Edited version of your private ruling

Authorisation Number: 1012589910803

Ruling

Subject: General deductions

Question 1

Is the expenditure on Deployment costs for the XY system incurred by Company C, deductible to Company C under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Are the usage fee charges for the XY system, deductible to Company C under section 8-1 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following periods:

1 July 20XX to 30 June 20XY.

The scheme commences on:

1 July 20XX.

Relevant facts and circumstances

Overview

Company C is the head company of a tax consolidated group (TCG). Company B and Company A are related entities of Company C.

Companies A, B and C (the Companies) all use multiple instances of X computer software with variations in business processes. The existing X systems were not adequately meeting the Companies' business requirements.

Following an investigation into possible solutions, the decision was made to standardise business processes across the Companies to reflect best practice and to adopt a single instance X system solution. This became known within the Companies as XY system.

XY system is a key company-wide, business transformation initiative that focuses on business improvement and enhancement that will enable scalable growth while allowing the Companies' businesses to leverage off each other through common processes and metrics supported by one integrated system.

The Companies decided that the XY system will be the only system used within the Companies and has determined, through clear principles and metrics, that all functionality in the XY system must be as standard as possible.

The XY system was built by Company A and deployed in a series of releases to the Companies. Various functions were expanded and updated in subsequent releases.

Deployment costs

Entities within the Companies have incurred expenditure (Deployment costs) in relation to the implementation of the standard business processes developed as part of the XY system and the integration of the XY system into the Companies' businesses. The XY system is a business transformation combined with a system change.

Deployment of the XY system business processes and the XY system is the responsibility of the Companies that will benefit from transitioning onto the XY system. To the extent the Deployment costs have been incurred by members of the TCG, Company C has claimed a deduction for the Deployment costs pursuant to section 8-1 of the ITAA 1997 in the year the costs were incurred.

The Deployment costs incurred enable the TCG members to use the XY system. These costs do not give the TCG members any rights in respect of the use of the XY system.

Under the release model, when new functionality is introduced into the XY system, the new functionality needs to be deployed to those TCG members that are already using the XY system.

Usage fee charges

Company C is charged a usage fee service charge by Company A for the intra-group services related to the XY system. This charge does not result in Company C securing any intellectual property rights in respect of the XY system other than those necessary for the use of the XY system in Company C's businesses.

The usage fee charge is an allocation of the costs incurred by Company A for the development of the XY system to XY system users. The fee is calculated over the expected economic life of XY system proportionate to the anticipated benefit received by users of the XY system.

Company A charges the usage fee to users based on an allocation.

Company C pay the usage fee charges at regular intervals, commencing from the date on which the TCG member begins using the XY system and will continue for several years from that date; reflecting the expected economic life of the XY system to the TCG member.

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 paragraph 40-30(2)

Income Tax Assessment Act 1997 Division 40

Income Tax Assessment Act 1997 Division 328

Income Tax Assessment Act 1997 section 701-1

Income Tax Assessment Act 1997 subsection 995-1(1)

Reasons for decision

All legislative references are to the Income Tax Assessment Act 1997.

Issue 1

Question 1

Summary

The expenditure on Deployment costs for the XY system incurred by Company C, is deductible to Company C under section 8-1.

Detailed reasoning

Single entity rule

Pursuant to section 701-1 (the single entity rule) Company C, as the head company of the income tax consolidation group, is taken for income tax purposes to incur the Deployment costs and usage fee charges.

Section 8-1

The Deployment Costs will be deductible under section 8-1 if either of the positive limbs in subsection 8-1(1) are satisfied and it does not fall within any of the negative limbs in subsection 8-1(2). The relevant negative limb is paragraph 8-1(2)(a), which denies a deduction to the extent that the expenditure is capital, or of a capital nature.

Positive Limb

In operating its business, Company C has undertaken the business improvement project of developing and then deploying the XY system to the subsidiary members to improve operational efficiency and achieve operational excellence through increasing revenue and decreasing costs.

Company C (and its subsidiary members) have incurred expenditure on Deployment Costs for each release of the XY system, for the sole purpose of integrating the standard business processes and the integration of the XY system into the businesses of Company C, to enable Company C to use the XY system. The deployment of the XY system business processes and the XY system is the responsibility of Company C as they will benefit from transitioning onto the XY system. Such expenditure is a loss or outgoing incurred for the purpose of subsection 8-1(1).

All members of the Companies, including Company C, need to be using the XY system that is supported by the XY system in order to obtain the benefits of the XY system. Many of the benefits of the XY system result from reducing the cost of the functions of the Companies that are performed centrally and the ability to monitor company-wide information. These benefits can only be obtained if all members of the Companies are using the XY system.

Accordingly, there is a sufficient nexus between the expenditure incurred by Company C on the Deployment costs for each release of the XY system and the derivation of its assessable income (Herald and Weekly Times Ltd v FCT (1932) 48 CLR 113; (1932) 2 ATD 169), Amalgamated Zinc (De Bavay's) Ltd v FCT (1935) 54 CLR 295; (1935) 3 ATD 288, W Nevill & Co Ltd v FC of T (1937) 56 CLR 290; 4 ATD 187; (1937); 1 AITR 67, Ronpibon Tin NL v FCT (1949) 78 CLR 47; 4 AITR 236; (1949) 8 ATD 431, Charles Moore & Co (WA) Pty Ltd v FCT (1956) 95 CLR 344; (1956) 6 AITR 379; (1956) 11 ATD 147).

Negative Limb

To consider whether the outgoing is of a capital nature, Dixon J observed in Sun Newspapers Ltd v. FC of T (1938) 61 CLR 337 (Sun Newspapers) at 359 in explaining the capital versus revenue distinction as the difference:

'between the business entity, structure, or organisation set up or established for the earning of profit and the process by which such an organisation operates to obtain regular returns by means of regular outlay, the difference between the outlay and the returns representing profit or loss.

The identification of what expenditure is calculated to effect involves both a consideration of the character of the expenditure and, in many cases, an examination of the business structure and the operations of the business in the course of which the expenditure has been incurred.'

Reference is made to Taxation Ruling TR 98/13 - Income tax: deductibility of year 2000 (millennium bug) expenses (withdrawn). Whilst the taxation ruling was not intended to apply to expenditure on software acquired or developed other than in relation to Y2K compliance the following paragraphs on the relevance of the Sun Newspaper principles are useful.

Paragraph 35 recognises:

'Although the repair/improvement terminology is limited in its application to computer software, it does indicate the approach taken by the courts in applying the Sun Newspapers' test to work done on a capital asset. The test is not so much whether the expenditure itself provides an enduring benefit, but whether the expenditure enhances the asset itself so as to add to the structure of the business, or whether the expenditure is part of day to day processes of the business in operating its assets. This is an important qualification, because it is inappropriate to apply an enduring benefit test to work done on computer software of a capital nature, which by its nature does not suffer from wear and tear such that the work done would (subject to obsolescence) always provide an enduring benefit.'

Paragraph 36 adds further:

'It is the character of the expenditure at the time it is incurred that is relevant. …. The expenditure is not incurred to enhance the software so as to add to the structure of the business itself, but is part of the day to day processes of the business to keep its software operational. Such expenditure would be of a revenue nature.'

A further distinction is contained in paragraph 38:

'However, where the work done to make software Y2K compliant results in what is, in essence, the original software being substantially rebuilt, it produces a different software system and the expenditure is treated as being incurred in acquiring a new software program….'

The Deployment cost expenditure is made to integrate the XY system built by Company A into Company C (and its subsidiary members).

The Deployment cost expenditure represents work completed to successfully integrate the business processes and the XY system into the way Company C undertakes its business activities. Under the release model, when new functionality is introduced into the XY system, the new functionality needs to be deployed to those Company C businesses that are already using the XY system. On this basis, the deployment of the XY system is an ongoing process. The advantage sought by the expenditure made by Company C on deployment is operationalising the standard business processes developed as part of the XY system so that Company C is able to use the XY system following each release.

Consequently, the XY system enables Company C to carry on its business in a more effective and cost efficient manner due to Company C users increased ability to monitor company-wide information. These costs do not give Company C any rights in respect to the use of the XY system or the intellectual property as developed as part of XY system.

For Company C, the Deployment costs are not regularly incurred, each release is operationalising the standard business processes developed as part of that release. Consequently, the Deployment Costs did not create, acquire or enhance an asset to add to Company C's business structure but are part of day to day processes in operating its ordinary business which enables Company C to use the XY system in their operations in an effective and effective manner.

The essential character of the outgoings in question is that of revenue and not capital, for the reasons explained.

Therefore, the Deployment Costs incurred by Company C for each release of the XY system is not a loss or outgoing of a capital nature and will not fall within any of the negative limbs in subsection 8-1(2).

Conclusion

The expenditure on Deployment Costs for each release of the XY system incurred by Company C is deductible to Company C under section 8-1.

Question 2

Summary

The usage fee charges for the XY system, are deductible to Company C under section 8-1.

Detailed reasoning

Subsection 40-30(2) provides that in-house software, that is not trading stock, is a depreciating asset. The definition of 'in-house software' in subsection 995-1(1) excludes computer software, or a right to use computer software, for which you can deduct amounts under a provision of the ITAA 1997 outside of Divisions 40 and 328. Therefore, where amounts can be deducted for software (or the right to use software) under another provision, such as section 8-1, the software is not in-house software and will not be a depreciating asset for the purposes of Division 40.

Section 8-1

The usage fee charges will be deductible under section 8-1 if either of the positive limbs in subsection 8-1(1) are satisfied and it does not fall within any of the negative limbs in subsection 8-1(2). The relevant negative limb is paragraph 8-1(2)(a), which denies a deduction to the extent that the expenditure is capital, or of a capital nature.

Positive Limb

In operating its business, Company C needs to continually undertake business improvement projects that are designed to improve operational efficiency and achieve operational excellence through increasing revenue and decreasing costs.

The XY system is a key company-wide, business transformation initiative that focuses on business improvement and enhancement that will enable scalable growth while allowing the Companies' businesses to leverage off each other through common processes and metrics supported by one integrated system. The XY system will enable company-wide information to be monitored by allowing the provision of information and means to manage the business effectively in a decentralised environment. Consequently, the usage of the XY system is integral to the production of business income in a more effective and cost efficient manner.

The usage fee charge is an allocation of the costs incurred by Company A for the development of the XY system to XY system users, this includes Company C and its subsidiary members. The usage fee charge is allocated using an allocation key which is attributable to the level of use of the XY system by Company C in its business. This basis of allocation indicates that there is a direct correlation between the usage fee charges and the actual use of the XY system by Company C in its business operations.

Accordingly, there is a sufficient nexus between the expenditure incurred by Company C on the usage fee charges for the XY system and the derivation of its assessable income (Herald and Weekly Times Ltd v FCT (1932) 48 CLR 113; (1932) 2 ATD 169), Amalgamated Zinc (De Bavay's) Ltd v FCT (1935) 54 CLR 295; (1935) 3 ATD 288, W Nevill & Co Ltd v FC of T (1937) 56 CLR 290; 4 ATD 187; (1937); 1 AITR 67, Ronpibon Tin NL v FCT (1949) 78 CLR 47; 4 AITR 236; (1949) 8 ATD 431, Charles Moore & Co (WA) Pty Ltd v FCT (1956) 95 CLR 344; (1956) 6 AITR 379; (1956) 11 ATD 147).

Negative Limb

The usage fee service charges are incurred by Company C in performing its business processes and functions in respect to their business for the purpose of gaining assessable income. A loss or outgoing cannot be deducted under section 8-1 to the extent that it is a loss or outgoing of capital, or of a capital nature (paragraph 8-1(2)(a)). The issue is whether the usage fee service charges to secure the intra-group services related to the use of the XY system in its business are on capital or revenue account.

The lead Australian authority on this issue is the judgment of Dixon J in Sun Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 23; (1938) 1 AITR 403. Dixon J outlined the following three matters to be considered in distinguishing between revenue and capital outgoings at 363:

'(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.'

The advantage sought by Company C for paying the regular usage fee service charge is to secure the intra-group services related to the use of XY system in their business. As stated above, the usage fee service charge represents the recovery costs incurred by Company A for the development of the XY system. Company C does not secure any intellectual rights in respect of the XY system. The fee is calculated over the expected economic life of XY system proportionate to the anticipated benefit received by Company C users.

The use of the allocation corresponds with the level of use of the XY system by Company C in its business. This basis of allocation indicates that there is a direct correlation between the usage fee charges and the actual use of the XY system by Company C in its business operations. To this end, the basis applying to the XY system usage fee service charge suggests the expenditure is of a recurrent nature and does not provide any enduring benefit.

The manner in which the XY system will be used by Company C is in performing its business processes and functions. These business processes and functions are integral to how Company C carries on its business and produce assessable income.

Further, the payment of the usage fee service charge on a regular basis represents a periodic outlay that secures the intra-group services related to the use of the XY system for a period that is commensurate with those payments. Each usage fee service charge features all the traditional characteristics of an outgoing on revenue account, that is, it does not give rise to any enduring benefit for the taxpayer; and it is a recurrent, repeated or continual cost to the business rather than a final or 'once and for all' payment. Rather than replacing or enlarging the profit-yielding subject of Company C's business, the usage fee service charges are costs that are necessarily incurred in operating their business.

Conclusion

For these reasons it is considered that the usage fee service charges are not outgoings of capital or of a capital nature under paragraph 8-1(2)(a). Therefore, the usage fee charges for the XY system, are deductible to Company C under section 8-1.