwise incur in identifying separate software projects. Draft legislation was released for public comment on 14 December 1998. Comments received were taken into consideration when finalising the Bill.
22. These measures will address the policy objectives by introducing a depreciation regime for software which better matches the true economic life of software to the income it generates. The Y2K amendments will address the policy objectives of providing certainty concerning the taxation treatment of millennium bug expenses and encouraging businesses to achieve Y2K compliance.
23. Option (b), which allows a 2 year write-off for all software, is the Governments preferred option. It would be expected to involve noticeably lower compliance and administration costs than under option (a), but will involve similar costs as under option (c). Option (b) also allows for a shorter average write-off period than options (a) and (c).
24. The Treasury and the ATO will monitor this taxation measure, as part of the whole taxation system, on an ongoing basis.