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A little bit SaaSy

Tax Alert - April 2023

Authors: Troy Andrews & Alex Kingston

With nine days to spare before 2022 income tax returns were due, Inland Revenue released it's draft Interpretation Guideline, PUB00464: Deductibility of software as a service (SaaS) configuration and customisation costs (the Draft Guidance) on 22 March 2023. This gave taxpayers a fairly short window to consider Inland Revenue’s (draft) position before potentially submitting their tax returns, but helpfully there weren’t too many surprises. In short, a deduction should be allowed for costs incurred in configuring or customising a software as a service (SaaS) application; but there is some complexity involved in determining what timeframe costs are deductible. Like any good tax question, the answer will ultimately depend on the actual arrangements entered into.

The Draft Guidance covers the deductibility of expenditure a taxpayer incurs in configuring or customising a SaaS application. This may sound like a specific category of expenditure to get its own 50+ pages of Inland Revenue guidance on but, as any organisation that has implemented a new ERP system recently knows, these costs can be quite material.

The requests for clarity over Inland Revenue’s view on these costs were borne out of two recent International Financial Reporting Interpretation Committee (IFRIC) Agenda Decisions (discussed further here). These decisions resulted in many reporting entities having to consider (or re-consider) how they treat/treated expenditure related to SaaS projects for accounting purposes. In many cases, this resulted in SaaS-related expenditure having to be expensed, where previously it may have been recognised as an intangible asset.

The second IFRIC Agenda Decision defines Configuration & Customisation (C&C) as:

i) Configuration involves the setting of various ‘flags’ or ‘switches’ within the application software, or defining values or parameters, to set up the software’s existing code to function in a specified way.

ii) Customisation involves modifying the software code in the application or writing additional code. Customisation generally changes or creates additional, functionalities within the software.

While the Draft Guidance only applies to SaaS C&C expenditure (aligning with the scope of the second IFRIC decision), there is often other (significant) expenditure incurred as part of a SaaS project that falls outside the scope of this Draft Guidance, e.g. feasibility/product selection, data migration, and training, which taxpayers may need to also come to a landing on.

General deductibility & capital limitation

Inland Revenue accepts it is highly likely SaaS C&C costs will have the necessary nexus with income to be deductible, but that in many cases expenditure will be capital in nature. It reaches this conclusion with reference to case law on the capital/revenue divide, and points to the main factors being because taxpayers primarily incur SaaS C&C costs to “transform or enhance the taxpayer’s business structure” and, by incurring SaaS C&C costs, the taxpayer obtains an “enduring benefit” through gaining access to a customised, technologically advanced, SaaS application. As capital expenditure, Inland Revenue then discusses the two broad ways a deduction could still be allowed: as research & development (R&D) expenditure, or under the depreciation rules.

Our comment: While Inland Revenue references certain case law tests, it seems reluctant to mention a SaaS contract length that may indicate C&C costs being revenue (as opposed to capital) in nature. For example, in the BP Australia case (referenced in the Draft Guidance) it was suggested that a contract length of 1-2 years may point to it being revenue in nature (and the actual length of 5 years was considered neutral from a capital/revenue standpoint). There are also some areas left open to interpretation, for example, whether the enduring test should be applied from a “legal” or “functional” point of view. For example, whether a two-year contract should be viewed as giving rise to a two-year benefit (for the purposes of applying the test), compared to the taxpayer's purpose which might be to try and regularly roll it over for a longer period.

Deductible R&D (DB 34 deduction)

Despite being capital in nature, an immediate deduction is allowed for expenditure incurred on R&D that is expensed for accounting purposes, when applying particular parts of NZ IAS 38 (a “DB 34 deduction”). Inland Revenue’s view in the Draft Guidance is that s DB 34 may apply, but to internally generated SaaS C&C costs only. That is, costs incurred “in-house” or incurred on third-party contractors engaged directly by the taxpayer to undertake C&C. Costs incurred on the C&C work undertaken by the SaaS provider, or the SaaS provider’s subcontractor wouldn’t qualify.

To qualify as a DB 34 deduction, expenditure must also meet the definition of R&D. Inland Revenue’s view is that:

  • It is unlikely C&C would meet the definition of research.
  • It is possible configuration activities could be considered development depending on the specific nature of activities undertaken, and this would more likely be the case when configuration requires the application of techniques that are complex and new.
  • Customisation has greater scope to be development when it is not routine or business-as-usual, but instead involves modifications, improvements or enhancements of a SaaS application.

Our comment: It is helpful that Inland Revenue has reached the view that the specific parts of IAS 38 referenced in s DB 34 can potentially apply.

Practically, it may be difficult for taxpayers to trace expenditure back to specific activities, in order to consider if the definition of development has been met. Robust processes and tracking of costs would be needed. In our view, any application of s DB 34 should be undertaken carefully against the IAS 38 definitions and well documented. In addition, taxpayers will need to consider whether such expenditure may need to be disclosed as ‘research and development’ given the IAS 38 disclosure requirements. Inland Revenue is silent on these disclosure requirements in the Draft Guidance which is something taxpayers and their auditors will need to consider carefully.

Depreciable intangible property

In the absence of s DB 34 applying, Inland Revenue’s view is that SaaS C&C costs should form part of the cost base of depreciable intangible property (DIP), being the “right to use” software (which is a right usually granted to the SaaS user, and is specifically depreciable for tax purposes). The cost base includes all amounts of expenditure the taxpayer incurs for that item until it is in usable condition, including C&C costs and subscription payments incurred prior to the DIP being available for use. Regular subscription payments after a SaaS application is available for use should be deductible as they’re incurred.

Generally, right-to-use software will be depreciated at standard software depreciation rates (of 40% straight line or 50% diminishing value). However, in some situations, where a SaaS arrangement has a fixed term, the right to use the software may be fixed life intangible property (FLIP). FLIP is DIP with a “legal life” that is the same length as the property’s estimated useful life. For FLIP, costs are depreciated over the legal life of the SaaS arrangement. Inland Revenue’s view appears to be that FLIP could arise where SaaS contracts are less than 4 years’ duration, and where a SaaS arrangement is greater than 4 years (or has an indefinite life) then the standard software depreciation rates above would apply.

Our comment: It would be helpful for Inland Revenue to be more explicit about the treatment of contracts less than a 4-year duration, and whether these could be FLIP. There is effectively a 4-year “bright line” contract length that taxpayers may need to monitor, particularly where there is a bundle of contractual terms to negotiate. However, the overall outcome does provide a degree of comfort for taxpayers that SaaS C&C costs should be depreciable over a maximum of four years.

Finance lease rules

Inland Revenue’s view is that the finance lease rules should not apply, due to these types of arrangements falling outside of what Parliament would have contemplated when introducing such rules.

The movement by organisations to cloud-based solutions like SaaS has grown significantly in recent times and is a key part of many organisations’ digital strategies. So it is helpful that Inland Revenue has provided guidance in this area. Overall, the position is reasonably positive for taxpayers, with the main question being a question of timing.

As noted above, the guidance is limited to SaaS C&C costs only, and there is a raft of other expenditure types that may be incurred as part of a SaaS implementation or wider digital transformation. There are some unhelpful comments in the Draft Guidance around how to view these wider costs, particularly how to assess whether they are incurred as part of a single capital project. We expect there may be submissions on this point.

There could be a deferred tax impact where the tax treatment differs from the accounting treatment of SaaS C&C costs. This is less likely when applying s DB 34, as the accounting treatment of internal and direct subcontractor costs may be able to be followed. In addition, we understand for accounting purposes it is more likely for costs incurred directly with the SaaS provider to be spread (as a prepayment over the life of the SaaS contract) if they are not considered distinct from the SaaS application. For this expenditure, s DB 34 wouldn’t be applicable so spreading would also likely be required for tax purposes.

Finally, we note that the Draft Guidelines essentially adds to a suite of guidance that Inland Revenue has released over the years in respect of software tax issues (some of which is arguably out of date in the modern world), and also doesn’t cover certain issues like withholding taxes. It may be useful for existing Inland Revenue guidance to be consolidated and updated to provide taxpayers with greater certainty about the treatment of this complex area.

Submissions on the Draft Guidelines close on 3 May 2023. Please contact your usual Deloitte advisor if you would like to discuss this further.

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