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

Key points at a glance
  • PwC R&D Specialist, Brendan White talks through what can and can't be classed as R&D in the software sector for tax purposes
  • The most important part of a claim is identifying your R&D activity as solving a technical unknown based on a hypothesis
  • Two types of tests can be applied to determine this - hypothesis testing and operational testing
  • The incentive exists to help reduce the financial burden of taking on risk to conduct R&D work
  • Businesses in the software sector can use Nifty Forms, backed by PwC, ensure your claim is compliant

Startups 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 local businesses to innovate is offered through the Research & Development (R&D) Tax Incentive, reducing the financial risk involved in undertaking R&D. By reducing the 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 a targeted tax offset of up to a 45% refund of costs for eligible activities that are undertaken in Australia. 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, does not mean that all activities qualify for the R&D Tax Incentive.

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 Incentive claim is correctly identifying your core R&D activities. Core R&D activities are required to solve a problem with a technical unknown based on a hypothesis, and there must be an experiment or experiments being carried out for the purpose of generating new knowledge. It is important that the problem you are 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 is not able to determine the outcome based on information available, and investigation is required, it is usually a good indication that you are undertaking 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 R&D Tax Incentive, technical knowledge gaps need to be identified, and the activity must not be undertaken for the purpose of your own internal administration.

When tests and experiments are not classed as R&D

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

Hypothesis testing (as I just mentioned above) is all about testing a technical theory. Expenses for activities classed as hypothesis testing and activities directly related to hypothesis testing are likely to be eligible for a tax offset.

Operational testing on the other hand, covers common software trials such as bug testing, beta programs, and user acceptance testing. Operational testing expenses on the other hand, are not, 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. As a result, most configuration and implementation projects are not considered to be R&D activities.

Whole of platform claims

It has been flagged by the Australian Tax Office who jointly administer the R&D Tax Incentive program with AusIndustry that there is a trend for some businesses to lodge R&D claims for entire software platforms as core R&D when only elements of the software development contain true R&D activities. It is important to discuss with your advisor how to properly separate elements of the platform that are business as usual, and what can be claimed as R&D.

Examples of eligible R&D activities

To highlight what is and isn’t software R&D I have two examples:

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 has to run live tests to trial the solution.

In this activity the developer was generating new technology in the form the algorithm, they didn’t know if it would work and conducted live trials. All of these factors add up to an eligible R&D activity.

An ineligible activity, development of an online quoting tool.

To allow for an automated quoting engine a software developer must collect all of the information about the products and pricing. Once this information is collected the developer will implements 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 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 as a commercial risk rather than a technical one. This means that this activity would be ineligible for the R&D Tax Incentive.

Registering R&D activities

AusIndustry provides help documents that outline further information on how you can assess software activities for the R&D Tax Incentive. However, these can be time consuming and complicated to navigate.

Don’t let this put you off applying. The easiest way to ensure you’re conducting activities the right way is with a helping hand. PwC can offer specific guidance relating to your business to give you the answers you need.

If you're spending less than $500,000 on R&D, PwC offers an accessible solution that will help determine your eligibility, with online platform Nifty Forms. It’s free to signup and will start you on the right track to claiming R&D tax rebates.

Brendan White

Brendan works directly with clients to claim government incentives, such as the R&D Tax Incentive, through Nifty Forms. He has a keen interest in startups and innovative companies.