New Zealand's tax treatment of software development and sale
With several high-profile software businesses being sold in New Zealand (including a number of transactions in which DLA Piper New Zealand has acted) and with continued investor interest in software businesses, the tax treatment of software development and sale has become increasingly topical. Inland Revenue have indicated this is an area they will review.
New Zealand has no general capital gains tax, so one of the advantages of developing and owning software in New Zealand can, in certain circumstances, be that a New Zealand company can sell software (more specifically, copyright in the code) and related intellectual property without being subject to tax on the gain.
In order to determine if software will be taxable on sale, the key questions are: did the company develop the software for use within its own business (capital account property); or was the software developed for sale (revenue account property).
Software held on capital account
In 1993 the Inland Revenue issued a detailed Policy Statement (Tax Information Bulletin Vol 3, No 10, May 1993) that, among other things, confirmed that software developed by a company for use within its own business will be treated as being held on capital account.
For software held on capital account, development expenditure is not immediately deductible but is required to be capitalised and depreciated over time. This does not generally have a significant timing impact as New Zealand has relatively high annual depreciation rates for software, being 40% straight line or 50% diminishing value. In practice, this means the capitalised software development expenditure on a completed software project can generally be fully deducted within two and half years. In addition, predevelopment expenditure and certain 'research' and 'development' expenditure under accounting standard (IAS 36) may still be immediately deductible.
Where a person sells software that they have previously depreciated (and claimed tax deductions), those depreciation deductions can be ‘clawed’ back upon a subsequent sale giving rise to depreciation recovery income (DRI). The maximum DRI payable on any asset is equal to the asset’s historical cost. Any gain over the historical cost of the software is not subject to further income tax.
Most software developed by an operating company and that is used within its business will be held on capital account. This means there is an ability to sell that software without incurring a significant income tax cost, which is advantageous to the vendor. To consider an example, if a book store owner developed a software programme solely to maintain an effective inventory of the books held in its book store, that software should be capital account software. If that book store sold that software, then any gain over and above its historical cost should not be subject to tax.
Inland Revenue issued a draft Issues Paper in 2016 (IRRUIP10) which again confirmed its current view that software could be held as capital account property. It also confirmed that software development expenditure is not the cost of producing trading stock where software is being developed for use in providing SaaS or non-exclusive licensing. However, the draft Issues Paper was never finalised, and Inland Revenue have recently indicated this is an area they intend to review further.
Software held on revenue account
By comparison, if a company is developing software for sale or to provide it on an exclusive licence basis, then the software will be regarded as 'trading stock' and revenue account property. For this revenue account software, expenditure should be immediately deductible. In the event the software is sold, all proceeds from the sale of that software will be taxable on sale.
In some cases, it will not be clear whether software is being developed for sale. To further consider the example above, if the book store owner was also developing the inventory software programme with an ultimate plan to sell the software to a third party, the software may be revenue account property. Issues can also arise where, for example, a New Zealand company has treated all software development expenditure as immediately deductible, without considering whether the expenditure should be treated as capital expenditure and depreciated. In these cases, income tax may be payable when the software is sold.
Share sale vs Asset sale
Related to the discussion above is whether any eventual exit by a software business owner will be by way of a share sale or an asset sale. Without going into all of the detail, a share sale can be preferrable for a New Zealand seller, particularly if the shares are held on capital account, and can remove the issues associated with tax on depreciation recovery income and any software held as revenue account property. However, an asset sale can be preferred by a buyer, as they can acquire the software without any of the tax issues associated with the selling company and may get a 'step up' in the value of the software being acquired. This will require careful consideration of the issues above.