Private ruling: Income tax ~~ Deductions ~~ General deductions - section 8-1
Published: March 2015
Ruling period: Income year ending 30 June 2010 | Income year ending 30 June 2011 | Income year ending 30 June 2012 | Income year ending 30 June 2013
Date scheme commenced: 16 June 2004

Ruling: Q1: Is the taxpayer entitled to a deduction under subsection 8-1(1) of the Income Tax Assessment Act 1997 (ITAA 1997) for certain development expenditure (the Expenditure) incurred during the years ended 30 June 2010 to 30 June 2013? | A1: Yes. | Q2: Was the Expenditure incurred by the taxpayer a loss or outgoing of capital, or of a capital nature pursuant to paragraph 8-1(2)(a) of the ITAA 1997? | A2: No

Relevant facts and circumstances: The taxpayer internally develops specialised software (software X) that is made available to customers by way of a licensing agreement. The licence is non-transferrable and non-exclusive and allows the software to be used by a single computer or installed on a network server. As part of licencing the software, the taxpayer charges customers a monthly maintenance fee under a service agreement. The taxpayer operates in an area of rapid advancing technology that requires high levels of research and development expenditure to stay relevant and competitive in the market in which it participates. Software can be rendered obsolete within very short timeframes. The industry in which the taxpayer operates requires participants to continually update and develop software applications. Therefore, the taxpayer would lose a substantial portion of its customer base if it did not commit to the ongoing development of its suite of software applications. On this basis the taxpayer incurs significant amounts of expenditure in modifying, updating and maintaining software X; as well as developing, updating and maintaining additional applications (associated software applications) that operate within software X to maintain and increase the usability and functionality of the existing software application. Although the associated software applications are able to operate independently, they derive their value from operating with the initial software and are only licenced in conjunction with software X. During this process there might be a copyright that arises, provided the software is sufficiently original in function. The copyright in the underlying code is valuable so long as the application which is created by that code remains market relevant. It is the market relevance which is what enables the software to be successfully licensed and not the software developer's copyright. As such, the taxpayer creates a new version of software X which supersedes the old version that is no longer licensed to the customers. The significant majority of expenditure that the taxpayer has incurred in carrying out the above activities represents employee expense such as salary and wages, and related expenses including superannuation, payroll tax, and Workcover payments, including payments to third party software developers. Of the total amount incurred by the taxpayer, part of the expenditure has been subject to either the Research and Development (R&D) tax concession or the R&D tax incentive. Accordingly, this ruling considers the correct treatment of the balance which has not been subject to the R&D tax incentive or concession and which relates to software X and its associated software applications (the 'Expenditure'). As the taxpayer's employees engage in a variety of activities in the context of the taxpayer's business, it is difficult to allocate the Expenditure to the different specific types of activities, which can include development, updates, bug-fixes, maintenance and support. This is particularly the case since the lifecycle of a specific software application can be quite short and the development and maintenance process is not characterised by clearly defined stages. The characterisation of such activities is highly subjective and each of the activities can also have more than one purpose.

Relevant legislative provisions: Income Tax Assessment Act 1997 subsection 8-1 (1) | Income Tax Assessment Act 1997 subsection 8-1 (2)(a) | Income Tax Assessment Act 1997 subsection 8-1 (2)(b) | Income Tax Assessment Act 1997 subsection 8-1 (2)(c)

Reasons for decision: Summary: The taxpayer is entitled to a deduction under subsection 8-1(1) of the ITAA 1997 for certain development expenditure (the Expenditure) incurred during the years ended 30 June 2010 to 30 June 2013. | Detailed Reasoning - Detailed reasoning: Section 8-1 of the ITAA 1997 allows a deduction for a loss or outgoing to the extent it is incurred in gaining or producing assessable income, or necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income except where the loss or outgoing is of a capital, private or domestic nature, or is incurred in relation to gaining or producing exempt income, or another provision operates to deny the deduction under section 8-1 of the ITAA 1997 (see paragraph 8-1(2)(d)). In order to determine whether the Expenditure is deductible under subsection 8-1(1) of the ITAA 1997, it is necessary to consider whether it will be incurred in gaining or producing the taxpayer's assessable income or necessarily incurred in carrying on a business for that purpose and the expenditure is not capital, private or domestic in nature. The two 'positive limbs' of subsection 8-1(1) are not mutually exclusive and the similarities between the requirements, that expenditure be 'incurred' has been recognised by the Courts: AGC (Advances) Ltd v. Federal Commissioner of Taxation (1975) 75 ATC 4057 per Mason J at 4071 - 4072. | Detailed Reasoning - When is an expense incurred?: In order to be able to claim a deduction under section 8-1 of the ITAA 1997, a taxpayer must have incurred an expense. The word 'incurred' is not defined in the legislation; therefore in determining whether an amount will have been incurred for income tax purposes, regard must be had to the ordinary meaning determined by the courts. Federal Commissioner of Taxation v. James Flood (1953) 88 CLR 492 establishes that a loss or outgoing is incurred where the taxpayer has 'completely subjected itself' to the loss or outgoing. Further, in the case of Nilsen Development Laboratories Pty Ltd v. Federal Commissioner of Taxation (1981) 144 CLR 616, the word incurred was taken to mean when the taxpayer has a 'presently existing liability'. During the income years ended 30 June 2010 to 30 June 2013, the taxpayer incurred expenditure relating to research and development. The Expenditure as specified in the ruling application was incurred in relation to developing, modifying, maintaining and updating the taxpayer's existing suite of software applications in order to provide the developed software and associated services to the taxpayer's established customer base in exchange for fees. Specifically, the Expenditure comprises mainly of salary and wages paid to employees engaged for maintaining, updating and developing the software. Accordingly, these amounts represent the taxpayer's present existing liabilities for work completed and are irretrievable by, or non-refundable to, the taxpayer. Therefore for the purpose of this ruling, it has been determined that the Expenditure relating to the development and maintenance of the software has been 'incurred' by the taxpayer as required by section 8-1 of the ITAA 1997. | Detailed Reasoning - Purpose of the loss or outgoing:: To be deductible under the first limb of section 8-1 of the ITAA 1997, a loss or outgoing must be relevant and incidental to the gaining or producing of assessable income (Ronpibon Tin NL & Tongkah Compound NL v. Federal Commissioner of Taxation (1949) 8 ATD 431 at 436). For an outgoing to be deductible under the second limb of section 8-1 of the ITAA 1997 as expenditure necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income, it must have the character of a working or operating expense of the entity's business or be an essential part of the cost of its business operations. In John Fairfax & Sons Pty Ltd v. Federal Commissioner of Taxation (1958-9) 101 CLR 30 Menzies J stated at page 49: ... there must, if an outgoing is going to fall within its terms, be found (i) that it was necessarily incurred in carrying on a business; and (ii) that the carrying on of the business was for the purpose of gaining assessable income. The element that I think is necessary to emphasise here is that the outlay must have been incurred in the carrying on of a business, that is, it must be part of the cost of trading operations. Expenditure will satisfy the positive limbs of section 8-1 of the ITAA 1997 if the essential character of the expenditure has a sufficient connection with the operations or activities which more directly gain or produce the taxpayer's assessable income: Lunney v. Federal Commissioner of Taxation (1958) 100 CLR 478 at 498-499. The characterisation of particular expenditure is by its nature a question of fact. It involves an enquiry about what the expenditure was for and what it was intended to achieve in relation to the taxpayer's income earning activities or business from a practical and business point of view: Magna Alloys & Research Pty Ltd v. Federal Commissioner of Taxation (1980) 80 ATC 4542 at 4549 and Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634 at 648. In the present case, the taxpayer is engaged in the business of providing specialised IT services and software applications to customers in exchange for fees. The taxpayer incurred expenditure in relation to the maintenance and development of software X and certain associated software applications (the Expenditure). At the time the Expenditure was incurred, the taxpayer was already in the business of providing the developed software and associated services to its established customer base. The Expenditure incurred was in the normal course of the taxpayer's business. It has been concluded that the Expenditure incurred by the taxpayer in relation to the development software X has sufficient connection with its operations and business activities which directly gain or produce the taxpayer's assessable income. Therefore, the Expenditure constitutes losses or outgoings incurred in gaining or producing assessable income and were necessarily incurred in carrying on the taxpayer's business for the purpose of gaining or producing its income. In conclusion, the Expenditure incurred by the taxpayer satisfies the positive limbs of section 8-1 of the ITAA 1997. However, to be deductible pursuant to subsection 8-1(1) of the ITAA 1997, the expenditure must not be excluded by one of the negative limbs of section 8-1 of the ITAA 1997. | Summary: The Expenditure incurred by the taxpayer is not a loss or outgoing of capital or of a capital nature pursuant to paragraph 8-1(2)(a) of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: Paragraph 8-1(2)(a) of the ITAA 1997 denies a deduction under section 8-1 to the extent that a loss or outgoing is capital, or of a capital nature. It is therefore necessary to determine, whether or not the Expenditure incurred by the taxpayer is excluded from deductibility on the basis that it is capital, or of a capital nature. In determining whether expenditure will be classified as revenue or capital in nature, regard must be had to the principles identified by the courts. The decision in Sun Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337 ( Sun Newspapers ) is a leading authority on the distinction between revenue and capital expenditure, where Dixon J stated at 363: There are, I think, three matters to be considered, (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 Sun Newspapers test is described as being based on a conceptual approach to the distinction between the business structure or entity and the process of operating the business. To express it in another way, a distinction is made between the profit-yielding subject and the profit yielding process of a business. In Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634 (Hallstroms) Dixon J reaffirmed his approach by stating that: [T]he contrast between the two forms of expenditure corresponds to the distinction between the acquisition of the means of production and the use of them; between establishing or extending a business organization and carrying on the business; between the implements employed in work and the regular performance of the work in which they are employed; between an enterprise itself and the sustained effort of those engaged in it. In GP International Pipecoaters Pty Ltd v. Federal Commissioner of Taxation (1990) 170 CLR 124 at 137 the High Court held that the character of expenditure is ordinarily determined by reference to the nature of the asset acquired and that the character of the advantage sought by the making of the expenditure, is a critical factor in determining the character of what is paid. In relation to the character of the advantage sought by the expenditure it is necessary to examine whether the expenditure secures an enduring benefit for the business. This test was outlined in British Insulated and Helsby Cables Ltd v. Atherton [1926] AC 205 at 213 - 214 by Viscount Cave where he stated: But when an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, I think that there is very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such an expenditure as properly attributable not to revenue but to capital. ATO Interpretative Decision ATO ID 2011/42 Deductibility of salary or wages to the extent that employees are engaged in the self-construction of depreciating assets sets out the general principles on the distinction between revenue and capital expenditure on salary and wages. Whether such expenditure is of revenue or capital in nature is a question of fact and degree that depends on the character of the advantage sought in making the expenditure from a practical and business point of view and having regard to the actual work done by the relevant employees. For example, expenditure incurred on salary and wages for employees engaged wholly in affairs of capital is properly characterised as capital in nature. As noted above, when the matters stated by Dixon J in the Sun Newspapers Case are considered, the character of the advantage sought by making the expenditure is the chief, if not the critical factor in determining the character of what is paid. The nature or character of the expenditure will therefore follow the advantage that is sought to be gained by incurring the expenditure. If the advantage to be gained is capital or of a capital nature, then the expenditure incurred in gaining the advantage will also be capital or of a capital nature. This general rule is found in the frequently quoted statement of Dixon J at 359, where he said: The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction 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 attain regular returns by means of regular outlays… As general conceptions it may not be difficult to distinguish between the profit yielding subject and the process of operating it. In the same way expenditure and outlay upon establishing, replacing and enlarging the profit-yielding subject may in a general way appear to be of a nature entirely different from the continual flow of working expenses which are or ought to be supplied continually out of the returns or revenue. Prima facie, it can be concluded that the expenditure incurred by the taxpayer is capital, or of a capital nature. The expenditure was incurred in relation to the development of software. Software is the intellectual property of the developers, which is covered by the Copyright Act 1968 . Pursuant to this Act, software attracts copyright protection of an enduring kind. The software is used by customers on a fee-per-use basis. For this purpose, the software can be seen as a capital asset which provides an enduring benefit for the taxpayer. Hence, related expenditure, for that reason, would be of a capital nature. In the Hallstroms Case , Dixon J states that the distinction between an outgoing of capital and one on account of revenue 'depends upon what is calculated to effect from practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured'. Paragraph 6 of Taxation Determination TD 95/44 Income tax: can research and development expenditure incurred by a business be deductible under section 8-1 of the Income Tax Assessment Act 1997 ('the 1997 Act')? states: To be deductible, the nature of the business should require ongoing [research and development (R&D)] activities as a necessary part of that business, so that recurring outlays on R&D are a part of the continual flow of working or operating expenses. This is most easily established where business is carried on in a field of high or rapidly advancing technology with a continuous need for R&D in order to carry on the business (see Goodman Fielder Wattie , supra). Therefore, for the Expenditure to be revenue in nature, it must be working expenses incurred in carrying on the taxpayer's business. In this respect, we consider that it is appropriate to have regard to the actual work done by the relevant employees in determining whether the expenditure on salary or wages was calculated to effect from a practical and business point of view. The Expenditure in relation to salary and wages and associated employee related expenses are a regular recurring cost incurred in relation to the taxpayer's central business process, which is the process of continually updating software X and the associated software applications, in order to remain functional and relevant. The salary and wages form part of the continual flow of expenses in the ongoing software development, maintenance and service provision from which the taxpayer derives its income. The taxpayer asserts that the Expenditure has not enlarged the framework within which the taxpayer carries on its business of providing specialised IT services and software applications, nor has it resulted in the acquisition or creation of an enduring asset. The taxpayer operates in an area of rapidly advancing technology that requires continual research and development expenditure to stay relevant and competitive in the market in which it participates. Further, this is an area that requires continual changes to technology and product specifications. This means that the benefit obtained by the taxpayer only lasts for a very short period as new versions of software X are released on a monthly basis, which is nowhere near the enduring benefit/legal length of copyright. The superseded software version is essentially valueless, on the basis that it cannot be licensed to customers. An example of where expenditure, in relation to research and development directed at obtaining an intellectual property right of a lasting kind, was held to be of a revenue nature is found in Case 55/ 95 (95 ATC 454) and ATO Interpretative Decision ATO ID 2003/905 Income Tax Deductions: expenses in updating and revising a book. In that case it was held that the expenses incurred in preparing or editing a book were incurred in connection with the gaining of future royalty income and further that these activities are in the course of the derivation of that income (rather than a preliminary activity). Consequently such expenses were deductible, notwithstanding it related to copyright material. The expenses, however, were stationary and postage expenses, travel expenses and library expenses. In the present case, the Expenditure in relation to software X and the associated software applications, were incurred in connection with the gaining of future fees from licences and service fees, and further these activities are in the course of the derivation of that income. These expenses are recurring and continuous as the employees continually improve and update the software.