Software R&D Tax Guidance: Talking Frascati, Time Travel and What Does It All Mean

February 28, 2019 Kris Gale

It was hard to miss last week’s publication by AusIndustry of two Guidelines relating to eligible software development under the R&D Tax Incentive (the Incentive). Both can be downloaded from the AusIndustry website.

• Software activities and the R&D Tax Incentive (Guideline 1)
• Guide to Common Errors (Guideline 2)

  There has already been  a lot of press and sharing of opinions about the content and impact of the Guidelines.

MJA was attracted to a paragraph that appeared in an article in the startup daily newsletter on Friday, 22 February, the day after the Guidelines were released: https://www.startupdaily.net/2019/02/government-guidelines-software-development-eligible-rd-tax-incentive/?mc_cid=ca7aea1912&mc_eid=9eab7d3201
Written by Gina Baldassarie. The paragraph in question read as follows:

“Activities that do not involve R&D include the development of business application software and information systems using known methods and existing software tools, adding user functionality to existing application programs, and solutions to technical problems that have been overcome in previous projects that have the same technical characteristics, such as the same operating systems and computer architecture.”

The notion that the development of business application software and information systems using known methods and existing software tools and adding user functionality to existing application programs are activities that never qualify for the Incentive is causing shockwaves in the IT and start up communities as many, many R&D projects can be labelled that way.

The burning question is whether the stated notion accurately reflects the law. Thankfully, the answer is no.  And why the answer is no lies in, you guessed it, The Frascati Manual (Frascati).

The startup daily article clearly is quoting from Page 5 of Guideline 1 where it says:

“The Frascati Manual notes the following will not involve R&D:

• software-related development activities of a routine nature. Such activities include work on system-specific or program specific advances that were publicly available prior to the commencement of the work
• solutions to technical problems that have been overcome in previous projects that have the same technical characteristics, such as the same operating systems and computer architecture
• the development of business application software and information systems using known methods and existing software tools
• adding user functionality to existing application programs (including basic data entry functionalities)
• the creation of websites or software using existing tools
• the use of standard methods of encryption, security verification and data integrity testing
• the customisation of a product for a particular use, unless during this process knowledge is added that significantly improves the base program
• routine debugging of existing systems and programs, unless this is done prior to the end of the experimental development process”

  But does Frascati actually say this? Guideline 1 opens up with an introduction that clearly sets out that Frascati has been relied upon in formulating the Guideline as it “…assists with providing practical guidance on what are likely to be eligible  R&D activities “ (Page 1). MJA supports this position. The predecessor R&D Tax Concession was also heavily informed by Frascati. Guideline 1 mentions that the Manual was recently revised in 2015. However, unless the legislators that delivered the Incentive had access to the same technology as Doc and Marty McFly in “Back To The Future”, they could have only had access to the 2002 version of Frascati.

  Here is what was actually said by Frascati in 2002:

  “141. Software-related activities of a routine nature which do not involve scientific and/or technological advances or resolution of technological uncertainties are not to be included in R&D. Examples are: – Business application software and information system development using known methods and existing software tools. – Support for existing systems. – Converting and/or translating computer languages. – Adding user functionality to application programmes. – Debugging of systems. – Adaptation of existing software. – Preparation of user documentation.” (Page 47)

  When compared with Guideline 1, the omission of the words highlighted in bold immediately above is beyond glaring. Frascati clearly states the conditions in which the described activities can involve R&D. And those conditions have been the hallmarks by which many software R&D activities have been characterised and claimed as eligible by taxpayers since 2011. The impact of the omission of the highlighted words is profound and unavoidably impacts on all stakeholders including AusIndustry assessors.

  And it gets more confusing, and the situation more dire, when we look at what Guideline 2 has to say on the matter. Page 1 states the following:

  “Activities unlikely to be core R&D activities are:
  software-related development activities of a routine nature. Such activities include work on system-specific or program specific advances that were publicly available prior to the commencement of the work
  solutions to technical problems that have been overcome in previous projects that have the same technical characteristics, such as the same operating systems and computer architecture
  the development of business application software and information systems using known methods and existing software tools
  adding user functionality to existing application programs (including basic data entry functionalities)…”

  This position contemplates scenarios where the described activities are potentially eligible, albeit unlikely, so it can be read as somewhat consistent with Frascati even though it still omits the qualifying criteria.

  It also stands in direct contradiction with the principal document, Guideline 1.

  What Guideline 1 has done is omit a key paragraph from Frascati 2015 which has a direct qualifying effect on the quoted “will not involve R&D” list.

  “2.70 The nature of software development is such that it is difficult to identify its R&D component, if any. Software development is an integral part of many projects that in themselves have no element of R&D. The software development component of such projects, however, may be classified as R&D if it leads to an advance in the area of computer software. Such advances are generally incremental rather than revolutionary. Therefore, an upgrade, addition or change to an existing program or system may be classified as R&D if it embodies scientific and/or technological advances that result in an increase in the stock of knowledge. The use of software for a new application or purpose does not by itself constitute an advance.”

  The net effect of this paragraph and the list quoted in Guideline 1 is entirely consistent with the approach taken in 2002. At any rate, the 2002 version is the key text here as the 2015 text was not written until four years after the Incentive became law.

  In summary, the published Guidelines are untenable as they do not accurately reflect the contents of Frascati 2002 which was the latest version available to the authors of the 2011 legislation. And remember that not one word of the definition of eligible R&D activities has changed since the legislation took effect in 2011. Surely the Guidelines needs to be withdrawn and rewritten to accurately the position taken in Frascati 2002 (and 2015 for that matter).

  The next MJA Update will tackle a range of additional concerns with the new Guidelines but we will leave you with some food for thought. The Incentive specifically excludes software developed for the purposes of internal business administration. Given the access the legislators had to Frascati 2002, if they definitively wanted to exclude other forms of software development such as those detailed in the list in Guideline 1, why didn’t they include them in the Excluded Activities list? After all, Guideline 1 assures us that that will never involve R&D. Could it be because the legislators believed that they absolutely could?

  Do not hesitate to contact Kris Gale on kris.gale@mjassociates.com.au or 02 9810 7211.