Developing computer programs – eligibility for R & D tax relief
05 June 2015
Posted by: Author: PwC South Africa
Author: PwC South Africa
One of the issues facing taxpayers who carry on research and development in order to enhance their products is whether the costs incurred in this respect will be eligible for the enhanced deductions allowed under section 11D of the Income Tax Act. The enhanced deduction is equivalent to an additional deduction of 50% of the qualifying expenditure over and above the expenditure that would normally be allowed as a deduction.
One of the areas that may qualify for the enhanced deduction is the development of computer programs, and the Tax Court in Cape Town was recently called upon to adjudicate in a matter relating to the claim for enhanced deduction by a taxpayer (Case No. IT13541, judgment given on 20 April 2015).
A company (ABC) developed and distributed computer programs for freight forwarding, customs clearing and cargo transporting companies, to control the clearance of consignments of goods from point of origin to final destination.
Use of the programs enables customers to comply with the statutory requirements of a variety of regulatory agencies for the importation or export of goods into or from the Republic, interfacing with the SARS customs operating systems to verify data relating to the import or export of goods.
The programs are designed to meet the specific needs of the customer and each customer is invoiced monthly based upon that customer’s utilization of the program applicable to that customer.
Research and development are an integral part of the business of ABC and is a major contributor to its licensing fee revenue. The process commences where it is found that existing programs are unable to meet a customer’s specific requirements. The project is then allocated to a developer, who will develop a solution that addresses the customer’s requirements. After further evaluation and quality control checking, the program is released.
In the 2010 year of assessment, ABC submitted information of its research and development activities to the Minister of Science and Technology, as required under section 11D. It also claimed the actual expenditure incurred in research and development in its return of income for that year, but did not at that time claim the enhanced allowance.
Then in 2011, after having been assessed to income tax for 2010, ABC requested that the assessment be reopened and claimed an additional allowance equal to 50% of the research and development expenditure, to which, it asserted, it was entitled under section 11D.
SARS disallowed the deduction, and following disallowance of an objection, ABC appealed the decision to the Tax Court.
In the Tax Court, SARS readily accepted that ABC had incurred the costs in respect of research and development, however, it contended that the nature of the research and development was such that deduction was specifically denied by reason of section 11D(5)(b). Section 11D(5) provides:
Notwithstanding any other provision of this section, no deduction shall be allowed in terms of subsection (1) or (2) in respect of expenditure or costs relating to –
(a) exploration or prospecting;
(b) management or internal business processes;
(c) trade marks;
(d) the social sciences or humanities; or
(e) market research, sales or marketing promotion.
The purpose of the programs developed by ABC was for use in the management and internal processes of its customers. Therefore, SARS contended, the amount incurred was not eligible for the enhanced deduction.
ABC argued strenuously that the term "management and internal business processes” referred to the development of computer programs for the developer's own internal or management processes and not for programs intended for sale to third parties.
SARS took a further technical issue that it was incorrect to claim an allowance equal to 50% of expenditure in terms of section 11D, but that section 11D allowed a deduction of 150% of qualifying expenditure, in which case section 23B(2) denies a deduction of the actual expenditure that would otherwise be claimed under section 11(a).
Considering first the technical issue raised by SARS, Ndita J confirmed that SARS was correct in asserting that, if a claim lay under section 11D, such claim should be for 150% of the expenditure and it was not correct to claim 50% of the expenditure under that section. However, since the real point at issue was the deductibility of any amount under section 11D, he was not inclined to dismiss the claim of ABC.
In deciding the matter Ndita J had regard to the principles of interpretation that should be followed in interpreting the provisions of a statute, and that a phrase must "take its colour, like a chameleon from its settings and surrounds in the Act”.
What was really to be decided was whether the research and development expenditure was "expenditure relating to … management or internal business processes”.
After finding that the term "relating to” was synonymous with "in connection with”, Ndita J then proceeded to examine whether the expenditure was connected with management or internal processes.
The basis for the findings is set out in paragraphs  and  of the judgment:
The judgment also affirmed the principle that where the taxpayer may be regarded as privileged, the provisions of the law should be construed strictly, stating (at paragraph ):
 … According to the interpretation the Appellant proffers, it is the nature of the expenditure that is excluded in section 11D(5) and not the capacity of the software.
 If this interpretation is correct, the relevant words must be read to mean ‘expenditure relating to the management or internal business processes of the taxpayer’. But that is not what the words say. In my view, a proper interpretation is to be found in the words ‘expenditure .... relating to’. To my mind this make sense because what is prohibited is the expenditure ‘which is connected with’ any of the items listed in paragraphs (a) to (e) thereof. On this score, I agree with
submissions made by Counsel for the Respondent, the ‘connectedness’ arising from ‘relation to’ must be determined with reference to the use for which the computer program resulting in the expenditure incurred by the developer was developed. To my mind, this [is] a sensible approach.
In the matter at hand, I am satisfied the intention of the legislature is discernable (sic) from the setting and surrounds in the Act. I am fortified in this view by the dictum in Western Platinum Limited v Commissioner for the South African Revenue Service 67 SATC 1 (SCA) para  at 6B-C:
"The fiscus favours miners and farmers. Miners are permitted to deduct certain categories of capital expenditure from income derived from mining operations. Farmers are permitted to deduct certain defined items of capital expenditure from income derived from farming operations. These are class privileges. In determining their extent, one adopts a strict construction of the empowering legislation. That is the golden rule laid down in Ernst v Commissioner for Inland Revenue 1954 (1) SA 318 (A) at 323 C-E and approved in Commissioner for Inland Revenue v D & N Promotions (Pty) Ltd1995 (2) SA 296 (A) at
By parity of reasoning, it must be accepted that section 11D creates a class privilege for certain categories of research and development expenditure, by permitting the deduction of 150% thereof, whereas the norm is that only the actual amount of qualifying expenditure can be deducted. I see no reason why in principle such an approach should not be applied in a matter such as the present. Section 11D(5) places a curb on the class privilege available to such categories of research and development expenditure. In my judgment, section 11D(5) must be interpreted as I have done, in the manner set out by Conradie J (sic), in D & N Promotions, supra."
The judgment provides confirmation of the approach to be made in principle where a claim for a deduction is made under section 11D, namely that the deduction to be claimed must be for 150% of qualifying expenditure. In cases where a deduction is claimed, the usual deduction for expenditure incurred in the production of income under section 11(a) may not also be claimed.
Secondly, this is yet another example of the purposive approach to the interpretation of statutes, and confirmation of the approach that, where the extent of a class privilege is at issue, the golden rule is that the law should be interpreted strictly.
This article first appeared on pwc.co.za.