Explanatory Memorandum(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)
General outline and financial impact
Amends the income tax law to :
- allow taxpayers to depreciate over 2 years expenditure incurred in acquiring, commissioning or developing software; and
- allow an immediate deduction for expenditure on acquiring new software (including upgrades) or substantially rebuilding current software which has the predominant nature of ensuring Y2K compliance.
Date of Effect: The amendments will apply to expenditure incurred after 10 am legal time in the Australian Capital Territory on 11 May 1998.
Proposal Announced: 1998-99 Budget, 12 May 1998 (Treasurers Press Release No. 52 of 1998). Further changes were announced in Assistant Treasurers Press Release No. 48 of 14 December 1998.
Financial Impact: The cost to the revenue has been estimated at $30m in 1998-99, $205m in 1999-2000, $295m in 2000-01 and $520m in 2001-02.
Cost of Compliance Impact: The nature of compliance costs for depreciation of software is similar to that for all other capital expenditures. Taxpayers compliance costs will increase 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 five years after the deduction is claimed. The Government has recognised the additional compliance costs for these taxpayers who develop in-house software and will have to track expenditure for each individual software project. These taxpayers and others who commission the development of software projects will be able to choose to depreciate expenditure under a pooling method which does not require the allocation of expenditure to particular projects.
Main Points: 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.
Policy Objective: The Government announced several measures concerning the taxation treatment of software expenditure. The depreciation amendments will improve the equity of the taxation system by 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.
Chapter 1 - Taxation Treatment of Software
1. New Division 46 will be inserted into the Income Tax Assessment Act 1997 (the 1997 Act). New Division 46 will:
- modify the depreciation provisions in Division 42 of the 1997 Act to allow a deduction, over 2 years, for expenditure incurred in acquiring, developing or commissioning software;
- include an option to allow taxpayers to choose to pool expenditure on in-house development or commissioning of software projects; and
- allow an immediate deduction for:
- certain Year 2000 (Y2K) expenditure until 31 December 1999; and
- expenditure incurred until 30 June 1999, on software projects which commenced up to 10 am by legal time in the Australian Capital Territory on 11 May 1998.
2. New Subdivision 46-B will modify the depreciation provisions in Division 42 of the 1997 Act so that:
- expenditure incurred in acquiring, developing or commissioning software will be depreciated over 2 years on a prime cost basis at 40% per year;
- if, in an income year, software is no longer used and installed, any undeducted expenditure can be deducted in full in that year; and
- expenditure in relation to software projects (either commissioned or developed in-house) is capitalised and depreciated from the time the software is first used or installed ready for use.
3. New Subdivision 46-C will contain rules to allow an immediate deduction for expenditure incurred:
- on software purchases of $300 or less provided the total cost of all purchases of identical software does not exceed $300 in an income year;
- in relation to software projects (commissioning or developing in-house) which are abandoned before the software is used or installed ready for use. The undeducted expenditure on those projects will be allowed in full in the year of abandonment; and
- before 1 January 2000 on new software (including upgrades) or on substantially rebuilding current software provided that the principal purpose of the expenditure is to ensure Y2K compliance in relation to an existing computer system. Where the principal purpose of the expenditure incurred before that date is not to ensure Y2K compliance, an immediate deduction will be available in relation to the Y2K compliance expenditure. The remaining expenditure that is not Y2K compliance expenditure will be deductible under either new Subdivision 46-B or 46-D.
4. New Subdivision 46-D will allow taxpayers who incur expenditure in developing software in-house to choose to depreciate that expenditure under a pooling method. Under this method:
- the choice to pool will be irrevocable if made in relation to the second income year after 11 May 1998 or later;
- if the choice is made in the first income year after 11 May 1998, taxpayers will be able to opt out of the pooling arrangements in the second income year after 11 May 1998 for that and later income years;
- eligible expenditure will be written off over 2 years at a specified rate from the year after the expenditure is incurred; and
- any consideration received in relation to the software in respect of which the expenditure has been pooled will be included in assessable income.
5. The amendments proposed will not affect the current deductibility of expenditure on software where such expenditure does not enhance functionality. Expenditure on maintenance, testing, code reviews, minor alterations/modifications and remedying defects are not within the scope of New Division 46 and will therefore continue to be dealt with under existing law. The amendments will also not affect the immediate deductibility of:
- certain Y2K expenditure discussed below; and
- expenditure incurred before 1 July 1999 on in-house developed or commissioned software where the project commenced up to 10 am by legal time in the Australian Capital Territory on 11 May 1998. [Item 22]
6. The proposed amendments to depreciate expenditure on software will apply to expenditure incurred after 10 am by legal time in the Australian Capital Territory on 11 May 1998. [Item 21]
7. Taxation Ruling IT 26 (IT 26), which issued in 1979, allowed expenditure on computer software which was not integral to the computer hardware to be immediately deductible, despite the fact that most software had a reasonably long life. Software which was integral to the hardware, such as operating systems software, was depreciated at the same rate as the computer hardware. IT 26 was withdrawn on 11 May 1998 on the basis that it no longer reflected the correct application of the existing law in relation to expenditure incurred on acquiring, developing or commissioning software. The view implicit in these changes is that, because software provides an enduring benefit, the expenditure should be subject to depreciation rather than being immediately deductible.
8. The Government announced in the 1998-99 Federal Budget that software expenditure should be written off over 2 years. Details of the new legislative rules to depreciate software expenditure were contained in Treasurers Press Release No. 52 of 12 May 1998. This treatment was modified when the legislation was released as an exposure draft on 14 December 1998. The details of the modifications were detailed in Assistant Treasurers Press Release No. 48 of 1998. The modifications included:
- introducing pooling as an alternative to depreciation;
- discarding the separate treatment for non-renewable licences; and
- modifying of the multiple purchases rule.
9. The Commissioner of Taxation released Taxation Ruling TR 98/13 on 5 August 1998 which discussed the treatment of expenditure incurred to achieve Y2K compliance. The ruling provides that the majority of expenditure incurred on existing systems to achieve Y2K compliance is deductible when incurred as it is revenue in nature.
10. Under the ruling, expenditure incurred on acquiring new software or substantially rebuilding current software is regarded as capital in nature and is no longer immediately deductible. In order to encourage businesses to achieve Y2K compliance, legislative amendments will allow such expenditure to be immediately deductible provided it is incurred before 1 January 2000.
11. This Bill will introduce New Division 46 into the 1997 Act and make other consequential amendments to the 1997 Act and the Income Tax Assessment Act 1936 (the 1936 Act). [Items 1 to 20]
12. New Division 46 has the following Subdivisions:
- New Subdivision 46-A - Definition and scope of Division
- New Subdivision 46-B Depreciation of software
- New Subdivision 46-C Deductions for certain expenditure on software
- New Subdivision 46-D Software pools.
13. Computer software is generally described as computer programs consisting of encoded instructions designed to cause a computer to perform a particular task or to produce a particular result. Expenditure on software for the purposes of the new depreciation arrangements includes expenditure on acquiring software and expenditure on software projects. Expenditure on software projects includes costs of developing and/or commissioning software. The term software is defined to include a right to use software. This of course includes a licence to use software. It also includes the acquisition of a right to use software in a situation where the licence is held by a separate entity (eg. where a company has outsourced its information technology function to a service provider) and the taxpayer has a right to use that software and pays the separate entity for that right. In such situations the payment made could be part of a service payment. [ sections 46-5 and 46-10]
Building a website on the Internet will normally involve:
Example B - Repairs/Bugfixers Expenditure in the nature of repairs to or maintenance of software is not covered by the scope of new Division 46 . Taxation Ruling TR 98/13 Deductibility of Year 2000 (Millennium Bug) Expenses provides an analysis of repairs to software. If the expenditure is incurred to remove a problem in the software to allow the existing system to continue functioning in the same way, the expenditure would not qualify under new Division 46 as expenditure on software. The expenditure is not incurred to enhance the functionality of software.
14. Some taxpayers cannot purchase software packages to perform a particular desired function. In such cases they may either commission a third party to develop the software or they develop the particular software application using in-house expertise. In-house development could involve commissioning certain aspects of a particular software development project. It could also involve acquiring certain software for use in the project being developed.
15. Where the taxpayer commissions a third party to develop the software, all expenditure incurred in having that third party develop the software is to be capitalised. Once the resultant software is used or installed ready for use, the capitalised expenditure on that software can commence to be depreciated.
16. In relation to in-house software development projects, there are several critical questions, the answers to which will determine the timing and extent of overall expenditure on software and the resultant depreciation deductions. Some of those questions are:
- Has a choice been made to pool all project development expenditure?
- When does a project begin?
- What project expenditure is to be depreciated or pooled?
- When does a project end?
These issues are discussed further in the following paragraphs.
17. There are two depreciation methods under which deductions can be claimed for expenditure incurred in developing or commissioning the development of software:
- the general depreciation method [Subdivision 46-B] under which depreciation is calculated on a project basis, deductions are allowable once the software developed is used or installed ready for use and an immediate deduction is available where software is subsequently abandoned; and
- the pooling approach [Subdivision 46-D] under which all expenditure incurred in software development or commissioned projects are written off over 2 years from the income year following the year in which the expenditure is incurred.
- When does a project begin?
18. The point at which a project begins will be a question of fact in all cases. A fundamental requirement for the commencement of a project would be actual activity relating to identifying and satisfying user requirements. This could be in the form of a feasibility study, scoping, an impact statement or the development of a business case. A management/board decision to undertake a feasibility study would probably be too early to constitute the commencement of a project. However, the work of a project team following such a decision would indicate the commencement of a project. The work of the project team could commence with the gathering and analysis of user requirements.
19. After a management decision to go further with a project and to actually commence developing a software application, the further work may continue in-house or may be commissioned (perhaps following a tender process). The commissioning of this further work would not be considered to be a separate project, but merely part of the on-going project to develop the software application.
20. Expenditure on a software project which is to be capitalised will include any cost that is directly related to the project. Such costs will generally consist of salaries and consumables. Where a project is undertaken in the same place as business-as-usual activities, it may be extremely difficult to accurately apportion costs such as utilities or salaries of support staff not directly involved in the development process. It will not be necessary to treat such costs as expenditure on software for new Division 46 purposes.
21. If a software development project is undertaken at a separate, discrete site, all the costs of that site will be project costs, including salaries, rent, and utilities and would represent expenditure on software.
22. Expenditure on plant (eg. computer hardware) and software that are used as tools in the software development would be depreciated under Division 42 and New Division 46 of the 1997 Act respectively.
Example C - Depreciating software expenditure where the software project has distinct sub-projects A software application has to be developed and the overall project consists of various sub-projects. The expenditure incurred for each sub-project can begin to be depreciated at 40% once the sub-project is completed and the resultant software is used or installed ready for use. Where a choice has been made to pool, the expenditure incurred in a particular year on all software development can commence to be written off at 40% in the following year.A project may be split into sub-projects for the purposes of claiming depreciation under the general method where separately identifiable applications are produced. For example, a general ledger, an assets register and payroll system which progressively come on line would be considered as separate projects within an accounting system project.
23. The project or each sub-project ends once the particular software application is used or installed ready for use. For example, completion of user testing and a sign off would normally indicate software development has ended. Testing costs such as those involved in the simulation of real time processing prior to final installation or first use would therefore be included in the software expenditure for a particular project.
24. Expenditure on software may receive a more favourable tax treatment under section 73B (research and development) of the 1936 Act or under section 330-15 (exploration and prospecting) of the 1997 Act. Such expenditure is not deductible under New Division 46 . The new software arrangements will also not apply to software which is trading stock or which forms part of trading stock. [ section 46-15] The latter situation may arise, for example, where a taxpayers trading stock is a drilling machine, into which software is loaded to assist in its automated operation.
25. Division 373 of the 1997 Act, which deals with capital expenditure on intellectual property and Division 10B of the 1936 Act which deals with capital expenditure on industrial property, will have no application to expenditure on software. New paragraph 373-10(2)(c) and new subsection 373-60(5) of the 1997 Act and new paragraph 124K(2)(c) of the 1936 Act will ensure that new Division 46 has precedence over Division 373 and Division 10B. [Items 1 and 15 to 17]
26. Under the measures proposed, expenditure on software can, subject to certain exceptions, be written off under the general depreciation provisions. If a choice is made to use the software pooling method then the pooling method will be used for all expenditure on in-house development and the commissioning of software, rather than the general depreciation provisions.
27. These two methods are discussed below.
28. New section 46-25 sets out the broad principle that the rules relating to plant, contained in Division 42 of the 1997 Act, will apply to expenditure which a taxpayer incurs on software as if that software was plant which is owned by the taxpayer. New Subdivision 46-B explains how those rules are modified in order to calculate a deduction for expenditure on software under Division 42.
29. A deduction for software will be based on its expenditure. New section 46-25 provides the link to Division 42 and tells you how the deduction is to be calculated. The steps are:
- Step 1.
- Work out your expenditure on software using the table below. If more than one row applies, use the expenditure under the last applicable row.
- Step 2.
- The table indicates provisions that may adjust the expenditure. Refer to them to see if an adjustment is necessary.
- Step 3.
- If more than one provision adjusts the expenditure, apply them in the order they appear in the table to:
- the expenditure; or
- the adjusted expenditure after applying the last applicable provision.
- Step 4.
- The result is your expenditure which can be depreciated.
30. New section 46-30 provides that the amount to be depreciated is calculated using the table set out in section 42-65 of the 1997 Act. This can be summarised as:
|For software:||The expenditure is:||May be adjusted by:|
|you are the original owner of the software:
|Common rule 2 (non-arms length transactions)|
|you acquire/bought with, or attached to, other assets without a specific value being allocated to it||so much of the overall expenditure as is reasonably attributable to the software||
|you acquire under subsection 42-335(1)||the market value of the software immediately before its acquisition||
|you stop holding software as trading stock and acquire under section 70-110||the amount worked out under section 70-110||double deduction (section 42-85)|
The wording of new section 46-30 is intended to clarify the table referred to in new section 46-50 when it is adapted to expenditure on software. The words are not to be interpreted restrictively (ie. as applying only to items in the table which contain the words its cost to you).
31. New Division 46 is intended to apply to software which is acquired or developed for use within the business. It is not intended to extend to situations where software development for exploitation is the business. To ensure this result the expression 'expenditure on software' in new section 46-10 focuses on the functions which the software was intended to perform. If the acquisition or development was principally (at least 50% of the expenditure) for this purpose, the expenditure is dealt with under the Division. A software distributor, manufacturer or developer would acquire or develop software for the principal purpose of exploiting that software with a view to profit.
32. A taxpayer may have a dual purpose in incurring expenditure on software. For example a taxpayer may routinely develop new software applications for its own business purposes but licence it to other taxpayers in its industry. In such situations it will be a question of fact as to the principal reason for the expenditure. Examples 1 and 2 in new section 46-10 further clarify the intended application.
33. Expenditure by software manufacturers, developers and the like which does not come within the definition of expenditure on software under new Division 46 may be, depending on the particular circumstances, revenue in nature or covered by specific capital expenditure provisions (eg. Division 373 of the 1997 Act).
34. Section 42-15 will allow you to deduct an amount for depreciation of a unit of software for an income year if, in that year you use the software or have it installed ready for use, for the purpose of producing assessable income.
35. New section 46-40 provides that the depreciation arrangements use an effective life, for the purposes of using the depreciation provisions in Division 42, of 2 years.
36. The following paragraphs elaborate on the linkages to Division 42, the prime cost method and the balancing adjustments where software ceases to be used within the 2 year effective life.
37. New section 46-35 provides that the amount you can deduct will be worked out using the prime cost method under Subdivision 42-E of the 1997 Act. However, you cannot deduct more than the undeducted expenditure on the software (subsection 42-20(2)). New section 46-30 provides that the calculation of your deduction will be based on your expenditure on software. The rate you use to calculate your deduction is set out in new section 46-45 as 40% per annum.
38. The prime cost method is set out in section 42-165 of the 1997 Act. Under this method the deduction for an income year is calculated using the following formula:
expenditure x days owned/365 X rate
39. Under the depreciation provisions in Division 42 of the 1997 Act, the deduction is reduced by an amount that reasonably reflects the extent (if any) you neither used the software, nor had it installed ready for use, for the purpose of producing assessable income during the period in the income year you were its owner (section 42-170). In the case of taxpayers who are individuals, for example, this means the extent to which you used the software for private purposes.
40. Under subsection 42-30(3), a balancing event will occur in relation to software where it is disposed of, is lost or destroyed or subsection 42-330(1) applies (partial change in ownership). New subsection 46-50(1) includes an additional event to cover the situation where you do not dispose of the software but effectively cease to use it and no longer have it installed ready for use.
41. Subsection 42-30(1) provides that where a balancing adjustment event occurs and you have deducted or could have deducted an amount for expenditure on software, you must make a balancing adjustment calculation. A balancing adjustment calculation is also required where a balancing event occurs and, if Common rule 1 (roll-over relief for related entities) applied to your acquisition of software, the transferor or an earlier successive transferor deducted or can deduct an amount for expenditure on software.
42. Subsection 42-30(1) provides that no balancing adjustment calculation is required if Common rule 1 applies to the balancing adjustment event. Also, where a balancing adjustment calculation results in you being required to include an amount in assessable income, balancing adjustment relief may be available (see sections 42-285, 42-290 and 42-295).
- Purchased software no longer used within 2 years*
(* The examples in this explanatory material are for illustration purposes only and may not reflect market prices etc.)Consider the case of software which is purchased to assist in the preparation of taxation returns for a specific year. That software is purchased for $350 on 1 June 1998 for the preparation of taxation returns for the year ending 30 June 1998. If you assume that the software is installed ready for use on the date of purchase, the deduction for the income years ending 30 June 1998 and 1999 will be:
30 June 1998:
30/365 days x 40% x $350 =
30 June 1999:
40% x $350 =
|Income Year||Calculation||Amount Deductible|
|30 June 1998||30/365 days x 40% x $350||$11.51|
|30 June 1999||40% x $350||$140.00|
|30 June 2000||40% x $350||$140.00|
|30 June 2001||Balance of expenditure*||$58.49|
|* subsection 42-20(2) limits deductions to no more than the undeducted expenditure on the software.|
Example E - Upgrades etc. You acquire Windows 95 on 15 May 1998 for $500 and then on 30 July 1998 acquire Windows 98 for $160. Windows 95 is to be depreciated over 2 years from 15 May and Windows 98 is deductible in full under new section 46-65 in the income year in which the expenditure is incurred as its value does not exceed $300. The undeducted expenditure on Windows 95 cannot be written off on 30 July 1998 as it remains on the system and is required for Windows 98 to operate.
Example F - New acquisition to replace existing software You acquire Word 6 on 15 May 1998 for $400 and then on 30 July 1998 acquire Word 97 for $500. You uninstall Word 6 and install Word 97. New section 46-50 will allow the undeducted expenditure on Word 6 to be written off in the 1998-99 year of income as Word 6 is no longer used from 30 July 1998.
43. Sometimes software is purchased as part of a package. For instance a computer may be sold with several software packages, a printer and a fax/modem for one undissected price. The expenditure on software for depreciation purposes will be so much of that total undissected price as is reasonably attributable to the software (item 2 of section 42-65).
Example G - Software acquired as part of a package A computer is purchased for $3,000 with three software packages included in the price. If the computer and the software were purchased separately, the software would cost $2,000 and the computer would cost $2,000. As the software represents 50% of the value of the package, $1,500 (ie. 50% of $3,000) would be reasonably attributed to the software. Assuming the cost of each package exceeded $300, the $1,500 would be written off at 40% per annum over 2 years.
44. New subsection 46-65 allows an immediate deduction for expenditure on software which does not exceed $300. The conditions under which this deduction is allowed are:
- the total cost of the software does not exceed $300;
- the expenditure relates to a unit of software and the total cost to you of that unit of software and any other identical or substantially identical units of software acquired in the current income year does not exceed $300; and
- the software is used, or installed ready for use in the current income year, for the purpose of producing assessable income.
45. Section 42-170 will operate to reduce the deduction to the extent that the software is used, or installed ready for use, for purposes other than gaining or producing assessable income.
46. Where multiple copies of the same software package (or similar packages) are purchased in a year, and the total expenditure is in excess of $300, the expenditure is required to be written off over 2 years.
Example H - Bulk purchases A business with 10 employees connected by a local area network purchases 10 copies of the same $200 software package on the same day. The total expenditure ($2,000) will be deductible over 2 years.
Example I - Treatment for each software application when more than one is acquired A taxpayer purchases a copy of a $200 software package on 1 July 1998. The taxpayer purchases another copy of the same package on 1 January 1999. The expenditure on both packages must be deducted over 2 years. For the 1998-99 year of income, the deduction for the first package will be $80.00 (40% of $200) and the deduction for the second package will be $39.67 [181/365 of (40% of $200)] .
47. New section 46-70 allows an immediate write-off of any unrecouped expenditure where software is effectively abandoned before it is used or installed ready for use. If any consideration is received from disposal of an abandoned software project new subsection 46-70(2) ensures that the total deduction available in respect of the project is equivalent to the total unrecouped expenditure of the software project less any consideration received in respect of the project. Where the proceeds of a sale exceed the total unrecouped expenditure, in relation to a software project, the excess will be assessable either as a capital gain or as income according to ordinary concepts.
48. A deduction for undeducted expenditure is also available where the software is 'abandoned' after it is used or installed ready for use under new subsection 46-50(1).
49. Expenditure on software which has the principal purpose of ensuring that an existing computer system attains Y2K compliance will be deductible in full in the year it is incurred provided the expenditure is incurred before 1 January 2000. Principal purpose means that at least 50% of the expenditure is in respect of Y2K compliance. [ subsection 46-75(1)]
50. Where the expenditure does not have a principal purpose of ensuring Y2K compliance, an immediate deduction will be available to reflect the extent of Y2K expenditure. [ subsection 46-75(2)]
51. New subsection 46-75(3) only allows the deductions available under new subsection 46-75(1) or (2) to the extent that the expenditure is incurred with the intention of producing assessable income.
52. New section 46-75 is necessary to provide the concession available for Y2K expenditure which is no longer immediately deductible following the withdrawal of IT 26. The type of expenditure envisaged would be capital in nature and would cover expenditure incurred in acquiring new/replacement software or substantially rebuilding current software to ensure an existing computer system attains Y2K compliance.
53. Y2K compliance work would include, for example, activities to ensure that the following occurrences do not result in the inaccurate representation of a date or dates:
- the year 2000, or subsequent years requiring a 4 digit representation;
- the year 2000 is a leap year; or
- using 99 or 00 as reserve values on the basis that an application would not be used past 1998.
54. Other Y2K compliance work could arise in relation to:
- platform limitations such as register storage sizes; or
- licences for software expiring when the 00 date is reached.
55. The question of what is the principal purpose of the expenditure will be a question of fact in all cases. A taxpayer may purchase or develop software with a mix of purposes but if Y2K compliance is not the principal purpose, the extent of other expenditure which is not Y2K related will be dealt with under new Subdivision 46-B or 46-D . For example, if a taxpayer purchased a new version of a software program in order to gain the benefits of improvements through increased functionality over the existing version and the new software was also Y2K compliant, the principal purpose of that expenditure may not be to ensure Y2K compliance.
Example J - No immediate deduction On 10 December 1999, Buford Pty Ltd commences business and incurs $3,000 expenditure on acquiring new software which is Y2K compliant.Regardless of Bufords purpose, the expenditure is not immediately deductible under new section 46-75 as it is not in relation to an existing computer system. It must therefore be considered under new Subdivision 46-B and depreciated over 2 years. The same result would occur where the software was acquired to computerise an activity (eg. invoicing or payroll) which was previously done manually.
- Immediate deduction where principal purpose of expenditure is to achieve Y2K compliance
Buford Pty Ltd incurs $2,000 expenditure on rebuilding software on 10 December 1999, to support its existing business. The rebuild is done in-house. The principal purpose (60%) of the expenditure is to ensure Y2K compliance. The residual (40%) purpose is to provide increased functionality. On 15 January 2000, Buford incurs a further $1,000 in relation to the rebuild before it comes on-line.The expenditure of $2,000 incurred on 10 December 1999 is immediately deductible under new subsection 46-75(1) as:
- Not to achieve Y2K compliance
Buford Pty Ltd incurs $2,000 expenditure on rebuilding existing software on 10 December 1999, partly to ensure Y2K compliance (30%). However, the main purpose of the expenditure, is to provide increased functionality (70%). The rebuild is done in-house.The expenditure incurred on 10 December 1999 (ie. $2,000) is to be apportioned, $600 (being 30% of $2,000) which is immediately deductible under
new subsection 46-75(2)
56. New Subdivision 46-D will allow taxpayers, in certain circumstances, to choose to calculate depreciation deductions under a software pooling method. Expenditure incurred before 1 July 1999 on software projects which commenced up to 10 am by legal time in the Australian Capital Territory on 11 May 1998 are not pooled as Item 22 allows for an immediate deduction. Software projects may be developed in-house and/or commissioned in terms of new paragraphs 46-10(1)(b) and (c).
57. New section 46-80 provides that the choice must be in writing. Once made, the pooling method will apply to all expenditure incurred in developing software, whether developed in-house or commissioned. All expenditure incurred on software development which commenced in the income year when the choice is made will be pooled, including expenditure on projects which were completed and projects which were abandoned during the income year. Transitional arrangements are discussed below.
58. Software development projects commenced before the income year in which the choice to pool is made must continue to be depreciated under the general software provisions contained in new Subdivision 46-B.
59. The software pooling method is only available where expenditure is incurred in having software developed. Further, the expenditure must be incurred in relation to software developments which are to be used wholly for income producing purposes. [ paragraph 46-85(c)]
60. Expenditure on software which will be eligible for an immediate deduction under new Subdivision 46-C or the special transitional provisions detailed at Item 22 will be excluded from the pooling arrangements. Such expenditure includes:
- expenditure, incurred up to 31 December 1999 to rebuild or replace existing computer software, which has the principal purpose of ensuring Y2K compliance; [ section 46-75] and
- expenditure on specifically commissioned and in-house developed software incurred up to 30 June 1999, other than Y2K work above, provided the project commenced up to 10 am by legal time in the Australian Capital Territory on 11 May 1998. [Item 22]
61. Expenditure in having software developed may include expenditure on acquiring software which, if it was not part of the software development and was incurred in its own right, would fall within new paragraph 46-10(1)(a) and not be subject to pooling.
62. Once a choice is made to pool, software development expenditure in relation to a project that is abandoned cannot be written off at that time under new section 46-70 , but must continue to be depreciated as part of the pool.
63. Under the software pooling method, depreciation will be allowed at the rate of 40% in each of the following two years after the expenditure is incurred and 20% in the third year. No deduction will be allowed in the income year in which the expenditure is incurred. [ section 46-90]
64. New section 46-95 requires you to include in your assessable income any consideration you receive for software in relation to which expenditure has been pooled. This would include, for example, consideration received for:
- the disposal or part disposal of software;
- the granting of a licence in relation to software; and
- the loss or destruction of software (insurance proceeds).
65. New section 46-100 will allow Common rules 1, 2 and 3 to apply to new Subdivision 46-D . However, in order to apply correctly to expenditure on software which has been subject to pooling, Common rules 1 and 2 are modified. The major modification to the application of Common rule 1 is that roll over relief is not mandatory in the circumstances set out in section 41-20 relating to capital gains tax rollover. [ subsection 46-100(1)] This recognises that it may not be possible to extract expenditure relating to particular software where that expenditure was incurred over several years and forms part of several pools.
66. Special transitional arrangements will apply under the pooling arrangements for the first income year after the application date of the amendments (11 May 1998). Where a choice is made in that income year to pool software development expenditure the choice may also apply from 11 May 1998. [Item 23]
67. In these circumstances the first pool would contain expenditure incurred from 11 May 1998 to the end of the relevant income year and a second pool would contain expenditure incurred in the income year for which the choice is made.
Example M - Application of pooling method Blitz Pty Ltd chooses on 30 June 1999 to apply the pooling method (from 11 May 1998) to software development expenditure for the 1997-98 (from 11 May 1998 to 30 June 1998) and 1998-99 income years. It commenced several software development projects, none of which are in relation to Y2K compliance, and incurred the following expenditure:
|June 1998||Project A commenced||$10,000|
|July 1998||Acquires and installs off the shelf software *||$2,000|
|October 1998||Project B (software completed and installed on 1 January 1999)||$1,500|
|January 1999||Project A and other new projects||$2,000|
|May 1999||Project A and other new projects||$3,000|
Depreciation can be claimed under the pooling arrangements as follows:
|30 June 1998||Pool 1||$10,000||$0.00|
|30 June 1999||Pool 1||$10,000||$4,000.00|
|30 June 2000||Pool 1||$10,000||$4,000.00|
|30 June 2001||Pool 1||$10,000||$2,000.00|
|30 June 2002||Pool 2||$6,500||$1,300.00|
|* 'off the shelf' software cannot be pooled. It is depreciable under new Subdivision 46-B .|
|** Pool 2 includes expenditure incurred in the 1998-99 income year and therefore includes expenditure incurred in October 1998 ($1,500) January ($2,000) and May 1999 ($3,000).|
If a choice is made for the first income year beginning after 11 May 1998, taxpayers will be able to opt out of the pooling arrangements for the second income year after 11 May 1998 and later income years. [Item 24]
Example N - Opting out of the software pooling method Scuzzy Pty Ltd operates on a 30 June income year. On 15 May 1998 it begins a new software project and incurs the following expenditure:
|15 May 1998||$2,000|
|15 July 1998||$5,000|
Scuzzy choses to pool for the first income year after 11 May 1998 (ie. the 1999 income year from 1 July 1998 to 30 June 1999) and to pool all software development expenditure back to 11 May 1998.
Scuzzy could choose to stop using the pooling method for the 2000 income year (being the second income year after 11 May 1998). In this case, Scuzzy would not pool any expenditure incurred during the year ended 30 June 2000 but would have to continue to apply the pooling method to the 1998 and 1999 pools (Pool 1 and Pool 2 respectively).
Assume Scuzzy starts a second project on 1 September 1999 (Project 2) and completes this project in May 2000. The software is installed on 1 June 2000 at a total cost of $7,000. Under the general method of depreciation, Scuzzy is able to write this expenditure off at 40% from 1 June 2000.
Depreciation can be claimed as follows:
|30 June 1998||Pool 1||$2,000||0%||$0.00|
|30 June 1999||Pool 1||$2,000||40%||$800.00|
|30 June 2000||Pool 1||$2,000||40%||$800.00|
|30 June 2001||Pool 1||$2,000||20%||$400.00|
|30 June 2002||Pool 2||$5,000||20%||$1,000.00|
|30 June 2003||Project 2||$7,000||40%**||$1,169.86|
|* 30 days depreciation claimed|
|** subsection 42-20(2) limits deductions to no more than the undeducted expenditure on the software.|
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.