Edited version of your private ruling

Authorisation Number: 1012589958545

Ruling

Subject: Software development pool and general deductions

Question 1

Can the Development costs for each release of the XY system incurred by Company A as the head company of the Company A tax consolidated group (TCG) be allocated to a software development pool pursuant to subsection 40-450(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Is the expenditure on Deployment Costs for each release of the XY system incurred by each member of the TCG, deductible to Company A 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 A is the head company of a tax consolidated group (TCG). Company B and Company C are related entities of Company A.

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.

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.

Development costs

Company A entered into development agreement with Company B to design, build and implement services for the XY system. This agreement related only to the development of the XY system.

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

All costs associated with the development of the XY system were incurred by Company A.

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 A 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 by the members within the TCG enable the members of the TCG to use the XY system. These costs do not give the members of the TCG 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 members of the TCG that are already using the XY system.

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 subsection 40-25(1)

Income Tax Assessment Act 1997 paragraph 40-30(2)(d)

Income Tax Assessment Act 1997 subsection 40-450(1)

Income Tax Assessment Act 1997 subsection 40-450(2)

Income Tax Assessment Act 1997 subsection 40-450(3)

Income Tax Assessment Act 1997 subsection 40-450(4)

Income Tax Assessment Act 1997 Division 46 (repealed as of 30 June 2001)

Income Tax Assessment Act 1997 section 701-1

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

Reasons for decision

All legislative references in this Ruling are to the ITAA 1997 unless otherwise stated.

Question 1

Summary

The Development Costs for each release of the XY system incurred by Company A as the head company of the Company A tax consolidated group (TCG) can be allocated to a software development pool (SDP) pursuant to subsection 40-450(1) upon satisfaction of the conditions contained in subsections 40-450(2) to (4).

Detailed reasoning

Under the Uniform Capital Allowances rules, you can choose to allocate to a SDP expenditure you incur in developing (or having developed) in-house software you intend to use solely for a taxable purpose; section 40-450.

'In-house software' is a defined term in subsection 995-1(1):

'in-house software' is computer software, or a *right to use computer software, that you acquire, develop or have another entity to 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 under a provision of this Act outside Divisions 40 and 328.

The definition of in-house software is explained in the Explanatory Memorandum to the Taxations Laws Amendment (Software Depreciation) Bill 1999 (EM) that introduced former Division 46. This is confirmed in paragraph 1.18 of the Explanatory Memorandum to the New Business Tax System (Capital Allowances) Bill 2001:

The treatment of in-house software in this Bill does not however, represent an in-substance change in the way in which software is treated. Previously software on which you incur expenditure was treated as if it were plant and now in-house software that satisfies the definition is a depreciating asset.

The EM states in paragraph 31 that former Division 46 is intended to apply to software that 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 former 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 former Division 46.

Computer software, or a right to use computer software, that you acquire, develop or have another entity develop that is mainly for you to use in performing the functions for which the software was developed is in-house. In-house software is a depreciating asset (paragraph 40-30(2)(d)) in respect of which a deduction for decline in value is available (subsection 40-25(1)) or amounts of expenditure incurred can be allocated to a SDP (section 40 450).

Company A incurred expenditure to develop the XY system to be used across the Companies. Expenditure incurred by Company A in developing the XY system is taken to be expenditure incurred Company A.

The XY system is not developed for the purpose of being sold but developed for integrated use in the businesses of the Companies. The main purpose of developing the XY system is to improve the in-house software of the Companies (including Company A) by developing a single, fully integrated XY based system. The occurrence of a single, fully integrated XY system is the main function for which the software was developed. It is mainly designed to function conjointly for the Companies (including Company A) and to be used conjointly by the Companies. Therefore, the XY system is mainly for Company A to use in performing the functions for which it was developed and therefore satisfies the definition of in-house software.

Expenditure on in-house software may only be pooled if the following conditions are satisfied:

(1) the expenditure must be incurred in developing or commissioning computer software (subsection 40-450(1));

(2) a separate SDP must be created for each income year for which an amount of expenditure on developing or commissioning in-house software is incurred (subsections 40-450(2) and (4)); and

(3) the taxpayer must intend to use the in-house software solely for 'taxable purposes' (subsection 40-450(3)).

Condition 1:

Company A commissioned Company B with developing the XY system by configuring and customising core XY software for the Companies' internal business purposes only.

The Development Costs are paid by Company A to Company B and are taken to be expenditure incurred by Company A. For the purposes of allocating expenditure incurred for the development of the XY system under section 40-450, Company A is the relevant taxpayer.

The Development Costs incurred for each release of the XY system do not include costs incurred to use the core SAP software. The Development Costs incurred for each release of the XY system are incurred by Company A since 20XX to develop and modify XY software into the XY system. The expenditure incurred by Company A relates to all expenditure incurred by the Company B and is for the development of in-house software (subsection 40-450(1)). Condition 1 is satisfied.

Condition 2:

Company A chose to allocate the Development Costs incurred for each release to a SDP since the year ended 30 June 20XX (subsection 40-450(1)).

All expenditure on developing in-house software that is incurred after the SDP is created (whether in that income year or in a later year) must be allocated to a SDP (subsection 40-450(2)).

Company A advised that Development Costs for each release incurred in each income year were allocated to separate software development pools (subsection 40-450(4).

Condition 2 is satisfied when all expenditure on developing in-house software that is incurred is allocated to a SDP for each income year.

Condition 3:

Condition 3 requires Company A to use the in-house software solely for taxable purposes. The meaning of taxable purpose is contained in subsection 40-25(7):

(a) the *purpose of producing assessable income; or

(b) the purpose of *exploration or prospecting; or

(c) the purpose of *mining site rehabilitation; or

(d) *environmental protection activities.

The XY system is a single, standardised, integrated system which enables scalable growth while allowing the Companies' businesses to leverage off each other through common processes and metrics. The XY system enables company-wide information to be monitored to manage the business effectively in a decentralised environment.

The XY system is developed for the purpose of producing assessable income and is used solely for taxable purposes. Condition 3 is satisfied.

Company A may choose to allocate amounts of expenditure incurred for each release to develop the XY system in an income year to a software development pool pursuant to subsection 40-450(1) upon satisfaction of the conditions contained in subsections 40-450(2) to (4).

Question 2

Summary

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

Detailed reasoning

Single entity rule

Pursuant to section 701-1 (the single entity rule) Company A, as the head company of the income tax consolidated group, is taken for income tax purposes to incur the Deployment Costs for each release of the XY system.

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 A 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 A (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 A, to enable Company A and the subsidiary members to use the XY system. Such expenditure is a loss or outgoing incurred for the purpose of subsection 8-1(1).

All members of the Companies need to be using 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 A 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 the Company B into the Company A businesses.

The Deployment Cost expenditure represents work to successfully integrate the business processes and XY system into the way the Company A entities undertake their business activities. The deployment work completed does not relate to the construction or upgrade of the software. The activities carried out do not change the XY system. That work is undertaken by the Company B as part of the development of the XY system.

The Deployment Costs are incurred to prepare the Company A businesses for each release. Company A can only use the XY system, if the deployment work for each release is undertaken. The advantage sought is operationalising the standard business processes developed as part of the XY system so that Company A is able to use the XY system following each release.

For Company A, the Deployment Costs are not regularly incurred, each release is operationalising the standard business processes developed as part of that release. Further there was no asset created or acquired, and no long term enduring benefit to the capital or profit making structure of Company A's business. The benefit for Company A is not an enlargement of the framework from which Company A carries on its ordinary activities but the benefit of enabling Company A to use the XY system in their operations in an 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 for each release incurred 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 Deployment Costs incurred by Company A (as head company of the tax consolidated group) in respect each release will be allowable deductions under section 8-1 in the year they are incurred.