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Ruling

Subject: Deductibility of cost of developing software applications

Question

Are you entitled to depreciation for the cost of developing software applications?

Answer

Yes

This ruling applies for the following period

Year ended 30 June 2011

The scheme commenced on

1 July 2010

Relevant facts

You have developed two software applications for the Gadget.

You have incurred upfront expenses to pay developers and programmers that you contracted to write the codes for the applications.

There may also be some ongoing expenses for improvements on the applications.

You have not previously carried on a business relating to the creating and developing of software applications.

Your intention is to create some Gadget applications. Currently there are only two applications being developed.

You do not have a formal business plan but you intend to make a profit from the applications. You plan to increase sales of your applications by exposing them to the public. You state it is difficult to have a business plan as it is unknown how many people will start using the applications.

You advise that the application is owned by you and can be withdrawn at any time.

You state that the agreement can be described as a commission agreement as every time someone downloads the application you receive 70% of the amount. Alternatively, if the user on the interest purchases 'credits' 70% of those credits go to you. You describe it as 'a combination of a commission/royalty agreement'.

You plan to develop further applications.

As the other Gadget sales continue to increase, the applications will most likely be developed for both platforms.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Taxation Ruling TR 93/12 Income Tax: computer software, looks at the income tax implications arising from the development and marketing of computer software.

Paragraphs 11 and 15 of TR 93/12 outline what a computer program is and the treatment for copyright purposes.

'11. A computer program as distinct from its carrying medium is in essence knowledge or information; it is an item of intellectual property. The carrying medium is tangible property, but the computer program is intangible property. It is strictly not the carrying medium but what is stored on the carrying medium (i.e. the computer program) which constitutes software.'

'15. By the Copyright Amendment Act 1984, assented to on 15 June 1984, The Copyright Act 1968 (Cth) (the Copyright Act) was amended to protect computer software as a literary work and to clarify the nature and scope of that protection having regard to the distinctive features of computer software. The amendments specifically includes computer programs in the existing copyright category of "literary works" and gives to computer programs the protection applied to literary works.'

As a result of the operation of the Copyright Act, you as creator of the software application automatically become the owner of copyright (an intangible asset) to the software applications you have developed. Copyright is not something that you have to 'apply for'.

Capital Expenditure

The courts have held that, in the absence of special circumstances, expenditure is capital in nature where it is made with the view to bringing into existence an asset or an advantage (tangible or intangible) for an enduring benefit. It is the nature of the advantage sought by the taxpayer that is relevant.

In your case, the software applications were developed by you to derive assessable income by exploiting the copyright in the application so as to derive licence fees, and not to use the software in your own operations.

The copyright in the applications provides an enduring benefit. Therefore the expenditures directly incurred to develop the content of the applications would be considered of a capital nature.

Therefore a deduction is not allowable under section 8-1 of the ITAA 1997 for the cost of developing the applications, but the expenses may be deductible under Division 40 of the ITAA 1997.

Deductions for capital assets

You can deduct an amount equal to the decline in value for an income year of a depreciating asset under subsection 40-25(1) of the ITAA 1997. A depreciating asset is, broadly, defined in subsection 40-30(1) as an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used. While intangible assets are generally excluded from the definition, subsection 40-30(2) specifically includes items of intellectual property as depreciating assets, provided they are not trading stock.

The definition of intellectual property is found within section 995-1 of the ITAA 1997. It includes the rights that an entity has under a Commonwealth Law as the owner, or licensee of a copyright or the equivalent rights under a foreign law.

The creation of the new software applications entitles you to the intellectual property rights as owner of the program in which copyright subsists. As an item of intellectual property, copyright (in a computer program or software application) is a depreciating asset (Paragraph 40-30(2)(c) of the ITAA 1997).

The developer's services included writing the code for the Gadget applications from information supplied by you. It is considered that you legally own the copyright to the software applications and you are free to migrate them to any alternative providers/mediums.

The cost of a depreciating asset that a taxpayer holds consists of two elements: namely, the first element of cost and the second element of cost as outlined under section 40-175 of the ITAA 1997.

The first element of cost of a depreciating asset includes all capital amounts paid to hold the depreciating asset and is worked out under section 40-185 of the ITAA 1997.

As the creation of the copyright necessarily entails bringing into existence the subject matter which it protects, the first element of cost of copyright includes capital amounts incurred directly in creating the subject matter which the copyright protects.

In this case, the first element of cost of the copyright includes all capital costs directly incurred by the taxpayer in developing the application. In your case, this will include amounts paid to developers and programmers writing code for the Gadget applications.

For Division 40 purposes, second element costs are the capital amounts that are taken to have been paid to bring a depreciating asset to its present condition and location from time to time (section 40-190 of the ITAA 1997).

Section 40-95 of the ITAA 1997 outlines the choices available of determining the effective life for depreciating assets. There is an exception for intangible depreciating assets in subsection 40-95(7) of the ITAA 1997. The effective life of copyright is shown at item 5 in the table as the shorter of 25 years or the period until the copyright ends. This means that you do not have the option to determine your own effective life for copyright.

You will be able to claim a deduction for the capital expenses incurred in developing the copyright in the applications under Division 40 of the ITAA 1997 based on an effective life of 25 years.

Treatment of expenditure on improvements.

In your case, there may be some ongoing expenses for improvements to the applications. If the improvement enhances the software, the expenditure will be on capital account and depreciable over 25 years. However, for each of the changes that are made, it will be necessary to determine whether the expenditure is of a revenue or capital in nature.