IRD ruling could stifle software projects: NZCS CEO

Originally published 5/11/2011 on Computer World:

Notice that spending on unsuccessful projects isn’t tax-deductible may deter overseas investors, Paul Matthews Says

A recent notice from Inland Revenue saying money spent on “unsuccessful” software projects is not tax-deductible, could well lead international companies to think twice about setting up development facilities locally, says NZ Computer Society CEO Paul Matthews.

If other countries give more favorable tax treatment to expenditure on unsuccessful projects, this may tip the balance when deciding where to put a development shop. This would have a detrimental effect on the ICT sector of New Zealand’s economy, he says.

The IRD finding also delivers negative and confusing signals to teams developing software for domestic industries, he says. Software successfully developed and used in an organisation becomes an asset and can therefore be depreciated and gain tax deductions, says IRD. Work done at an early stage in assessing the feasibility of developing software is also deductible, as an ordinary cost of doing business.

“Once a decision has been made to proceed with the development, any expenditure incurred beyond that point will relate to the acquisition of the software and/or rights in the software” says the note. “From that point on, expenditure should be capitalized,” that is, considered as part of the development of the software asset.

However, if the project fails and no asset is produced that can be used in the course of business, there is nothing to depreciate and the development funds will be lost.

The point at which a feasibility exercise passes over into an actual process of development is often hard to pin down, says Matthews. A major project typically has several processes going on concurrently in development of the software’s constituent parts; some of these could be at the feasibility stage at the same time as others are in the development phase.

This could make it very hard to judge what expenditure is legitimately deductible, says Matthews.

“Government has to change IRD’s interpretation,” he says; the potential consequences for the ICT sector of the economy and ICT development teams in any organisation are too grave for it to be let alone. A change in the regulations or even the law will be necessary.

Other sources, commenting in online media, point out that the ruling could be a recipe for unreasonably pushing a mediocre software project through to production of a depreciable asset, rather than the wiser but less immediately profitable course of abandoning it to develop something better.

A more optimistic commentator suggests it may push organisations towards an agile style of development. This entails developing software in small self-sufficient parts, so even if the project as a whole is abandoned there will still be some usable (and in a tax context depreciable) software assets.

The ruling supersedes one given in 1993, relying on the section of the Income Tax Act [EE39 in the current Act] referring to “items no longer used.” Such items can be depreciated and the 1993 note assumed this would be as applicable to failed software as to failed equipment or abandoned buildings. However, the new ruling says an unsuccessful software development is never used to earn the business any income, so it does not qualify under this provision.

This is the second controversial IRD notice in less than six months with potential impact on ICT. A notice last year suggested data centers running cloud computing operations had to have the data based in New Zealand for tax purposes . Prominent cloud companies such as accounting software company Xero are still in discussion with IRD over possible exemptions to this rule.