Tax break for South African software developers

Carrot

The South African government is often slated for not doing enough to promote new business creation and technology innovation. However, there are actually several incentive schemes that companies can benefit from if they are building software products. This article reviews one such scheme: SARS’s Research and Development Tax Incentive Programme. The programme was launched in 2006 with the intention that companies could get tax relief for their research and development spending. However, there were several types of R&D that were specifically excluded. These were:

  • exploration or prospecting,
  • management or internal business processes,
  • trade marks,
  • social sciences or humanities,
  • market research, sales or marketing promotion

The definition of “management or internal business processes” was expanded to include any software system that was used to manage a business process. All ERP, MIS and other business software was therefore excluded from benefiting from this tax break. Since the software also had to “be of a scientific or technological nature” this also excluded any consumer desktop software, web apps and mobile apps.

Fast-forward to 2012 and the Amendment to Income Tax Act 58 of 1962 promulgated on 10 January 2012. This Amendment stated that from 1 April 2012, any software development R&D qualifies for the tax break as long as it is for building software products for resale. Unfortunately, a little while later, the Minister of Science & Technology announced a delay in the implementation from April 2012 to October 2012. This is most likely to give the department time to put in place the systems and processes needed to manage the flood of incoming applications.

International Accounting Standard (IAS) 38 governs the accounting requirements for intangible assets. According to IAS38, all research costs should be expensed, whilst development costs can be capitalised if the commercial feasibility of the product has been established. All development costs are then capitalised up until the product ships. Any costs thereafter are considered support and maintenance and therefore expensed, even if they contribute to the product’s features. The development costs then sit on the company balance sheet as an intangible asset which is amortised over the commercial lifetime of the product.

This is where the benefit of the programme becomes evident. It allows a tax deduction of 150% of all R&D spending. That’s both research and development. So, instead of expensing 100% of your research costs, you can now expense 150% for tax purposes. As for your development costs, instead of capitalising the costs, you get to expense them (at 150%) and thereby further reduce your tax bill. To illustrate this, let’s look at two fictional companies both of whom build and sell software products. Company A doesn’t bother applying for the tax relief we’ve discussed. Company B applies for the tax relief and their application is approved. If they have identical incomes and expenses, let’s look at that benefit the tax relief brings Company B:

 

Company A
Income R 1 000 000
Research costs R 100 000
Development costs R 200 000 This is capitalised and therefore not tax deductible.
Other expenses R 500 000
Profits R 200 000
Taxable Income R 400 000
Tax payable (28%) R 112 000

 

Company B
Income R 1 000 000
Research costs R 100 000 R150,000 is tax deductible.
Development costs R 200 000 R300,000 is tax deductible.
Other expenses R 500 000
Profits R 200 000
Taxable Income R 50 000
Tax payable (28%) R 14 000

 

Company B has managed to reduce their tax bill by a considerable amount!

What types of expenses could potentially be covered by this scheme? Whilst this isn’t specifically spelled out, we think that these expenses would qualify:

  • Staff salaries
  • Hosting fees
  • Licensing fees

In addition, there is also an accelerated depreciation schedule for assets used exclusively for R&D purposes:

  • 50% in year 1
  • 30% in year 2
  • 20% in year 3

There is one caveat. This asset depreciation benefit does not apply to existing assets. It has to be brand new assets purchased for the sole purpose of doing R&D. For example, you can’t use an existing building and re-purpose it as an R&D lab. You need to purchase a brand new building and set it up for doing R&D.

As a software development company, we are often contracted by companies to build software products for them. Since we are doing the development, in theory we would also qualify for the tax break. However, when there is a recoupment of an amount which is claimed as a deduction (the recoupment would be the client paying us for building their product for them) then SARS considers the 150% deduction as taxable income. The net result is that the tax benefit can only be claimed once, by the client paying for that work.

There is another complication if two companies contracting with one another for the provision of R&D work are related parties (part of the same group of companies). In this case, the deductions allowed are limited to only the direct costs incurred by the contractor. No extra deduction is allowed on the mark-up one company charges the other. So, the deduction will have to be the salary of the employee in the contractor company and not the cost on-billed to the client company.

So, if you are building a software product for resale, how do you apply? You need to send your application form to the Department of Science & Technology after October 2012. The application forms are here:

http://www.dst.gov.za/index.php/services/the-rad-tax-incentives-programme

The unfortunate thing about the delayed implementation is that if your application is successful you are only entitled to tax relief on expenditure incurred AFTER October 2012 and not before.

All-in-all, this scheme sounds like a terrific idea and should definitely stimulate new software product development amongst South African tech companies.

Maxxor offers outsourced software development services to help companies who have a software product but who would prefer to focus on marketing and selling rather than product development. We can design, build and maintain your product to allow you to focus on building your business. Contact us to kickstart your product development.