Edited version of your written advice

Authorisation Number: 1051402998691

Date of advice: 23 July 2018

Ruling

Subject: In-house software

Question 1

Is the Software ‘in-house software’ within the meaning of subsection 995-1(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

Is the Company entitled to a deduction for the cost of the Software over five years based on the statutory effective life in Item 8 of the table under subsection 40-95(7) of the ITAA 1997?

Answer

Yes

This ruling applies for the following periods:

1 July 20xx – 30 June 20xx

The scheme commences on:

1 July 20xx

Relevant facts and circumstances

The Company is a tax resident of Australia and the head company of the Consolidated Group A.

The Consolidated Group A acquired 100% of the Consolidated Group B, which is also tax resident of Australia.

An independent valuation of assets was completed immediately after the acquisition. The primary reason for commissioning this valuation was the requirement by the statutory auditors to reflect the market value of assets in the financial accounts.

The Software

It took the Consolidated Group B’s employees several years to internally develop a specialised IT software platform (the Software) to meet the complex legislative compliance requirements required to operate in its industry.

The Software has been operational for a few years. Continuous building of improvements and added features continued until the Consolidated Group B was acquired.

The Software facilitates interactions between different stakeholders.

The Software facilitates regulatory compliance, provides significant cost savings, and improves efficiency within the Consolidated Group B’s business.

The platform allows for economies of scale and improves the compliance and risk management processes.

The platform is fundamental to the daily delivery of the services and cannot be stored offline/locally on a device, offered or enjoyed separately from the service offered by the Consolidated Group B.

Based on the independent market valuation of the intangibles in the Consolidated Group B (Valuation Report), the Software consists of the several key components. It is significant to the daily operation of the business as it removes a significant amount of administrative tasks normally required by back-office support.

The Software is not (and never has been) licensed to other entities in the industry or any other third parties and is not offered as a separate service offering or re-sale by the Consolidated Group B.

Tax cost of the Software

Following the acquisition of the Consolidated Group B, the Consolidated Group A sought an independent market valuation of the intangibles in the Consolidated Group B. The Valuation Report identified the market value for the Software.

The Valuation Report notes that the Software is “unique (equivalent software cannot be purchased) which provides the business with a competitive advantage”. The Software was valued using a “deprival approach” using forecasts regarding what would be the cost to the Consolidated Group B to rebuild the asset, together with the lost income during the rebuilding period. The replication cost methodology (which broadly does not consider the lost profits) was not considered to be appropriate as the Software does not fulfil a compliance role for the Consolidated Group B.

An Entry allocable cost amount (‘Entry ACA’) and tax cost setting calculations have been prepared in respect of the Consolidated Group B joining the Consolidated Group A.

For the purposes of the calculations, the Software has been treated as a reset tax cost base asset and the tax cost setting amount has been reset and capped to the higher of the terminating value and the market value.

The expenditure in relation to the development of the Software has not been allocated to a software development pool, either prior to the acquisition by the Consolidated Group A or following completion of the acquisition.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Division 40

Income Tax Assessment Act 1997 Subsection 40-95(7)

Income Tax Assessment Act 1997 Division 328

Income Tax Assessment Act 1997 Part 3-90

Income Tax Assessment Act 1997 Section 701-1

Income Tax Assessment Act 1997 Subdivision 705-A

Income Tax Assessment Act 1997 Section 701-10

Income Tax Assessment Act 1997 Division 705

Income Tax Assessment Act 1997 Subsection 705-10(2)

Income Tax Assessment Act 1997 Subsection 705-10(4)

Income Tax Assessment Act 1997 Section 705-20

Income Tax Assessment Act 1997 Section 705-25

Income Tax Assessment Act 1997 Subsection 705-30(3)

Income Tax Assessment Act 1997 Section 705-35

Income Tax Assessment Act 1997 Paragraph 705-35(1)(c)

Income Tax Assessment Act 1997 Section 705-40

Income Tax Assessment Act 1997 Section 701-55

Income Tax Assessment Act 1997 Subsection 701-55(2)

Income Tax Assessment Act 1997 Section 701-60

Income Tax Assessment Act 1997 Section 705-60

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

Reasons for decision

Question 1

Software

“Software” is not defined in the income tax legislation.

Taxation Ruling 2016/3 Income tax: deductibility of expenditure on a commercial website (TR 2016/3) notes that:

Meaning of 'software'

219. 'Software' is not defined in the income tax legislation and takes its ordinary meaning in the absence of contrary intent. Nothing in section 8-1 or Divisions 40 and 328 requires 'software' to take other than its general meaning in ordinary usage. This is its meaning for the purposes of the defined term 'in-house software'.

Software is, functionally, anything that instructs another part of the computer system; more generally, it is a digital system made up of programs and associated documentation. It may include website content.

Further, Taxation Ruling TR 93/12 Income Tax: computer software (TR 93/12) provides further guidance regarding the definition of software:

12. Software can be classified as either system software (also known as operating software) or application software. System software activates the computer itself and is essential for its operation regardless of the use for which the computer is required. These programs are normally supplied by the manufacturer of the computer in which they are to be used. Application software provides the computer with instructions as to the specific tasks required of it by the users e.g., payroll, inventory, debtors, word processing, creation of data bases, spreadsheets, games etc. These programs can be used with different types of computers and may be supplied either by the computer manufacturer or distributor or by an independent software house, or may be developed by the computer user.

The Software falls within the definition of computer software for the purpose of the “in-house software” definition in subsection 995-1(1) of the ITAA 1997 as it is a “digital system made up of programs and associated documentation”.

In-house software

Subsection 995-1(1) of the ITAA 1997 defines “in-house software” as:

“in-house software” 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 under a provision of this Act outside Divisions 40 and 328.

TR 2016/3 provides further guidance regarding the definition of “in-house software” and what should be included in or excluded from “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 (See Examples 22 & 23)

(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. (See Example 2 of this Ruling).

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. (See Example 1 of this Ruling).

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'. (See Example 24 of this Ruling).

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. (See Example 4 of this Ruling).

Acquire, develop or have another entity develop

The terms “acquires” and “develops” are not specifically defined in the tax legislation. Accordingly, these words should be given their ordinary meaning.

The Software was developed by the Consolidated Group B by an in-house team over several years. Therefore, the Software satisfies the “develops” aspect of the definition of “in-house software” for the period prior to the transaction.

When the Consolidated Group B joins the Consolidated Group A, the head company of the Consolidated Group A is deemed to acquire the assets of the underlying group at the time the subsidiary members join the tax consolidated group, pursuant to the single entity rule under section 701-1. Accordingly, as a result of the Consolidated Group A acquiring the Consolidated Group A, it can be said that Company, the head company of the Consolidated Group A, “acquired” the Software for the relevant purposes of Division 40.

Therefore, the requirement of “acquire/develop” has been satisfied.

Mainly for use in performing the functions for which the software was developed

The next element of the definition of “in-house software” refers to the use.

The Software will be “in-house software” where it is developed “mainly for you to use in performing the functions for which the software was developed.”

In TR 2016/3, the Commissioner’s view of this element is considered in paragraphs 214 – 215:

214. The expression ‘for you to use in performing the functions for which the software was developed’ in paragraph (a) of the definition excludes software that is developed for the purpose of exploitation for profit. It does not exclude software provided by the website owner for use by clients as a means of interacting with the business or to enable the business to transact further with the client. Client use in those circumstances falls within the ‘use’ of the software by the website owner for the purposes for which it was developed. The website owner mainly uses the software to generate client interactions that serve the broader (profit-making) purposes of the business.

215. Application software made available through a website to users mainly for their independent benefit, and not for engaging with the user as a customer, is not regarded as software that the website owner uses in performing the functions for which it was developed. It is not in-house software and could be said to have a functional identity that is independent of the website. Typically, a website owner provides such application software for the purpose of deriving income from fees or generating other revenue.

This is further supported by the EM which states:

Expenditure incurred by software developers and manufacturers

31. New Division 46 is intended to apply to software which 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.

...

32. A taxpayer may have a dual purpose in incurring expenditure on software.

For example a taxpayer may routinely develop new software applications for its own business purposes but licence it to other taxpayers in its industry. In such situations it will be a question of fact as to the principal reason for the expenditure.

Further, example 4 in TR 2016/3 indicates a situation where software expenditure was not considered to be “in-house software”:

Example 4 — software not part of website

66. Wattso Pty Ltd provides estimating services for electrical installation work. The company has developed a software estimating tool for component inputs and labour which it uses in its estimating work but also licenses to electrical contractors. Under the terms of the licence, Wattso provides periodic upgrades and retains copyright in the software. The company also provides user access to the estimating tool as a web based application on its website for a fee.

67. Since developing the software tool, Wattso’s income is mainly derived from licence and access fees, in accordance with its business plan. The software tool, both as a product for sale and as a web-based application, is not part of Wattso’s website. It is not in-house software [emphasis added].”

The Software was a developed with a clear purpose to act as an integrated management system for the Consolidated Group B through its seven components. It was developed to streamline the Consolidated Group B’s interaction with stakeholders.

It was not developed “for the purpose of exploitation for profit”. The Consolidated Group B does not (and did not) license the Software and has no intention of licensing or selling the Software in the future.

Whilst there are some components of the Software that include a “mobile-friendly website”, this is used as a means to interact with the stakeholders.

However, the access given to third parties is only to provide, update or access information in relation to the supply of services by the Consolidated Group B. There is no separately downloadable content or application software that is made available to the Consolidated Group B’s customers for their independent benefit.

Example 4 of TR 2016/3 is also factually distinguishable as the profits of the Consolidated Group B relate to the provision of services. The profits of the Consolidated Group B do not relate to the sale or licensing of any component of the Software.

For which no amount can be deducted outside Division 40 (capital allowances) and Division 328 (small business entities)

Section 8-1

Section 8-1 is a general deductibility provision that allows a deduction from assessable income for any loss or outgoing to the extent that:

(a) It is incurred in gaining or producing assessable income; or

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

(together known as the “positive limbs”).

However, such loss or outgoing will not be deductible under section 8-1 to the extent that it falls within one of the following four categories:

(a) It is capital or of a capital nature;

(b) It is of a private or domestic nature;

(c) It is incurred in relation to the gaining or producing of exempt income or non-assessable, non-exempt income; or

(d) A deduction is denied by another specific statutory provision.

(together known as the “negative limbs”).

The expenses incurred in respect of the Software meet the requirements in the positive limbs as it is expenditure incurred in gaining or producing the assessable income of the Consolidated Group B.

However it is accepted that, as the expenditure relates to the development of a particular asset of the Consolidated Group B (i.e. the Software), the expenditure should be “capital or of a capital nature”.

Therefore, an immediate deduction under section 8-1 should not be available in respect of the Software.

Other provisions

Based on the background facts above specifying the nature of the expenditure, it is submitted that there is no other provision under which the expenditure should be deducted except the capital allowances provisions in Division 40.

For completeness, we note that Division 328 should not apply as the Consolidated Group B (and the broader the Consolidated Group A) should not be considered a small business entity.

Conclusion

We consider the Software is “in-house software” within the meaning of subsection 995-1(1).

Question 2

Asset of the head company

Subsection 705-10(2) of the ITAA 1997 outlines the object of Subdivision 705-A:

The object of this Subdivision is to recognise the head company’s cost of becoming the holder of the joining entity’s assets as an amount reflecting the group’s cost of acquiring the entity. That amount consists of the cost of the group’s membership interests in the joining entity, increased by the joining entity’s liabilities and adjusted to take account of the joining entity’s retained profits, distributions of profits, deductions and losses.

If Subdivision 705-A has effect, section 705-20 states that the tax cost setting amount of an asset is worked out under the Subdivision.

Tax cost setting amount

Section 701-55 explains what is meant when an “assets tax cost is set”. In particular, subsection 701-55(2) outlines what the expression means for depreciating assets:

If any of Subdivisions 40-A to 40-D, sections 40-425 to 40-445 and Subdivisions 328-D and 355-E is to apply in relation to the asset, the expression means that the provisions apply as if:

(a) the asset were acquired at the particular time for a payment equal to its tax cost setting amount; and

(b) at that time the same method of working out the decline in value were chosen for the asset as applied to it just before that time; and

(c) where just before that time the prime cost method applied for working out the asset’s decline in value and the asset’s tax cost setting amount does not exceed the joining entity’s terminating value for the asset — at that time an effective life were chosen for the asset equal to the remainder of the effective life of the asset just before that time; and

(d) where just before that time the prime cost method applied for working out the asset’s decline in value and the asset’s tax cost setting amount exceeds the joining entity’s terminating value for the asset — either:

(i) the head company were required to choose at that time an effective life for the asset in accordance with subsections 40-95(1) and (3), and any choice of an effective life determined by the Commissioner were limited to one in force at that time; or

(ii) an effective life for the asset were worked out under subsection 40-95(7), (8), (9) or (10) at that time; and

(e) where neither paragraph (c) nor (d) applies — at that time an effective life were chosen for the asset equal to the asset’s effective life just before that time.

As the Software is “in-house software”, it is a “depreciating asset” to which Subdivisions 40-A to 40-D apply, therefore subsection 701-55(2) applies to determine how the tax cost is set.

Subsection 701-55(2) was amended in 2014 by the Tax and Superannuation Laws Amendment (2014 Measures No.4) Act 2014 and addresses the situation where the effective life for certain intangible depreciating assets is specified in the legislation. The relevant EM states:

5.60 When an entity joins a consolidated group, the consolidation tax cost setting rules apply to reset the tax costs of its assets. If a depreciating asset receives an increased tax cost under those rules, and the joining entity used the prime cost method to work out its depreciation deductions, paragraph 701- 55(5)(d) of the ITAA 1997 requires the head company to choose an effective life for that asset in accordance with subsections 40-95(1) and (3) for the purpose of determining future depreciation deductions.

5.61 However, for certain intangible depreciating assets, the effective life is specified in subsection 40- 95(7) (rather than being determined under subsections 40-95(1) and (3))…

5.62 Therefore, the amendments make a technical correction to paragraph 701-55(2)(d) to ensure that, for relevant assets, the effective life of the asset can be worked out under subsections 40-95(7) to (10).

As a result of the acquisition of the Consolidated Group B by the Consolidated Group A, the members of the Consolidated Group B joined the Consolidated Group B as subsidiary members.

Section 701-10 sets out how an asset of a subsidiary is treated when a subsidiary joins a consolidated group. Subsection 701-10(4) provides that each asset's tax cost is set at the time the entity becomes a subsidiary at the asset's tax cost setting amount. Section 701-60 provides that the tax cost setting amount set by section 701-10 is worked out under Division 705.

The Software will be a reset cost base asset as it is not a retained cost base asset as defined in section 705-25. Its tax cost setting amount is worked out under section 705-35 and is as follows:

Tax cost setting amount for reset cost base assets

(1) For each asset of the joining entity (a reset cost base asset) that is not a retained cost base asset, the asset’s tax cost setting amount is worked out by:

a) first working out the joined group's allocable cost amount for the joining entity in accordance with section 705-60; and

b) then reducing that amount by the total of the tax cost setting amounts in accordance with section 705-25 for each retained cost base asset (but not below zero); and

c) finally, allocating the result to each of the joining entity's reset cost base assets (other than excluded assets) in proportion to their market values.

Pursuant to paragraph 705-35(1)(c), the market value of the Software at the joining time is the amount which should be used under section 705-35 in allocating the residual allocable cost amount (after allocation to retained cost base assets) to reset cost base assets (except excluded assets) in proportion to their market values.

In the present case, the Consolidated Group A obtained an independent valuation report of the market value of the underlying intangibles in the Consolidated Group B.

The operation of section 705-35 is restricted by section 705-40 for depreciating assets in that the tax cost setting amount must not exceed the greater of the asset’s market value and the joining entity’s termination value. Subsection 705-30(3) states the joining entity’s terminating value for a depreciating asset is equal to the asset’s adjustable value just before the joining time.

The terminating value at the relevant time, for the purposes of Part 3-90, was lower than the independent market value.

Accordingly, where the allocable cost amount (as defined in section 705-60) is sufficient to apportion over the reset cost base assets, the tax value of the software will be reset to the greater of the market value of the asset and the joining entities terminating value of the asset.

Based on this process, there was sufficient ACA in the calculations for the tax cost setting amount of the Software to be reset to a value capped at the market value.

As a consequence of the above analysis, when the tax cost of the Software is set the following applies:

● the Company, as head company of the Consolidated Group A, is treated as having acquired the Software for an amount equal to the tax cost setting amount;

● As the Software is in-house software that is depreciated using the prime cost method prior to consolidation, the same depreciation method applies after the Consolidated Group B joins the Consolidated Group A; and

● As the tax cost setting amount of the Software is greater than the terminating value, and the effective life is worked out under subsection 40-95(7), paragraph 701-55(2)(d)(ii) applies.

The table under section 40-95(7) sets out the statutory effective lives of certain intangible depreciating assets. Item 8 of the table states that the effective life of “in-house software” is five years.

Therefore, the Company acquired the Software for an amount equal to the tax cost setting amount and this amount should be depreciated over five years from the joining time using the prime cost method.