Cap on internal-use software expenditure eligible for a credit (sections LH 9 to LH 13 and LH 17)

2007 legislation means a maximum of $3 million of internal software development expenditure will be eligible for a research and development tax credit in any year.

A maximum of $3 million of internal software development expenditure will be eligible for an R&D tax credit in any year. Where businesses undertaking internal software development are under common control, they form an internal software development group and must count their expenditure on such development towards a single $3 million cap.

In exceptional cases, the level of the cap may be increased by the Minister of Finance for an individual or an internal software development group if certain conditions, essentially relating to national interest, are met.

In other jurisdictions, claims for R&D incentives relating to internal software development have been problematic. In Australia, the 125 percent and 175 percent deductibility R&D tax incentives are not available for software developed for solely internal use.

The New Zealand credit allows claims for internal software development, but caps these claims to limit the fiscal risk of abuse.

The cap does not affect a business's entitlement to credits for expenditure that does not relate to internal software development.

Outline of the sections

Section LH 9 adjusts the eligible expenditure on internal software development a business can claim a credit for. Subsection (1) determines when a business is eligible for a credit for internal software development and therefore has to apply section LH 9. Subsection (2) determines which other sections to use in adjusting the eligible expenditure.

Section LH 10 adjusts eligible expenditure on internal software development for periods when the business is not a member of an internal software development group.

Section LH 11 adjusts eligible expenditure on internal software development for periods when the business is a member of an internal software development group in which all members have the same income year.

Section LH 12 adjusts eligible expenditure on internal software development for periods when the business is a member of an internal software development group in which not all members have the same income year.

Section LH 13 sets the maximum annual eligible expenditure on internal software development, and allows for Ministerial discretion to increase the maximum in certain circumstances.

Section LH 17 defines the terms "associated internal software developer", "internal software development", "internal software development controller" and "internal software development group".

Internal software development

In section LH 17, "internal software development" is defined as a research and development activity of developing software that:

  • does not have as its main purpose sale, rent, license, hire or lease to two or more people who are not associated with the developer or with each other; or
  • has as a purpose the use of the software in the internal administration of the business activities of the developer (such as payroll, bookkeeping or personnel management) or of an associate; or
  • has as a purpose the provision of services to customers of the developer or an associate, if the main reason those customers use the services is to obtain services other than the use of the developer's (or associate's) computer technology or software (such as if they use the services to obtain accounting, consulting or banking services).

There is an exception to the definition - software which is an integral part of an electrical or mechanical device for which the software is developed is not internal software development if the electrical or mechanical device is developed mainly for sale, rent, lease or license to customers as part of the developer's business.

Software developed as a supporting activity, as well software developed as a SIE activity, is subject to the cap.

Examples: Definition of internal software development (main purpose of sale)
  1. Company B is undertaking R&D to develop software which it will use internally. The cap applies, because Company B is developing the software with no purpose of sale. Company B may not claim credits in any year for more than $3million of its software development expenditure.
  2. Company C is undertaking R&D to develop software which it will sell to Company D, its parent. The cap applies, because Company C is developing the software with a purpose of sale only to an associate.
  3. Company E is undertaking R&D to develop software which it will use internally. The board members of Company E have also discussed the possibility of sale of the software to other large companies that are not competitors, to recoup some development costs. The board members have instructed a staff member to investigate the potential market for the software and to ensure that the software is easily customised. The developers have been advised that they need to build some flexibility into the design of the software. The cap applies, because Company E has a purpose of sale of the software, but does not have a main purpose of sale of the software. The purpose of sale is ancillary to the purpose of internal use.
  4. Company F is undertaking R&D to develop software which it will sell to utility companies. It has signed contracts with three companies to supply the software and it is actively marketing to other interested parties. F will not be using the software in the internal administration of its business. None of these companies is connected in any way to Company F or to each other. In this case, the cap is unlikely to apply, since the main purpose of development is sale to multiple non-associates.

Examples: Definition of internal software development (internal use or use to provide services)

  1. Company G is undertaking R&D to develop software which it will sell to utility companies. It has signed contracts with eight companies to supply the software and it is actively marketing to other interested parties. G's parent company will also be using the software to bill its customers. The cap applies, since there is a purpose of using the software in the internal administration of the business activities of an associate of G.
  2. Company H is undertaking R&D to develop software to integrate a new enterprise resource planning package with its legacy information systems. Once it has done this, it intends to sell an integration package to other companies with the same legacy systems. The cap applies even though there is a purpose of sale of the software, because there is another purpose of using the software in the internal administration of the business.
  3. Company J, a management consultant, is undertaking R&D to develop software that will allow its clients to view all work they have commissioned and all past communications between the client andJ. The software will run on J's web server. A portion of clients' fees implicitly entitles them to authenticated access to a website controlled by the software. The cap applies - clients are using the service mainly to obtain management consulting services they have commissioned, and not mainly to obtain the use of J's computer technology or software.
  4. Company K, a telecommunications company, is undertaking R&D to develop software which will allow its customers to independently configure account settings, and add and remove lines and services. K plans to charge customers a licence fee for using the software. The cap applies because the software will be used by K's customers mainly to obtain a telephone service, and not mainly to obtain the use of K's computer technology or software.
  5. Company L, a bank, is undertaking R&D to develop web-banking software. L plans to charge its customers a licence fee for using the software. The cap applies because the software will be used by L's customers mainly to obtain a banking service, and not mainly to obtain the use of L's computer technology or software.
  6. Company M, a bank, is undertaking R&D to develop a computer game which simulates financial markets. The game is to be played on-line, and will run on the bank's servers. M plans to license access to the game to schools, and will not use the R&D for any other purpose. The cap is not likely to apply in this case, since schools which buy an access licence are doing so primarily to obtain the use of the software and not to obtain another (for example, banking) service.

Examples: Definition of internal software development (exception when integral to hardware

  1. Company N develops a stand-alone video recorder for sale. Software is developed to run inside the recorder and remove offensive language or images from incoming video as it is recorded. Assume the software development meets the definition of R&D. The software is written specifically for the video recorder and the video recorder cannot operate without it. The video recorder is developed for sale to the public. The software is integral to the recorder, and the recorder is developed for sale to customers as part of N's business, so the cap does not apply.
  2. Company P develops software to be used for conducting cash transfers between its customers over the internet. P also buys computer hardware and modifies it to prevent physical tampering. The software will run on the tamper-proof hardware, which will be administered by P's customer at its own premises. P intends to mass-produce the modified hardware and sell it to non-competitors who can use it to run their own security-sensitive applications. The software is not integral to the modified hardware and will not be supplied as part of the hardware when sold to external customers. It could also, with minor modifications, be run on other hardware. The software is subject to the cap, because it is not integral to the modified hardware and is not developed with the main purpose of sale.

Internal software groups (section LH 17)

To prevent multiplication of caps through the use of subsidiaries or other controlled entities, businesses that undertake internal software development are required to group themselves with other developers under the same control. The expenditure of the entire group counts towards a single cap.

Each business undertaking internal software development (a "developer") has an internal software development controller (a "controller"). The controller is the person, or group of people, who have ultimate control over the developer. In simple cases, the developer and the controller might be the same person. The intent is to ensure that the ultimate controller is identified, rather than any intermediate entity in a chain of controlling entities.

The test for control of an entity by a person is that the person has the power to govern the financial and operating policies of the entity to obtain benefits from its activities. The test is based on the definition of "control" in New Zealand International Accounting Standard 27 (Consolidated and Separate Financial Statements), so if two people would be required to consolidate for financial reporting purposes, it is highly likely that they would be under common control.

When a business has the same controller as other businesses, those businesses are members of an internal software development group (a "group"). A business is a member for as long as its controller does not change, provided that there is at least one other business with the same controller at the same time.

A business can be a member of no group for all or part of the year, one group for all or part of the year, and more than one group over the course of a year.19

Examples: Mechanics of internal software development groups
  • ACo, BCo and CCo have the same internal software development controller (implying they undertake internal software development) and are therefore members of an internal software development group. ACo stops doing internal software development. Therefore, ACo no longer has an internal software development controller, and ACo is not a member of the group any longer. The group continues to exist, however, with BCo and CCo as members.
  • DCo, ECo and FCo have the same internal software development controller and are therefore members of an internal software development group. DCo and ECo stop doing internal software development. Therefore, DCo and ECo no longer have an internal software development controller, and are not members of the group any longer. FCo no longer has any other person having the same internal software development controller, so the group ceases to exist.
  • GCo and HCo both have the same, single shareholder, Carol. GCo undertakes internal software development, and Carol is GCo's internal software development controller. HCo does not undertake internal software development. HCo begins internal software development. Therefore, GCo and HCo are now the members of an internal software group.
  • JCo and KCo are the members of an internal software development group, X, controlled by Mrs X. LCo and MCo are the members of another internal software development group, Y, controlled by Mr Y. Mr Y sells LCo and MCo to Mrs X. Group Y ceases to exist, and LCo and MCo become members of Group X.
  • At the beginning of the year, NCo, OCo and PCo have the same internal software development controller and are therefore in an internal software development group, Z. OCo is sold to a non-associate in the middle of the year. QCo is purchased by PCo in the last quarter of the year. NCo, OCo, PCo and QCo are all members of Z at some time over the course of the year. NCo and PCo are members for the entire year, OCo is a member for the first half of the year and QCo is a member for the last quarter of the year
Allocation of the cap (sections LH 10 to LH 13)

When not a member of any group (section LH 10)

For the period a developer is not a member of any internal software development group, the developer will have eligible expenditure on internal software development.

The eligible expenditure on internal software development for which a credit may be claimed is capped. The cap is $3 million for a full year. If the period for which the business is not a member of any group is not a year, then the formula in section LH 10(1)(b) prorates the $3 million on a daily basis.

Example: Credit for internal software development when not in a group

ACo undertakes internal software development. For the first 73 days of the year, ACo is not under common control with any other developer. However, on 13 June2008, BCo - also a developer - purchases 100 percent of ACo. For the purposes of claiming a credit, ACo adjusts down its eligible expenditure on internal software development, for the period it was not in any group, to a maximum of $3 million multiplied by 73 divided by 365 = $600,000. If ACo's eligible expenditure for the period in the absence of section LH 10 is $300,000, ACo will be able to claim a credit for $300,000. If ACo's actual eligible expenditure for the period in the absence of section LH 10 is $700,000, ACo will only be able to claim a credit for $600,000

Allocation when a member of a group (sections LH 11 and 12)

For the period that a business is a member of an internal software development group, it is not entitled to any credits for eligible expenditure relating to internal software development, but might be entitled to a share of credits for the combined eligible expenditure of group members.

The entitlement to credits for a share of the combined eligible expenditure of group members depends on the nature of the group, but in no case can a group allocate more than $3 million across all its members for a full year. The group members are free to decide the exact allocation, subject to the restrictions described below.

An overriding requirement in all cases is that no member may have eligible expenditure relating to internal software development which is greater than the eligible expenditure that business would have had, during the period of membership, in the absence of sections LH 9 to LH 13.

Note that in the special case where a business leaves a group and one member or no-one is left in the group, the group ceases to exist. In that case, the business leaving and the business remaining (if any) will have their entitlement to credits determined on the basis of part-year membership.

Members of a group with identical income years (section LH 11)

If all the members of the group have the same income year (same length of year and same balance date), a member can have eligible expenditure allocated to it and claim a credit.

The maximum eligible expenditure relating to internal software development that is available to be allocated to all group members is $3 million for a full year, and this amount is required to be prorated on a daily basis where the period for which the member is in the group is less than a full year.

Members of a group with non-identical income years (section LH 12)

If any member, X, of the group has an income year which differs from the income year of another member, X will only be able to receive an amount of credit if X has been a member of the group for X's entire income year.

The maximum eligible expenditure relating to internal software development that is available to be allocated across all group members is $3 million for a full year.

Examples: Allocation of the cap
  • ACo and BCo are members of an internal software development group. ACo and BCo have the same (standard) income years, and are members of the group for the entire year. ACo would have eligible expenditure relating to internal software development expenditure of $2.2 million for the year, in the absence of sections LH 9 to LH 13. BCo would have eligible expenditure of $1.5 million. ACo and BCo may share credits for eligible expenditure of $3 million. The allocation may be made as the parties see fit, as long as ACo receives credits for no more than $2.2 million and BCo receives credits for no more than $1.5 million.
  • CCo and DCo, which have standard income years, are not members of any internal software group, but are under common control. CCo and DCo begin internal software development on 1 July 2008. Therefore, they are the members of an internal software development group from 1 July. The group exists for 274 days of the incomeyear (1 July 2008 to 31 March 2009), and CCo and DCo are members for this entire period. CCo would have eligible expenditure relating to internal software development of $4 million in the absence of sections LH 9 to 13. DCo would have eligible expenditure of $5 million. CCo and DCo can share credits for eligible expenditure of $3 million multiplied by 274 divided by 365 = $2,252,054 (see subsection LH 11(5)). This can be shared in any way.
  • ECo and FCo are members of an internal software development group. ECo and FCo have the same (standard) income years, and are members of the group for the entire year. ECo would have eligible expenditure relating to internal software development of $2.2 million for the year, in the absence of sections LH 9 to 13. FCo would have eligible expenditure of $1.5 million. GCo, an internal software developer with a standard income year, is bought by FCo on 1 July 2008, so is a member of the group for 274 days of the year. In the absence of sections LH 9 to 13, GCo would have eligible expenditure relating to internal software development of $1 million for the first 91 days of the year, and $3 million for the other 274days. GCo calculates that the group can allocate up to $3 million multiplied by274 divided by 365 = $2,252,054 to it for the period it is a member (according to section LH 11). ECo and FCo calculate that the group can allocate up to $3 million to the pair for the full-year period they are members (again according to section 11). Assume GCo has received a credit for the full $2,252,054 available for the period it was a member. Then of the $3 million of eligible expenditure allocable to the group over the (full-year) period of ECo and FCo's membership, $747,946 is left for distribution to ECo and FCo. This distribution may be made as the pair see fit. GCo is also entitled to a credit for $3 million multiplied by 91 divided by 365 = $747,945 for eligible expenditure relating to internal software development incurred during its time outside the group.
  • HCo and ICo are members of an internal software development group. HCo and ICo have the same (standard) income years, and are members of the group for the entire year. HCo would have eligible expenditure relating to internal software development of $2.2 million for the year, in the absence of sections LH 9 to 13. ICo would have eligible expenditure of $1.5 million. JCo, an internal software developer with an income year ending 31 December 2008, is bought by ICo on 1July 2008, so is also a member of the group for 184 days of its income year. In the absence of sections LH 9 to 13, JCo would have eligible expenditure relating to internal software development of $2 million for the first 181 days of the year and $2 million for the other 184 days. HCo and ICo share credits for an eligible amount of $3 million (according to subsections LH 12(3) and (4)). The allocation may be made as the parties see fit, as long as HCo receives no more than $2.2 million and ICo receives no more than $1.5million. JCo receives no credit for the internal software expenditure incurred while a member of the group, because it is a member for less than its full income year (see subsection LH 12(2)). JCo is, however, entitled to a credit for $3 million multiplied by 181 divided by 365 = $1,487,671 for the eligible expenditure relating to internal software development incurred during its time outside the group (section LH 10).
  • KCo and LCo are members of an internal software development group. KCo has an income year ending 31 March and LCo has an income year ending 30 April. KCo would have eligible expenditure relating to internal software development of $2.2 million for the year, in the absence of sections LH 9 to 13. LCo would have eligible expenditure of $1.5 million. KCo is liquidated on 30 November 2008, and the group ceases to exist on this date. KCo and LCo are members of the group for only part of their 2008-09 income years and have different income years, so receive no credit relating to internal software development expenditure incurred while members of the group. LCo is entitled to credits for such expenditure incurred after the group dissolves, according to the formula in section LH 10.

Level of the cap (section LH 13)

The level of the cap is $3 million for a year. This is the level for an individual and for an internal software development group.

The $3 million cap is not expected to impact on most claimants, as few are likely to have more than $3 million of eligible expenditure on internal software development. In exceptional cases when expenditure does exceed the cap, a different level of the cap may be determined for an individual or an internal software development group, for a period, by notice in the New Zealand Gazette. The increase of the cap may be granted on application to the Minister of Finance if the Minister considers that three requirements, broadly relating to national interest, are met.

The three requirements are based on similar requirements for obtaining government-provided incentives in Australia and New Zealand, and are:

  • That the internal software development will be exploited mainly for the benefit of the New Zealand economy.
  • That New Zealand will derive a substantial net benefit from intended completion of the internal software development.
  • That the person (or in the case of the cap being increased for an internal software development group, the internal software development controller) has a commitment to retain the value of their business in New Zealand.

An increase in the level of the cap under section LH13 does not automatically entitle a person or internal software group to an amount of R&D tax credit. Allthe other requirements in the legislation, such as the requirement that the activity meet the legislated definition of R&D, must still be met.

The Minister of Finance may impose conditions on a determination to increase the level of the cap, and the determination will not apply unless those conditions are met.

 


19 The legislation refers to the expenditure of members of an internal software development group for income years corresponding to a tax year (sections LH 11(5)(a) and 12(4)(a)). This includes only expenditure for the period the businesses are members of the group, since any other expenditure is no longer expenditure of a “member”.