Tax deductions for SaaS configuration and customisation costsUnderstanding the Latest Guidance from Inland Revenue
New Zealand's Inland Revenue (IR) has published an exposure draft indicating its initial interpretation of the deductibility rules in the context of software as a service (SaaS) configuration and customisation (C&C) costs. This guidance is positive news, as IR has confirmed that, in most cases, expenses related to SaaS C&C should not be "black hole" expenditure and that an income tax deduction should be available, with the key question being when the deduction arises.
What is SaaS expenditure?
SaaS is a software delivery model that allows businesses to access software applications via the internet, without the need to install and maintain software on their own computers or servers. This delivery model is different from the traditional software delivery model which often requires businesses to develop software, or purchase licenses or packages, to access certain software. SaaS allows businesses of all shapes, sizes and industries to effectively outsource their software needs to third-party SaaS providers and focus on their core competencies of providing goods and services to their customers.
SaaS is not a 'one-size-fits-all' solution. In most cases, the specific SaaS product will require a degree of modification or customer systems will require changes, to integrate the applications or to add functionality or features, all of which require significant C&C expenditure. The majority of significant software development projects for New Zealand corporates will be some form of SaaS project, such as implementing a new enterprise resource planning (ERP) system or a customer relationship management (CRM) system. From a legal standpoint, SaaS agreements are generally drafted on the basis that the customer does not own the software and has no rights to the enhancements.
New Zealand income tax treatment of software development expenditure
The New Zealand income tax treatment of software development expenditure and, in particular, whether or not that expenditure is of a capital or revenue nature, can have significant tax implications for businesses. We have outlined this previously in an article found here.
In the majority of cases, software development expenditure will be regarded as capital expenditure for tax purposes and should be capitalised. However, if the software development expenditure is research and development (R&D) expenditure then, for tax purposes, the expenditure may be immediately deductible. Section DB 34 of the Income Tax Act 2007 (ITA) overrides the capital limitation if a person applies the New Zealand Equivalent to International Accounting Standard 38 (Intangible Assets) (NZ IAS 38) and the expenditure is either "research" or "development" under that accounting standard.
Before IR's exposure draft, the tax treatment for auxiliary but often necessary C&C expenditure was murkier. C&C expenditure may have an enduring benefit to a company, which can result in that expenditure being treated as a "capital expense". Generally, capital expenditure is only tax deductible where tax depreciation can be claimed over the useful life of an asset that is owned by the company. Under a SaaS arrangement, it is the SaaS provider who typically owns the intellectual property related to the SaaS product and related modifications (i.e., the SaaS provider "owns" the asset). Arguably, this meant a company that incurs C&C expenditure has no clearly identifiable asset when compared to the development of the software or purchase of a particular software licence (i.e. there is no fixed or fixed-life asset to depreciate).
Inland Revenue's Exposure Draft on SaaS expenditure
At a high-level, IR has indicated in its exposure draft that SaaS C&C costs will generally be tax deductible in circumstances where the expenditure is incurred for the purposes of generating assessable income. In coming to its conclusion, IR considers the general permission, the capital limitation, the availability of a deduction for R&D under section DB 34 of the ITA and the possibility of depreciation deductions, these are briefly summarised below.
Under section DA 1 of the ITA a New Zealand taxpayer is entitled to a deduction where there is a sufficient "nexus" (i.e. connection) between the expenditure incurred and income derived in the course of carrying on a business. In our experience, we would expect that most SaaS and C&C contracts would meet these general requirements. IR agrees with this view.
The Capital Limitation
The capital limitation, as set out in section DA 2 of the ITA, provides that a New Zealand taxpayer is denied a deduction for an amount of expenditure which is of a capital nature. The ITA does not define what is "capital" in nature, but case law concepts have found expenditure to be capital in nature where it produces an advantage of an "enduring benefit", or where the expenditure is not of a "recurrent" nature. In each case, the determination of whether expenditure is of a capital nature (and, therefore, not deductible) will be a fact-dependent exercise.
In the context of SaaS C&C expenditure, we have seen both SaaS contracts which are concluded on the basis of providing long-term and enduring benefits, which would suggest the expenditure is "capital" in nature, as well as others which are of a recurring nature and suggest that the expenditure is "revenue" in nature.
Research or Development expenditure
Section DB 34 of the ITA will override the capital limitation if a person applies NZ IAS 38, and the expenditure is either "research" or "development" under that accounting standard.
IR's view is that "in-house" costs incurred on SaaS C&C should qualify as "development" expenditure and should be immediately tax deductible. In our experience, most large companies in New Zealand apply NZ IAS 38 and so an immediate deduction should be available for such costs incurred by those companies.
Fixed Life Intangible Property
The exposure draft states that where SaaS C&C expenditure does not qualify for an immediate tax deduction under section DB 34 of the ITA, it may still be included as part of the "cost base" of a company's "right to use" software. The right to use software is depreciable intangible property that can be depreciated for tax purposes.
Depending on the terms of the agreement with the SaaS provider, the rights to use the SaaS product may be "fixed-life intangible property" and may be capitalised and depreciated over time. The timing of such deductions may then be dependent on the duration and terms of the SaaS and C&C contracts.
Importantly, the fact that a company does not own the software and has no rights to the enhancements, does not seem to impact the conclusions above. It would appear that IR has taken a more pragmatic and common-sense approach to dealing with the tax treatment of SaaS C&C expenditure.
IR's guidance is good news for companies and essentially means:
- where a company adopts the NZ IAS 38, IR considers that SaaS C&C costs may qualify as in house "development" expenditure and qualify for immediate deduction under section DB 34 of the ITA; or
- if the company does not qualify for an immediate deduction under section DB 34 of the ITA, it may be able to include SaaS C&C costs as part of the cost base of its right to use software. Depending on the terms of the agreement with the SaaS provider, the rights to use the SaaS product may be "fixed life intangible property" that is capitalised and depreciated over time and entitled to a tax deduction.
IR's exposure draft is positive news for businesses who use or intend to use SaaS to better meet their software needs. We expect this exposure draft to encourage New Zealand corporate taxpayers to invest in C&C so that SaaS solutions better align with their specific needs, driving greater efficiency, innovation and growth.
Ultimately, the tax treatment of SaaS C&C expenditure will still be somewhat fact dependent. To confirm the tax treatment will require careful consideration of how agreements are drafted with the SaaS provider or a third-party providing the C&C services.
A copy of the exposure draft can be found here. Comments on the exposure draft are due by 3 May 2023.
As always, our team is happy to help with any queries.