Private ruling: Deduction for research and development expenditure under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)
Published: June 2012
Ruling period: 1 July 2007 to 30 June 2008
Date scheme commenced: After 30 June 2006

Ruling: Q1: Is the taxpayer entitled to a deduction under section 8-1 of the ITAA 1997 for certain research and development expenditure incurred? | A1: Yes. Items of expenditure that will not be deductible under section 8-1 of the ITAA 1997 include: superannuation contributions as per section 290-10 of the ITAA 1997; expenditure of a capital nature that could be deductible under Division 40 of the ITAA 1997 (e.g. acquisition of plant or equipment such as computer hardware equipment); entertainment expenses as per Division 32 of the ITAA 1997; and expenditure to the extent that there will be derivation of exempt income.

Relevant facts and circumstances: The taxpayer internally develops software. The software is made available to customers typically on a fee-per-use basis. 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. In the year ended 30 June 2008, the taxpayer incurred expenditure relating to research and development. The expenditure was incurred in relation to the development of software X. The expenditure comprises mainly wages paid to employees engaged on the project and other relevant overheads attributable to the development of software X. The research and development expenditure as it relates to the development of software X is expenditure incurred in the normal course of the business of the taxpayer. The taxpayer had already commenced trading using the precursor product. The taxpayer was not registered with AusIndustry in the year ended 30 June 2008. It did not make a deduction under the research and development provisions, nor did it claim a research and development tax offset. This ruling covers the wages paid to employees engaged on the project and other relevant overheads attributable to the development of the software. However, this ruling does not cover items relating to superannuation contributions, acquisition of depreciable equipment, non-deductible entertainment expenses, or the proportion of expenses that may relate to the derivation of exempt income.

Relevant legislative provisions: Subection 8-1(1) of the ITAA 1997 | Paragraph 8-1(2)(a) of the ITAA 1997 | Paragraph 8-1(2)(b) of the ITAA 1997 | Paragraph 8-1(2)(c) of the ITAA 1997

Reasons for decision: Summary: 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 (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 guidance on its meaning can be found in case law. 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. 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'. For the purposes of this ruling, it has been determined that the taxpayer incurred the relevant expenditure. | 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 its essential character is that of expenditure that 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 ( Hallstroms) . In the present case, the taxpayer incurred expenditure relating to research and development in relation to the development of software X. 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 of software X has a sufficient connection with its operations and business activities which directly gain or produce its assessable income. Therefore, the relevant expenses do constitute 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 no be excluded by one of the negative limbs of section 8-1 of the ITAA 1997. | Detailed Reasoning - Revenue or capital in nature?: Paragraph 8-1(2)(a) of the ITAA 1997 denies a deduction 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. 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. Subsequently, in Hallstroms , Dixon J reaffirmed his approach: [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. More recently in GP International Pipecoaters Pty Ltd v. Federal Commissioner of Taxation (1990) 170 CLR 124 at 137 the High Court pointed out 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 a revenue or capital nature is a question of fact and degree that depends on the character of the advantage sought by making the expenditure from a practical and business point of view 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. 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. For the expenditure, to be revenue expenditure, it must be working expenses incurred in carrying on the taxpayer's business. 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). The taxpayer asserts that it does not derive an enduring benefit from the software. 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. 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, not withstanding it related to copyright material. The expenses there however were stationary and postage expenses, travel expenses and library expenses. In the present case, expenses in relation to research and development incurred by the taxpayer for software X were incurred in connection with the gaining of future fee-per-use income 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. Therefore, some of the expenditure (e.g. wages) is revenue expenditure.

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