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When is (and isn’t) software development classed as R&D for tax purposes?

    October 2020

    AusIndustry recently released updated guidance for software claims. Here are the key points at a glance:

    • The most important part of a claim is identifying your eligible R&D activity as solving a technical unknown, through experimentation, based on testing a hypothesis
    • The incentive exists to help reduce the financial risk of taking on technical risk to conduct R&D work

    Startups, early-stage companies and established businesses within the software industry understand the importance of innovation — it’s what sets you apart from the competition and keeps your business moving forward.

    The Australian Government also recognises how important innovation is to growing our economy, creating new jobs, and maintaining a high standard of living. Support for businesses to innovate is offered through the Research and Development Tax Incentive (RDTI). By reducing the financial risks associated with conducting R&D, the incentive seeks to boost productivity, innovation and economic growth for the nation.

    What this means for your business is that you could receive up to 43.5% of your development costs back through the tax process.

    Software development is experimental in nature and involves a lot of testing to get right. By this rationale, all development could be R&D, right? Unfortunately, it’s a little more complicated than that. Just because software development involves a life-cycle of testing and experimentation, doesn’t mean all software development activities qualify for the RDTI.

    So when is software innovation classed as R&D for tax purposes?

    Eligible R&D claims in the software industry

    The most important part of an R&D tax claim is correctly identifying your core R&D activities. Core R&D activities are required to resolve a technical unknown based on a hypothesis, and there must be an experiment or sequence of related experiments carried out for the purpose of generating new knowledge. It’s important that the problem you’re trying to solve is technical rather than commercial in nature, i.e. R&D is usually required for testing if something is even possible, rather than simply testing if your customers would use it.

    If a competent professional in the field can’t determine the outcome of the experimentation based on information available, and technical investigation is required, that’s usually a good indication of eligible R&D. This investigation, though, must directly relate to software development rather than lack of available information.

    For software activities to be considered eligible for the incentive, the technical knowledge gaps need to be identified, and the software development must not be undertaken for the purpose of your, or your associate’s, internal business administration.

    When tests and experiments are not classified as eligible R&D activities

    When it comes to developing new, or improving existing, software there are essentially two types of testing that are usually undertaken: hypothesis testing and operational testing.

    Hypothesis testing is all about testing a technical theory. Expenses for activities classed as hypothesis testing, and activities directly related to this, are likely to be eligible for the RDTI.

    Operational testing on the other hand, covers common software development tasks, such as bug testing, beta programs and user acceptance testing. Operational testing expenses are not eligible for the offset, as these tests are conducted to refine an idea or program that is already developed. Similarly, if your business purchases a commercial software platform and then slightly customises or configures it, these solutions can typically be developed with the right technical skills without the need for hypothesis testing through experimentation. As a result, most configuration and implementation projects are not likely to be considered eligible R&D activities.

    Whole of platform claims

    The Australian Taxation Office (ATO), which jointly administers the R&D Tax Incentive program with AusIndustry, has flagged a trend of businesses lodging R&D claims for the development of entire software platforms when only elements of the software development contain true core (or supporting) R&D activities. It’s important to discuss with your advisor how to properly separate elements of the project that are business as usual, and what can be claimed as R&D.

    Examples of eligible R&D activities

    Reposted from our former R&D partner, PwC Nifty.
    Here are two examples to highlight what is and isn’t software R&D:

    An eligible activity: Development of a database synchronisation method for a low bandwidth environment

    To allow for web-based content in rural Australia, a software developer decided to develop and trial a synchronisation algorithm, which would limit the bandwidth required to provide full synchronisation with the online system. At the outset, the developer did not know if the algorithm would limit the required bandwidth to a suitable level to operate in rural Australia, and so has to run live tests to trial the solution.

    In this activity, the developer was generating new technology in the form of the algorithm; they didn’t know beforehand if it would work effectively, and so needed to test it with live trials. All these factors add up to a likely eligible R&D activity.

    An ineligible activity: Development of an online quoting tool

    To enable development of an automated quoting engine, a software developer must collect all of the information about the products and pricing. Once collected, the developer will implement it within a quoting tool that takes various inputs and performs a relatively simple calculation to provide a quote.

    In this activity, the main risk is in acquiring all of the information to develop the quoting tool, as a competent professional in the field would know that the calculation and platform are able to be implemented successfully. Although information collection may create a risk to the completion of the project it would be deemed a commercial risk rather than a technical one. This means this activity would likely be ineligible for the RDTI.

    More information

    To learn more about eligible registrations, including the definitions of ‘experiment’, ‘hypothesis’ and ‘new knowledge’, download the guides and resources and other key documents from the AusIndustry website. lt also has sector guides that illustrate eligible core and supporting R&D activities through hypothetical customer stories, and more.