Business priorities shift depending on where a business is in its lifecycle from start-up to early growth and maturity.
Seizing opportunities to deduct business expenditure is especially important for businesses in their start-up and early growth stages.
Expenses in the early business lifecycle period are burdensome when cash flow and profits are non-existent or just starting. This is when deductions become pivotal to survival.
As a case study consider deductions for software development expenses. Who can benefit? What are the deduction options and levels?
Expenses on in-house software development at an early stage of a business can be a burden and if they are not sufficiently deductible for tax purposes, the cash flow can be adversely affected when the time comes to pay taxes.
The good news is that tax deductions are available for in-house software development. A complexity is that taxation rules applicable to deduction for in-house software development vary depending on the circumstances.
Definitions
What is in-house software?
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The Australian Taxation Office has defined in-house software in ID 2004/255 as “computer software or a right to use such software, that is acquired, developed or commissioned, and that is mainly for the taxpayer to use in performing the functions for which the software was developed, that is not for resale.”
In a recent ATO ID 2014/16, the Commissioner has taken the view that in-house software does not cease to be so merely because it is put to conjunctive use within the taxpayer company’s group. Conjunctive use means the use of the software mainly by the company with the other members of the group using the software to assist the taxpayer company’s use of it within the business organisation.
What is a small business under tax law?
A small business for tax purposes is considered to be an entity that caries on business and has an annual aggregate turnover of less than $2 million.
Three options
Expenses incurred by a small business on in-house software can be written off in anyone of three methods:
- immediate write-off of low cost assets;
- depreciation as a pooled asset; and
- depreciation in a software development pool.
Option 1 – Immediate write off
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A small business can use the immediate write off option.
Both in the case of immediate write off and in pool deduction, the software need not be used solely in the business. Only the proportion of business use (taxable purpose proportion) will be allowed for deduction. Thus if software costing $5,000 is used only 60% in a business, then $5,000 x 60% = $3,000. Hence $3,000 will be allowed as a deduction.
Immediate write off is available only in the case of low-cost assets (less than $6,500). Any addition to a low-cost asset less than $6,500 in the year of its purchase can be written off in that same year.
However, if the additional cost equals or exceeds $6,500, the asset and the additional cost are transferred to the small business depreciation pool. Therefore it is important to keep additional expenses below $6,500 in the year of the software purchase for an immediate write off.
Option 2 – Depreciation for pooled assets
We turn to depreciation for pooled assets of a small business under Australian taxation law.
Pooling enables a business to group its assets that cost greater than $6,500 (and $5,000 for motor vehicles) and depreciate them as a whole. Accounting for tax is thus made less cumbersome by applying a common rate of depreciation to the pooled assets.
Only the proportion of business use (taxable purpose proportion) can be pooled. For example, if software costing $15,000 is used only 60% in a business, then only $9,000 ($15,000 x 60%) can be pooled.
The depreciation rate of 30% applies to the pool. A 15% deduction will be allowed on assets added to the pool whether in the year of purchase or in any other year.
Option 3 – Depreciation for software development pool
This is different from the pooling referred to above and is available only in the case in-house software that is not acquired “off-the-shelf”. For this, the software in question must be used solely for producing taxable business income.
The amount pooled is all expenditure incurred in developing or commissioning the in-house software. Deductions from pooling become available in the year in which the expenses are incurred. Therefore, a small business can claim deductions even before the software is in actual use.
The rates of deduction in the pool are set out in the table below.
| Income year | Deduction Rate |
| First year | Nil |
| Second year | 40% |
| Third year | 40% |
| Fourth year | 20% |
To develop in-house software, assume there are two projects, project A and project B. Further assume that:
- expenditure on Project A incurred in 2014 is $100,000; and
- expenditure on Project B incurred in 2015 is $ 50,000.
Allowable deductions will be as follows:
| Income Year | Project A | Project B | Total |
|---|---|---|---|
| 2014 | Nil | – | Nil |
| 2015 | $ 40,000 | Nil | $ 40,000 |
| 2016 | $ 40,000 | $ 20,000 | $ 60,000 |
| 2017 | $ 20,000 | $ 20,000 | $ 40,000 |
| 2018 | Nil | $ 10,000 | $ 10,000 |
If pooling is not available because the in-house software was acquired “off-the-shelf”, expenditure incurred must be capitalised and written off over four years.
What if the project is a failure?
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Risk is ever-present in software development. Failure of software projects is common. We have more than six decades of software venture and project case studies, books and other evidence that evidence this.
Several recent sources indicate that failure in software ventures has become increasingly more common than success. When software projects fail the scope for writing off the expenditure can be significant for the sustainability of the affected business.
In the event of project failure, can a small business write off the balance of the expenditure not already written off? If pooling is selected the balance cannot be written off as at the time of failure but must be carried in the pool and written off.
Practical steps to take
Record keeping of expenditure incurred is very important in a claim for depreciation, especially in a software pool. Information to be maintained include:
- payment amounts and the dates on which payments were made;
- separate accounts for each of the software projects; and
- the number of hours the software is put to use split between business and other use.
The best commercial and tax outcomes are dependent on a range of considerations for review and pre-planning by the legal and tax advisers of a business. Taking steps to claim all legally allowed deductions is significant. This is best done while also considering related factors such as:
- the structure under which your business is carried on;
- identification of assets and who holds legal interests in them;
- agreements and other documentation for asset protection and management; and
- exit, succession or retirement planning.
All of these factors have ongoing significance. As stated at the outset, business priorities shift depending on where a business is in its lifecycle. Whilst income tax is a major concern, capital gains tax assumes a greater role when a business or its key assets are to be re-organised or sold or the owner needs to exit or retire. Although small business has several tax concessions specific to capital gains tax the requirements to qualify are not straightforward. It too needs pre-planning working with advisers.
Contact us with any questions or requests.
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