Inland Revenue has released its much-anticipated analysis on the tax treatment of software as a service configuration and customisation (“SaaS C&C”) costs, in draft, for consultation.

The need for this guidance was prompted by a change of interpretation in relation to the accounting treatment of SaaS C&C costs. Specifically, a 2021 International Financial Reporting Interpretation Committee (“IFRIC”) decision that SaaS C&C costs will typically not result in an intangible asset under the relevant accounting standard (NZIAS 38) and, if so, these costs should be expensed for accounting.

This creates a potential mismatch for tax if SaaS C&C costs have been capitalised and depreciated as the right to use software. Of particular concern, was whether these costs could become non-deductible and non-depreciable for tax – “black hole” expenditure – with the change in accounting view.

Under Inland Revenue’s draft interpretation guideline:

  • SaaS C&C costs are broadly defined as those incurred in integrating a SaaS application into an existing system. “Configuration” includes defining values or parameters for the software’s code to function in a particular way while “customisation” includes changing or adding to the software’s functionality.  
  • The income tax treatment of SaaS C&C costs will depend on the contractual agreements in place and the services under those agreements.
  • There will be a nexus with income for SaaS C&C costs, but consideration will need to be given whether the expenditure is capital in nature.
  • In some cases, an immediate deduction may be available if the requirements of section DB 34 of the Act are met.
  • In other cases, the SaaS C&C costs will need to be capitalised either as depreciable intangible property (“DIP”) (as part of the right to use software under a SaaS arrangement) or as fixed life intangible property (“FLIP”) (depending on the legal term of the particular SaaS arrangement).
  • Different tax depreciation rates may apply. If DIP, the software rate can be used. If FLIP, the depreciation rate is based on the legal term. However, if a SaaS arrangement is longer than 4 years, the Commissioner considers that the capitalised C&C costs cannot be FLIP (as that is more than the estimated useful life for the underlying software) and must be depreciated at the software rate. 

Some initial thoughts

The release of the draft interpretation confirming that SaaS C&C costs will receive tax recognition is very welcome, given the tax uncertainty created by the 2021 IFRIC decision, and the need for taxpayers to take positions in their 2022 tax returns.

There are some things to be aware of:

The draft interpretation guideline concludes that to apply section DB 34, which was introduced to allow an immediate deduction for research and development (“R&D”) expenditure that is expensed for accounting, the SaaS C&C costs must meet all of the following requirements:

(a)  The expenditure must be within the scope of NZ IAS 38; and

(b)  The SaaS C&C costs must be either “research” or “development” expenditure as defined in NZ IAS 38; and

(c)   The SaaS C&C costs must be recognised as an expense under paragraph 68(a) of NZ IAS 38; and

(d)  Paragraphs 54 to 67 of NZ IAS 38 must be applied when determining whether SaaS C&C costs are expensed under paragraph 68(a) of NZ IAS 38.

Therefore, if relying on section DB 34, businesses should ensure they have robust accounting support on the application of NZ IAS 38 to the relevant costs.

Further, due to the nature of the expenditure allowed to be expensed under NZ IAS 38 – internally generated R&D – Inland Revenue considers that its application is limited to internal costs. Therefore, the draft guideline considers that section DB 34 can only apply in the case of internal SaaS C&C projects, not where the SaaS provider undertakes the C&C work.

Depending on whether the SaaS arrangement gives right to a DIP or a FLIP, different depreciation rates will apply. Counterintuitively, SaaS arrangements with a term greater than 4 years will result in the associated C&C costs being treated as DIP and depreciable at the annual software rate of 50% (diminishing value) or 40% (straight line). C&C costs relating to SaaS arrangements with a term of less than 4 years will need to be depreciated over that term – so, for example, a 3-year term will result in a 33% straight line rate.

There are also a number of practical issues to consider:

  • The need to identify and track the relevant SaaS C&C costs in tax fixed asset registers (if not applying section DB 34). 
  • What needs to be included in the SaaS cost base. The draft guideline considers that this includes all costs incurred in order to get the SaaS product into a condition for its use. This is potentially quite wide. It is not clear whether this is intended to capture activities such as data migration into a new SaaS product. Conversely, where costs cannot be included in the SaaS cost base, their tax treatment may be unclear.   
  • In many cases there will be no fixed contractual term for use of the SaaS product. Equally, where contracts have rights of renewal or extension, that will need to be factored into the calculation of legal life. These may impact whether the relevant C&C costs are DIP or FLIP for tax purposes.   

Submissions on the draft interpretation guideline can be made by 3 May 2023.