New R&D Tax Incentive Guidance from AusIndustry – What does this mean for software claims?

BSI Admin

On Tuesday 22 November, AusIndustry released new guidance (available here) to assist companies and their advisors in getting Research and Development (R&D) tax incentive claims right.

The new guidance addresses four key industries:

  • Software development
  • Building and construction
  • Mining
  • Farming

This article focuses on the software development guidance only.

Based on recent figures released by AusIndustry, in 2015 more than 15,024 companies claimed the R&D tax incentive on R&D expenditure of $17.89 billion. The number of registrants for 2015 increased by around 10 per cent, with the strongest growth in small registrants (turnover of less than $20 million), increasing from around 10,330 to more than 11,600 R&D-performing companies (+12.5%) over the period. Software development registrants comprise a significant proportion of total registrants.

Before delving into the detail of the guidance, it is worth quickly recapping on what “R&D” means for the purpose of claiming the R&D tax incentive. The definition is per the Australian Income Tax Legislation (i.e. Income Tax Assessment Act 1997) and is as follows:

  • R&D activities are core or supporting R&D activities.
  • Core activities are experimental activities
    • Whose outcome cannot be known or determined in advance on the basis of current knowledge, information or experience, but can only be determined by applying a systematic progression of work that:
      • is based on principles of established science; and
      • proceeds from hypothesis to experiment, observation and evaluation, and leads to logical conclusions; and
    • that are conducted for the purpose of generating new knowledge (including new knowledge in the form of new or improved materials, products, devices, processes or services).
  • Supporting activities are activities directly related to the core R&D activities.

There are a number of specific exclusions to the core activities definition e.g. market research, market testing or market development, sales promotion, management studies or efficiency surveys, research in social sciences, arts or humanities, developing, modifying or customising computer software for the dominant purpose of use for internal administration.

Software R&D

The intangible nature of software often makes it particularly challenging to show that each of the required elements of a core R&D activity are in fact present. In this regard, AusIndustry has provided the following examples of common errors companies make in relation to software R&D claims:

  • Claiming an entire software development project that includes activities (and expenditure) that are neither a core or supporting R&D activity. Companies must identify specific experiments and separate any experimental activities from routine software design, coding and verification activities.
  • Continuing to claim software development project activities (and expenditure) after the R&D activity is complete.
  • Mistaking “testing” activities for core activities. Companies overlook the requirement that the outcome of the testing cannot be known or determined in advance and that the activity must be conducted for the purpose of generating new knowledge.  Further, forgetting that the testing must be part of a systematic progression of work that starts with a clearly stated hypothesis that then proceeds to an experiment (which could include testing) and then leads to observations and evaluation and logical conclusions – all of which must be documented in real-time.

Through this latest guidance AusIndustry seeks to further explain the definition of core and supporting activities with particular reference to software development projects. AusIndustry is also keen to emphasise to potential registrants that not all software development activities necessarily meet the definition of core and supporting activities. Further commentary and specific examples of software related activities it considers to be ineligible are provided and include:

  • Bug testing
  • Beta testing
  • User acceptance testing
  • System testing
  • Requirements testing
  • Data mapping and data migration testing
  • Testing the efficiency of different algorithms that are already known to work
  • Testing websites in operation by measuring the number of hits
  • Development of software for the dominant purpose of use by the claimant for its own internal administration purposes.

AusIndustry considers that tests or trials that do not test causal relationships between technical variables, with an unknown outcome or an outcome that cannot be determined in advance, will not be eligible core R&D activities. There must be a clearly stated hypothesis that contains variables and a relationship/s to be tested and can be shown to be correct or incorrect.

With regard to generating new knowledge, AusIndustry seems to be reverting to the “competent professional” test i.e. a competent professional in the relevant field must not be able to know or determine the outcome of the experimental activities in advance with the current knowledge, information or experience reasonably available to them. More specifically, AusIndustry has highlighted the following examples of activities as not generating new knowledge:

  • Developing customised solutions from an existing commercial software package
  • Developing operating systems, data systems, network systems, firmware, microcode, middleware, applications, and mobile application software where the inherent complexity and technical challenges can be resolved with the right (existing) knowledge and expertise.

It is critical for a registrant to identify (and document) the specific technical knowledge gaps and evidence that they cannot be bridged routinely by a competent professional in the field using current, knowledge, information and experience.  Applicant companies must show that this technology gap can only be bridged by undertaking one or more targeted and hypothesis-driven experiments. This could be a rather subjective test and it will be interesting to see more case studies in this regard.

Finally, AusIndustry has again emphasised the importance of contemporaneous documentation and noted the requirement for records to substantiate not only that all eligibility requirements are met but also the relevant connection(s) to claimed R&D expenditure. As such, AusIndustry suggests that project records maintained by applicant companies:

  • Show how the experiments were undertaken. Projects using methodologies which don’t fully record steps need to maintain adequate records to evidence that experiments were undertaken, not just a record of the final source code. Using an ‘Agile’ methodology is not an excuse for failure to keep records to substantiate how activities were carried out in an eligible way.
  • Show how the company assessed that the outcome of the activities could not be known or determined in advance
  • Verify the amount of the expenditure incurred on the registered activities and the relationship of the expenditure to the activities
  • Show how expenditure was apportioned between eligible R&D activities and non-R&D activities.

We highly recommend companies embarking on a software R&D project ensure the project is planned and structured properly from the outset.  In addition, appropriate documentation throughout the life cycle of the project is critical to the task of proving eligibility of the activities conducted. Should you need assistance with these or any other aspect of your R&D Tax Incentive claims then please contact us on (02) 9126 9100 or at