Edited version of your written advice

Authorisation Number: 1051270483552

Date of advice: 18 August 2017

Ruling

Subject: Integration expenditure

Question 1

Is the expenditure incurred by XYZ to integrate the EYZ service business into XYZ’s business, other than expenditure incurred to modify Head Co’s website, deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

Is the expenditure incurred by XYZ to transition its website, expenditure on 'in-house software’ and deductible under Division 40 of the ITAA 1997?

Answer

Yes

This ruling applies for the following periods:

1 July 2015 to 30 June 2017

The scheme commenced in:

2016

Relevant facts and circumstances

Head Co’s acquisition of X Pty Ltd

● XYZ Service was a provider of services to customers.

● On a date specified Y Pty Ltd and Head Co signed an Implementation and Sale Agreement for the sale of the XYZ Service. Y Pty Ltd is a subsidiary member of the Head Co consolidated group.

● On a date specified, X Pty Ltd was incorporated to facilitate the sale of XYZ Service. X Pty Ltd was incorporated to enable the transfer of all of the issued capital in X Pty Ltd to Y Pty Ltd. X Pty Ltd’ sole share was legally and beneficially held by a separate entity.

● On a specified date, all assets and liabilities of the XYZ Service were transferred to X Pty Ltd and then transferred to Head Co’s subsidiary Y Pty Ltd. Y Pty Ltd became the owner of all of the issued capital of X Pty Ltd for a consideration paid. The XYZ Service workforce became employees of Head Co after the acquisition.

● As of a specified date, X Pty Ltd became a subsidiary member of the Head Co income tax consolidated group. Prior to that date, X Pty Ltd was a tax exempt entity.

● The purpose of the acquisition was to improve Head Co’s market position in its sector.

● For the purposes of this private ruling, the acquisition or integration of X Pty Ltd is interchangeably referred to as the acquisition or integration of the XYZ Service.

Head Co’s background and business activity prior to its acquisition and integration of X Pty Ltd

● Head Co is a company formed by merger.

● Head Co is the Head Company of the Head Co Australian tax consolidated group (the Head Co consolidated group).

● Head Co has been operating in its services sector for many years in Australia.

● Head Co has a regional delivery model and its operational structure was already established to facilitate growth through a regional structure prior to the acquisition of X Pty Ltd. It was expected that there would be minimal change to that approach post acquisition.

● Head Co had a pre-existing business operating in its sector prior to its acquisition of X Pty Ltd and had been steadily growing that business through the acquisition of small operators and winning new service and funding contracts.

● Business elements such as the operational framework, clientele, staffing, internal systems and processes and goodwill were already in existence prior to the acquisition of X Pty Ltd and have been operational in Head Co for a number of years.

● Prior to the acquisition of X Pty Ltd, Head Co had supported the administration of its business with the acquisition of licences for customer billing software as well as the existing business and finance functions of the broader Head Co group.

● As part of the acquisition, Head Co acquired XYZ Services’ existing employees.

● As part of Head Co’s acquisition of X Pty Ltd, Head Co acquired XYZ Services’ existing customers.

X Pty Ltd

● X Pty Ltd was incorporated by a separate entity on a specified date.

● At the time Head Co acquired X Pty Ltd, X Pty Ltd carried on a service providing enterprise. X Pty Ltd earned income from offering these services contractually to various bodies, to private organisations, to other government funded organisations and directly to private individuals.

● The revenue sources of X Pty Ltd and the broader Head Co business has not significantly changed post acquisition.

Integration process and “integration expenditure”

● As part of the acquisition all entities entered into a Transition Agreement whereby post acquisition all of the normal day to day operations would continue to be maintained by a separate entity on its internal systems and processes.

● On a geographical region basis, the XYZ Service’s workforce and customer base were integrated onto Head Co’s own internal systems and processes. It was originally planned to fully integrate the X Pty Ltd in the 24 month period post acquisition. However, Head Co completed the integration of the XYZ Service in a shorter period of time. All integration expenditure was fully incurred by a specified date.

● The overall intent was to operationalise the acquired business onto Head Co’s internal systems and processes, as well as to drive business efficiencies across that business from contract management, more efficient accounts receivable, timesheet management and IT infrastructure.

● The total cost of integration was $x ('integration expenditure’). This amount includes the costs incurred by Head Co to modify its website. The integration cost wholly related to expenditure to integrate the XYZ Service business into that of Head Co.

● The integration expenditure was contractually incurred by two legal entities that are wholly owned subsidiaries of Head Co and are members of the same income tax consolidated group.

● The integration expenditure in itself did not expand or further Head Co’s business and did not result in an enduring capital benefit or in an expansion of the income stream of X Pty Ltd or Head Co.

● Each of the payments for which an income tax deduction is being claimed by Head Co has either been paid during the year or is supported by invoices at year end.

● The integration expenditure was segregated into project streams, details of which have been supplied.

Expenditure on modifying website/’in-house software’

● The total expenditure on the commercial website improvements was $x. The website serves an important role in providing information and a place for communicating with existing and prospective customers.

● The expenditure reflects the transition of the XYZ Service website to Head Co and subsequent modifications to accommodate this. The existing website was built on a platform that did not suit the requirements of Head Co. The website was made redundant and a new website was built on a platform that is already used across Head Co’s other businesses.

● The website modification costs incorporated both 'front end’ and 'back end’ costs:

● The 'front end’ costs were external consulting costs on a new design and content to reflect the updated Head Co corporate style. Resources employed to effect the modifications included support from a digital agency to deliver design and front end development (designers, content writers, developers, project management).

● The “back end costs” were internal business technology costs. This included a new content management system using a specific platform; and module development to support that platform. The website was made scalable to devices such as tablets in order to provide customers with a web experience that is both accessible and user friendly. The back end developer project was managed by the Head Co Business Technology department and required to support systems and infrastructure, security, developers and project management; and Head Co marketing resource to facilitate project management and delivery.

● The website improvements occurred over a period of months.

● The website was made scalable to devices such as tablets in order to provide customers with a web experience that is both accessible and user friendly.

● With regard to ongoing maintenance to the website, maintenance projects will be scheduled based on requirements with releases estimated to fall quarterly.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 subsection 8-1(1)

Income Tax Assessment Act 1997 subsection 8-1(2)

Income Tax Assessment Act 1997 Division 40

Income Tax Assessment Act 1997 Division 328

Reasons for decision

Question 1

Summary

Yes, the expenditure incurred by Head Co to integrate the XYZ Service’s business into Head Co’s business, other than expenditure incurred to modify Head Co’s website, is deductible under section 8-1 of the ITAA 1997 (ITAA 1997). This expenditure (referred to in the reasons for decision as 'integration expenditure’) is considered to be necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income, satisfying the requirements of subsection 8-1(1), and is not excluded from being deductible under the negative limbs of subsection 8-1(2).

Detailed reasoning

Section 8-1 of the ITAA 1997 is about general deductions. It states that:

(1) You can deduct from your assessable income any loss or outgoing to the extent that:

a) it is incurred in gaining or producing your assessable income; or

b) it is necessarily incurred in carrying on a *business for the purpose of gaining or producing your assessable income.

(2) However, you cannot deduct a loss or outgoing under this section to the extent that:

a) it is a loss or outgoing of capital, or of a capital nature; or

b) it is a loss or outgoing of a private or domestic nature; or

c) it is incurred in relation to gaining or producing your exempt income or your non-assessable non-exempt income; or

d) a provision of this Act prevents you from deducting it.

Accordingly, in order for Head Co to be entitled to a deduction for the integration expenditure under this provision, subsections 8-1(1) and (2) must be satisfied.

Positive limbs:

The integration expenditure must have been incurred in gaining or producing assessable income for Head Co or be necessarily incurred in the carrying on of Head Co’s business for the purpose of gaining or producing assessable income. Therefore a sufficient nexus between the integration expenditure and the carrying on of a business is necessary in order for the satisfaction of this limb.

Head Co is a service provider. Prior to the acquisition of X Pty Ltd, Head Co carried on a pre-existing business in that same sector and had been steadily growing that business. As part of its provision of its services, Head Co enters into funding agreements with various organisations and clients.

Head Co’s business includes acquiring other existing operators to expand its business and increase its revenues. The acquisition of X Pty Ltd is in line with Head Co’s previous growth strategy. Thus, on the facts provided Head Co is carrying on a business of providing services in its sector and continues to expand this business by winning contracts and via the acquisition of existing operators.

In Ronpibon Tin NL v FCT (1948) 78 CLR 47, the court found that

For expenditure to form an allowable deduction as an outgoing incurred in gaining or producing the assessable income it must be incidental and relevant to that end.

Further, in Charles Moore & Co (WAA) Pty Ltd v FCT (1956) 95 CLR 344, Dixon CJ found that:

Phrases like…’incidental and relevant’, when used in relation to the allowability of losses as deductions do not refer to the frequency, expectedness or likelihood of their occurrence…but to their nature or character. What matters is their connection with the operations which more directly gain or produce assessable income.

On this basis the integration expenditure needs to be 'incidental and relevant’ to gaining or producing Head Co’s income from the provision of services and/or the nature of the integration expenditure must have sufficient connection with Head Co’s operations in directly gaining or producing its assessable income. The integration expenditure incurred by Head Co was expended in order to integrate the newly acquired XYZ Service into Head Co’s existing business operations as a service provider.

Such expenditure is considered to be sufficiently connected to Head Co’s operations as a service provider from which it directly gains or produces assessable income.

With regards to the meaning of 'incurred’ for the purposes of section 8-1, Taxation Ruling TR 1997/7 Income tax: section 8-1 - meaning of 'incurred' - timing of deductions (TR 1997/7) states:

4. There is no statutory definition of the term 'incurred'.

5. As a broad guide, you incur an outgoing at the time you owe a present money debt that you cannot escape. But this broad guide must be read subject to the propositions developed by the courts, which are set out immediately below.

6. The courts have been reluctant to attempt an exhaustive definition of a term such as 'incurred'. The following propositions do not purport to do this, they help to outline the scope of the definition. The following general rules, settled by case law, assist in most cases in defining whether and when a loss or outgoing has been incurred:

(a) a taxpayer need not actually have paid any money to have incurred an outgoing provided the taxpayer is definitively committed in the year of income. Accordingly, a loss or outgoing may be incurred within section 8-1 even though it remains unpaid, provided the taxpayer is 'completely subjected' to the loss or outgoing. …

The integration expenditure has been paid by Head Co or is supported by invoices indicating a definitive commitment by Head Co to pay at year end such that the integration expenditure is considered to be incurred for the purposes of section 8-1 on the views provided by TR 1997/7.

Accordingly, the positive limbs at subsection 8-1(1) are satisfied.

Negative limbs:

(a) The loss or outgoing is of capital, or of a capital nature:

There is no statutory criteria for determining whether losses or out goings are of a revenue or capital nature. Taxation Ruling TR 2016/3 Income tax: deductibility of expenditure on a commercial website (TR 2016/3) at paragraphs 159 to 163 provides the following in distinguishing between an outgoing of capital and revenue:

159. The capital/revenue distinction was explained by Dixon J in Sun Newspapers at CLR 359:

The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure, or organization set up or established for the earning of profit and the process by which such an organization operates to obtain regular returns by means of regular outlay, the difference between the outlay and returns representing profit or loss.

160. His Honour went on to identify the following considerations relevant to the capital/revenue characterisation of expenditure in Sun Newspapers at CLR 363:

There are, I think, three matters to be considered, (a) the character of the advantage sought and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment.'

In the subsequent case of Hallstroms at CLR 647, Dixon J stated:

... the contrast between the two forms of expenditure corresponds to the distinction between the acquisition of the means of production and the use of them; between establishing or extending a business organization and carrying on the business; between the implements employed in work and the regular performance of the work in which they are employed; between an enterprise itself and the sustained effort of those engaged in it.

161. Whilst the lasting quality of an advantage is often an indicator of an affair of capital, it is just one factor to be considered under the tests set out by Dixon J in Sun Newspapers at CLR 362 and is not necessarily determinative of whether expenditure is of a capital nature. As the High Court stated in Mount Isa Mines at CLR 147-8:

The fact that no tangible asset or benefit of an enduring kind is acquired as result of the expenditure does not of itself preclude a finding that expenditure is on capital account. It certainly points the way but it is not determinative. Likewise, the recurrence of a specific item of expenditure is not a test; it is a relevant consideration the weight of which depends upon the nature of the expenditure.

and at CLR 153:

While it is certainly true that in some cases the revenue-capital classification has been seen to depend on the nature of the asset or intangible benefit acquired or protected, as we have pointed out, the primary focus of the inquiry has been and must be on the expenditure itself and what it is intended to secure to the business.

162. In Citylink Melbourne, the majority stated (citing Hallstroms and GP International Pipecoaters) at CLR 43:

The characterisation of an outgoing depends on what it 'is calculated to effect', to be judged from 'a practical and business point of view'. The character of the advantage sought by the making of the expenditure is critical.

163. The test is not so much whether the expenditure itself provides an enduring benefit, but whether the expenditure enhances or augments the profit-yielding structure of the business or, on the other hand, whether the expenditure is incurred as a cost of operating the business.

As established, Head Co is carrying on an existing business of providing services through the business structure set out in the facts and it continues to expand this business by winning contracts and via the acquisition of existing operators such as the XYZ Service.

The integration expenditure has been expended with the intention of:

● ensuring that the newly acquired XYZ Service is encompassed into the existing Head Co business structure and to drive business efficiencies through the integration; and

● enabling continuity in providing services to clients.

As part of Head Co’s business includes the acquisition of existing operators, the practical costs of integrating XYZ Service into its existing business structure is considered to be incurred as a cost of operating the business and therefore an outgoing that is of a revenue nature. Consistent with this view, the advantage of business efficiencies and continuity of services to its clients is considered to be in the ordinary course of the business.

It is considered that the integration expenditure does not enhance the existing business structure of Head Co and is not a loss or outgoing that is of capital, or of a capital nature.

(b) The loss or outgoing is of a private or domestic nature:

On the basis of the facts provided, the integration expenditure is not considered to be of a private or domestic nature.

(c) & (d) The loss or outgoing is incurred in relation to gaining or producing your exempt income or your non-assessable non-exempt income; or a provision of this Act prevents you from deducting it:

On the basis of the facts provided, these limbs are not considered to apply.

Accordingly, the negative limbs at subsection 8-1(2) do not apply to prevent the deduction of the integration expenditure.

Therefore the integration expenditure incurred by Head Co to integrate X Pty Ltd into its business is considered to be necessarily incurred in carrying on a business for the purposes of gaining or producing assessable income and is deductible under section 8-1 of the ITAA 1997.

Question 2

Summary

Yes, the expenditure on the website transition is considered to be expenditure on 'in-house software’ under Division 40 of the ITAA 1997. The expenditure on modifying the website is considered to be of a capital nature and is therefore not deductible under the general deduction provisions. However, as the website satisfies the definition of 'in house software’ as provided by TR 2016/3, the expenditure incurred will be deductible as a depreciating asset under Division 40.

Detailed reasoning

The Commissioner provides guidance on the deductibility of expenditure on modifying a commercial website in TR 2016/3. As outlined in paragraph 6 of TR 2016/3, a website is an intangible asset consisting of software and includes software integrated into the website for online use by a website user. As per paragraphs 8 and 9, the deductibility of expenditure on a commercial website under section 8-1 depends upon whether the expenditure is of a capital or revenue nature. Expenditure on a commercial website that is not deductible under section 8-1 (or any other provision outside Divisions 40 and 328) may be 'in-house software’ and deductible under the capital allowances regime.

With regard to acquiring or developing a website, paragraph 18 of TR 2016/3 provides:

Acquiring or developing a website

18. Expenditure incurred in acquiring or developing a commercial website for a new or existing business is capital expenditure. (See Examples 6 and 7 of this Ruling). The expenditure is treated as expenditure on 'in-house software' if:

● the expenditure relates directly to the commercial website

● the commercial website is mainly used by the business for interaction with customers (that is, any copyright in the website is not itself exploited for profit), and

● the expenditure is not deductible under a provision outside Divisions 40 and 328.

With regard to modifying a website and the distinction between revenue and capital expenditure, paragraphs 25 to 27 of TR 2016/3 provide as follows:

Modifying a website

25. The character of expenditure incurred on modifications to a website is a matter of fact and degree. The more significant the change or improvement is to the profit-yielding structure of the business, the more likely the expenditure is capital in nature.

26. The purpose and significance of the website modification and the associated expenditure is to be judged from a practical and business perspective. Factors to be taken into account in determining the character of expenditure incurred in modifying a website include:

● the role of the website in the business

● the nature of the modification to the website and its significance to the business

● the size and extent of the modification

● the degree of planning and level of resources employed in effecting the modification

● the level of approval required for the modification, and

● the expected useful life of the modification.

27. The addition of new functionality to a website, or the upgrading of existing functionality in a website, may add to or enhance the profit-yielding structure of the business rather than being an operational cost. Expenditure on a modification that represents a structural advantage to the business is capital expenditure.

Head Co submits that its website serves an important role in providing information and a place for communicating with existing and prospective customers. As part of the integration of the XYZ Service into the existing Head Co business, the existing XYZ Service website was made redundant and a new website was built on a different platform and transitioned into the Head Co website. The Head Co website hosts content from the range of different Head Co business segments.

In this case, the transition included both “front end” and “back end” costs. The “front end” costs were external consulting costs. This included a new design and content to reflect the updated Head Co corporate style. Resources employed to effect the modifications included support from a digital agency to deliver design and front end development (designers, content writers, developers, project management).

The “back end costs” were internal business technology costs. The existing XYZ Service website was made redundant and a new website built on a platform already used across Head Co’s other businesses. The “back end costs” included a new content management system using the different platform; and module development to support this platform. The website was made scalable to devices such as tablets in order to provide customers with a web experience that is both accessible and user friendly.

The back end developer project was managed by the Head Co Business Technology department and was required to support systems and infrastructure, security, developers and project management; and Head Co marketing resources to facilitate project management and delivery.

Head Co’s total expenditure on the website transition was $xx. The website improvements occurred over a period of months.

To the extent that Head Co’s expenditure on website transition was on acquiring and developing a new website that expenditure is capital in nature as per paragraph 18 of TR 2016/3.

In determining whether Head Co’s expenditure on the website modifications is of a revenue or capital nature, the purpose and significance of the modifications need to be considered.

On the facts submitted, the website modifications included significant improvements to front and back end functionality (as outlined above) in order for the XYZ Service website to be integrated into the existing Head Co website.

In considering each of the factors outlined in paragraph 26 of TR 2016/3, Head Co’s expenditure on website modifications as a whole is considered an upgrade of existing functionality to the website and may add to or enhance the profit-yielding structure Head Co’s business. Therefore the expenditure on the website transition is capital expenditure; which excludes it from being deductible under the general deduction provision (pursuant to subsection 8-1(2) of the ITAA 1997).

With regard to the deductibility of such capital expenditure, TR 2016/3 provides the following at paragraphs 40 to 46:

40. A website is not a depreciating asset under Divisions 40 and 328, except to the extent it can be classified as 'in-house software’.

In-house software

41. Software is 'in-house software’ where it is:

computer software, or a right to use computer software, that you acquire, develop or have another entity develop:

(a) that is mainly for you to use in performing the functions for which the software was developed; and

(b) for which you cannot deduct amounts other than under Divisions 40 and 328.

42. The term 'software’ takes its ordinary meaning for the purposes of Divisions 40 and 328, and may include content.

Software that is 'in-house software’

43. In-house software includes:

(a) software in a commercial website that enables the website owner to interact with the user, where any independent benefit to the user is no more than incidental to the interaction

(b) software provided on a commercial website for installation on the user’s device if its purpose is solely to provide a user interface for interacting with the business, and

(c) content on a website which is incidental to the website and not an asset having value separate from the website.

Software that is not 'in-house software’

44. Application software made available through a commercial website for installation on the user’s device for offline use is a separate asset from the website, and is not 'in-house software’. This includes downloadable software provided on a website for profit-making by sale or licence.

45. Application software made available through a commercial website for online use and provided by the website owner for a main purpose other than enabling the website owner to further interact with the user is a separate asset from the website and is not 'in-house software’.

46. Software associated with a website that does not meet the requirements of the definition of 'in-house software’ is an asset separate from the website. The tax treatment of expenditure on such software, whether capital allowances (in relation to copyright) or capital gains tax, is determined according to the nature of the asset.

In this case, the website transition undertaken by Head Co and its employed external resources was to enable Head Co to better perform its business functions upon the acquisition of XYZ Service. The front and back end functionality upgrades included modifying content to allow scalability to desktop, tablet and mobile platforms and to provide for the ability of the website to be enhanced in the future to cater for customer payments. The enhancement is expected to reduce response times for users, enhance storage efficiency, enable future functionality improvements and reduce maintenance costs. The website enables customers to connect with Head Co around the services it provides.

Further, at paragraphs 100 to 106 of TR 2016/3 the Commissioner provides examples of capital expenditure that would be considered to be 'in house software’ and deductible under Division 40. These examples are analogous with the facts provided in this case. The exclusions from in-house software in paragraphs 44 to 46 of TR 2016/3 do not apply, as they are focused on where a separate asset that is downloaded or the software is not otherwise for interacting with the users of the website.

On this basis, the expenditure incurred on the website transition is considered to fit the requirements of 'in-house software’, can be classified as a depreciating asset and will be deductible under Division 40 in accordance with Paragraph 47 of TR 2016/3.

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