Classification of investments in intelligent infrastructures in the financial accounts and the tax accounts
The ongoing digitalisation and the growing use of networked technologies are leading to profound changes in the design and use of modern infrastructures. Against this background, the question arises as to the appropriate classification of the respective investments for tax and financial reporting purposes.
1. Intelligent infrastructures
The term ‘intelligent infrastructures’ is understood to mean systems that can be operated more efficiently, sustainably, and flexibly through the use of information and communication technologies, sensor technology, data-driven control systems and, increasingly, also cloud computing solutions. In particular, cloud-based platforms enable central database processing, scalability and real-time control systems; consequently, they thus constitute an integral part of intelligent infrastructures. Against this backdrop, investments in intelligent infrastructures are increasingly gaining in importance in both the public as well as private sectors.
2. Maintenance expenses or production costs?
In the case of physical or tangible assets, a question that routinely arises when these are renewed or renovated is whether the costs constitute immediately deductible maintenance expenses, or whether they need to be capitalised as acquisition or production costs and depreciated or amortised over their average useful lives.
The relevant criterion here is whether, as regards the asset in question, there is a substantial improvement beyond its original condition. Establishing the difference in the case of tangible assets already poses a challenge, such as, for example the extensive renovation of buildings. When making the corresponding adaptations to existing intangible assets it is even more difficult to make a distinction, for example when integrating an AI chatbot into an existing website.
The principles are however the same. If there has been a substantial improvement in an existing asset beyond its original condition then there would be production costs. They are destined to be treated similarly to the thus ‘renewed’ asset. A distinction has to be made between self-created and purchased assets.
Self-created
- Self-created intangible assets - which are continually growing in significance within the scope of digitalisation - are generally subject to a capitalisation prohibition for tax purposes. The original expenses directly reduce the taxable income. For subsequent expenses the issue of distinguishing between capitalisation and maintenance expenses would thus not even arise. Under German commercial law there is a right to choose capitalisation for self-created intangible assets. However, this capitalisation option is rather for information purposes or ‘window dressing’ because, in this respect, capitalised expenses are subject to a statutory restriction on distribution and profit transfer (Section 268(8) of the German Commercial Code, Section 301 of the German Stock Corporation Act.).
Purchased
- However, if the (tangible or intangible) asset has been purchased, then the expenses have to be capitalised as subsequent acquisition or production costs and depreciated or amortised over the remaining useful life.
By contrast, expenses that serve solely to adapt to technical innovations and do not provide a substantial improvement beyond the original condition will constitute immediately deductible maintenance expenses. These would include, for example, regular software updates or, in the area of tangible assets, replacing heating systems or windows to bring them up to the current standard.
3. Distinction between stand-alone assets and dependent components
In the case of components such as sensor and control technologies in machines and systems, the question that arises is whether, here, these are assets that can be appraised on a stand-alone basis or are independently usable and, thus, according to the principle of single unit valuation are stand-alone assets that can be capitalised, or whether they are merely dependent components for the respective system and thus included in its acquisition and production costs. According to case law, independence would be ruled out if the items to be assessed were interwoven with the ‘main asset’ via a technical connection or interlinking in such a way that separating them would result in either the item to be assessed or the ‘main asset’ from which it was separated ceasing to be usable for the business. It is therefore particularly important whether, based on their outward appearance, the items on their own seem to be incomplete.
1st Example In 2018, the Münster tax court decided that, in the case of a biogas plant, the systems and control technology was not a stand-alone asset, but rather merely a dependent component of the asset that was the biogas plant.
2nd Example The Accounting Standards Committee of Germany (ASCG), in its officially released German Accounting Standard (GAS) 24 (Intangible Assets in Consolidated Financial Statements) indicated, in GAS 24.12, that control software - which controls the basic function of a machine without which it would not be capable of functioning and which cannot be separated (in terms of value) from the machine - is considered to be an integral part of the machine and, therefore, it must be regarded as an asset together with the machine.
4. Depreciation/amortisation - What is the useful life?
The costs of depreciable or amortisable assets are gradually written down on a scheduled basis over their average useful lives. Special consideration should generally be given to the taxpayer’s assessment.
Determining the useful life of intangible assets has consistently proved to be difficult, especially as technical wear and tear can normally be excluded. In the opinion of the fiscal administration (Federal Ministry of Finance circular of 22.2.2022), in the case of certain computer hardware and certain software (such as ERP software), an average useful life and, thus, a depreciation/amortisation period of one year can be applied, although explicit upward deviations are also possible.
5. Rental/leasing models and cloud computing
With these models - depending on the service model - no IT hardware, operating systems or applications are purchased. In fact, users avail themselves of the provider’s assets via the internet (e.g., e-mail server, ERP software). In practice, the common service models here are:
- Infrastructure as a Service (IaaS),
- Platform as a Service (PaaS),
- Software as a Service (SaaS).
In the IaaS model, use is made of the provider’s cloud hardware infrastructure (servers, storage systems, etc.). In the case of the PaaS system, besides the pure cloud hardware infrastructure, a ready-made work environment including operating systems is also used, whereby the overall IT software management is outsourced and the IT administration costs are thus greatly reduced. One SaaS solution is, for example, Microsoft 365. In such cases, ready-made software applications are used directly via a web browser or an app. The data are stored in the cloud infrastructure and thus the maintenance, updates and security processes are carried out entirely at the provider level.
The user, i.e., the company using the software, does not become the legal or economic owner of the software that is used. Consequently, the software may not be recognised in the balance sheet. However, this raises the question of how the costs for implementation, configuration and customisation should be treated; these can be many times higher than the ongoing service fees for the application. The accounting recognition and measurement of such expenses are the subject of controversial debate in the specialist literature and case law.
Accounting recognition of the right to use the software regularly fails because of the principles of the non-recognition of executory contracts. According to tax court rulings, this has also decided the fate of customisation costs; if the right to use the software has not been capitalised, then capitalising the customisation costs as ancillary costs of acquisition would also be ruled out. According to the Munich tax court, in its ruling of 4.2.2021 (case reference: 10 K 1620/20), without the underlying right of use the implementation has no value.
Besides the views in the specialist literature that concur with the above ruling, there are also opinions that, under certain conditions or depending on the circumstances of the specific case - in line with the accounting principles for leasehold improvements in buildings - would prefer customisation costs to be capitalised as an asset referred to as ‘leasehold improvements in software’ or as a constructed ‘sui generis’ asset (i.e., one of a kind).
Even at the Institute of Public Auditors in Germany (Institut der Wirtschaftsprüfer, IDW) there is anything but consistency of opinion. In its opinion statement IDW RS HFA 11, the IDW’s Main Technical Committee commented on the legal principles for ‘Accounting for purchased software at the level of the user’; however, as the contents of this statement were essentially developed at the beginning of this millennium, they only deal with the arrangements prevailing at that time, namely the production and purchase of software. The service models, such as SaaS, were only developed later, therefore, the IDW opinion statement published back then cannot actually cover the current issues, at least not explicitly. However, some IDW representatives believe that the guidelines are transferable and, accordingly, that capitalising customisation costs as a stand-alone asset would conflict with IDW RS HFA 11. However, the so-called WP-Handbuch [German public auditor manual,] published by the IDW, insists on the capitalisation of customisation costs, analogous to the accounting treatment of leasehold improvements, if a third party bears the production risk for the customisation of a SaaS solution used by the reporting entity, even if it does not acquire economic ownership of the software.
