Software Development and Research: Tax Incentives

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Increased audit focus on software development R&D tax incentive claims may affect your business. In this article, Fullstack explains how to meet the R&D tax rules and reduce risk.

The Australian startup community benefits from a wide range of tax incentives. Since 2018, changes to the software research and development tax incentive approach and the way claims are made have resulted in ongoing discussion, with many startups concerned about the apparent crackdown on software development R&D tax incentive claims.

Australian software R&D tax incentive claims and eligibility requirements can be confusing. In this article, Fullstack will break down the basics on how to meet R&D tax incentive requirements and minimise risk.

Are Software R&D Tax Incentives Changing?

Software development funded by the R&D tax incentive is critical to the growth of the tech sector and the businesses that operate in it. Scrutiny applied to the R&D tax incentive has therefore catalyzed a minor panic amongst tech-oriented startups and generated a series of misconceptions.

Understanding how the incentive requirements work provides Australian companies with a clear understanding of how to best align their practices with the rules in order to access tax incentive benefits in a legitimate manner.

The most common misconception regarding software R&D tax incentives is that the rules and requirements are changing. The Australian government is currently investigating how the current incentive program can be improved, but the fundamental concepts that apply to Australian startups and businesses haven’t changed since 2011.

The Australian government is now assessing the effectiveness of the R&D tax incentive program through a series of policy reviews and is proposing new laws. This process represents an attempt to ensure the incentive program is used correctly and is not the first case in which the government has scrutinized a tax incentive program.

The Austrailan government has previously audited the mining industry and the construction industry — the software industry is now the subject of auditor attention, which means tech startups must follow a rigorous R&D documentation strategy.

The Frascati Manual & Agile Methodology

Innovative software companies and startups are required to support their R&D claims with documentation. This process, however, can be difficult for some companies. The manner in which R&D is defined can prove complex for many startups.

The Australian government currently references the Frascati Manual as a benchmark for the definition of R&D. The Frascati Manual, however, was composed in the 1960’s and does not take into account recent developments in the R&D process and new methodologies.

The Frascati Manual definition of R&D focuses on a process of hypothesis, experimentation, observation, and conclusion. This definition does not align with modern development methodologies such as the modern Agile methodology, which places a strong emphasis on rapid experimentation and functionality over keeping detailed documentation.

The disconnect between the definition of R&D under tax law and the manner in which most software is developed is the primary cause of confusion regarding software R&D tax incentive requirements.

The Australian government has not announced any intention to redefine the tax law that governs R&D tax incentives. Startups seeking to benefit from R&D tax incentives must therefore adapt to current requirements, regardless of how outdated or irrelevant they may appear form a modern software development perspective.

When assembling documentation with the intent of claiming R&D tax incentives, Australian businesses should take the same approach as when assembling a pitch deck or approaching a potential investor. The investor — or in this case, the government — requires that your startup meet specific milestones before approving incentives. Startups and businesses that want to access R&D tax incentives must handle these requirements with care.

For example, 10 hypotheses around aspects of your innovative technology should be accompanied by 10 sets of documentation covering the initial research, steps in the experiment and the outcome by 30 June.

Real time Documentation is Essential

    Capturing real-time documentation is essential. In the event of an audit, your business will be required to demonstrate eligibility by presenting the following records:

  • Weekly Test Reports
    Business can meet this requirement by customizing records such as Asana, Trello, or Atlassian to meet Frascati Manual definitions. Records should begin with a hypothesis centered on technical uncertainty, then provide a clear flow through experimentation, evaluation, and logical conclusions that either prove or disprove the original hypothesis.
  • Weekly/Daily Labor Tracking
    Employees that perform R&D tasks must be tracked, allocated for each core or supporting R&D activity.
  • Contractor Agreements and Invoices
    The details of contractors engaged to perform R&D tasks must be logged. These records must include contractor names, timesheets, and the total expenses allocated for each core or supporting R&D activity.
  • Ongoing Documentation
    All documentation, including GANTT records, code repositories, and research records including internet-based search result screenshots should be recorded on an ongoing basis.

AusIndustry Guidance: What You Need to Know

AusIndustry has released detailed guidance on claiming R&D tax incentives for software development. This guidance provides businesses with comprehensive information on what is considered eligible and ineligible Core R&D activities. It’s important to note that some ineligible activities can be classified as Supporting activities.

AusIndustry considers the following activities to be ineligible for classification as Core R&D activities:

  • Routine software-related development activities
  • Routine debugging of existing programs and systems with the exception of debugging performed prior to the end of an experimental development process
  • Solutions to technical problems that have already been overcome in previous projects. If a technical problem has been solved in a project that has the same technical characteristics, such as architecture or operating system, it is not classified as a Core R&D activity
  • The addition of user functionality to existing programs
  • The use of known methods and existing software tools to develop business application software or information systems

The following activities are probably ineligible for classification as Core R&D activities:

  • Beta testing
  • Bug testing
  • Systems testing
  • Requirements testing
  • User acceptance testing
  • Data migration and data mapping testing
  • Algorithm efficiency testing of algorithms that are known to work
  • Testing websites by measuring hit count
  • Routine software and hardware maintenance
  • Data manipulation of any kind
  • Automated reporting systems of any kind
  • The conversion of any existing computerized or manual record keeping system to a new system.

Ensuring that you are following a compliant documentation strategy is critical in the case of an audit or review. If you’re not sure about your software R&D tax incentive documentation requirements, reach out to Fullstack for guidance today.

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Stuart Reynolds is the founder of Fullstack Advisory, an award-winning accounting firm for businesses leading the future. He is a 3rd generation accountant who specialises in tech & online companies.

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