Edited version of your written advice

Authorisation Number: 1051358479618

Date of advice: 11 April 2018

Ruling

Subject: App development expenses

Question 1

Are the expenses you incurred in relation to the development of a mobile application (the App) deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer:

No.

Question 2:

Are the expenses you incurred in relation to the development of the App deductible under section 25-40 of the ITAA 1997?

Answer:

No.

Question 3:

Is the App a capital gains tax (CGT) asset under section 108-5 of the ITAA 1997?

Answer:

Yes.

Question 4:

Do the expenses incurred in relation to the development of the App form part of the cost base or reduced cost base of the App?

Answer:

Yes.

Question 5:

Was there a CGT event in the year ended 30 June 20XX with respect to the App?

Answer:

No.

Question 6:

Is a deduction allowable under section 40-880 of the ITAA 1997 for the expenses incurred in relation to the development of the App?

Answer:

No.

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ended 30 June 20XX

The scheme commenced on

1 July 20XX

Relevant facts and circumstances

You commenced developing an idea for a mobile application (the App) in the 20XX income year.

You prepared a business plan in relation to the App.

You stated in your private ruling application that: ‘it was always my intention to derive ongoing revenue streams which would in turn increase the value of the App for potential resale’.

You engaged a company that provides mobile application and computer software development services to commence the development of the App.

After a period you terminated the develop of the App as it was unlikely the development of the App would be profitable both in terms of ongoing revenue streams and increasing the value of the App for future sale.

You hold the intellectual property rights for the App.

No prototype or working App was developed.

You are employed full-time in a field not related to information technology.

You spent on average 28 hours a week on the activity

You do not hold any licences or qualifications to develop Apps.

You have not been involved in the creation of Apps previously.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 995-1.

Income Tax Assessment Act 1997 section 6-5.

Income Tax Assessment Act 1997 section 8-1.

Income Tax Assessment Act 1997 section 15-15.

Income Tax Assessment Act 1997 section 25-40.

Income Tax Assessment Act 1997 subsection 25-40(1)

Income Tax Assessment Act 1997 subsection 25-40(2).

Income Tax Assessment Act 1997 section 40-30.

Income Tax Assessment Act 1997 section 40-85.

Income Tax Assessment Act 1997 subsection 40-95(7).

Income Tax Assessment Act 1997 section 40-185.

Income Tax Assessment Act 1997 section 40-285.

Income Tax Assessment Act 1997 paragraph 40-295(1)(a).

Income Tax Assessment Act 1997 section 40-300.

Income Tax Assessment Act 1997 section 40-880

Income Tax Assessment Act 1997 subsection 40-880(1).

Income Tax Assessment Act 1997 subsection 40-880(5).

Income Tax Assessment Act 1997 paragraph 40-880(5)(a).

Income Tax Assessment Act 1997 paragraph 40-880(5)(f).

Income Tax Assessment Act 1997 section 108-5.

Income Tax Assessment Act 1997 section 118-24.

Reasons for decision

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

Overall summary

You are not entitled to a deduction under section 8-1 for the reasons explained further below. Although your intellectual property rights in relation to the unfinished App is a CGT asset, if you cease to hold the asset in the future, any capital gain or loss from the CGT event will be disregarded as the tax consequences will be dealt with as a balancing adjustment to a depreciating asset. This is because your CGT asset is also a depreciating asset. Although you will not be able to claim any depreciation deductions if you never use the asset, or have it ready to use, to earn income, you may be entitled to a balancing adjustment deduction if you cease to hold the asset. As your expenditure on the App is taken into account through the depreciating asset provisions, you are not entitled to a deduction under section 40-880.

Detailed explanation

Section 8-1

Section 8-1 allows you to claim a deduction for a loss or outgoing that is incurred in gaining or producing your assessable income, or necessarily incurred in carrying on a business to gain or produce assessable income. These deductions are limited by the exclusion of losses or outgoings that are capital, private or domestic in nature.

Capital expenses

Expenses of capital, or of a capital nature, cannot be claimed as a deduction under section 8-1.

An expense will usually be capital in nature where it is incurred with the intention to create an asset or advantage of a lasting and enduring nature (British Insulated & Helsby Cables Ltd v. Atherton (1926) AC 205; (1926) 10 TC 155).

Capital expenditure often produces an enduring benefit, that is, the structure of the advantage or asset. Revenue expenditure is often repetitious or recurring in nature and often does not produce assets or advantages of an enduring nature.

Carrying on a business

Subsection 995 states the term ‘business’ includes any profession, trade, employment, vocation or calling, but does not include occupation as an employee. The question of whether a business is being carried on is a question of fact and degree to be determined on a case by case basis.

To determine whether an activity, or series of activities, amounts to a business, the activity needs to be considered against the indicators of a business established by case law.

In the High Court of Australia case of Hope v. Bathurst City Council (1980) 144 CLR 1; (1980) 29 ALR 577; (1980) 80 ATC 4386; [1980] HCA 16, a business was described in the following ways:

It is the words “carrying on'' which imply the repetition of acts and activities which possess something of a permanent character.

…activities engaged in for the purpose of profit on a continuous and repetitive basis.

Transactions were entered into on a continuous and repetitive basis for the purpose of making a profit…manifested the essential characteristics required of a business.

The Commissioner’s view on whether a taxpayer is carrying on a business is found in Taxation Ruling TR 97/11 (TR 97/11) which uses the following indicators to determine whether a taxpayer is carrying on a business:

● whether the activity has a significant commercial purpose or character;

● whether there is repetition and regularity of the activity;

● whether the activity is of the same kind and carried on in a similar manner to that of the ordinary trade in that line of business;

● whether the activity is planned, organised and carried on in a businesslike manner such that it is directed at making a profit;

● the size, scale and permanency of the activity; and

● whether the activity is better described as a hobby, a form of recreation or a sporting activity.

In determining whether a taxpayer is carrying on a business, no one indicator will be decisive. The indicators must be considered in combination and as a whole. Whether a business is being carried on depends on the large or general impressions gained.

In your case you had an idea for an App and took steps to have the App developed. Your intention was to derive ongoing revenue streams which would in turn increase the value of the App for potential resale. You have not been involved in the creation of Apps previously, have no qualifications in App development and are employed full time in a separate field.

Generally the creation of a single asset that is to be held to generate an income stream and for potential resale sometime in the future would not constitute the carrying on of a business.

Although activities are undertaken in the creation of the asset these are not permanent continuous repetitive activities that would occur throughout the entire period that income was to be earned from the undertaking.

For a person to be carrying on a business of developing Apps it is considered that they would have to have developed, or be developing, multiple Apps. This would be required so that there is repetition and regularity to the undertaking such as creating ideas and designs for Apps, engaging or employing designers or computer software developers, register their designs, creating development accounts, developing prototypes and Apps and undertaking activities in relation to selling and marketing their products to the general public for sale.

A situation analogous to yours is where a person develops a single property with the intention of earning rental income and a gain on a possible sale sometime in the future. The person in this situation would not be considered to be carrying on a business in relation to the property. Also, the costs of developing the property would be capital in nature and therefore not deductible under section 8-1.

In your private ruling application you referred to FCT v. Walker (1984) 84 ATC 4553 (Walker’s Case). The issue in that case was whether a cattle breeding business was being carried on. Your case involves the development of a single asset which would be held to generate an income stream and for possible resale at some point in the future for a profit. We consider that Walker’s Case can be distinguished from yours as the income earning activities in each case are substantially different.

Isolated transaction

Alternatively, it is your view that the expenses you incurred to develop the App are deductible as a loss arising from carrying on or carrying out a profit-making undertaking.

The Commissioner’s view on profits and losses from an isolated transaction are outlined in Taxation Rulings TR 92/3 Income tax: whether profits on isolated transactions are income and Taxation Ruling TR 92/4 Income tax: whether losses on isolated transactions are deductible respectively.

However, from the explanation and examples in TR 92/3 and TR 92/4, it is considered that these rulings don’t apply to a situation where a taxpayer acquires an asset with the intention of receiving an income stream from it but with the possibility of also making a gain on the potential sale at some point in the future.

Also, it is noted that you still own the intellectual rights to the App. Even if TR 92/4 applied to your situation, a loss on an isolated transaction is only deductible when the transaction is completed and the loss can be conclusively determined. As you still own the intellectual rights to the App the transaction has not been completed.

Summary

It is not considered that you were carrying on a business or entitled to a deduction for a loss from an isolated transaction. In any case, it is considered that the expenses in developing the App are capital in nature as they were incurred in order to provide an enduring benefit, that being, an asset that would generate an income stream. As the expenses are capital in nature, they are not deductible under section 8-1.

Section 25-40

Subsection 25-40(1) states:

You can deduct a loss arising from the carrying on or carrying out of a profit-making undertaking or plan if any profit from that plan would have been included in your assessable income by section 15-15 (which is about profit-making undertakings and plans).

Subsection 15-15(2) states:

This section does not apply to a profit that:

(a) is assessable as *ordinary income under section 6-5; or

(b) arises in respect of the sale of property acquired on or after 20 September 1985.

You have stated that ‘it was always my intention to derive ongoing revenue streams which would in turn increase the value of the App for potential resale’.

The revenue streams would have been assessable as ordinary income under section 6-5. Also any profit made on the sale of the App would have been a profit arising in respect of the sale of property acquired on or after 20 September 1985. Therefore, subsection 15-15(2) would have applied to exclude any gain made from the App from being assessable under section 15-15.

As stated above, a deduction under section 25-40 for a loss from a profit-making undertaking or plan is only allowable where if a profit was made from that undertaking or plan, that profit would have been been assessable under section 15-15.

In your case, if you had of made a profit from the development of the App, it would not have been assessable under section 15-15.

Therefore, you are not entitled to a deduction under section 25-40.

Capital gains tax (CGT)

You make a capital gain or capital loss when a CGT event happens to a CGT asset.

Section 108-5 provides that a CGT asset is any kind of property or a legal or equitable right that is not property.

Intellectual property is a CGT asset. Therefore, the disposal of intellectual property will have capital gains tax implications. That is, the disposal of an item of intellectual property will give rise to CGT event A1.

The cost base of a CGT asset is generally the cost of acquiring the asset, plus certain other costs associated with holding and disposing of the asset (section 110-25).

Your intellectual property rights in relation to the App is a CGT asset and the costs incurred in developing the App are included in the cost base, or reduced cost base.

As you still hold the intellectual property rights in relation to the App, no CGT event has yet happened to the CGT asset.

However, you should note that section 118-24 provides that a capital gain or loss from a CGT event is disregarded if the asset is a depreciating asset, where its decline in value was worked out under Division 40, or would have been if the asset had been used. Division 40 contains the rules for the treatment of depreciating assets for income tax purposes.

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. 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.

In your case, you hold intellectual property rights to the App, that is, copyright to the App. A deduction for the capital expenses incurred in developing the copyright is based on an effective life of 25 years (subsection 40-95(7)). In working out the cost of your intellectual property you may include the expenses to develop the App as part of the first element of the cost of that copyright (section 40-180).

However, you can only start claiming a depreciation deduction in relation to your copyright if you start using if for a taxable purpose or you have it ready to use for a taxable purpose. As the App is not completed you have not started using it and it is not ready to use for a taxable purpose so you are not able to claim a depreciation deduction until that changes.

Although you may never claim a depreciation deduction in relation to your copyright, if you stop holding it, for example, if you sell the copyright in relation to the unfinished App, a balancing adjustment event will happen (paragraph 40-295(1)(a)).

Subsection 40-285(2) states that you can deduct an amount if a balancing adjustment event occurs to a depreciating asset you held whose decline in value you would have worked out under Subdivision 40-B if you had of used the asset and the asset’s termination value is less than its adjustable value.

Generally an asset’s termination value is the amount received and its adjustable value is its cost less any decline in value.

If you dispose of your copyright of the unfinished App before you ever use it or have it ready to use then the adjustable value is its cost, that is, your expenses in developing the App. You would not have to subtract any amount for decline in value as there would be no decline in value because you never used the asset or had it ready to use.

Therefore, if on the disposal of the asset you receive no amount, or the amount is less than the cost of the asset, you will be entitled to a deduction in relation to the balancing adjustment event for the amount the cost exceeded the amount received.

However, if on the disposal of the asset you receive an amount greater than the cost of the asset then the difference would be assessable income (subsection 40-285(1)).

Summary

If in the future you cease to hold the copyright to the unfinished App, any capital gain or loss from the CGT event will be disregarded as the tax consequences will be dealt with as a balancing adjustment.

If you never used the copyright or had it ready to use as you never finished the App then you would never have been entitled to any depreciation deductions.

If on ceasing to hold the asset, you received no amount or an amount less than its cost, then you would be entitled to a balancing adjustment deduction for the difference.

Section 40-880

The object of section 40-880 is to make certain business capital expenditure deductible over 5 years if:

a) the expenditure is not otherwise taken into account; and

b) the deduction is not denied by some other provision; and

c) the business is, was or is proposed to be carried on for a taxable purpose.

There are however some limitations and exceptions to the deductibility of these costs.

Subsection 40-880(5) states that you cannot deduct anything under section 40-880 for an amount of expenditure incurred to the extent that it:

● forms part of the cost of a depreciating asset (paragraph 40-880(5)(a))

● is taken into account in working out the amount of a capital gain or capital loss from a CGT event (paragraph 40-880(5)(f)).

As noted above, the expenditure for the development of the App forms part of the cost of a depreciating asset. Accordingly, a deduction is not allowable under section 40-880.