[FAQ] The tax implications of software development costs

[FAQ] The tax implications of software development costs

• 17 February 2021
• Capital Gains Tax
• Piet Nel

This article is based on tax law for the year ending 28 February 2021.

Background

A taxpayer created a piece of software to help him in his current business operation. It was not meant for resale. He has now sold this asset to someone who showed interest in the software. A legal sale agreement has been signed with a 3 part payment linked to it. Please advise on the following:

• If the taxpayer is in the software development industry, does this transaction attract Capital Gains Tax(CGT)?
• If the taxpayer is not operating as a software developer, how will this transaction be treated?
• If CGT is applicable and payment is made in instalments, when will CGT be due and what will the base cost be?

Answer

The Income Tax Act

You are reminded that SAIT's technical query system policy prescribes that only guidance should be provided in relation to requests submitted. To do otherwise would cause SAIT to compete with its own members. Guidance implies that sources or references relevant to the request are provided, but that ultimately the tax practitioner’s own professional judgment is required to be applied to the specific circumstances.

SAIT cannot answer the questions you asked, but the following guidance may help you arrive at a tax position.

It must be remembered that the taxpayer bears the onus of proof should the matter be disputed by SARS - in this instance if the tax position is taken that the receipt is capital in nature. The following may be useful to consider when you provide the taxpayer with an opinion or take a tax position.

The ultimate answer will depend on the intention of the taxpayer. Our courts have dealt with this issue on many occasions – the most recent being in the CSARS v Capstone 556 (Pty) Ltd (20844/2014) [2016] ZASCA 2 (9 February 2016). Judge van Der Merwe confirmed that “…our courts have … consistently applied the test that a gain made by an operation of a business in carrying out a scheme of profit-making, is income and vice versa.” See paragraph 24 of the case report. (With ‘income’ the judge of course referred to ‘gross income’.)

The Judge continued, in paragraph 26, as follows:

“There must be “an operation of business in carrying out a scheme for profit-making” for a receipt to be income. That expression refers to the use of the taxpayer’s resources and skills to generate profits, usually, but not always, of an on-going nature.” and in paragraph 34:

“If the receipt or accrual arises from a detailed commercial transaction the transaction must be considered in its entirety from a commercial perspective and not be broken into component parts or subjected to narrow legalistic scrutiny.”

Judge Smallberger, for the majority, in Commissioner for Inland Revenue v Pick ‘n Pay Employee Share Purchase Trust [1992] ZASCA 84; 1992 (4) SA 39 (A), said that:

“The appropriate test in a matter such as the present is a well-established one. The receipts accruing to the Trust will be revenue if they constitute “a gain made by an operation of business in carrying out a scheme for profit-making” …”

“The corollary is that they will be non-revenue if they do not derive from “an operation of business in carrying out a scheme for profit-making” …”

“In this respect I agree with what is said in Meyerowitz and Spiro on Income Tax: para 299 that "[t]he rather clumsy phrase: 'operation of business in carrying out a scheme of profit-making' in plain language really means that receipts or accruals bear the imprint of revenue if they are not fortuitous, but designedly sought for and worked for".

”According to Judge Hefer, in CSARS v Volkswagen of South Africa (Proprietary) Limited (Case No: 153/99), “in the absence of a change of intention a computer in the first case and a motor vehicle in the second cannot be converted from capital assets into trading stock whenever it has to be replaced and is sold.”

With respect to your facts, the question is what the intention of the taxpayer was when the software was developed – either developed with the intention to sell at a profit or to use (licencing or otherwise).

The base cost of the asset would be the cost of acquisition of the asset less the deduction allowed under section 11(gC). The tax law relevant to the time of disposal, of an asset not held as trading stock, is found in paragraph 13(1) of the Eighth Schedule to the Income Tax Act. It reads as follows:

“The time of disposal of an asset by means of a change of ownership effected or to be effected from one person to another because of an event, act, forbearance or by the operation of law is, in the case of—

• an agreement subject to a suspensive condition, the date on which the condition is satisfied;
• any agreement which is not subject to a suspensive condition, the date on which the agreement is concluded;”

It is unlikely that payment terms relating to the transfer of the disposal of the property will constitute a suspensive condition. Judge Wallis, in the recent CSARS v Bosch, said:

“A suspensive condition is one that suspends the exigible content of a contract, either in whole or in part, pending the occurrence of an uncertain future event.”

You will have to determine whether the contract is subject to a suspensive or resolutive condition. Payment terms are generally not a suspensive condition.

Webinar Commentary

Further webinar commentary on Capital Gains Tax can be accessed here.

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