Section 11D of the Income Tax Act, No 58 of 1962 ("the Act") provides for a tax incentive in respect of research and development ("R&D") expenditure incurred by taxpayers in South Africa after 1 November 2006. The incentive comprises a 150% deduction for qualifying expenditure directly incurred in respect of R&D activities, and an accelerated depreciation allowance in respect of the cost of capital assets used for R&D purposes.
In order for the incentive to apply, the expenditure incurred must relate to activities comprising, inter alia, the devising, developing or creation of any computer program as defined in section 1 of the Copyright Act, No. 98 of 1978 ("the Copyright Act"), if that computer program is of a scientific or technological nature and is intended to be used by the taxpayer in the production of income, or is devised, developed or created by the taxpayer for the purposes of deriving income.
R&D activities undertaken by taxpayers frequently relate to the development of computer software, such as computer programs to monitor sales, fleet management software and the like.
No deduction is however, allowed in respect of expenditure or costs relating to, inter alia, management or internal business services, trademarks, market research, sales or marketing promotion.
The question arises whether software development activities would qualify as a "computer program" for purposes of section 11D of the Act and, if so, whether computer programs developed for the purpose of managing certain business operations would constitute excluded "management or internal business services".
scientific or technological nature
The first question for consideration is whether the software constituting computer programs, is "of a scientific or technological nature".
The Cambridge Online Dictionary defines "technology" as "(the study and knowledge of) the practical, especially industrial, use of scientific discoveries". The phrase "computer technology" is used as an example. The Merriam-Webster Online Dictionary defines "technology" as including "the practical application of knowledge especially in a particular area", "a capability given by the practical application of knowledge", "a manner of accomplishing a task especially using technical processes, methods or knowledge" and "the specialised aspects of a particular field of endeavour". The American Heritage Dictionary defines the word as meaning "the application of science, especially to industrial or commercial objectives", "the scientific method and material used to achieve a commercial or industrial objective" and "electronic or digital products and systems considered as a group".
It is submitted that a computer program is by its very nature of a scientific or technological nature. The nature of a computer program is not determined by ascertaining the practical uses to which it may be put by the user, but by examining the program itself: a set of instructions written in a computer language and capable of being used in a computer to direct the latter’s operations to bring about a result.
In relation to computer programs, the only requirement in section 11D of the Act (in addition to its inherent scientific or technological nature) is that the program should comply with the definition in section 1 of the Copyright Act. The program does not actually have to qualify for copyright, i.e. it does not need to be "original" as contemplated in section 21 of the Copyright Act. Nor does the program have to be inventive or novel. It is enough that it has been devised, developed or created. Although the software may well qualify for copyright, for purposes of section 11D of the Act, it is irrelevant whether it, in fact, does.
directly for the purpose of R&D
The activities eligible for a deduction must have been undertaken "directly" for a R&D purpose. The expenditure must be incurred directly in respect of qualifying R&D activities and directly for purposes of the discovery of novel, practical, and non-obvious information or the devising or development of, inter alia, a computer program.
A Draft Interpretation Note dealing with the deduction for scientific or technological research and development was issued by the South African Revenue Service ("SARS") on 3 November 2008. The Interpretation Note states that in the case of an entire project having an R&D purpose, say the development of a computer program, not all activities are undertaken directly for the R&D purpose, e.g. if an employee was not directly engaged in R&D activities in the year of assessment 100% of the time, the employee’s salary must be apportioned between R&D and non-R&D expenditure.
SARS considers activities such as activities to create or adapt software, materials or equipment needed to resolve a scientific or technological uncertainty, scientific or technological planning activities, data collection for use in experiments, mathematical modelling to analyse the results of experiments, and the design, construction and operation of prototypes used in experiments as activities directly undertaken for R&D purposes.
The Draft Interpretation Note also lists certain activities to be excluded from the ambit of R&D. These include commercial, legal and financial activities necessary for research and development and for marketing of the new intellectual property created, manufacturing and distribution of goods and services, administration and general support (such as human resources costs, transportation, storage, cleaning, repair, maintenance and security), training required to direct and support an R&D project, clinical trials and feasibility studies to inform the strategic direction of a specific R&D activity.
management or internal business processes
As mentioned above, any expenditure that relates to "management or internal business processes" is excluded from the deduction provided for by section 11D of the Act.
SARS adopts a very wide interpretation of the exclusion. If a program has been devised to assist users to manage their enterprise more efficiently, the devising of the program would not qualify for the 150% deduction.
The alternative view is that the exclusion applies to the management and internal business processes of the taxpayer incurring the R&D expenditure in the course of discovering or devising the information or thing referred to in section 11D(1) of the Act.
It is submitted that the exclusion of expenditure relating to management and internal business processes would apply in respect of the management and other internal business processes typically undertaken by a taxpayer engaged in R&D work in order to administer and support the R&D project. This type of expenditure would thus not be deductible, since it would not be sufficiently directly related to the R&D to qualify for the special deduction.
This opinion is, in my view, supported by the ordinary meaning of the words used in the excluding provision. The expenditure which a taxpayer incurs to develop software which will, for example enable the users thereof to manage their businesses more efficiently is not expenditure incurred in relation to management and internal business processes, but expenditure relating to the development of the computer program. It is the scientific or technological nature of the development process which is encouraged by the legislation. The end use of the product is not decisive.
Finally, to the extent that the phrase "management or internal business processes" is capable of both a broad and a narrow interpretation, and if the ambiguity cannot be resolved with reference to the ordinary language and presumed purpose of the legislature, an interpretation in favour of taxpayers and against the fiscus would be preferred.
Although the legislation itself is silent on the question as to whether the computer program must be on-sold or leased, the Draft Interpretation Note indicates that the practice followed globally for determining the eligibility of computer software for tax incentive purposes is that the software development must be carried out for the purpose of sale, rent, licence, hire or lease of two or more non-associates of the company, commonly referred to as a multiple sale. There must also be sufficient documentary evidence to prove the existence of a multiple sale.
However, according to the Draft Interpretation Note, the existence of a multiple sale is not a requirement under section 11D. For the expenditure in respect of the devising of software to qualify as an R&D purpose, the computer program must meet the definition under section 1 of the Copyright Act, be of a scientific or technological nature, be intended to be used by the taxpayer in the production of income, and not be for any excluded activity.