EY’s Guide to Scientific Research and Experimental Development [3 ed.] 9781525403125

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3RD EDITION

from EY’s Guide to Income Tax

EY’s GUIDE TO

Scientific Research and Experimental Development BISHOP • ECK • PRINGLE • ROBINSON

3RD EDITION

from EY’s Guide to Income Tax

EY’s GUIDE TO

Scientific Research and Experimental Development BISHOP • ECK • PRINGLE • ROBINSON Provides an understanding of the scientific research and experimental development (SR&ED) rules in Canada.

TAX18233_EY's SRED_inside-cover.indd 1

10/15/2018 12:47:03 PM

COPYRIGHT All rights reserved. No part of this work may be reproduced or used in any form or by any means (graphic, electronic, or mechanical, including photocopying, recording, taping, or information storage and retrieval systems) without prior written permission. The contents of this publication are protected under the following copyright: © — 2018 Ernst & Young Electronic Publishing Services Inc. DISCLAIMER OF LIABILITY This publication is sold with the understanding that Ernst & Young, Chartered Professional Accountants of Canada (CPA Canada), and any person involved in the preparation of this work are not responsible for the result of any actions taken on the basis of information in this work, nor for any errors or omissions contained herein. Secondly, Ernst & Young, CPA Canada, and any person involved in the preparation of this work are not attempting through this work to render legal, accounting, or professional services. If legal or accounting advice is required, the services of a professional should be sought.

Canadian Cataloguing in Publication Data Cataloguing information available from the National Library of Canada

ISBN: 978-1-5254-0312-5

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CPA Canada 277 Wellington Street West Toronto, Ontario M5V 3H2 (416) 977-3222

PREFACE EY’s Guide to Scientific Research and Experimental Development has been prepared to assist Canadian tax professionals in understanding the scientific research and experimental development (SR&ED) rules in Canada. The SR&ED rules for investment tax credit claims and deductions from income are detailed and complex, and their application often involves questions of law and fact, especially when determining whether SR&ED work has occurred and what expenditures are eligible for tax benefits. The numerous changes in the legislation in the recent past have helped to simplify the rules in some areas, but the application of these rules to specific situations remains complex. The first two chapters of this guide provide the reader with an overview of the SR&ED program, including its objectives and advantages, as well as how it is administered by the Canada Revenue Agency (CRA). Chapters 3 and 4 provide an in-depth examination of what constitutes SR&ED eligible work (from a scientific perspective), what expenditures are eligible, and how they and the investment tax credit are calculated. Finally, Chapter 5 describes the steps involved in claiming these tax benefits — from investigating eligible SR&ED work within an organization to preparing and submitting a claim. We hope you will find this third edition of EY’s Guide to Scientific Research and Experimental Development a useful addition to your reference library. Comments and questions may be directed to [email protected].

NAVIGATION TIPS Each table of contents entry is linked to its location in the guide. Links within the guide are denoted with blue text. To “retrace your steps” (e.g., links visited, pages scrolled), press Alt + the left arrow key.

ACKNOWLEDGEMENTS Thanks to our contributing editor, EY senior manager Yves Plante, whose involvement in revising this guide was absolutely invaluable. His guidance and patience are greatly appreciated. Thanks also to the rest of the EY editorial team, whose efforts made this third edition possible: Candra Anttila, Alessia Cianni, Melinda Shiers, Amanda Stewart, Antonella Stinson, and Jennifer Wilson. Susan Bishop, FCPA, FCA Kevin Eck, PEng, MBA Elizabeth Pringle, MSc Krista Robinson, CPA, CA July 2018

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EY’s Guide to Scientific Research and Experimental Development Preface and acknowledgements. . . . . . . . . .iii 1. The SR&ED Program . . . . . . . . . . . . . . . . . . 1 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 History of the SR&ED program . . . . . . . . . 2 1986–1990 . . . . . . . . . . . . . . . . . . . . . . . . . . 2 1990–1994 . . . . . . . . . . . . . . . . . . . . . . . . . . 3 1995–1998 . . . . . . . . . . . . . . . . . . . . . . . . . . 4 1999–2002 . . . . . . . . . . . . . . . . . . . . . . . . . 4 2003–2006 . . . . . . . . . . . . . . . . . . . . . . . . . 5 2007–present . . . . . . . . . . . . . . . . . . . . . . . 6 Administrative improvements . . . . . . . 7 Tax policy intent . . . . . . . . . . . . . . . . . . . . . 10 SR&ED within the CRA . . . . . . . . . . . . . . . 10 CRA’s objective and commitments . . . 10 CRA’s service standards . . . . . . . . . . . . . 11 CRA’s structure and resources . . . . . . . . 11 Risk management – Claims assessment . . . . . . . . . . . . . . . . . . . . . . . . 13 Claims review process . . . . . . . . . . . . . 13 For further reference . . . . . . . . . . . . . . . . . 15 Forms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Guides and manuals . . . . . . . . . . . . . . . . 15 Web resources . . . . . . . . . . . . . . . . . . . . . 15 2. Tax benefits of SR&ED . . . . . . . . . . . . . . . 17 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 Availability of incentives . . . . . . . . . . . . 17 Basic requirements . . . . . . . . . . . . . . . . . 17 Investment tax credits . . . . . . . . . . . . . . . 18 ITC for CCPCs – 35% credit . . . . . . . . . . 19 Expenditure limit . . . . . . . . . . . . . . . . . 19 Refund of 35% ITC . . . . . . . . . . . . . . . . . 20 Qualifying corporations . . . . . . . . . . . 20 Non-qualifying corporations . . . . . . . 21 ITC for other claimants – 15% credit . . 22 Refund of 15% ITC . . . . . . . . . . . . . . . . . . 22 Using ITCs . . . . . . . . . . . . . . . . . . . . . . . . . 22 Summary of ITC rates . . . . . . . . . . . . . . 23 Deduction – SR&ED pool . . . . . . . . . . . . . 27 Timing of deduction . . . . . . . . . . . . . . . . 28 Related to the business of the claimant 28 For further reference . . . . . . . . . . . . . . . . . 29 Income Tax Act . . . . . . . . . . . . . . . . . . . . 29

Forms . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 Guides . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 SR&ED program policies . . . . . . . . . . . . 30 3. What is eligible? – Scientific and technological aspects . . . . . . . . . . . . . . . . . 31 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 What is SR&ED? . . . . . . . . . . . . . . . . . . . . . 31 Legislative definition . . . . . . . . . . . . . . . . 31 CRA’s view . . . . . . . . . . . . . . . . . . . . . . . . 34 Scientific or technological uncertainty (CRA’s methodology – Step 1, Question 1) . . . . . . . . . . . . . . . . . . . . . . 36 Hypotheses formulation (CRA’s methodology – Step 1, Question 2) . 38 Systematic investigation or search (CRA’s methodology – Step 1, Question 3) . . . . . . . . . . . . . . . . . . . . . . 38 Scientific or technological advancement (CRA’s methodology – Step 1, Question 4) . . . . . . . . . . . . . . . 39 Recording (CRA’s methodology – Step 1, Question 5) . . . . . . . . . . . . . . . . 41 Summary (re Step 1 of CRA’s methodology) . . . . . . . . . . . . . . . . . . . . 41 How to identify SR&ED – Practical considerations . . . . . . . . . . . . . . . . . . . . . . 42 Shop floor . . . . . . . . . . . . . . . . . . . . . . . . 42 Technology transfer . . . . . . . . . . . . . . . . 43 Data collection . . . . . . . . . . . . . . . . . . . . 43 Standard practice . . . . . . . . . . . . . . . . . . 43 Routine engineering . . . . . . . . . . . . . . . 44 Jurisprudence . . . . . . . . . . . . . . . . . . . 45 SR&ED in specific contexts . . . . . . . . . . . 50 Software development . . . . . . . . . . . . . 50 Scientific or technological advancements in software development . . . . . . . . . . . . . . . . . . . . 50 Scientific or technological uncertainty in software development . . . . . . . . . . 53 Systematic investigation or search in software development . . . . . . . . . . 54 Software development as support work . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 Common mistakes made on software development claims . . . . . . 56

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3. What is eligible? – Scientific and technological aspects (cont’d) Experimental production . . . . . . . . . . . . 56 Definitions of experimental production and commercial production . . . . . . . . . . . . . . . . . . . . . . . 57 Distinguishing experimental production from commercial production in conjunction with experimental development . . . . . . . . 58 Experimental production factors . . . 59 Identifying the experimental development zone . . . . . . . . . . . . . . . .60 Determining the duration of experimental development . . . . . . . . 61 Supporting experimental production claims . . . . . . . . . . . . . . . . 62 For further reference . . . . . . . . . . . . . . . . . 62 Income Tax Act . . . . . . . . . . . . . . . . . . . . 62 Case law . . . . . . . . . . . . . . . . . . . . . . . . . . 63 Guides . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64 SR&ED program policies . . . . . . . . . . . . 64 Web resources . . . . . . . . . . . . . . . . . . . . . 64 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . 64 4. What is eligible? – Financial aspects . . 67 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . 67 Eligible SR&ED expenditures . . . . . . . . . . 68 Proxy and traditional methods – Overview . . . . . . . . . . . . . . . . . . . . . . . . . . 68 Labour . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69 Salaries for employees directly engaged in SR&ED (proxy method salaries) . . . . . . . . . . . . . . . . . . . . . . . . . 69 Salaries for employees who directly undertake, supervise, or support SR&ED (traditional method salaries). 71 Labour allocation . . . . . . . . . . . . . . . . . 72 Determining the cost . . . . . . . . . . . . . . 74 Unpaid amounts . . . . . . . . . . . . . . . . . . 75 Labour – Form T661 . . . . . . . . . . . . . . . 75 Materials consumed or transformed . . 77 Material . . . . . . . . . . . . . . . . . . . . . . . . . . 77 Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78 Materials consumed . . . . . . . . . . . . . . . 78 Materials transformed . . . . . . . . . . . . . 78 Examples of materials consumed or transformed . . . . . . . . . . . . . . . . . . . 79 Materials – Form T661 . . . . . . . . . . . . . 80 Subcontracts – SR&ED performed on behalf of the taxpayer . . . . . . . . . . . 81

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Directly undertaken on behalf of the taxpayer . . . . . . . . . . . . . . . . . . . . . . 81 Look-through rule . . . . . . . . . . . . . . . . 82 Subcontract expenditures – Form T661 . . . . . . . . . . . . . . . . . . . . . . . 82 Lease of premises, facilities, and equipment . . . . . . . . . . . . . . . . . . . . . . . . 82 Buildings . . . . . . . . . . . . . . . . . . . . . . . . 84 Lease costs of equipment – Form T661 . . . . . . . . . . . . . . . . . . . . . . . 84 Other expenditures . . . . . . . . . . . . . . . . 85 Directly related to SR&ED . . . . . . . . . 85 Incremental to SR&ED . . . . . . . . . . . . 87 Labour deductible as DRAI expenditure . . . . . . . . . . . . . . . . . . . . . 88 Additional items deductible as DRAI expenditures . . . . . . . . . . . . . . . 89 DRAI expenditures – Form T661 . . . 89 Third-party payments . . . . . . . . . . . . . . 90 Eligible payments . . . . . . . . . . . . . . . . 90 Look-through rule . . . . . . . . . . . . . . . . . 91 Approved institution . . . . . . . . . . . . . . 91 Meaning of entitled to exploit . . . . . 92 Third-party payments versus expenditures for SR&ED performed on taxpayer’s behalf . . . . . . . . . . . . . . 92 Third-party payments – Form T661 . 93 Current expenditures all or substantially all attributable to SR&ED . . . . . . . . . . . 93 Capital expenditures . . . . . . . . . . . . . . . 94 Cost of capital asset . . . . . . . . . . . . . . 94 Timing of capital expenditure . . . . . . 95 Used assets . . . . . . . . . . . . . . . . . . . . . . 95 Buildings . . . . . . . . . . . . . . . . . . . . . . . . 95 Demonstrating intent . . . . . . . . . . . . . 95 Rights to SR&ED . . . . . . . . . . . . . . . . . 97 Expenditures deductible under more than one provision . . . . . . . . . . . . . . . . . 98 Proxy and traditional methods – Summary and comparison . . . . . . . . . . 98 Accounting versus tax – Direct and indirect salaries . . . . . . . . . . . . . . . . . 100 SR&ED expenditure pool . . . . . . . . . . . . . 101 Previous year’s balance – Line 450 of Form T661 . . . . . . . . . . . . . . . . . . . . . . . .103 Current expenditures . . . . . . . . . . . . . .103 SR&ED performed in Canada . . . . . .103 SR&ED performed outside Canada 104 Property acquired outside Canada 106 Related to the business . . . . . . . . . . 106

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4. What is eligible? – Financial aspects (cont’d) Current expenditures – Form T661 . 107 Capital expenditures . . . . . . . . . . . . . . . 107 Capital expenditure amount deemed to be capital cost allowance . . . . . . 107 Investment tax credit reduces capital cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107 Computing the amount of a capital expenditure . . . . . . . . . . . . . . . . . . . . . 107 Sale of SR&ED capital assets . . . . . . 109 Amounts deducted in preceding taxation years . . . . . . . . . . . . . . . . . . . . 110 Negative SR&ED expenditure pools taken into income . . . . . . . . . . . . . . . . . 110 Amount available for deduction in current taxation year . . . . . . . . . . . . . . 110 ITCs claimed in prior years . . . . . . . . . 110 ITCs claimed on capital assets . . . . . . 111 ITCs allocated by a partnership or trust . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111 ITCs claimed included in income . . . 111 Prior-year ITCs claimed – Form T661 111 Assistance . . . . . . . . . . . . . . . . . . . . . . . . . 112 Assistance relating to prescribed proxy amount . . . . . . . . . . . . . . . . . . . . 112 Assistance relating to depreciable property . . . . . . . . . . . . . . . . . . . . . . . . . 112 Repayment of assistance . . . . . . . . . . 112 Assistance no longer expected to be received . . . . . . . . . . . . . . . . . . . . . . 112 Recapture of SR&ED ITC . . . . . . . . . . . .113 SR&ED qualified expenditure pool . . . . .113 Qualified expenditures . . . . . . . . . . . . . .114 Eligible SR&ED expenditures and qualified expenditures . . . . . . . . . . . . .115 Prescribed proxy amount . . . . . . . . . .115 Shared-use equipment . . . . . . . . . . . . 117 Prescribed expenditures . . . . . . . . . . . 121 Assistance and contract payments 123 Unpaid amounts . . . . . . . . . . . . . . . . . .131 Non-arm’s length transactions . . . . . . 132 Purchase of properties or services from non-arm’s length suppliers . . . 133 Non-arm’s length SR&ED contracts 134 Transfer of qualified expenditures . . . 137 Anti-avoidance rules . . . . . . . . . . . . . 138 Timing of transfer . . . . . . . . . . . . . . . . 139 Administration . . . . . . . . . . . . . . . . . . 139 Investment tax credits . . . . . . . . . . . . . . 139

Claiming ITCs . . . . . . . . . . . . . . . . . . . . . 141 Earning SR&ED ITCs . . . . . . . . . . . . . . . 141 Expenditure limit for 35% ITC . . . . . .142 Superallowance . . . . . . . . . . . . . . . . . .145 Repayments of assistance or contract payments . . . . . . . . . . . . . . .145 ITC carryback and carryforward . . .146 Recapture of ITC . . . . . . . . . . . . . . . . . .147 Purpose . . . . . . . . . . . . . . . . . . . . . . . . .148 Requirements . . . . . . . . . . . . . . . . . . . .148 Timing of the acquisition . . . . . . . . . 150 Shared-use equipment . . . . . . . . . . . 150 Definition of property . . . . . . . . . . . . . 151 Definition of disposition . . . . . . . . . . . 151 Proceeds of disposition . . . . . . . . . . . 151 Conversion to commercial use . . . . . 152 Deemed fair market value . . . . . . . . . 152 Disposition of equipment to non-arm’s length party . . . . . . . . . . . . 152 Recapture of ITC on property previously transferred to a non-arm’s length party . . . . . . . . . . . .153 Recapture of ITC on qualified expenditures transferred to a related party . . . . . . . . . . . . . . . . . . . . .153 De minimis rule . . . . . . . . . . . . . . . . . .154 Incorporeal property . . . . . . . . . . . . .155 Unpaid amounts . . . . . . . . . . . . . . . . .155 Recapture – Forms . . . . . . . . . . . . . . .156 Refundable investment tax credits . . . .156 Qualifying corporations . . . . . . . . . . . .156 Excluded corporations . . . . . . . . . . . . . 157 Refund for CCPC that is not a qualifying corporation . . . . . . . . . . . . . . 157 Refund for CCPC that is a qualifying corporation . . . . . . . . . . . . . . . . . . . . . . .158 Special situations . . . . . . . . . . . . . . . . . . .158 Partnerships . . . . . . . . . . . . . . . . . . . . . . .158 SR&ED deduction . . . . . . . . . . . . . . . .158 Allocation of ITC to a partner . . . . . .159 Expenditure reduction resulting from allocation of ITCs . . . . . . . . . . . 160 Election to renounce ITCs . . . . . . . . . 161 Non-arm’s length SR&ED work performed for or on behalf of a partnership . . . . . . . . . . . . . . . . . . . . . . 161 Recapture . . . . . . . . . . . . . . . . . . . . . . . 161 Filing requirements . . . . . . . . . . . . . . . 161 Partnership summary . . . . . . . . . . . . .162 Cooperative corporations . . . . . . . . . .163

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4. What is eligible? – Financial aspects (cont’d) Individuals operating a business as a sole proprietorship . . . . . . . . . . . . 163 Filing-due dates . . . . . . . . . . . . . . . . . 163 ITCs . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164 Refundable ITCs . . . . . . . . . . . . . . . . . 164 Trusts . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164 Graduated rate estates and communal organizations . . . . . . . . . 164 Refundable ITCs . . . . . . . . . . . . . . . . . 164 Reporting deadlines . . . . . . . . . . . . . 165 Transfer from amalgamation or windup . . . . . . . . . . . . . . . . . . . . . . . . . . . 165 Amalgamation . . . . . . . . . . . . . . . . . . 165 Windup . . . . . . . . . . . . . . . . . . . . . . . . . 165 Loss restriction event . . . . . . . . . . . . . . 165 SR&ED expenditure pool . . . . . . . . . 166 ITCs . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166 For further reference . . . . . . . . . . . . . . . . 166 Income Tax Act . . . . . . . . . . . . . . . . . . . 166 Case law . . . . . . . . . . . . . . . . . . . . . . . . . 167 CRA rulings and interpretations . . . . . 169 Forms . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169 Guides . . . . . . . . . . . . . . . . . . . . . . . . . . . 170 Income tax folios . . . . . . . . . . . . . . . . . . 170 Interpretation bulletins . . . . . . . . . . . . 170 SR&ED program policies . . . . . . . . . . . 170 Other publications . . . . . . . . . . . . . . . . . 171 Web resources . . . . . . . . . . . . . . . . . . . . . 171 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . 171 5. SR&ED claims submission process . . . 173 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . 173 Fundamentals . . . . . . . . . . . . . . . . . . . . . . 173 What to file . . . . . . . . . . . . . . . . . . . . . . . 173 When to file . . . . . . . . . . . . . . . . . . . . . . 175 How and where to file . . . . . . . . . . . . . 175 Reducing the claimant’s processing risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176 Investigating SR&ED within an organization . . . . . . . . . . . . . . . . . . . . . . . 177 Companies with established products and processes . . . . . . . . . . . . . . . . . . . . 178 What are the science and technology improvement drivers? . . . . . . . . . . . . . 178 What development plans already exist? . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179 Conducting the initial SR&ED scan . . 180

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Defining the entire project . . . . . . . . . . 181 Claiming a project at the right level – Managing risk . . . . . . . . . . . . . . . . . . . . . 182 Preparing the claim . . . . . . . . . . . . . . . . . . 183 Form T661 Part 1 – General information . . . . . . . . . . . . . . . . . . . . . . .184 Form T661 Part 2 – Project information . . . . . . . . . . . . . . . . . . . . . . .184 Section A – Project identification . . 185 Section B – Project descriptions . . .186 Section C – Additional project information . . . . . . . . . . . . . . . . . . . . . . 187 Form T661 Part 3 – Calculation of SR&ED expenditures . . . . . . . . . . . . . . .188 Form T661 Part 4 – Calculation of SR&ED expenditures for investment tax credit (ITC) purposes . . . . . . . . . . .188 Form T661 Part 5 – Calculation of prescribed proxy amount (PPA) . . . . .189 Form T661 Part 6 – Project costs . . . .189 Form T661 Part 7 – Additional information . . . . . . . . . . . . . . . . . . . . . . .189 Form T661 Part 8 – Claim checklist . .189 Form T661 Part 9 – Claim preparer information . . . . . . . . . . . . . . . . . . . . . . 190 Form T661 Part 10 – Certification . . . 190 Gathering documentation and supporting information – A yearround process . . . . . . . . . . . . . . . . . . . . . 191 CRA review process . . . . . . . . . . . . . . . . .193 Service standards . . . . . . . . . . . . . . . . . .193 Completeness checks . . . . . . . . . . . . . .193 Risk assessment . . . . . . . . . . . . . . . . . . .193 First-time claimant advisory service .194 Site visit and detailed review . . . . . . . .194 Research and technology review report and CRA proposal package . . . 197 Disagreements between the claimant and the CRA . . . . . . . . . . . . . .198 Objections and appeals . . . . . . . . . . . . . 202 CRA Appeals Branch . . . . . . . . . . . . . . 203 Tax Court of Canada . . . . . . . . . . . . . . 203 For further reference . . . . . . . . . . . . . . . 205 Income Tax Act . . . . . . . . . . . . . . . . . . 205 Case law . . . . . . . . . . . . . . . . . . . . . . . . . 205 Forms . . . . . . . . . . . . . . . . . . . . . . . . . . . 205 Guides, manuals, and pamphlets . . . 206 SR&ED program policies . . . . . . . . . . 206 Other publications . . . . . . . . . . . . . . . . 206 Web resources . . . . . . . . . . . . . . . . . . . 206

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1. The SR&ED Program Overview The federal scientific research and experimental development (SR&ED) program is a tax incentive program to encourage all Canadian businesses to conduct research and development (R&D) in Canada. In fact, the SR&ED program has been the single largest source of federal funding for industrial R&D performed in Canada for many years, and remains one of the largest federal government programs to support R&D in the country; it is also one of the most generous R&D programs in the world.1 However, Canada still lags behind other countries in terms of R&D spending.2 The income tax benefits of the SR&ED incentive program include •

a 35% refundable tax credit for qualifying Canadian-controlled private corporations;

•

a 15% non-refundable tax credit for other corporations;3

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tax credits for proprietorships, partnerships, and trusts (refundable, non-refundable, or both); and

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a deduction for current SR&ED expenditures,4 which may be deducted in the year incurred or pooled for deduction in subsequent years (except in the case of partnerships, where the expenditures must be deducted in the year incurred).

These benefits are discussed in greater detail later in this guide: •

Chapter 2, Tax benefits of SR&ED, provides an overview of the tax credits and deduction and explains the advantages they offer to businesses performing SR&ED;

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Chapter 3, What is eligible? – Scientific and technological aspects, discusses the types of work that qualify as SR&ED (from a scientific and technological perspective), as well as how to identify this work and distinguish it from non-SR&ED work; and

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Chapter 4, What is eligible? – Financial aspects, describes, in detail, the calculations involved in determining SR&ED expenditures, the deduction, tax credits, and refundability.

The legislation governing the program is contained in the federal Income Tax Act and Income Tax Regulations and therefore is the responsibility of the Department of Finance. However, the Canada Revenue Agency (CRA) is responsible for the program’s administration.

1

OECD Science, Technology and Industry Scoreboard (2017).

2

According to the latest available data from the OECD (from 2016), Canada ranks 18th among OECD countries in gross domestic expenditures on R&D as a percentage of gross domestic product (GDP).

3

Effective January 1, 2014 (previously 20%).

4

Capital expenditures are no longer eligible for the SR&ED deduction (applicable for expenditures incurred after 2013).

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The SR&ED program is a tax incentive program, not a grant program,5 and is demand driven. There is no ceiling on how much the government may pay out to claimants in any particular year. If a business performs SR&ED, incurs qualified expenditures, and meets the filing requirements, it is legally entitled to the tax credits earned. Chapter 5, SR&ED claims submission process, outlines these filing requirements and describes the other steps involved in preparing and submitting a claim. Following a brief review of the history of the SR&ED program, the remainder of this chapter outlines the policy intent of the program and its objectives, as well as how the program is administered by the CRA.

History of the SR&ED program The federal government has provided tax assistance for R&D since 1944. Indeed, while investment tax credits (ITCs) were introduced for SR&ED expenditures in 1977, the program, as it exists today, basically came into being as a result of the May 1985 budget. Since 1985, the SR&ED program has grown significantly. Information from the Department of Finance shows that the value of claims was $781,000 in 1988 and $1.25 billion in 1992. In 2016–17, over $2.7 billion in tax assistance was provided to businesses through the SR&ED program. The changes in 1985 followed the introduction of partial refundability in 1983 and the scientific research tax credit (SRTC) program, which was also introduced in 1983 but cancelled in the May 1985 budget. The SRTC program, which resulted in losses of approximately $2 billion, allowed claimants to earn credits before SR&ED was actually performed and permitted the transfer of these credits through shares or debt instruments. Under the current system, SR&ED must be performed before ITCs are earned, and transfers through shares or debt instruments are prohibited. Despite the difficulties with the SRTC program, the government continued to recognize that if businesses (particularly small- and medium-sized companies) were to grow, they needed cash to help them fund their SR&ED work. In 1985, the government introduced 100% refundability of ITCs for certain small- and medium-sized businesses. Specifically, companies that were Canadian-controlled private corporations throughout the taxation year and whose prior taxable income did not exceed $200,000 would be entitled to a 35% refundable ITC on up to $2 million of expenditures. The entitlement to the fully refundable credit has been modified over time, and the current entitlement is discussed in Chapter 2, Tax benefits of SR&ED. The May 1985 budget also announced that all 35% refundable claims would be validated before being assessed.

1986–1990 The changes announced in the May 1985 budget meant that the CRA needed to hire personnel and set up a structure that would enable it to validate all refundable claims prior to assessment. During the two years following the budget, the CRA hired scientific and engineering staff and introduced Form T661, Claim for Scientific Research and Experimental Development (SR&ED) Carried Out in Canada, and Information Circular 5

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Grant programs set limits on how much grant money is given out each year, and the government departments decide who receives the grants.

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IC86-4, Scientific Research and Experimental Development, to provide technical guidelines. Also, some CRA auditors were asked to be part of the SR&ED audit process instead of the regular tax auditor function. In 1987, the government made some key changes to the program. Expenditures on building leases or rents and expenditures to acquire buildings were excluded from SR&ED expenditures (with an exception for prescribed special-purpose buildings), and the following restrictions on SR&ED ITCs were introduced: •

the 20% refund for large corporations was eliminated; and

•

the rules were changed so that ITCs could be fully utilized in the year instead of being capped at 75% of taxes payable.

SR&ED claims from companies earning 20% ITCs were not validated prior to assessment and were not subject to a defined review process, and a non-refundable claim could be audited in subsequent years. The CRA’s policy was that once an SR&ED claim was validated, it would not be looked at again, so the claimant knew that the ITCs would not be subject to review in the future. The program experienced a number of growing pains during these years, including a significant backlog in the processing of claims for small businesses. As a result, the CRA made a commitment (around 1988) to process all refundable 35% claims within 180 days of receiving a complete claim.

1990–1994 Between 1990 and 1994, a number of key administrative and legislative changes were implemented. The CRA made a commitment to process refundable claims within 120 days of receiving a complete claim. For claims meeting certain criteria, the target was 60 days, but these claims were subject to subsequent verification after the credits had been received. Pre-assessment refunds were introduced into law,6 and the CRA stated that it was going to look at providing greater certainty with respect to non-refundable claims. During this period, the proxy method and the 18-month rule were introduced. The proxy method provides for a simplified method of determining ITCs (see Chapter 4, What is eligible? – Financial aspects), and the 18-month rule refers to the filing deadline for submitting SR&ED claims (see Chapter 5, SR&ED claims submission process). The 18-month rule was introduced because there had previously been no time frame for filing an SR&ED claim; as a result, the CRA was receiving many claims dating back into the 1980s. When the 18-month rule was introduced, claimants were given a window of approximately eight months to submit their older claims. The CRA received a flood of claims (often referred to as “the bulge”) during this transitional period, before the window closed on September 13, 1994.

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Pre-assessment refunds still exist in law today (ITA s. 164(1)(a)(i)), but they are not used very often.

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1995–1998 The period from 1995 to 1998 is sometimes referred to as “the dark years.” The CRA did not have the resources to handle the large volume of claims it received in 1994. For various reasons, there were problems with the quality of the claims received, including a lack of information to support them. Also, because many of the claims dated back to the 1980s, it was difficult to locate and talk to anyone who had actually worked on the projects for which the claims were made. Claims were not being processed in a timely manner, and audits were frequently difficult and contentious. Many claimants opted out of the program as a result of their experiences during these years. Numerous notices of objection were filed, and the volume of complaints to the minister of national revenue was very high. In short, the program was discouraging businesses from participating, rather than providing incentives to encourage SR&ED work. To address the deteriorating relationship among the CRA, claimants, and industry, a minister’s conference was held in Vancouver in June 1998. At this conference (called “Building Partnerships”), industry and government discussed the SR&ED program with a view to mending these relationships and making the program work more effectively as an incentive program. In late 1998, the minister released a 13-point action plan based on recommendations heard at the conference.

1999–2002 The first action item in the 13-point plan was to make the program more independent, with a focus on science, technology, and incentives. To this end, a separate SR&ED Directorate with a director general was established at headquarters, and separate SR&ED divisions were subsequently set up in coordinating tax services offices. The CRA was committed to firmly establishing the program as an incentive for economic development in Canada. Other steps taken included •

the formation of the joint CRA-industry Steering Committee;

•

the implementation of initiatives such as pre-claim project review and account executive;

•

the development and publication of key guidance documents; and

•

the establishment of specific CRA-industry sector committees to work together and develop sector-specific guidance documents.

Pre-claim project review was intended to provide businesses with an upfront review and preliminary opinion on the eligibility of projects for SR&ED tax credits, and the account executive service provided claimants with a designated CRA SR&ED contact person. (Both were subsequently replaced, in June 2016, by a pre-claim consultation service.) A second conference (called “Continuing the Partnership”) was held in Montreal in January 2000 to review the progress made on the action plan and to gather more input from industry and claimants. The result of this conference was a commitment by the CRA to continue to work with industry and fully implement the action plan by the end of 2000.

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The third and final conference (called “Working Together to Deliver Research and Development Incentives”) was held in Ottawa in May 2001. At this conference, the completion of the 1998 action plan was announced, and it was noted that the SR&ED program was now •

more focused on clients in its day-to-day operations;

•

more responsive to the needs of Canadian business;

•

better understood by Canadian companies because of improved communications;

•

characterized by greater consistency and certainty in its delivery; and

•

enhanced through fair and effective methods for reviewing claims.

The program was flourishing, and the relationship between the CRA and stakeholders was very good. Previous claimants returned to the program, and more and more new claimants began to participate. In 2002, the Steering Committee and Advisory Committee were disbanded, and the Partnership Committee was formed (in September 2002) to continue the CRA’s collaboration with industry.

2003–2006 Headquarters restructuring and management changes continued after 2002. Industry’s role in assisting the CRA with the administration of the SR&ED program gradually diminished, although the joint CRA-industry SR&ED Partnership Committee did develop Pamphlet RC4382, Scientific Research & Experimental Development Tax Incentive Program – Strategic Business Plan 2005, which identified three key priorities (or “strategic directions”) of the program: These strategic directions provide a framework within which new and unforeseen demands can be prioritized, and will guide the evolution of the administration of the SR&ED program over the next three years. Our strategic directions are to ensure: •

effective delivery of the SR&ED program

•

awareness of the SR&ED program through enhanced communications initiatives

•

accessibility to the SR&ED program for small business

Despite the encouraging results of a 2005 claimant survey, there were concerns that the program was experiencing some significant problems — such as audits once again becoming difficult and contentious — although the CRA may not have agreed with this view. All the SR&ED joint CRA-industry committees, including the Partnership Committee, had been disbanded as part of a government cost-cutting initiative, and there was very little consultation between the CRA and stakeholders.

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2007–present In the 2007 federal budget (and in line with the government’s strategic plan for science and technology),7 the government indicated its commitment to revitalizing and improving the program: Canada’s scientific research and experimental development (SR&ED) tax incentive program is one of the most advantageous systems in the industrialized world for promoting business investment in R&D, providing over $3 billion in tax assistance to innovative Canadian businesses in 2006. It is the single largest federal program supporting business R&D in Canada, and it will continue to play a leading role in fostering a competitive and dynamic business environment in Canada. Yet we can and will do better. Over the coming year, the Government will identify opportunities to improve the SR&ED program, including its administration, to further encourage research and development within the business sector in Canada.

So, although there were clearly some issues that needed to be addressed, as in 1998, industry and government started to come together to ensure the program’s continued success. In fact, in October 2007, the Department of Finance and the CRA began consultations on the SR&ED program, with the goal of improving the SR&ED tax incentives and making them more effective for Canadian businesses.8 Over 150 submissions were received from various stakeholders during these consultations, resulting in an announcement in the 2008 federal budget of improvements to the program and its administration. Program improvements included •

an increase in the maximum qualified expenditures on which the enhanced 35% refundable tax credit could be earned (from $2 million to $3 million);

•

an increase in the upper limit of both the taxable income phase-out range and taxable capital phase-out range for the 35% enhanced tax credit (from $600,000 and $15 million to $700,000 and $50 million, respectively); and

•

an extension of the SR&ED program to salaries and wages for certain activities carried on outside Canada by Canadian-resident employees.

In line with an announcement made in the March 2010 federal budget, collaborative efforts to further improve the SR&ED program (and, more broadly, to better support business R&D) were continued in October 2010, when the federal government appointed an independent expert panel led by Thomas Jenkins to conduct a comprehensive review of the federal support for R&D, with a view to maximizing its effect. Indeed, despite the generosity of the SR&ED program, Canadian business expenditures on R&D — a key indicator of innovation activity — were continuing to lag significantly behind peer countries. Over 200 written submissions were received from various stakeholders during the consultations conducted by the Jenkins panel. This resulted in an announcement, in the 2012 federal budget, of improvements to the program’s administration as well as some

7

See Mobilizing Science and Technology to Canada’s Advantage (Ottawa, 2007).

8

See Department of Finance, Tax Incentives for Scientific Research and Experimental Development – Consultation Paper (October 2007), for more details.

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program streamlining, which would allow the government to place more emphasis on direct funding of business-led and industry-relevant R&D and venture capital funds (as requested and recommended).9 The streamlining of the program included •

a reduction in the general ITC rate from 20% to 15% (the enhanced tax credit rate was maintained at 35%);

•

the exclusion of all capital expenditures from eligibility for the SR&ED deductions and ITCs;

•

a phased-out reduction (over two years) from 65% to 55% in the rate of the prescribed proxy amount that may be used in lieu of itemizing claimable overhead expenditures; and

•

a reduction from 100% to 80% in the inclusion rate for eligible expenditures incurred for SR&ED performed for or on behalf of a taxpayer by another person.

See Chapter 4, What is eligible? – Financial aspects, for more details on the program’s streamlining.

Administrative improvements To address the challenges, identified during the 2007 consultations, relating to the accessibility, predictability, and consistency of the SR&ED program, the 2008 federal budget announced that the CRA would simplify the SR&ED claim form and guide, develop an eligibility self-assessment tool, and conduct a review of the SR&ED program policies and procedures. The CRA would also increase its scientific capacity and improve its service to claimants through various measures. These improvements are described below: •

New SR&ED form and guide — A new simplified claim form and revised guide to the form were released in November 2008: Form T661, Scientific Research and Experimental Development (SR&ED) Expenditures Claim, and Guide T4088, Scientific Research and Experimental Development (SR&ED) Expenditures Claim – Guide to Form T661. The new form was more amenable to electronic filing of SR&ED claims, and in October 2009, the CRA’s capabilities for corporation internet filing were expanded. This made it possible for corporations to transmit their SR&ED claims to the CRA electronically, with their corporate income tax returns, using any CRAcertified software. Form T661 and Guide T4088 were subsequently revised in June 2010 and in May 2011 (e.g., to add to the preamble of Form T661 that the information requested in the form and the documents supporting the expenditures claimed are prescribed information; replace Section E in Part 2 of the form with a new Part 6 to list projects claimed in the taxation year with their associated costs; and add new fields for science and technology codes to Appendix 1 of Guide T4088, such as software technology, and tooling machinery and equipment).

•

Eligibility self-assessment tool — The SR&ED eligibility self-assessment tool was launched in November 2008 to help claimants determine whether their R&D projects qualify under the SR&ED program. The tool was further enhanced in 2014.

•

SR&ED policies review — In November 2010, the CRA officially introduced the SR&ED policy review project on which it had been working since the 2008 budget

9

See Innovation Canada: A Call to Action (October 2011) — also referred to as the Jenkins report — for details on the recommendations made by the panel.

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announcement. The stated objectives of the project were to consolidate and clarify more than 70 policy and related guidance documents with respect to the SR&ED program, as well as to present this information in a user-friendly way on the CRA website. The policy review project was completed in December 2012 with the release of 20 new SR&ED policy documents and a glossary. All former SR&ED application policies and related guidance were replaced by new topically organized SR&ED policy documents, although the CRA stated that the underlying principles explained in the former documents were unchanged. The SR&ED policies were later revised (in December 2014 or, for a few, July 2016) essentially to take into consideration legislative changes announced in the 2012 and 2013 budgets. •

Scientific capacity and services to claimants — The CRA worked on increasing the scientific capacity of the program with the help of the additional $10 million a year in funding announced in the 2008 federal budget. This additional funding was also to be used for measures to improve services to claimants. The measures undertaken to increase the scientific capacity of the SR&ED program included an increased number of research and technology staff, along with additional training and technical support for this staff. To improve services to claimants, the government undertook to devote more time to its program services (e.g., the pre-claim project review service, the account executive service, and outreach and information seminars). The government also announced that it would be working on improving quality assurance of its methodology at the national and local levels and would embark on a review of the dispute resolution procedures to ensure their effectiveness.

•

Review manuals — To reflect claimants’ concerns, raised during the 2007 consultations, about a perceived lack of consistency in processing SR&ED claims across the country, a new claim review manual (Claim Review Manual for Research and Technology Advisors) was developed and released in June 2010 (in a severed version), with a draft version of an accompanying claimants’ guide (The SR&ED Technical Review: A Guide for Claimants). The claim review manual is intended to provide the CRA’s research and technology advisors (RTAs) more detailed procedures and background information for conducting a technical review of SR&ED claims. It also promotes greater coordination with financial reviewers, strongly emphasizes the importance of working with claimants, and provides what both the RTA and the claimant can expect from each other during a technical review, while setting clear timelines for responding to information requests. The final version of the claimant’s guide and an amended version of the claim review manual were released in July 2011. A revised version of the manual was subsequently released in June 2014 and again in April 2015; similarly, a revised version of the claimants’ guide was released in April 2015. In March 2013, a severed version of the Financial Claim Review Manual – Review Procedures for Financial Reviewers was made available (subsequently revised in June 2015). This manual is written for the CRA’s financial reviewers to outline their requirements concerning review procedures.

Additional administrative changes to the SR&ED program were announced in the 2012 federal budget, taking into account the Jenkins report’s recommendations, or were consequential to the streamlining of the program described above: •

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Eligibility self-assessment tool — The SR&ED eligibility self-assessment tool that was launched in November 2008 was further enhanced to educate businesses on the SR&ED program eligibility requirements and to assist them in preparing their SR&ED

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claims. As a result, a rebranded self-assessment learning tool (SALT) was launched in January 2014. •

Pre-approval — In January 2013, the government launched a pilot project for a formal pre-approval process (FPAP) for SR&ED claims. A feasibility study followed in June 2013 for interested parties who were not able to participate in the pilot. These interested parties could provide input through a consultation questionnaire.

•

Notice of objection — The notice-of-objection process was improved in December 2012 to allow for a second review of scientific eligibility determinations. More specifically, the improvements were – the addition of personnel with science and engineering expertise, providing a more specialized and timely review of the issues raised under objection; – a greater focus during the reviews on addressing the SR&ED eligibility issues raised by claimants in their notices of objection; and – communication between the CRA’s notice-of-objection advisors and the claimants.

•

Contingency fees — Following the 2012 budget announcement, a study was launched (in August 2012) on the contingency fees charged by tax preparers for SR&ED claims and their potential impact on the SR&ED program. Although the government subsequently concluded that its intervention was not required to directly regulate these fees, two measures emerged from the consultation process and were announced in the 2013 federal budget: – New funding was announced to focus more resources on SR&ED claims where the risk of non-compliance or lack of eligibility of the work claimed is perceived to be high. Changes were announced to Form T661 to require more detailed information about claim preparers and billing arrangements, and a new penalty was announced to enforce this disclosure requirement. – New funding was announced to conduct more direct outreach with first-time claimants. The resulting in-person first-time claimant advisory service (FTCAS) was launched in January 2014. Webinars were also developed in January 2014, a new video series was launched in September 2014, and the CRA’s SR&ED website was redesigned in April 2015.

•

SR&ED form and guide — Form T661 and Guide T4088 were revised in October 2012 to take into account the 2012 budget changes that came into effect on January 1, 2013. The form and guide were revised again in October 2013 for the 2012 budget changes that came into effect on January 1, 2014; for the 2013 budget changes (relating to new Part 9 on claim preparer information, which also took effect on January 1, 2014); and for consistency with the 2012 revised policy documents. Guide T4088 was further revised in January 2015 to continue implementing these 2012 and 2013 changes. A revised administrative optional filing measure was introduced in May 2014 to allow Part 9 of Form T661 to be filed separately if a claim preparer has concerns about information confidentiality. Both Form T661 and Guide T4088 were subsequently revised (in November 2015) to reflect changes to the Eligibility of Work for SR&ED Investment Tax Credits Policy released in April 2015.

The various administrative improvements made to the SR&ED program over the last few years, as well as the 2012 streamlining, are in line with the February 2012 recommendations of the taxpayers’ ombudsman that the CRA should continue to be proactive in its communication with SR&ED claimants and their representatives, and that

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stakeholders would benefit from greater clarity on the CRA’s policies and procedures.10 In that spirit, and to provide more predictability, the CRA launched two new, free ondemand services in the summer of 2016: •

The pre-claim consultation service enables potential claimants to find out from the CRA, before they submit their claim, whether their work would generally be eligible for SR&ED.

•

The pre-claim review service allows claimants to obtain assurance from the CRA that it will accept their claim before they file it (i.e., by determining how much of the work undertaken by the claimant is eligible and what specific expenditures would qualify). Unlike the pre-claim consultation service, the pre-claim review involves an analysis of the extent of the work conducted by the potential claimant. The pre-claim review service was introduced as a pilot and rolled out gradually out across the country.

Tax policy intent The Legislative Policy and Regulatory Affairs Branch of the Department of Finance is responsible for developing and evaluating tax policy and legislation. Finance has stated that the federal tax policy objectives of the SR&ED program are to •

encourage the private sector to carry out SR&ED in Canada through broadly based financial support;

•

help small businesses carry out SR&ED;

•

offer incentives that provide immediate benefits as much as possible;

•

ensure the incentives are simple to understand and comply with, and as certain in application as possible; and

•

promote SR&ED that is consistent with sound business practices.

SR&ED within the CRA CRA’s objective and commitments As indicated in the Overview (on page 1), the CRA is responsible for the administration of the SR&ED program. The CRA has stated that the objective of the program is to deliver SR&ED incentives in a timely, consistent, and predictable manner, while encouraging R&D performers to prepare their own claims in compliance with tax laws, policies, and procedures. The CRA has also stated that it is committed to •

making businesses aware of the program and providing easy access to it (ensuring that entitlements are received, investment benefits of SR&ED incentives are maximized, and the costs of compliance and administration are minimized); and

•

administering the program with fiscal integrity (i.e., applying the SR&ED legislation correctly, consistently, and fairly, and ensuring that claimants receive the full SR&ED deduction or credit to which they are entitled).

10 On February 10, 2012, the Office of the Taxpayers’ Ombudsman issued an observation paper after conducting a review of the SR&ED program following complaints received from claimants and tax intermediaries (accounting firms, tax preparers, industry associations, etc.) about SR&ED program administration.

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CRA’s service standards The CRA must report annually on its performance for the previous fiscal year and rate its achievements against the key targets and indicators set out in its corporate business plan. The CRA has four key SR&ED program-delivery service standards. These standards all relate to processing times and have been in place for many years.11 Specifically, the CRA aims to process •

refundable claims within 120 calendar days from the receipt of a complete claim;

•

non-refundable claims within 365 calendar days from the receipt of a complete claim;

•

claimant-requested adjustments to refundable claims within 240 calendar days from the receipt of a complete claim; and

•

claimant-requested adjustments to non-refundable claims within 365 calendar days from the receipt of a complete claim.

Except in very limited circumstances, once a claim has gone through a CRA review and has been processed, the claim is accepted, and the CRA will never look at it again. It is important to note that these standards are not contained within the legislation; rather, they are administrative targets that the CRA tries to achieve at least 90% of the time. The CRA continually reports that it is meeting its delivery service standards, even though the SR&ED program has grown significantly over the years.12 However, the CRA’s tracking of the time spent to complete a file may not be consistent across the country.

CRA’s structure and resources The CRA is composed of 13 branches and five regions, each of which is headed by an assistant commissioner (see figure below). Within CRA headquarters, the SR&ED program is the responsibility of the SR&ED Directorate, which is part of the Domestic Compliance Programs Branch. The SR&ED Directorate, which is headed by a director general, is responsible for establishing policies, procedures, and budgets. The director general reports directly to the assistant commissioner of the Domestic Compliance Programs Branch, who reports to the CRA commissioner. Field offices, known as tax services offices (TSOs), are responsible for reviewing and processing claims. Six TSOs (known as coordinating TSOs) ensure the coordination and delivery of the SR&ED program among the TSOs. The coordinating TSOs are as follows: •

Nova Scotia for claimants in New Brunswick, Prince Edward Island, Nova Scotia, and Newfoundland and Labrador;

11

www.canada.ca/en/revenue-agency/services/scientific-research-experimental-development-taxincentive-program/program-service-standards.html.

12 The CRA reports processing approximately 21,000 claims every year, worth over $2.7 billion in investment tax credits in 2016–17.

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CRA organizational structure Minister of national revenue Board of management Commissioner and deputy commissioner

Assistant commissioner Appeals

Assistant commissioner Atlantic

Assistant commissioner and chief privacy officer Public Affairs

Assistant commissioner Assessment, Benefit, and Service

Assistant commissioner Quebec

Assistant commissioner International, Large Business and Investigations

Assistant commissioner Ontario

Assistant commissioner Domestic Compliance Programs Assistant commissioner Legislative Policy and Regulatory Affairs Assistant commissioner Collections and Verification

Assistant deputy attorney general Legal Services

Assistant commissioner Prairie

Assistant commissioner Pacific

Assistant commissioner and CFO Finance and Admin. Assistant commissioner Human Resources Assistant commissioner and CIO Information Technology Assistant commissioner and chief data officer Strategy and Integration

Assistant commissioner and chief audit executive Audit, Evaluation, and Risk

•

Western Quebec for claimants in Quebec (e.g., in Chicoutimi, Laval, Montreal, Montérégie-Rive-Sud, Outaouais, Quebec, Rimouski, Rouyn-Noranda, Sherbrooke, and Trois-Rivières);

•

Toronto Centre for claimants in Ottawa, Toronto Centre, Toronto East, Toronto North Eastern, East Central and Northern Ontario (e.g., in Barrie, Belleville, Kingston, Peterborough, and Sudbury), and Nunavut;

•

Toronto West–Thunder Bay for all other claimants in Ontario (e.g., in Hamilton, Kitchener-Waterloo, London, Mississauga, St. Catharines, Thunder Bay, and Windsor);

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•

Edmonton for claimants in Manitoba, Saskatchewan, Alberta, and the Northwest Territories; and

•

Fraser Valley and Northern for claimants in British Columbia and Yukon.

Each of these coordinating TSOs has a director who is responsible for all operations of that office (including SR&ED) and an assistant director of SR&ED who heads the SR&ED Division of the TSO. The assistant director of SR&ED reports to the TSO director, who in turn reports to the assistant commissioner for the region (e.g., the assistant commissioner for Ontario). Regional assistant commissioners report to the CRA commissioner in Ottawa and have an oversight role with respect to how the TSOs are delivering the program. They also work with headquarters on resource allocations. Within each coordinating TSO, the SR&ED Division is responsible for the audit or approval of the claims it receives. The coordinating TSOs are also responsible for providing claimant seminars, pre-claim consultation services, first-time claimant advisory services, and pre-claim review services, and for assisting claimants in their endeavours to obtain their entitlements. Although TSOs do not report to the SR&ED Directorate at headquarters, they may occasionally ask headquarters for assistance on complex issues or files. Generally, however, headquarters does not get involved in helping claimants and TSOs resolve differences of opinion on eligibility.

Risk management – Claims assessment Risk management is key to the successful delivery of the SR&ED program. The program, and indeed the Canadian tax system as a whole, relies on self-assessment. The CRA does not have the time or resources to review every claim at the level of a detailed audit. Furthermore, if all claims were subjected to a detailed audit, claimants would have to wait an extraordinary amount of time after filing before receiving the audit results. Obviously, a program based on self-assessment is not foolproof, and there will always be some “leakage” in its delivery. But because fiscal integrity is paramount to the program’s success, checks and balances must be in place so that claimants can be reasonably assured they will receive their proper entitlements and that any leakage is immaterial. For information on risk management and claims assessment from the perspective of the claimant, see Chapter 5, SR&ED claims submission process.

Claims review process Since the beginning of the SR&ED program, claimants have been required to file their claims with their tax returns for the year and send them to the applicable taxation centre.13 Taxation centres have a significant amount of responsibility with respect to initial screenings and risk assessment. The taxation centre is responsible for the

13 The CRA’s four taxation centres are not to be confused with the CRA’s TSOs or the three national verification and collection centres (NVCCs). The taxation centres are located in the following provinces: Manitoba (in Winnipeg), Ontario (in Sudbury), Prince Edward Island (in Summerside), and Quebec (in Jonquière). The NVCCs are located in British Columbia (in Surrey), Newfoundland and Labrador (in St. John’s), and Quebec (in Shawinigan-Sud).

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completeness check, and it contacts the claimant if it believes the claim is incomplete. If the claim is not complete, the claimant is usually informed of the deficiencies by a letter requesting that additional information be submitted within 30 days. The taxation centre may disallow the claim in its entirety if the required information is not received by the deadline. Once the taxation centre has determined that a claim is complete, it conducts an initial risk assessment. If the claim passes this assessment, the claim is processed accordingly. Although the general public does not have access to the risk assessment criteria used by the taxation centres, it is reasonable to assume they include •

the total amount of investment tax credits being claimed;

•

the claimant’s previous filing history;

•

the claimant’s previous audit history;

•

the claimant’s industry;

•

whether the claim is amending a previous claim or tax return;

•

the size of the claim relative to recent claims; and

•

the types of expenditures being claimed.

If the result of the taxation centre’s risk assessment is that further review is required, the claim will be sent to the appropriate coordinating TSO, where the subsequent review may involve up to three different stages.

Stage 1 Claims sent to the coordinating TSO are generally subject to a desk review by CRA science and financial staff. The CRA may contact the claimant for more information as part of the initial review. It is important to note that when a claim is processed through a desk review, the CRA is not indicating that the work is eligible or the expenditures qualified; rather, this indicates only that the CRA has chosen to process the claim as filed, on the basis of the desk review. Claimants cannot assume that a project or expenditure will be accepted in a subsequent year, as it is the CRA’s position that each year must stand on its own.

Stage 2 If the CRA does not accept the claim on the basis of the desk review, the risk management process moves to the second stage. This decision may be made for various reasons. From a science perspective, the CRA may not be comfortable enough with what is stated in the project descriptions to accept the claim. From an expenditure perspective, the numbers may have increased significantly or may appear to be inconsistent with what the CRA expects for costs. If the CRA has questions or concerns that cannot be resolved by a desk review, it may call or visit the claimant to address them. If, after discussing and reviewing some additional information, the CRA considers the questions or concerns to be resolved, the claim may be processed. As with a desk review, the CRA is not required, at this stage, to render a decision on the eligibility of the work or expenditures; it simply needs to document a rationale for why it decides to process the file without further review.

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Stage 3 If the CRA is still not satisfied with the claim, the third stage of the risk management process will begin — essentially, a full-scale review (financial, scientific, or both) of one or more projects or expenditures. The depth of the review is at the CRA’s discretion, and the level of detail sometimes changes as the CRA gathers more information. Most of the time, the CRA will conduct a “joint review” where both the financial and scientific aspects are audited. However, in some cases, only one type of review is conducted (i.e., either financial or scientific). In these instances, the CRA always reserves the right to do a full review according to the new information obtained from the first one. If only a scientific or technical review is performed, and the CRA has concerns about the work claimed, a financial reviewer will determine the dollar amount of any adjustments. Generally, the CRA will present the results of the review in a preliminary technical review report (assuming it is not just expenditures that are being reviewed). The CRA will explain, both orally and in writing, any concerns about the work or expenditures, identifying what the concerns are and how they relate to law or policy.

For further reference Forms T661

Scientific Research and Experimental Development (SR&ED) Expenditures Claim

Guides and manuals Guide

The SR&ED Technical Review: A Guide for Claimants

Manual

Claim Review Manual for Research and Technology Advisors

Manual

Financial Claim Review Manual – Review Procedures for Financial Reviewers

Web resources Claiming SR&ED tax incentives www.canada.ca/en/revenue-agency/services/scientific-research-experimentaldevelopment-tax-incentive-program/claiming-tax-incentives.html Evolution of the SR&ED program – Historical perspective www.canada.ca/en/revenue-agency/services/scientific-research-experimentaldevelopment-tax-incentive-program/evolution-program-a-historical-perspective.html

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2. Tax benefits of SR&ED Overview This chapter outlines the tax benefits a claimant may receive for qualifying SR&ED expenditures.1 The main benefits of the federal SR&ED incentive program are •

investment tax credits (ITCs) for qualified expenditures, including refundable and non-refundable credits; and

•

a deduction for SR&ED expenditures.

The chapter provides an overview of these credits and the deduction. A more detailed discussion is provided in Chapter 4, What is eligible? – Financial aspects. Although many of the provinces also offer similar tax incentives for SR&ED expenditures, this guide focuses on the federal program. A table summarizing the provincial and territorial rates is provided under Summary of ITC rates (on page 23).

Availability of incentives Federal SR&ED tax incentives are available to most businesses in Canada, including •

proprietorships (individuals) and trusts;

•

public corporations;

•

private corporations;

•

foreign corporations; and

•

partnerships.2

Basic requirements To benefit from the SR&ED tax incentives, a claimant generally must •

carry on business in Canada in the year;

•

perform SR&ED work3 (or have SR&ED work performed on its behalf) that is related to the business of the claimant (see Related to the business of the claimant (on page 28)); and

•

complete and file the following forms with prescribed information: – Form T661, Scientific Research and Experimental Development (SR&ED) Expenditures Claim, and – Form T2SCH31 (Schedule 31), Investment Tax Credit – Corporations, or Form T2038(IND), Investment Tax Credit (Individuals), as applicable.

1

For a definition of SR&ED, see Chapter 3, What is eligible? – Scientific and technological aspects.

2

See Chapter 4, What is eligible? – Financial aspects, for a discussion on the limitations that apply to limited partnerships.

3

See Chapter 3, What is eligible? – Scientific and technological aspects, for details on what constitutes eligible SR&ED work.

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The reporting deadline is 12 months after the filing-due date of the return for the fiscal period in which the expenditures were incurred. Any claim that is not filed by the deadline will be rejected by the CRA. Any claim that is filed by the deadline but is still incomplete by the deadline may be rejected in whole or in part by the CRA. For more information on the forms and filing deadlines, see Chapter 5, SR&ED claims submission process.

Investment tax credits [§127(5)–(36), §127.1] — The federal SR&ED investment tax credits (ITCs) are generally available to claimants that carry on a business in Canada, perform SR&ED in Canada that is related to that business, and incur qualified expenditures. ITCs are calculated as a percentage of the qualified expenditures. The rate of the credit depends on the claimant. For taxation years ending after 2013, the credit rates are •

15% for all eligible claimants entitled to a credit; and

•

35% for Canadian-controlled private corporations (CCPCs) — CCPCs are therefore eligible for an additional 20% credit (on top of the 15% base credit) on expenditures incurred in a taxation year (up to the expenditure limit).

For taxation years ending prior to 2014, the base credit rate for all claimants was 20%, and the additional credit rate for eligible CCPCs was 15% (so no change in the total credit rate of 35% for eligible CCPCs).4 As defined in subsection 127(9) of the Income Tax Act, a qualified expenditure is •

an expenditure that is incurred in the year by the claimant in respect of SR&ED and is – a current expenditure as described in subparagraph 37(1)(a)(i) (e.g., salary and wages of employees directly engaged in SR&ED), – 80% of a current expenditure for arm’s length contracts or third-party payments as described in subparagraphs 37(1)(a)(i.01) to (iii),5 or – prior to February 1, 2017, and under certain circumstances, an expenditure for firstor second-term shared-use equipment (i.e., certain depreciable property acquired prior to 2014); or

•

the prescribed proxy amount (PPA).

Expenditures of a capital nature as described in former paragraph 37(1)(b)(i) were also qualified expenditures when made prior to 2014.6 For taxation years ending after 2013, capital expenditures no longer qualify for SR&ED incentives.

4

For taxation years straddling January 1, 2014, the applicable credit rates are prorated for the number of days in the taxation year before 2014 and after 2013.

5

Prior to 2013, 100% of the expenditures or payments could be categorized as qualified expenditures.

6

Similarly, prior to 2014, claimants did not have to reduce their third-party payments or SR&ED contract expenditures made to an SR&ED performer by any related expenditure of the SR&ED performer that was for capital property (or for its use or right to use).

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The definition of qualified expenditure also sets out various items by which the amount of otherwise qualified expenditures may be reduced (e.g., by expenditures for non-arm’s length SR&ED contracts). These reductions, as well as the components described above (including the PPA), are covered in depth in Chapter 4, What is eligible? – Financial aspects. Qualified expenditures are calculated in Part 4 of Form T661, Scientific Research and Experimental Development (SR&ED) Expenditures Claim, and claimed on Schedule 31, Investment Tax Credit – Corporations, of the T2 corporate income tax return, or on Form T2038(IND) – Investment Tax Credit (Individuals), as applicable. Claimants may also be eligible for a refund of ITCs that are not used to offset taxes otherwise payable. The refundability of ITCs is examined in greater detail in the sections that follow and is summarized under Summary of ITC rates (on page 23). Finally, it should also be noted that it is possible, under certain circumstances, to transfer qualified expenditures between related parties. See Chapter 4, What is eligible? – Financial aspects, for more details.

ITC for CCPCs – 35% credit CCPCs may claim an ITC for qualified expenditures at the enhanced rate of 35%. To be eligible for this enhanced rate, a corporation must be a CCPC throughout the taxation year (i.e., the corporation must be a CCPC throughout every day of that taxation year).7 For taxation years ending after 2013, the 35% ITC consists of the base rate of 15% plus an additional 20%.8 The enhanced ITC is available on qualified expenditures up to the corporation’s annual expenditure limit (discussed below). For qualified expenditures exceeding the expenditure limit, the ITC rate is the base rate of 15%. Normally, it is small- to medium-sized CCPCs that are eligible for the enhanced tax credit.

Expenditure limit [§127(10.2)–(10.6)] — There are three key elements in the calculation of the expenditure limit of a corporation. First, the expenditure limit cannot exceed $3 million.9 Second, the expenditure limit is reduced where the preceding year’s taxable income for the corporation and associated corporations exceeds a threshold linked to the maximum small business deduction business limit for the year (i.e., $500,000 for 2010 and subsequent taxation years). The expenditure limit is reduced by $10 for every $1 of the

7

ITA s. 249(3.1) simplifies this requirement by deeming a corporation to have a year-end at any time that it becomes or ceases to be a CCPC.

8

See ITA s. 127(10.1). For taxation years ending prior to 2014, the 35% ITC consisted of a base rate of 20% plus an additional 15%.

9

This limit was increased from $2 million for taxation years ending on or after February 26, 2008.

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preceding year’s taxable income that exceeds the threshold. For 2010 and subsequent taxation years, the $3-million expenditure limit is reduced to nil when the preceding year’s taxable income is $800,000 or more. Third, the expenditure limit is reduced when the taxable capital of the corporation (or associated group) for the preceding year exceeds $10 million, with a phase-out limit of $50 million. In addition, the annual expenditure limit must be shared among associated corporations.10 For more information on the expenditure limit, see Chapter 4, What is eligible? – Financial aspects.

Refund of 35% ITC [§127.1] — In addition to the enhanced ITC rate of 35%, CCPCs may receive a refund of all or a portion of the ITC earned on qualified expenditures incurred in a taxation year. The amount refundable depends on whether the CCPC meets the definition of qualifying corporation and is not an excluded corporation.11

Qualifying corporations Basically, a qualifying corporation is a corporation that •

is a CCPC in the taxation year; and

•

had taxable income for the preceding year that did not exceed its qualifying income limit for the taxation year.

Where a corporation is associated with one or more corporations in the taxation year, the taxable income of all the associated corporations for the preceding year cannot exceed the qualifying income limit of the corporation for the taxation year. The qualifying income limit is $500,00012 less any reduction where the taxable capital of the corporation (and of all its associated corporations) exceeds $10 million, with a phaseout limit of $50 million.13

10 See Schedule 49, Agreement Among Associated Canadian-Controlled Private Corporations to Allocate the Expenditure Limit, of the T2 return. 11

Excluded corporations are discussed in Chapter 4, What is eligible? – Financial aspects.

12 For taxation years that ended on or after February 26, 2008, and before 2010, this limit was $400,000. 13 For more information on whether a corporation is a qualifying corporation, see Chapter 4, What is eligible? – Financial aspects.

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For a CCPC that is a qualifying corporation, the following amounts are refundable: •

100% of the ITCs earned at the 35% rate on current expenditures; and

•

40% of the ITCs earned on all other current expenditures (i.e., ITCs earned at the base rate of 15%14 on qualified expenditures).15

Non-qualifying corporations Although a corporation, as a CCPC, is entitled to earn an ITC at the 35% rate, it may not necessarily be considered a qualifying corporation for purposes of the refundability of its ITCs if it does not meet the taxable income test mentioned above. Non-qualifying corporations are entitled to receive the 100% refund of ITCs on current expenditures up to the expenditure limit described above.16 However, no refund is available for expenditures that exceed the expenditure limit. Example Facts and assumptions: Company A is a CCPC with a December 31 year-end. In its 2017 taxation year, it incurs $4 million in qualified expenditures. Company A is not associated with any other corporations. For the 2016 taxation year, Company A had taxable income of $550,000 and taxable capital of less than $10 million. Tax consequences: Company A’s ITC entitlement is as follows: Expenditure limit = $3,000,000 – [10 x ($550,000 – $500,000)] = $2,500,00017 Refundable ITC = $2,500,000 x 35% = $875,000 Non-refundable ITC = ($4,000,000 – $2,500,000) x 15% = $225,000 Company A’s taxable income for 2016 ($550,000) exceeds the $500,000 threshold, and thus the expenditure limit is reduced by $500,000 ($10 for every $1 of the preceding year’s taxable income exceeding the threshold). So, Company A’s expenditure limit is $2.5 million; as a CCPC, it may claim an ITC at the rate of 35% on its qualified expenditures up to this amount and an ITC at the rate of 15% on the excess.

14 This rate applies for taxation years ending after 2013. For taxation years that ended prior to 2014, the base rate was 20%. 15 For taxation years ending prior to 2014, qualifying corporations were also able to claim a refund of 40% of ITCs earned at the 35% rate on capital expenditures. 16 For taxation years ending prior to 2014, non-qualifying corporations were also entitled to claim the 40% refund noted above on ITCs earned at 35% on capital expenditures. 17 As further discussed in Chapter 4, What is eligible? – Financial aspects, the formula used in ITA s. 127(10.2) to calculate the expenditure limit is expressed differently but provides the same result. The formula in s. 127(10.2) is as follows: $8,000,000 – [10 x (Greater of $500,000 and preceding year’s taxable income)].

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However, because Company A’s taxable income for 2016 exceeds the qualifying income limit for 2017 ($500,000), it is not a qualifying corporation. Therefore, Company A is entitled to a refund only on the ITC earned at the 35% rate; no refund is available for the $1,500,000 exceeding the expenditure limit. In summary, Company A may claim a total of $1,100,000 in ITCs — $875,000 that is refundable and $225,000 that may be used only to offset taxes otherwise payable.

ITC for other claimants – 15% credit Canadian corporations other than CCPCs, as well as individuals, partnerships, and trusts, may claim an ITC at the rate of 15% on qualified expenditures for taxation years ending after 2013. For taxation years ending prior to 2014, the ITC rate was 20%.18 As well, CCPCs may claim the 15% ITC (20% ITC prior to 2014) on expenditures that exceed the expenditure limit.

Refund of 15% ITC Individuals, partnerships, and trusts are eligible for a 40% refund of ITCs earned on current expenditures. No refund is available for corporations earning the 15% ITC (except, as discussed previously, for CCPCs that are qualifying corporations). For taxation years ending prior to 2014, the 40% refund was also available for ITCs earned on capital expenditures.

Using ITCs ITCs may be used to offset Part I tax otherwise payable in the year, may be carried back three years or forward 20 years to offset Part I tax,19 or, as discussed above, may be refundable. Before using ITCs to reduce previous years’ federal taxes or to claim a refund, a claimant must reduce, to the fullest extent possible, federal tax payable for the current year (using the non-refundable ITCs first). An ITC that has been claimed (either refunded or used to offset taxes otherwise payable) is brought into income in the year following the year the ITC was utilized (except in partnerships — see Chapter 4, What is eligible? – Financial aspects). Generally, ITCs claimed are taxed by deducting the ITC amount from the pool of deductible SR&ED expenditures. If there are no SR&ED expenditures or insufficient expenditures in a particular year to absorb the ITC earned in the previous year, the ITCs that exceed the SR&ED expenditures in the pool prior to this reduction are brought into income under paragraph 12(1)(v) of the Income Tax Act.

18 For taxation years straddling January 1, 2014, the applicable credit rate is prorated for the number of days in the taxation year before 2014 and after 2013. 19 The 20-year carryforward applies to ITCs earned in 2006 and subsequent taxation years (the carryforward period was previously 10 years). The carryforward period for unused ITCs between 1998 and 2005 has been extended as well — to 20 taxation years from 10; this amendment allows ITCs earned in 1998 to be carried forward to 2018. See Transitional application provisions (on page 147) in Chapter 4, What is eligible? – Financial aspects, for more details on the carryforward period.

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Summary of ITC rates The ITC rates are summarized in the following table. ITC rates Refund – Current expenditures

ITC rate

Refund – Capital expenditures

Taxation years ending before 2014

Taxation years ending after 2013

Before 2014

After 2013

Up to expenditure limit

35%

35%

100%

40%

None

Over expenditure limit – Qualifying corporations

20%

15%

40%

40%

None

Over expenditure limit – Nonqualifying corporations

20%

15%

None

None

None

Corporations other than CCPCs

20%

15%

None

None

None

Individuals, partnerships, and trusts

20%

15%

40%

40%

None

CCPCs

As mentioned in the Overview (on page 17), a number of provinces also provide tax credits for certain incurred SR&ED expenditures. The extent and nature of these credits depend on the status of the claimant and the nature of the expenditure. The following table provides an overview of these credits, indicating which provinces and territories offer these incentives, the rate of the credits, and the base on which the credits are calculated. Provincial and territorial tax credits Province or territory

Rate

Base

Alberta SR&ED tax credit (refundable)

10%

Eligible expenditures

10%

SR&ED qualified BC expenditures

British Columbia SR&ED tax credit (refundable and nonrefundable)

(continued)

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Provincial and territorial tax credits (cont’d) Province or territory

Rate

Base

Manitoba R&D tax credit (nonrefundable)

After April 11, 2017: 15%

Eligible expenditures

Before April 12, 2017: 20% R&D tax credit (refundable)

After April 11, 2017: 7.5%

Eligible expenditures

(15% if under contract with post-secondary institutions or eligible institutes) Before April 12, 2017: 10% (20% if under contract with post-secondary institutions or eligible institutes) New Brunswick R&D tax credit (refundable)

15%

Eligible expenditures

15%

Eligible expenditures

15%

Eligible expenditures

20%

Qualified expenditures

After May 31, 2016: 8%

Qualified expenditures

Newfoundland and Labrador R&D tax credit (refundable) Nova Scotia R&D tax credit (refundable) Ontario Business–research institute tax credit (refundable) Innovation tax credit (refundable)

(or 8%–12% for expenditures after March 27, 2018, as determined by a ratio of expenditures to gross revenues test)1 Before June 1, 2016: 10% R&D tax credit (nonrefundable)

After May 31, 2016: 3.5%

Eligible expenditures

(or 5.5% for expenditures over $1 million after March 27, 2018)2 Before June 1, 2016: 4.5% (continued) 24

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Provincial and territorial tax credits (cont’d) Province or territory

Rate

Base

3

Quebec

Tax credit for salaries and wages (refundable)

After June 4, 2014: 14% (for large businesses)

Salaries and payments to subcontractors

22% (for large biopharmaceuticals)4 14%–30% (for small and medium-sized enterprises (SMEs), as determined by an asset size test) 22%–30% (for biopharmaceutical SMEs, as determined by an asset size test)5 Before June 5, 2014: 17.5% (for large businesses) 27.5% (for large biopharmaceuticals) 17.5%–37.5% (for SMEs, as determined by an asset size test) 27.5%–37.5% (for biopharmaceutical SMEs, as determined by an asset size test) Tax credit for university research or research carried out by a public research centre or a research consortium (refundable)

Tax credit for fees or dues paid to a research consortium (refundable)

After December 2, 2014: Research contracts 14% (for large businesses) 14%–30% (for SMEs, as determined by an asset size test) Before December 3, 2014, and after June 4, 2014: 28% Before June 5, 2014: 35% After December 2, 2014: 14% (for large businesses) 14%–30% (for SMEs, as determined by an asset size test) Before December 3, 2014, and after June 4, 2014: 28% Before June 5, 2014: 35%

Fees or dues

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Provincial and territorial tax credits (cont’d) Province or territory Tax credit for precompetitive research in private partnership (refundable)

Rate After December 2, 2014: 14% (for large businesses)

Base R&D expenditures

14%–30% (for SMEs, as determined by an asset size test) Before December 3, 2014, and after June 4, 2014: 28% Before June 5, 2014: 35%

Saskatchewan6 R&D tax credit (nonrefundable after March 31, 2015; refundable after March 18, 2009, and before April 1, 2015)

After March 31, 2015: 10%

R&D tax credit (refundable)

After April 1, 2017: 10%

Eligible expenditures

Before April 1, 2015: 15% First $1 million of eligible expenditures of a CCPC

Yukon R&D tax credit (refundable)

1

2

3

4 5 6

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15%

Qualified expenditures

5%

Qualified expenditures paid or payable to the Yukon College

As proposed in the March 28, 2018 Ontario budget. Although the budget policy of the (former) Liberal government was adopted on April 25, 2018, this enhanced rate proposal was not introduced in a budget implementation bill prior to the Ontario general election on June 7, 2018. It remains to be seen whether this proposal will be adopted by the new Progressive Conservative government. As proposed in the March 28, 2018 Ontario budget. Although the budget policy of the (former) Liberal government was adopted on April 25, 2018, this enhanced rate proposal was not introduced in a budget implementation bill prior to the Ontario general election on June 7, 2018. It remains to be seen whether this proposal will be adopted by the new Progressive Conservative government. A patent box–type taxable income deduction is also available to qualifying innovative manufacturing corporations for taxation years beginning after December 31, 2016. The deduction is based on the value of qualified patented parts resulting from R&D work carried out in Quebec that has given rise to a refundable R&D tax credit. Special increased rates for biopharmaceuticals are eliminated for taxation years beginning after June 4, 2014. Special increased rates for biopharmaceuticals are eliminated for taxation years beginning after June 4, 2014. A patent box–type incentive in the form of a tax rebate is also available, effective January 1, 2017. The incentive effectively reduces the general corporate income tax rate to 6% on an eligible corporation’s taxable income earned from the commercialization of qualifying intellectual property in Saskatchewan. In addition, in its April 10, 2018 budget, Saskatchewan introduced a new tax incentive program, effective January 1, 2018, for qualifying investments in eligible startup businesses that are developing new technologies or applying existing technologies in a new way to create proprietary new products, services, or processes that are repeatable and scalable.

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Deduction – SR&ED pool [§37(1)] — In addition to investment tax credits (ITCs), the federal SR&ED tax incentive program provides another benefit to claimants by allowing them to •

fully deduct current SR&ED expenditures from income in the year they are incurred; or

•

carry forward these expenditures indefinitely, to offset taxable income in future years.

Basically, this is accomplished by including all current expenditures in an SR&ED pool in the year incurred and allowing claimants to take the deduction in that year or in a future year. SR&ED capital expenditures made after 2013 are not eligible for the deduction and cannot be added to the SR&ED pool. The SR&ED expenditure pool is calculated in Section C of Part 3 of Form T661, Scientific Research and Experimental Development (SR&ED) Expenditures Claim, and includes the total current SR&ED expenditures as well as capital expenditures for depreciable property available for use before 2014 (from Line 400 of Form T661) •

less – government and non-government assistance for these SR&ED expenditures, – SR&ED ITC claimed in the preceding taxation year (excluding the ITC on shareduse equipment), – unclaimed SR&ED expenditures for SR&ED capital assets acquired before 2014 and sold in the taxation year (the amount to be deducted from the SR&ED expenditure pool being the lesser of the proceeds of disposition and the unclaimed cost of the asset included in the previous year’s ending SR&ED pool balance),20 and – other deductions (e.g., a section 61.3 deduction for insolvency);

•

plus – SR&ED expenditure pool balance from the preceding taxation year, – ITC recaptured in the preceding taxation year, and – other adjustments to the SR&ED expenditure pool (repayments of government and non-government assistance and SR&ED expenditure pool transfer from an amalgamation or windup).

For corporations, the SR&ED expenditure pool amount is deducted on Schedule 1, Net Income (Loss) for Income Tax Purposes, of the T2 return. The calculation of the SR&ED expenditure pool is discussed in greater detail in Chapter 4, What is eligible? – Financial aspects.

20 If the proceeds are greater than the unamortized asset cost in the SR&ED pool, the difference is included in income (up to the amount of recapture of capital cost allowance, because the asset is deemed to be of a separate class).

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Timing of deduction As mentioned above, a claimant may deduct all or a portion of the expenditures in the SR&ED expenditure pool in the year they are incurred, or the expenditures may be carried forward indefinitely for deduction at some time in the future. This allows the claimant to carry forward current expenditures that would normally be deductible only in the year incurred, to offset taxable income in future years. This option is particularly valuable when a corporation has losses before deducting any SR&ED expenditures, as the ability to deduct loss carryforwards expires after 20 years. The carryforward period is limited when the claimant is subject to a loss restriction event (e.g., an acquisition of control) or when the claimant ceases to carry on a business in Canada.

Related to the business of the claimant As mentioned at the beginning of this chapter, to benefit from SR&ED tax incentives, the SR&ED work performed must be related to a business of the claimant. Although a detailed discussion of what constitutes a business is beyond the scope of this guide, the following section provides a general overview of some important points to consider when determining what it means to be related to a business for SR&ED purposes (more details are provided in Chapter 4, What is eligible? – Financial aspects). It is important to remember that whether a particular SR&ED expense or payment is related to a business depends on the facts of each particular case. [§37(8)(b), (c)] — Carrying out SR&ED, in and by itself, is not considered to be related to the business of a claimant unless all or substantially all (90% or more) of the claimant’s revenue is derived from carrying out SR&ED. Where this is not the case, the claimant must demonstrate that there is a link or connection between the SR&ED and the claimant’s business — for example, by showing that the results of the SR&ED can be directly applied to benefit the business. Under paragraph 37(8)(b), SR&ED that may lead to or facilitate an extension of a business is considered to be related to that business. Moreover, initial expenditures made for the purpose of beginning a new business may be deductible if the expenses were incurred for the purpose of gaining or producing income from the business. Thus, expenditures for SR&ED work performed at the start of a business may be considered related to the business of the claimant. However, the claimant may need to provide evidence that it was planning on being in that business, beyond the SR&ED work claimed. [§37(1.1)] — If the claimant is a corporation, SR&ED expenditures are also considered related to the business of the claimant where the SR&ED work performed by the claimant is related to a business actively carried on by a related corporation at the time at which the SR&ED is performed. This provision does not extend to SR&ED of a corporation related to a business of another entity that is not a corporation, or to SR&ED of an entity that is not a corporation that is related to a business of a corporation.

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[§37(1)(a)(i.1)] — Payments made by a claimant to a third party to be used for SR&ED carried on in Canada must also be related to a business of the claimant to be eligible. In addition, the claimant must have the right to exploit the results of that SR&ED. However, to claim SR&ED expenditures for work directly undertaken by or on behalf of a claimant, the claimant does not have to be entitled to exploit the results of the SR&ED. For example, many Canadian corporations perform SR&ED for foreign corporations and grant all rights to the results of the SR&ED to the foreign corporation. The Canadian corporation is still entitled to claim the SR&ED expenditures. It is only in the case of a third-party payment that the claimant must have the right to exploit the results of the SR&ED. Third-party payments are reviewed in Chapter 4, What is eligible? – Financial aspects.

For further reference Income Tax Act 37

SR&ED – Deduction from income

127(5)–(36)

Investment tax credit

127.1

Refundable investment tax credit

Forms T1146

Agreement to Transfer Qualified Expenditures Incurred in Respect of SR&ED Contracts Between Persons Not Dealing at Arm’s Length

T2SCH1 (Schedule 1)

Net Income (Loss) for Income Tax Purposes

T2SCH31 (Schedule 31)

Investment Tax Credit – Corporations

T2SCH49 (Schedule 49)

Agreement Among Associated Canadian-Controlled Private Corporations to Allocate the Expenditure Limit

T2038(IND)

Investment Tax Credit (Individuals)

T661

Scientific Research and Experimental Development (SR&ED) Expenditures Claim

Guides T4088

Scientific Research and Experimental Development (SR&ED) Expenditures Claim – Guide to Form T661

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SR&ED program policies Contract Expenditures for SR&ED Performed on Behalf of a Claimant Policy Pool of Deductible SR&ED Expenditures Policy SR&ED Capital Expenditures Policy SR&ED Investment Tax Credit Policy Third-Party Payments Policy

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3. What is eligible? – Scientific and technological aspects Overview The first step in determining whether a taxpayer is entitled to the SR&ED tax incentives is to ensure that, from a scientific or technological point of view, eligible work is performed — that is, that the work is considered to be scientific research and experimental development (SR&ED). The first half of the chapter focuses on what constitutes SR&ED for purposes of the Income Tax Act, as well as the general principles involved in determining how to find SR&ED in and among other development work and distinguish it from non-SR&ED work. The second half of the chapter discusses the identification of SR&ED in two specific, frequently encountered contexts: software development and experimental production.

What is SR&ED? Research and development (R&D) is a vague term that means different things to different people. What constitutes R&D may differ among industries, but most often, R&D applies to all a company’s product development efforts. For the purpose of the SR&ED program, it is important to distinguish SR&ED from R&D because SR&ED is specifically defined in the Income Tax Act. The definition in the Act is consistent with the one used by the Organisation for Economic Co-operation and Development (OECD). The OECD definition is accepted internationally and is the basis for R&D tax incentive programs in many countries.

Legislative definition [§248(1)] — Subsection 248(1) of the Act defines SR&ED as a systematic investigation or search that is carried out in a field of science or technology by means of experiment or analysis and that is (a) basic research, namely, work undertaken for the advancement of scientific knowledge without a specific practical application in view, (b) applied research, namely, work undertaken for the advancement of scientific knowledge with a specific practical application in view, or (c) experimental development, namely, work undertaken for the purpose of achieving technological advancement for the purpose of creating new, or improving existing, materials, devices, products or processes, including incremental improvements thereto, and, in applying this definition in respect of a taxpayer, includes (d) work undertaken by or on behalf of the taxpayer with respect to engineering, design, operations research, mathematical analysis, computer programming, data collection, testing or psychological research, where the work is commensurate with the needs, and directly in support, of work described in paragraph (a), (b), or (c) that is undertaken in Canada by or on behalf of the taxpayer, but does not include work with respect to

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(e) market research or sales promotion, (f) quality control or routine testing of materials, devices, products or processes, (g) research in the social sciences or the humanities, (h) prospecting, exploring or drilling for, or producing, minerals, petroleum or natural gas, (i) the commercial production of a new or improved material, device or product or the commercial use of a new or improved process, (j) style changes, or (k) routine data collection[.]

On first reading, the definition may appear straightforward. However, there are many nuances contained in the definition. First, there are three components in the preamble: 1. a systematic investigation or search — discussed later under Systematic investigation or search (CRA’s methodology – Step 1, Question 3) (on page 38); 2. carried out in a field of science or technology; and 3. by means of experiment or analysis. It is important to note that the work may occur by either experiment or analysis. Although experimentation is the most frequent way of doing SR&ED, it may sometimes involve analysis work only. This fact was confirmed in Hun-Medipharma Research Inc. v. The Queen,1 where the court stated that “the text itself of paragraph 2900(1) of the Regulations2 does not require that the systematic investigation be made by both experiment and analysis. It can be made by experiment or analysis, provided it is in fact a systematic investigation.” Once these three preconditions have been met, the work must also meet the requirements of paragraph (a), (b), (c), or (d) to be eligible. Paragraphs (a) and (b) are relatively clear and are generally not subject to significant debate. Paragraph (c), which defines experimental development, is more complicated. Note that there are two purpose tests (“for the purpose”) within paragraph (c): •

The first test requires that the work be undertaken for the purpose of achieving a technological advancement. If the work is not performed for that purpose, it is not experimental development.

•

The second test requires that the work be undertaken for the purpose of creating new, or improving existing, materials, devices, products, or processes.

The work performed must meet both purpose tests to meet the definition of experimental development. In industrial situations, it is often relatively easy for the work performed to meet the second purpose test; the challenge lies in identifying the work that meets the first test.

1

Hun-Medipharma Research Inc. v. The Queen, 99 DTC 407 (TCC).

2

The definition of SR&ED in ITA s. 248(1) was previously located in Reg. 2900(1). The wording of the definition has remained the same on this particular point.

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Paragraph (c) also states that experimental development includes “incremental improvements thereto.” This phrase is interpreted to mean that the work conducted need not be a major jump in technology (i.e., it does not have to be an earth-shattering achievement). As noted by the court in Northwest Hydraulic Consultants Ltd. v. The Queen,3 even infinitesimal advancements may qualify: “Most scientific research involves gradual, indeed infinitesimal, progress. Spectacular breakthroughs are rare and make up a very small part of the results of SRED in Canada.” Much discussion has centered on paragraph (d), which defines support work. The most important thing to note is that the CRA views the eight types of work listed in paragraph (d) as the only types that qualify.4 In other words, engineering, design, operations research, mathematical analysis, computer programming, data collection, testing, and psychological research are not merely examples of types of work that qualify; rather, the work must fall under one of these eight types to qualify. Also of importance in paragraph (d) is the phrase “undertaken in Canada.” Support work that is performed in Canada, but linked only to work meeting the requirements of paragraph (a), (b), or (c) that is performed outside Canada, is not viewed as SR&ED. It should be noted, however, that salaries and wages of Canadian residents incurred for SR&ED performed outside Canada may be deemed to be made in respect of SR&ED carried on in Canada for purposes of the income deduction under section 37 of the Income Tax Act and the SR&ED investment tax credit. See SR&ED performed in Canada (on page 103) in Chapter 4, What is eligible? – Financial aspects, for more information. It can also be a challenge to understand what is meant by “commensurate with the needs” and “directly in support” in paragraph (d). Commensurate with the needs means that the amount, size, extent, or duration of work done within the areas of engineering, design, etc. must reflect the needs, size, extent, or duration of the work that is necessary to carry out the basic research, applied research, or experimental development undertaken in Canada. In other words, the support work should not exceed the needs or demands of the SR&ED project. Directly in support means that the support work was necessary to perform the basic research, applied research, or experimental development (and thus necessary in attempting to achieve the scientific or technological advancement). Support work must be both commensurate with the needs and directly in support of the SR&ED project to be eligible. Sometimes, support work meets the requirements of “directly in support” and “commensurate with the needs” but may also play a secondary role in a commercial activity. In these cases, there may be concerns that the support work was not exclusively for SR&ED; however, there is no exclusivity requirement in the law from a scientific research or experimental development perspective.5 While paragraphs (a) through (d) describe work that is SR&ED, paragraphs (e) through (k) list the types of work that are not. Paragraphs (e) through (k) are not straightforward. For example, routine testing (i.e., that is known and done for

3

Northwest Hydraulic Consultants Ltd. v. The Queen, 98 DTC 1839 (TCC).

4

See Eligibility of Work for SR&ED Investment Tax Credits Policy.

5

See Chapter 4, What is eligible? – Financial aspects, for a discussion on expenditures that would not have been incurred if the prosecution of SR&ED had not occurred.

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commercial purposes only) is not SR&ED. However, testing that is directly in support and commensurate with the needs of work in paragraph (a), (b), or (c) is considered SR&ED (see paragraph (d)).

CRA’s view While the Act defines SR&ED, it is not always easy to apply the definition to “real life” projects. Therefore, in 1986, shortly after the creation of the government’s SR&ED program, the CRA (at that time, Revenue Canada) developed Information Circular IC864, Scientific Research and Experimental Development, to provide technical guidelines to clarify what constitutes SR&ED according to the Act. Three criteria, determined through an extensive consultative process with industry and other government departments, were included in the information circular to determine if work meets the SR&ED definition: •

scientific or technological advancement;

•

scientific or technological uncertainty; and

•

scientific and technical content.

Although these criteria were essentially endorsed by the Tax Court in the 1998 Northwest Hydraulic Consultants decision (98 DTC 1839 (TCC)), the court expanded on them to set out its own understanding of the approach to be taken when determining whether work qualifies as SR&ED for purposes of the Act.6 This approach has been confirmed by the Federal Court of Appeal7 and subsequently followed in jurisprudence.8 It forms the basis of the CRA’s current two-step methodology, outlined in the Eligibility of Work for SR&ED Investment Tax Credits Policy (referred to throughout the rest of this chapter as the Eligibility of Work Policy).9 The current methodology, which must also be followed by the CRA’s own research and technology advisors during their review of SR&ED claims, can be illustrated as follows:

6

The court’s approach, with added commentary, is reproduced in the Appendix (on page 64) at the end of this chapter.

7

See RIS-Christie Ltd. v. The Queen, 99 DTC 5087 (FCA), and C.W. Agencies Inc. v. The Queen, 2001 FCA 393.

8

See, for example, Novalia Power General Research Inc. v. The Queen, 2016 TCC 81; 2037625 Ontario Inc. (formerly ITC Invoice to Cash Inc.) v. The Queen, 2015 TCC 269; ACSIS EHR (Electronic Health Record) Inc. v. The Queen, 2015 TCC 263; R&D PRO-innovation Inc. v. The Queen, 2015 TCC 186; aff’d. 2016 FCA 152; and Les Abeilles Service de Conditionnement Inc. v. The Queen, 2014 TCC 313.

9

The policy was first released on December 19, 2012, as part of the CRA’s policy review project, during which the latest version of the information circular (IC86-4R3 of 1994) was replaced. For more details on the review, see History of the SR&ED program (on page 2) in Chapter 1, The SR&ED program. The policy also incorporates, among other things, elements of a former CRA guide entitled Recognizing Experimental Development, which was released in 2002 to provide a specific focus on identifying work described in paragraph (c) of the SR&ED definition.

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During Step 1, each of the following five questions, reproduced from the Eligibility of Work Policy, must be answered in the affirmative to conclude that there is SR&ED. (For comparison, and to illustrate how close the sets are to each other, the original five elements from the Tax Court’s approach in Northwest Hydraulic Consultants are also reproduced.) Step 1: Determine if there is SR&ED Eligibility of Work Policy

6RXUFH&ODLP5HYLHZ0DQXDOIRU  5HVHDUFKDQG7HFKQRORJ\$GYLVRUV  VHFWLRQ

Northwest Hydraulic Consultants decision

1. Was there a scientific or a technological uncertainty?

1. Is there a technical risk or uncertainty?

2. Did the effort involve formulating hypotheses specifically aimed at reducing or eliminating that uncertainty?

2. Did the person claiming to be doing SR&ED formulate hypotheses specifically aimed at reducing or eliminating that technological uncertainty?

3. Was the overall approach adopted consistent with a systematic investigation or search, including formulating and testing the hypotheses by means of experiment or analysis?

3. Did the procedures adopted accord with established and objective principles of scientific method, characterized by trained and systematic observation, measurement, and experiment, and the formulation, testing, and modification of hypotheses?

4. Was the overall approach undertaken for the purpose of achieving a scientific or a technological advancement?

4. Did the process result in a technological advance, that is to say an advancement in the general understanding?

5. Was a record of the hypotheses tested and the results kept as the work progressed?

5. Although the Income Tax Act and the regulations do not say so explicitly, it seems selfevident that a detailed record of hypotheses, tests, and results be kept, and that it be kept as the work progresses.

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Once it is determined that there is SR&ED — in other words, that basic research, applied research, or experimental development exists under paragraph (a), (b), or (c) of the SR&ED definition — the next step (Step 2) in the CRA’s methodology is to determine the extent of eligible work (essentially by including support work under paragraph (d) of the definition and excluding work listed under paragraphs (e) to (k)). As part of this second step, various issues may be examined in a production or manufacturing environment, most notably the following: •

the identification of the type of asset resulting from or used in SR&ED (pilot plants, commercial plants, prototypes, or custom products/commercial assets) — in this situation, consideration must be given as to what aspects of the development of the asset should be included as SR&ED work; and

•

the identification of the specific production runs that are part of the experimental development that is performed, as well as the circumstances under which each of these production runs is carried out (referred to by the CRA as context): experimental development resulting in experimental production (ED+EP), or experimental development in conjunction or simultaneously with commercial production (ED+CP) — in both situations, consideration must be given as to how much of the facility’s operation should be included as SR&ED work.

Additional details on the five components of Step 1 of the CRA’s methodology are provided below. Practical considerations in relation to Step 2 are discussed under How to identify SR&ED – Practical considerations (on page 42) and SR&ED in specific contexts (on page 50).

Scientific or technological uncertainty (CRA’s methodology – Step 1, Question 1) The first question that must be asked is, What scientific or technological uncertainties did the claimant attempt to overcome — uncertainties that could not be resolved using standard practice? The presence of scientific or technological uncertainty in a development project is what distinguishes that project from a normal or routine development effort. Uncertainties arise when standard or proven technologies, practices, methodologies, or techniques are unable to accomplish the claimant’s objective or are insufficient for its needs. The uncertainty is a necessary indicator of SR&ED because it implies that it is not known how to achieve the project’s goal or whether the goal is achievable. If a solution to a particular scientific or technological problem is known, none of the scientific or technological advancement that the SR&ED definition requires will result. The uncertainty is thus the impetus for any SR&ED work. Some CRA reviewers used to view the beginning of the SR&ED project to be when the scientific or technological uncertainty first manifested itself in a concrete way — for example, a first test showing failure (the phrase “when you hit the wall” is often used in this context). However, this conflicts with the CRA’s Eligibility of Work Policy, which states that an SR&ED project begins when the scientific or technological uncertainties are identified (the identification of these uncertainties will then result in the definition of the scientific or technological objectives of the SR&ED project). It is true that in some projects, the scientific or technological uncertainties or objectives are identified at the same point in time that the scientific or technological uncertainties manifest themselves.

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However, in other cases, the scientific or technological objectives of a project can be defined but significant preparatory work is required before the actual work to resolve the uncertainty can begin, and thus eligible work occurs before the scientific or technological “wall” is actually hit.10 In prior versions of Form T661, Scientific Research and Experimental Development (SR&ED) Expenditures Claim, the CRA also used the term technological obstacle, which had a somewhat similar definition to that of scientific or technological uncertainty. Similarly, Guide T4088, Scientific Research and Experimental Development (SR&ED) Expenditures Claim – Guide to Form T661, used obstacles/uncertainties, implying that the two terms were synonymous. Given stakeholders’ concern that a misuse of the term technological obstacle could increase the risk of mistakenly viewing the start of an SR&ED project as the “hit the wall” point, the term has been removed from both Form T661 and Guide T4088 (although it continues to appear in the CRA’s SR&ED Glossary). Additional key points concerning the concept of uncertainty include the following: •

Scientific uncertainty occurs in basic research or applied research, whereas technological uncertainty occurs in experimental development.

•

Scientific or technological uncertainties are those scientific or technological challenges that must be overcome, or anticipated scientific or technological roadblocks that need to be mitigated, to achieve the scientific or technological advancement.

•

It is the experiments or analyses that are conducted to overcome the uncertainties within the SR&ED project that represent the critical work within the project.

•

Scientific or technological uncertainties faced in some companies may have already been overcome by others. Each company’s body of knowledge is different, and it does not necessarily affect the eligibility of a given project within a particular company if the knowledge or capability obtained by others is proprietary and not publicly available. Indeed, the presence or absence of scientific or technological uncertainties is determined on the basis of the existing level of scientific and technological knowledge available within a particular company and the scientific and technological knowledge generally available publicly (referred to as the scientific or technological knowledge base). A claimant must be able to specifically identify what is lacking in the existing scientific or technological knowledge base to describe the uncertainty it is attempting to overcome.11

•

Inexperience or lack of understanding of the science or technology cannot form the basis for an SR&ED project.

•

Doubts about the business or commercial success of a developed device, product, or process do not equate to scientific or technological uncertainty.

10 Interestingly, Guide T4088, Scientific Research and Experimental Development (SR&ED) Expenditures Claim – Guide to Form T661, seems to differ from the Eligibility of Work Policy with respect to the start date of an SR&ED project. Specifically, the instructions in Guide T4088 for Line 202, Project start date, indicate that the “start of the project is defined as the point at which scientific or technological uncertainties are identified and the work to resolve those uncertainties commences” [emphasis added]. 11

The CRA’s SR&ED Glossary indicates that publicly available sources “generally include scientific papers, journals, textbooks, and internet-based information sources as well as expertise accessible to the company (for example, through recruiting employees or hiring consultants or contractors).”

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•

Trying to achieve cost targets may lead to scientific or technological uncertainty, as economic considerations may require that technologically uncertain paths be attempted where the only proven alternatives available are more or too costly.

Technological uncertainty may take various forms. For example, a system uncertainty is a form of technological uncertainty that occurs when standard or known technologies, devices, or processes are combined in a non-traditional way (the technological uncertainty that is created relates to whether all the components can function in a working integrated system, rather than to the individual components themselves). Such uncertainty is frequently observed when unconventional combinations of software or hardware occur. In the software industry, companies typically leverage third-party, offthe-shelf hardware and software as much as possible to reduce R&D costs. The result of using third-party software and hardware components is often non-traditional, non-trivial interactions among the components or subsystems, which were perhaps not originally intended to interact, or were not envisioned to interact in the way the company has attempted. In this example, the technological uncertainty may occur in trying to develop a suitable communication pathway to a working integrated system. For more information on SR&ED in the software industry, see Software development (on page 50).

Hypotheses formulation (CRA’s methodology – Step 1, Question 2) Once a scientific or technological uncertainty has been identified, hypotheses specifically aimed at reducing, eliminating, or resolving that uncertainty must be formulated for SR&ED to exist. Indeed, the formulation of hypotheses is a required step in the systematic investigation or search referred to in the preamble of the SR&ED definition of the Act (and further discussed below). The CRA views the term hypothesis in a broad sense to mean “an idea, consistent with known facts, that serves as a starting point for further investigation to prove or disprove that idea.”12

Systematic investigation or search (CRA’s methodology – Step 1, Question 3) As discussed under Legislative definition (on page 31), following a systematic investigation or search is part of the preamble of the definition of SR&ED.13 The advantage of the systematic approach is that it is unprejudiced. One can test an experiment and determine whether the results are true or false. The conclusions will hold regardless of the state of mind or bias of the investigator, and regardless of the subject of the investigation. The existence of a systematic investigation or search can often be determined by talking to people involved in the work or examining the project documentation (project documentation and other supporting information are discussed in Chapter 5, SR&ED claims submission process). The Eligibility of Work Policy states: In SR&ED, it is expected that a planned approach is formulated; that is: •

formulating one or more hypotheses designed to reduce or eliminate the

12 Eligibility of Work Policy. 13 In previous CRA guidance (e.g., IC86-4R3), this was referred to as requiring scientific and technical content.

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uncertainties; •

planning and executing the testing of the hypotheses by experiment or analysis; and

•

developing logical conclusions based on the results or findings of the experiment or analysis.

This means that the objectives of the SR&ED work, as well as the indicators and measures to be used to determine if those objectives have been met, must be clearly stated at an early stage in the work’s evolution. In addition, the method of experimentation or analysis by which the scientific or technological uncertainties are to be addressed must be clearly set out. Finally, the results of the SR&ED efforts that follow have to be properly identified. Often, this is an iterative process as new uncertainties are recognized and new or modified hypotheses are developed and tested based on the results of the prior iteration … It is expected that the work will be performed or directed by qualified individuals who are knowledgeable in the field and have relevant experience in science, technology, or engineering … The need for a systematic investigation or search does not preclude ideas that result from intuitive processes. These ideas can lead to hypotheses for testing that are part of experimental development.

These requirements from the Eligibility of Work Policy could leave the reader with the impression that a very formal and structured approach to conducting SR&ED is a necessity. However, as long as it can be demonstrated that the work was conducted through an overall approach that is consistent with the systematic process described above, it is likely that a systematic investigation or search has taken place and that the requirements have been met. For example, the Eligibility of Work Policy suggests that “in an industrial context, a ‘possible solution to the problem’ may be considered a hypothesis, and ‘building and testing of a prototype’ may be considered part of the experiment or analysis.” It should be noted, however, that the CRA does not consider solving problems by trial and error to be experiment or analysis within the required framework of a systematic investigation or search. The CRA views trial and error as simply executing a series of tests in no particular order without being part of a systematic plan. According to the Eligibility of Work Policy, experimentation involves structured and organized tests and studies to obtain information to address the formulated hypotheses that will help resolve the identified uncertainty (which may include work on the evolution of prototypes or models). Analysis is defined in the policy as the detailed examination of information to distinguish the various components of a whole, determine their attributes, or explain the relationships between each of them (using tools such as models, graphs, statistics, formulas, and computer programs).

Scientific or technological advancement (CRA’s methodology – Step 1, Question 4) Another factor that distinguishes a routine development activity from SR&ED is the attempt to achieve a scientific or technological advancement. In other words, the search for an advance in the body of scientific or technological knowledge must be present as a guiding element in every eligible project. Without this element, the work could simply involve the development of new products, processes, or materials using existing knowledge and capabilities and would therefore not be SR&ED. While the uncertainty is the impetus for the SR&ED work, the scientific or technological advancement must be its targeted outcome.

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The Eligibility of Work Policy states: Scientific or technological advancement is the generation of information or the discovery of knowledge that advances the understanding of scientific relations or technology. One implication of advancement is that the new knowledge could be useful to other situations or circumstances beyond the current project in which the advance was made … In experimental development, the work is carried out for the purpose of achieving technological advancement that, in turn, is for the purpose of creating new, or improving existing, materials, devices, products, or processes. This means that when a new or improved material, device, product, or process is created as a result of SR&ED, it must embody a technological advancement. Hence, the technological advancement that is being sought is not the same as the benefits of the new or improved material, device, product, or process. Technological advancement moves the scientific or technological knowledge base of a company to a higher level through an increase in the understanding of technology … [N]ovelty, innovation, uniqueness, feature enhancement, or increased functionality alone does not represent or establish technological advancement. Instead, it is how these attributes or features arise (that is, whether or not they arise through technological advancement) that is important.

The policy goes on to discuss the level at which one should look to define a scientific or technological advancement: Projects should be identified at a level where all the effort captured by the projects falls within the definition of SR&ED.

This idea is of particular importance because, depending on the context in which the work is examined, eligible work may appear ineligible. If work is examined at a level that is too low (e.g., looking at a laboratory test conducted using standard protocols, performing finite element analysis, or running existing simulation models to predict an outcome), everything begins to look routine. One must look at the work or project from the highest appropriate level in determining where the advancement lies. The overall scientific or technological goal sought is key: What was the level of technology at the beginning of the project, and what “jump” (however incremental) in technology was hoped to be realized by the end of the project? The following points are important to keep in mind with respect to the definition of advancement: •

For SR&ED projects, the advancement must represent, at the very least, an incremental increase in the organization’s knowledge or capability within a particular scientific or technological field of expertise. The advancement does not have to be sizable for the project to be eligible. Indeed, a common misconception among taxpayers is that their work must result in a significant breakthrough in science or technology to qualify under the SR&ED program. By looking for this “eureka moment,” many taxpayers may erroneously assume their day-to-day work is routine in nature and not eligible for SR&ED tax incentives.

•

Although an attempt at an advancement needs to be made, the advancement sought does not need to be achieved, as an attempt to achieve advancement is an attempt to resolve uncertainty. For example, the rejection of a hypothesis is advancement because it eliminates a possible solution.

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Recording (CRA’s methodology – Step 1, Question 5) A systematic investigation or search of the type referred to in the preamble of the SR&ED definition generally cannot be conducted without recording the work as it progresses, particularly during the experimentation or analysis phase, where there is a need to build on test results. A record of the hypotheses, tests, and results as the work progresses is therefore an indicator of SR&ED work potentially being performed. The Eligibility of Work Policy further states: It is expected that the work be recorded, clearly showing why each major element is required and how each fits into the project as a whole. It is also expected that the indicators or measures that will be used to determine if the goals of the work are met will be identified and recorded at an early stage of the work.

The recording, typically documentation, should occur naturally and be produced to fulfill the inherent needs of the systematic investigation or search being conducted. It should be noted that recent cases14 have stated that the Act does not contain any legislative requirement to file in evidence any documents demonstrating that the claimant followed a systematic approach in performing its SR&ED work. See Chapter 5, SR&ED claims submission process, for further details.

Summary (re Step 1 of CRA’s methodology) Although the Eligibility of Work Policy is not law, the CRA and industry use the five questions of Step 1 of the methodology (particularly in respect of scientific or technological advancement, scientific or technological uncertainty, and systematic investigation or search) as indicators when determining eligibility. Everyone, including the courts, agrees that all five questions must be answered in the affirmative for a project to be eligible. The success or failure of a project has no bearing on the eligibility of the work performed. To determine when an SR&ED project has been completed, one must consider the clearly established objectives set at an early stage of the project and recognize when all the scientific or technological uncertainties have been overcome or the advancement has been achieved or abandoned. Even when an SR&ED project is thought to be complete, the launch of a product or process sometimes results in the realization that scientific or technological uncertainties remain, and the original SR&ED project continues. Launching the product or process may also give rise to new technological challenges that may also result in completely new SR&ED projects.

14 See 6379249 Canada Inc. v. The Queen, 2015 TCC 77; ACSIS EHR (Electronic Health Record) Inc. v. The Queen, 2015 TCC 263; and Les Abeilles Service de Conditionnement Inc. v. The Queen, 2014 TCC 313.

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How to identify SR&ED – Practical considerations For a project to qualify as SR&ED, each of the five questions discussed in the previous section must be answered in the affirmative with respect to the project. However, even knowing where to begin to look for potential SR&ED work can be difficult (further details on how to go about looking for SR&ED work are provided in Chapter 5, SR&ED claims submission process). Because very few companies perform SR&ED exclusively, SR&ED is often found in and among other development work, and it may be difficult to correctly identify the SR&ED, define its boundaries, and distinguish it from non-SR&ED work. In identifying SR&ED work, the foremost concern is what is occurring on a scientific or technological level, not the commercial aspirations to be achieved. This is a critical point in assessing eligibility that is sometimes misunderstood. As discussed in the previous section, eligibility is defined by scientific or technological merit, not by the overall goals of the commercial project — what matters is that there is an attempt to resolve a scientific or technological uncertainty, for the advancement of the scientific or technological knowledge base, through the performance of a systematic investigation or search by means of experiment or analysis. In the following sections, some general situations are described to help clarify, from a practical perspective, the difference between SR&ED and ineligible work, taking into account the list of excluded work outlined in paragraphs (e) to (k) of the SR&ED definition in particular. This discussion is not meant to be comprehensive; rather, it is intended to summarize the general principles involved. Before deciding on the eligibility of a given piece of work, all details relevant to that particular situation should be fully considered.

Shop floor So, where does SR&ED work occur? Thirty years ago, many people held the view that work qualified under the SR&ED program only if it was carried out by scientists in laboratories. Although a significant amount of SR&ED is carried out in laboratories, much SR&ED occurs in a production or manufacturing environment (referred to as shop-floor environment). In fact, the CRA receives thousands of claims each year for eligible work that has occurred in machine shops, manufacturing environments, or full-scale production plants. In many cases, the eligible expenditures for these projects are quite significant. The difficulty in identifying SR&ED in this environment is that the SR&ED, especially experimental development, is generally not carried out in isolation. It usually occurs in conjunction or simultaneously with excluded commercial work.15 The CRA has issued documents to help claimants identify shop work that qualifies and has provided guidance in policy documents such as the SR&ED During Production Runs Policy. See SR&ED in specific contexts (on page 50) for more details.

15 In particular, paragraph (i) of the SR&ED definition excludes work with respect to the commercial production of a new or improved material, device, or product, or the commercial use of a new or improved process.

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Technology transfer The simple acquisition (purchasing or learning) of known technology is not eligible in and of itself. However, eligible work may exist if, in applying the known technology, a technological uncertainty arises and experimental development occurs to adapt the technology to the new situation. Similarly, eligible work may exist when experimental development using known technologies in a new process combination creates uncertainties as to whether the combination will advance technological capabilities. If the experimental development requires new knowledge beyond that commonly available in the field, the project to modify or adapt the technology would be eligible.

Data collection Generally, if an SR&ED project has been identified, all work with respect to data being collected for the SR&ED project is eligible as support work under paragraph (d) of the SR&ED definition, as long as the amount of data collected reflects the needs of the study performed as part of the SR&ED project. The amount of data collected must take into account both established statistical considerations and practical considerations. The systematic study design should account for the amount of information necessary to achieve the study objectives. As mentioned in the previous section, collecting data in excess of what is needed for the SR&ED is not commensurate with the needs of the study and is likely collected for other purposes. It is up to the claimant to justify the amount of data required for the SR&ED. Data collection of commonly encountered quality or processing parameters is considered eligible when conducted directly for the purpose of an experiment needed to resolve a scientific or technological uncertainty. Data collection of the same commonly encountered quality or processing parameters for commercial production to monitor process quality or performance is not considered eligible because it falls under routine data collection, which is specifically excluded under paragraph (k) of the SR&ED definition. The concept of eligible work within specific technology areas is discussed under SR&ED in specific contexts (on page 50).

Standard practice When determining eligibility, it may also be helpful to consider work in terms of standard practice. Standard practice or the application of the existing scientific or technological knowledge base is the application of known principles to a situation where the result is certain; it is summarized in the Eligibility of Work Policy as “directly adapting a known engineering or technological practice to a new situation when you are reasonably certain that the known technology or practice will achieve the desired objective.” Projects that utilize only standard practice to achieve the desired objective are generally considered ineligible because there is neither scientific or technological uncertainty nor a scientific or technological advancement in these circumstances. However, standard practice required as support work to overcome uncertainties to achieve a scientific or technological advancement would be eligible.

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Routine engineering Routine engineering is standard practice in engineering and so is not, in and of itself, SR&ED. However, in accordance with paragraph (d) of the definition of SR&ED, engineering that is directly in support and commensurate with the needs of experimental development is eligible. Depending on the SR&ED project, significant amounts of engineering work may be claimed. Engineers are also trained to resolve new technological and scientific uncertainties through the use of the systematic approach referred to in the previous section, and therefore such work would generally be considered SR&ED. Given that scientific knowledge and technological advancement are pursued rigorously every day all over the world, and often by engineers, there can be confusion about the difference between engineers performing SR&ED (or routinely performing SR&ED) and the practice of engineering (or routine engineering) itself. Although engineering is referred to in the SR&ED definition as support work, the term engineering (or routine engineering) is not defined in the Act or the regulations. The CRA SR&ED Glossary defines engineering and discusses the distinction between engineering and engineers practising SR&ED as follows: Engineering is the practice of designing, composing, evaluating, advising, reporting, directing, or supervising the construction or manufacturing of tangible products, assemblies, systems, or processes that requires in-depth knowledge of engineering science and the proper, safe, and economic application of engineering principles. By definition, and according to sound professional practice, engineering practice does not involve scientific or technological uncertainty and is thus not eligible on its own. However, engineering work that is commensurate with the needs and directly in support of basic research, applied research, or experimental development is eligible. It is important to distinguish between work with respect to engineering and the work that engineers perform. Even though engineering practice is not eligible on its own, engineers can still be carrying out basic research, applied research, and experimental development.

The key to differentiating between engineering (or routine engineering) and engineers performing SR&ED is to clearly identify and describe why the work being claimed was performed as part of a systematic investigation or search in an attempt to resolve a scientific or technological uncertainty. To meet this challenge, claimants should clearly describe the scientific or technological knowledge base prior to the start of an SR&ED project. As mentioned in the previous section, this base comprises information that is publicly available or known by competent professionals in that field, as well as information that is available to the company as a result of its own work. By demonstrating what was known and what was not known before commencing the project, the limitations in available scientific or technological knowledge become clearer. Overcoming (or attempting to overcome) limitations in available scientific or technological knowledge through a systematic approach by means of experimentation or analysis is the basis of making an SR&ED claim. Claimants must also clearly present the scientific or technological uncertainties the experimentation or analysis attempted to overcome. Claimants may need to demonstrate that what may appear to be routine, or simply engineering, to the CRA when the SR&ED claim is reviewed was in fact support work when the work was claimed, and why it was not routine (without any SR&ED connection).

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Jurisprudence The following Tax Court of Canada cases provide examples of how routine engineering has been dealt with in case law.

Progressive Solutions Inc. Progressive Solutions Inc. v. The Queen16 provides an example of an SR&ED claim made for routine engineering directly in support of a systematic investigation. At issue in this case was the disallowance of a portion of refundable investment tax credits claimed by Progressive Solutions Inc. (PSI) with respect to expenditures incurred for designing computer software. PSI designed a software system that could be broken down into two components: One component would act as a network manager, and the second component would perform financial and business management functions. Software to design the system existed on the market. To write the software program, PSI chose to work with Progress, a “fourth generation language.” PSI determined that the Progress language did not have all the functionality required. PSI also determined that no off-the-shelf software for financial and business management functions was capable of meeting PSI’s requirements. As a result, PSI was forced to design the additional software tools it required to create the two components of its software system. Designing these software tools was intended to extend the standard application development system, providing PSI with development tools for specific software applications and application services. The CRA’s position was that a small portion of the work claimed to develop software tools, and to further develop and test PSI’s software system, met the definition of SR&ED, but the rest of the development work constituted only routine activities based on standard practices and was not SR&ED. It should be noted that the lack of proper documentation was one of the most important factors influencing this conclusion. However, the court disagreed with the CRA and found that the development of software tools and subsequent development of the software components both qualified as SR&ED. The development of the software tools and development of the network manager were shown to be eligible. The design of the business application was found to be eligible as support work17 because the application needed to be built to test the tools and network manager. Thus, the court allowed PSI to claim an amount in respect of SR&ED expenditures that was based on PSI’s expert witness report.

Northwest Hydraulic In Northwest Hydraulic Consultants Ltd. v. The Queen,18 the Tax Court provided some specific insight in response to the following question: What is routine engineering? In the Northwest Hydraulic case, the taxpayer carried on hydraulic engineering in a niche area. Over a period of 11 years, the company carried out 17 projects in which designs were tested through the construction of physical models. The minister argued that none 16 Progressive Solutions Inc. v. The Queen, 96 DTC 1232 (TCC). 17 See the discussion on paragraph (d) of the definition of SR&ED under Legislative definition (on page 31) for more information on what constitutes support work. 18 Northwest Hydraulic Consultants Ltd. v. The Queen, 98 DTC 1839 (TCC).

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of the projects led to either a generic or specific technological advancement. The minister was also of the opinion that no real new or improved devices or processes were developed, but rather standard devices or processes routinely used in similar design situations were used. The parties agreed on a sample of five of the 17 projects as representative of all the projects, and these were reviewed in terms of SR&ED eligibility. In its decision, the court reviewed the guidelines the CRA used at the time to determine whether projects fell within the concept of SR&ED, stating that “most scientific research involves gradual, indeed infinitesimal, progress. Spectacular breakthroughs are rare and make up a very small part of the results of SRED in Canada.” Following this review, the court endorsed the three criteria described in (now cancelled) IC86-4R3 (scientific or technological advancement, scientific or technological uncertainty, and scientific and technical content) and followed by the CRA at the time. However, as mentioned in the previous section, the court expanded on these criteria and added commentary on the approach to be taken when determining whether work qualifies as SR&ED. In its commentary, the court stated that technical uncertainty in the context of the SR&ED program must be “a type of uncertainty that cannot be removed by routine engineering or standard procedures … If the resolution of the problem is reasonably predictable using standard procedure or routine engineering there is no technological uncertainty as used in this context.” See the Appendix (on page 64) at the end of this chapter for a full reproduction of the court’s approach and its added commentary. In ruling that four of the five projects were eligible, the court stated that “the technological uncertainty is something that exists in the mind of the specialist such as the appellant, who identifies it and articulates it and applies its methods to remove that uncertainty.” Similarly, (now cancelled) IC86-4R3 stated that “[u]ltimately, the final judgment of what is or is not standard practice in a given field of technology can only be made by specialists familiar with that field.” From these two statements, it is clear that technological uncertainty is best identified by technical people who have knowledge and experience in that particular area. In reviewing the opinions of the expert witnesses called by Northwest Hydraulic and the Crown, the court commented that “what divided them [the two experts] was the question whether the appellant’s activities constituted routine engineering or standard practice and whether technological advances were achieved.” The expert witness for the Crown referred to (now cancelled) IC86-4R3, which stated that “standard practice refers to directly adapting a known engineering or technological practice to a new situation when there is a high degree of certainty that the known technology or practice will achieve the desired objective.”19 As for routine engineering, the court stated in its commentary that it “describes techniques, procedures and data that are generally accessible to competent professionals in the field.” As noted earlier, in many situations, the distinction between routine engineering or standard practice and work that is eligible for the SR&ED tax credit is difficult to make. The court noted that it is particularly challenging because “what may appear routine and

19 As discussed earlier, this definition has essentially been carried over to the Eligibility of Work Policy.

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obvious after the event may not have been before the work was undertaken.” The presence of technological uncertainty is crucial in differentiating routine work from SR&ED and in demonstrating an “infinitesimal” technological advance.20 For example, with respect to the first project reviewed in the decision, the court was satisfied that there was a “high degree of technological risk [or technological uncertainty],” given the nature of the project and “the number of uncertainties inherent in the change to the flow pattern that the construction of the hydroelectric project would entail and the velocity of the flow to the power plant resulting from its construction deep into the bank opposite the locks.” Using the evidence of the engineer in charge of the project, the court concluded that conventional engineering would not have been adequate to deal with the variables and the uncertainties that were inherent in the major disruption and diversion of the flow of the river resulting from the construction. It noted that two models were required and that various problems were identified and resolved as a result, adding, “It would be easy to say, after the event, that these solutions are obvious and routine. They are not. They required a number of methodical and systematic experiments and progressive modifications to meet problems that could not have been predicted.” For these reasons, the court concluded that this project met all the criteria for SR&ED as defined in the Income Tax Act (then found in Regulation 2900) and in (now cancelled) IC86-4R3, and as identified by the court, stating: The result was a technological advance with respect to this particular problem of hydraulic engineering, involving, as it did, the juxtaposition of a lock and dam on a navigable river and a hydroelectric power plant. It is, I think, unduly simplistic to say that the appellant was merely applying technology that it had learned from working on similar projects. Each river is different and each project of this sort adds to the body of knowledge.

Les Éditions Progitech and ACSIS EHR Les Éditions Progitech Inc. v. The Queen21 and ACSIS EHR (Electronic Health Record) Inc. v. The Queen22 provide two examples of SR&ED claims made in the field of computer science and information technology.23 Unlike in Northwest Hydraulic, in Les Éditions Progitech, the Tax Court found that the work developed by the claimant constituted standard practice, and that there was no technological uncertainty or technological advancement. The Tax Court found the opposite in ACSIS EHR. Both of these cases are summarized below. At issue in Les Éditions Progitech was whether software developed by the claimant met the definition of SR&ED. The project descriptions filed by the claimant described work that was performed to develop accounting software. The Tax Court concluded that

20 Given that technological uncertainty and technological advancement are inextricably linked, the technological uncertainty need not be staggering in its level of difficulty either. 21 Les Éditions Progitech Inc. v. The Queen, 99 DTC 672 (TCC); aff’d. 2002 FCA 19. 22 ACSIS EHR (Electronic Health Record) Inc. v. The Queen, 2015 TCC 263. 23 Tax Court cases heard under the informal procedure and dealing with routine engineering or standard practice in this field have also been released. See Software development (on page 50) for more details.

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[a]ccording to the experts, everything developed by Mr. Nault [the software designer and the claimant’s sole shareholder and only employee] was a matter of common practice; it was not technological advancement. The product may have been improved, but no technological uncertainty was resolved. The knowledge was already accessible. It is [the court’s] view that with regard to his development activities the appellant has demonstrated neither the existence of technological uncertainties nor the making of valid assumptions for resolving them. Rather I find that the evidence revealed the normal activity of a programmer who wishes to develop a new piece of software based on an existing computer language. Where there were technological uncertainties or where there were barriers in the appellant’s way, Mr. Nault could only observe them and wait for someone else to provide the necessary tools to resolve the difficulty. The development of the software might have constituted development of a new product, but it was based on existing techniques. There was thus no scientific research or experimental development.

The claimant had argued that the definition of SR&ED gives priority to product development, not to technological advancement. The Tax Court disagreed with this argument, noting that technological advancement is an essential element of experimental development. For the reasons noted, the court found that there was neither technological uncertainty nor technological advancement and therefore dismissed the claimant’s appeal. In ACSIS EHR, the claimant was contracted by the Belize government to provide assistance in implementing a national health care system in that country. Due to, among other things, the poor telecommunications infrastructure in Belize, the claimant was unable to utilize its existing electronic health record solution and instead had to develop a new technology to “support and accommodate the applications that would preserve, transmit and store critical medical data with certainty and predictability in an unstable network environment” and thus mimic the availability of stable communications infrastructure. In allowing the claimant’s appeal, the court stated: Although the [Crown] argued that … possible available solutions were restricted by budgetary constraints and licensing considerations, the evidence of the [claimant’s] witnesses, which was not challenged on cross-examination, demonstrated that it was impossible to resolve the uncertainties, encountered by the [claimant], through routine engineering or standard procedures. The [claimant] … developed a new approach by creating a multi-write database replication system.

Jentel, Les Abeilles, R&D PRO-innovation, and 6379249 Canada Inc. The CRA has also raised the standard practice or routine engineering issue in a number of cases involving SR&ED claims in the manufacturing or processing field.24 Examples include •

Jentel Manufacturing Ltd. v. The Queen, 2011 TCC 261; aff’d. 2011 FCA 355;

•

Les Abeilles Service de Conditionnement Inc. v. The Queen, 2014 TCC 313;

•

R&D PRO-innovation Inc. v. The Queen, 2015 TCC 186; aff’d. 2016 FCA 152; and

24 Tax Court cases heard under the informal procedure and dealing with routine engineering or standard practice in this field have also been released. Recent cases include Joel Theatrical Rigging Contractors (1980) Ltd. v. The Queen, 2017 TCC 6; Formadrain Inc. v. The Queen, 2017 TCC 42; Robotx Solutions Inc. v. The Queen, 2017 TCC 73; and Flavor Net Inc. v. The Queen, 2017 TCC 179.

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•

6379249 Canada Inc. v. The Queen, 2015 TCC 77.

Each of these cases is summarized briefly below. In Jentel, the claimant set out to overhaul a small-parts storage system it had developed (Multi-Bins) to improve it by making a redesigned version that would be smaller and significantly lighter (the claimant was a company that developed and manufactured engineered thermoformed plastic products for consumer and industrial uses). The Tax Court, in dismissing the claimant’s appeal, concluded that the work involved routine engineering and standard procedures since the claimant’s evidence simply described “the use of existing manufacturing processes in an attempt to build a better product, while controlling manufacturing costs” (the thermoforming and injection moulding techniques, as well as the plug-assist forming technology used by the claimant, were existing manufacturing processes). In Les Abeilles, the claimant carried out four projects involving the development of new or improved manufacturing processes for mechanical and electrical systems, to increase efficiency in the sub-assembly line process while maintaining quality standards (the claimant was providing services to sub-assemble mechanical components for its customers). The Tax Court, in allowing the claimant’s appeal, found that in determining whether a multi-year project is experimental development, the history of the project should be considered, rather than considering each year in isolation, and stated that “it is important to consider each project globally in the year and not each test individually.” In R&D PRO-innovation, the claimant essentially undertook a project of developing a chocolate spread with cream and maple syrup using a cold-tempering process that differed from the standard industry practice of using heated methods.25 The claimant indicated that cold-tempering was a standard practice, but argued that stabilization of cold-tempering with new inputs in the chocolate did not exist. The Tax Court, in dismissing the claimant’s appeal, stated that the claimant’s “work was centered on the use of existing manufacturing processes and existing materials in an attempt to improve its spread.” In 6379249 Canada Inc., the claimant had developed a miniature, self-contained wireless portable printer for which it had successfully made SR&ED claims. The CRA denied subsequent claims for additional work that was required to resolve certain problems identified after the printer had been commercially launched on a small scale. In allowing the claimant’s appeal, the Tax Court found that the CRA “put too much emphasis on the commercial release of the printer. In doing so, [the CRA] ignored an essential element, namely, that, concretely, the printer did not function and had to be removed from the market.” The court also confirmed that a technological advancement can be made even if there is only an incremental improvement, which includes “a slight improvement to materials, devices, products or processes,” and indicated that it disagreed with the CRA’s approach of separately analyzing each activity undertaken by the claimant to fix the printer’s problems.

25 More precisely, the purpose of the project was to “develop a pure cocoa butter spread with cream and maple syrup, with a 5-3-1 carbohydrate-protein-fat ratio, cold-tempered, demonstrating stable colour and texture and a shelf life of three months, without vacuum processing and artificial ingredients” (or added preservatives).

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SR&ED in specific contexts This section discusses the identification of SR&ED in two specific contexts that are frequently encountered: software development and experimental production. Many other types of projects and processes may involve SR&ED, each with its own particularities and challenges in identifying eligible work. However, a discussion of each of these particularities and challenges is beyond the scope of this guide.

Software development SR&ED in software development can be difficult to identify. Software is intangible. Generic statements such as “with enough time and resources, a software project will be successful” or “because all software projects are iterative by nature and require testing, they should all qualify” may lead to misperceptions about the kinds of software development that qualify for SR&ED tax credits. Software is also more complex and difficult to claim when the development is distributed among multiple locations inside and outside Canada. The work performed in Canada26 must qualify for SR&ED tax credits on its own merit, even if the overall software project is shared among many people in many different geographical locations. In many cases, software development is also an activity in support of a larger SR&ED project and may not need to be examined for eligibility in and of itself. See Software development as support work (on page 55). The following sections discuss the kinds of software development that qualify as SR&ED and the kinds that do not.

Scientific or technological advancements in software development Advancements in computer science are typically related to scientific research or applied research; advancements in information technology are typically related to experimental development.27 The Academic Press Dictionary of Science and Technology28 defines computer science as “a branch of study that is concerned with theoretical and applied disciplines in the development and application of computers for information storage and processing, mathematics, logic, and many other areas,” and information technology as “the use of computers and telecommunications for the processing and distribution of information in digital, audio, video, and other forms.”29

26 Salaries and wages of Canadian residents incurred for SR&ED performed outside Canada may also be deemed to be made in respect of SR&ED carried on in Canada. See SR&ED performed in Canada (on page 103) in Chapter 4, What is eligible? – Financial aspects, for more information. 27 See descriptions of scientific research, applied research, and experimental development under Legislative definition (on page 31). 28 Christopher Morris, Academic Press Dictionary of Science and Technology (San Diego: Academic Press, 1992). 29 Similarly, Information Circular IC97-1 (Cancelled), Scientific Research and Experimental Development: Administrative Guidelines for Software Development, defined computer science as “the study of the theoretical and applied disciplines in the development and use of computers for information storage and processing, mathematics, logic, and many other areas,” and information technology as “the body of technical knowledge associated with collecting, storing, manipulating, and communicating information using computers and communications systems.”

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A scientific or technological advancement in software must push the scientific or technological boundaries or body of knowledge in computer science or information technology. The majority of advancements claimed are related to information technology. An example of a technological advancement in information technology is the creation of new software for more efficient communication to wireless devices, or new software that provides ultra-secure packet encryption beyond what is already commonly available and known in the industry. An example of an advancement in computer science is the creation of a new operating system capable of never-beforeattempted performance and platform independence. A claimant is expected to know what technology and knowledge are commonly known and available at the time the SR&ED project is initiated. If the software development is not pushing the body of knowledge of information technology, it is not likely to satisfy the criterion of technological advancement. Software development that creates functionality that already exists, attempts to customize off-the-shelf software to the claimant’s specific needs, or is well understood within the public knowledge domain will not likely constitute a technological advancement. For example, a word-processing application that functions in the same way as all other available word-processing applications in the market is probably not an advancement in the body of information technology knowledge, assuming the technological knowledge required to build an equivalent word-processing application is readily available to developers in the industry. Similarly, software development to pull data from an existing legacy information system where the data schema and system interfaces are well known and documented is not likely advancing technology in and of itself. Software development, as a technology and as an industry, moves very quickly. Therefore, technological advancements quickly and naturally become outdated. A technological advancement becomes a moving target; the process of experimental development, though, is constant and is the focal point in assessing eligibility. The determination of whether software development is a technological advancement must be made by experts in the particular area of development. It is important to remember that the success, failure, or final deliverable of the software project has no bearing on eligibility; as previously mentioned, it is the seeking of the technological advancement and the experimentation and analysis performed to attain the advancement that are crucial in determining eligibility. Advancements in software development are often related to software infrastructure, the creation of software development tools or operating systems, application development, and new communication protocols (standard and proprietary). For example, the creation of a new operating system for special-purpose devices, such as television on cellphones or household appliances, might constitute an advancement in technology. If such an operating system is not generally available in the market, or knowledge of how to create such an operating system is not commonly known in the public domain, the creation of the operating system could also constitute an advancement in computer science. Another example of software development that might constitute an advancement in technology is the creation of a software development tool for a unique application. In this case, it would need to be clear that existing software development tools were incapable of addressing the technological needs of this unique application, and that in the creation of this new tool, one or more advancements in information technology were

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sought. An important point is that the creation and testing of the software tool may constitute SR&ED, whereas the usage of the tool may not. The normal usage of the tool may be routine software development. Advancement in specific areas of computer science and associated technologies could also include30 •

the production of new theorems and algorithms (in theoretical computer science);

•

technological improvements in managing resources (processes, memory, etc.) or managing interfaces (in operating systems) — creating a truly new operating system or converting an operating system to a significantly different hardware environment could also constitute an advancement in operating systems;

•

new languages, significant extensions to an existing language, and new or significantly different language translators (in programming languages);

•

new combinations of established computer program components or known programming principles (in application software);

•

the development of algorithms to achieve significantly better basic operations, new or enhanced database query languages to significantly increase the power of search or manipulation capabilities, and new object representations or data structures (in data management);

•

advances in the methodology required to construct computer programs with greater flexibility, efficiency, reliability, and ease of maintenance (in software engineering); and

•

machine vision, robotics, inference, knowledge representation, expert systems, theorem proving, natural language understanding, automatic language translation, logic programming, and future generation systems (in artificial intelligence).

It should be noted that the Tax Court has rendered several decisions, relating to SR&ED claims for software development, under its informal procedure where it agreed with the CRA and found that there was no evidence of technological uncertainty or advancement in the work performed by the claimant; instead, the court found that the work was routine engineering or standard procedure. For examples, see the following: •

2037625 Ontario Inc. (formerly ITC Invoice to Cash Inc.) v. The Queen, 2015 TCC 269, where the claimant sought, among other things, to interface its own software with third-party commercial software in its financial factoring business while using various methodologies or techniques such as process mining;

•

Emotion Picture Studios Inc. v. The Queen, 2015 TCC 323, where the claimant’s objective was to create algorithms that would organize or structure data to significantly increase the likelihood of data being retrieved by web search engines while decreasing required links to make that happen;

•

Highweb & Page Group Inc. v. The Queen, 2015 TCC 137, where the claimant’s project involved enhancing its own product’s compatibility with other commercial operating system platform programs and commercial web-based server platforms; and

30 As indicated in Information Circular IC86-4R3 (Cancelled), Scientific Research and Experimental Development. Although the information circular has been cancelled, the listed examples remain possible advancements in specific areas of computer science and associated technologies, provided an attempt to resolve a scientific or technological uncertainty in the scientific or technological knowledge base is demonstrated.

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•

Hypercube Inc. v. The Queen, 2015 TCC 65, where the claimant’s work consisted of developing a program based on a “crawler” to read and analyze websites’ source code in order to detect any weaknesses in the code.

Scientific or technological uncertainty in software development When discussing uncertainty, it is important to reiterate that the uncertainty must be technological in nature, not business related. The uncertainties must be identified and expressed in technological terms. For example, uncertainties such as lack of resources, time, or adequate budget are often critical factors in achieving success on a project, but they are not technological uncertainties. However, these types of business factors may lead to technological uncertainties. For example, a lack of resources might lead to technological decisions to attempt alternative solutions that have never been tried before; in this situation, the technological uncertainty is not a result of the limited resources, but rather the attempt to use alternative solutions.31 If a software development project is not expected to encounter any technological hurdles (i.e., all the development is straightforward and routine), an SR&ED project might only commence if and when technological hurdles are in fact encountered. In contrast, a project might be SR&ED from the onset if the technological objectives, advancements, and uncertainties can be identified at the beginning of the project. Consistent with the descriptions of the categories of technological uncertainty defined under Scientific or technological uncertainty (CRA’s methodology – Step 1, Question 1) (on page 36), uncertainties related to software development can be roughly categorized in three ways: •

software development where there is a question of whether the software advancement can be achieved at all (i.e., whether the solution is truly unknown);

•

software development where it is reasonably certain that the advancement can be achieved, but there are many alternative solutions, and the alternative that will work (or work most efficiently) is not known; and

•

software development where there is system uncertainty whereby multiple components, devices, or technologies are combined in a unique, non-trivial fashion to achieve a technological advancement and, therefore, it is not certain that the system will work once the components have been integrated and tested as a single system.

In a software context, potential technological uncertainties may arise in, for example, software performance; system integration of multiple, independently created components from different sources (internal or external); or restrictions on available resources (such as memory). It is often difficult to determine whether an uncertainty is sufficiently technological to satisfy the criteria. Software development is not eligible if it involves adapting a known technology to a new situation, provided it is reasonably certain the approach will work. For example, using commercially available database software (known technology) for different purposes (new situations) is not likely SR&ED. However, using a commercially available operating system (known technology) for a

31 See also ACSIS EHR (Electronic Health Record) Inc. v. The Queen, 2015 TCC 263.

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computing platform to be launched on a satellite is potentially eligible work, given the significant change in the requirements of the operating system for robustness, recovery, and redundancy. Novelty, uniqueness, and innovation alone are not sufficient factors to determine the eligibility of a software project, as the achievement of the novel solution might be routine and straightforward. There must still be an element of technological uncertainty in seeking the technological advancement for the development to be eligible work. However, it is also necessary to consider the claimant’s environment and circumstances. Claimants are expected to have access to the knowledge in the public domain, but they are often constrained by many other factors, such as resource availability, access to new technology, or the embedded nature of existing technology. Therefore, a valid uncertainty for one claimant may not be a valid uncertainty for a different claimant. As discussed above under Scientific or technological advancements in software development (on page 50), the Tax Court has rendered several informal-procedure decisions relating to SR&ED claims for software development in which it found that the work performed by the claimant showed no evidence of technological uncertainty or advancement but rather was routine engineering or standard procedure.

Systematic investigation or search in software development Software development is iterative in nature (i.e., it requires designing, developing, testing, redesigning, redeveloping, and retesting), but that alone does not ensure eligibility. The iterative development must demonstrate the attempt to resolve technological uncertainties and seek technological advancements. Technical documentation plays an important role in demonstrating systematic investigation or search. Many claimants have internal development processes that require varying degrees of documentation. Documentation that demonstrates eligibility describes one or more of the following key elements: •

scientific or technological objectives, advancements, or uncertainties;

•

attempts to resolve technical problems (foreseen or unexpected);

•

details on experiments and trials (including attempted solutions and proof of concepts);

•

technical activities performed in the fiscal period being claimed, including design, development, and testing; or

•

the claimant’s software development process.

Such documentation is naturally produced during the performance of the systematic investigation or search as the work progresses — it is not necessarily suggestive of the types of information to support an SR&ED claim. When preparing and supporting SR&ED claims, it is critical that the claim-supporting documentation be technical in nature as well. With information technology projects, the documentation focus is often related more to business than technology. Claim documentation describing the business benefits of the project, market needs, user requirements, or behaviour of the system is not generally helpful in preparing and defending a claim.

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Documentation does not have to consist of formal documents with document identification numbers logged for International Organization for Standardization (ISO) purposes, although such documents may be useful. Information that is much more informal, such as lab notebooks, emails, meeting minutes, and even successive versions of source code, may also suffice (for further details on supporting information, see Chapter 5, SR&ED claims submission process). The important thing to remember is that the documentation must show the work that was necessary to achieve the technological advancements and resolve the technological uncertainties, not the work required to achieve the business objectives. Documentation — more specifically, documentation of the software development process — can also help delineate when an SR&ED project begins (and thus qualifies) and when it ends. Gate development processes are common, identifying when a project can proceed, describing the technological uncertainties, and identifying the milestones or gates throughout the project, which include the completion of testing and, presumably, commercial release. In this way, it is often possible to pinpoint the start and end points of an SR&ED project, which can be helpful for claimants, as internal processes can be adapted to track SR&ED documentation and costs within these periods; it is also very useful for the reviewers of the SR&ED claims. Apart from documentation, another key factor in meeting the systematic investigation or search criterion is the requirement that the personnel performing the work be appropriately qualified in software development, and that the work performed be proportionate with what is needed to achieve the technological advancements. Formal education and training, as well as experience, are important in demonstrating qualifications, as is hands-on software development experience. Furthermore, if a resource from one area of a project is spending an exceptional amount of time in another area, it may be an indicator of possible eligible work. For example, if a key software designer is spending a large amount of time with the software verification team, perhaps there is a technical issue that requires a systematic investigation to resolve.

Software development as support work Software development may also be claimed in support of one or more technological advancements sought in a larger project. If the software development itself does not satisfy the SR&ED criteria to qualify on its own as basic research, applied research, or experimental development, it may be necessary for and commensurate with the needs of work to achieve a technological advancement elsewhere. Some examples include the following: •

User interface development — Development required to test the core technological advancement.

•

Testing scripts — Development required to test software containing the core technological advancement.

•

Database schema development — Development required to house the data accessed by software required to test the core technological advancement.

Typically, user interface development, testing scripts, or database schema development does not qualify as SR&ED in its own right.

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In many cases, the support work commensurate with the needs of achieving or seeking the technological advancement is significant in terms of the team’s effort and, therefore, significant in terms of the eligible costs to claim. The technological advancement may be infinitesimal, but the work required to seek, and hopefully achieve, the advancement is often significant. An excellent example of such a scenario is found in Progressive Solutions Inc. v. The Queen.32 See Jurisprudence (on page 45) for a summary of this case.

Common mistakes made on software development claims When preparing an SR&ED claim for software, there are a number of common mistakes made by claimants. One such error is mistaking a business advancement for a technological advancement. As previously discussed, they are not equivalent: a business advancement is often expressed in terms of time frames to complete the project; budget, feature, and functionality benefits; or customer and user benefits — for example, the creation of a system that will allow customers easier access to time-sensitive data. It is imperative to go beneath the business layer to identify the technology that is being developed and evaluate this technology development against the SR&ED criteria. Another common error in determining eligibility is focusing on the outcome of the project rather than the systematic investigation and experimental development required to reach the outcome. As described earlier, the outcome (success or failure) is not directly relevant in deciding whether a project qualifies for an SR&ED tax credit; it is the identification of the technological objectives and uncertainties, the attempt to overcome these technological uncertainties to advance the knowledge base in information technology, and the systematic investigation or search used that are important. Although Form T661, Scientific Research and Experimental Development (SR&ED) Expenditures Claim, no longer includes a requirement to describe the scientific or technological knowledge base available to the claimant or in the public domain,33 Guide T4088, Scientific Research and Experimental Development (SR&ED) Expenditures Claim – Guide to Form T661, recommends that the claimant describe the scientific or technological knowledge base that existed at the beginning of the experimental development project, when answering the question “What scientific or technological uncertainties did you attempt to overcome?” on Form T661. This implies that it would be prudent to provide some details on the knowledge base. Deficiencies in this requirement are common in software claims. Describing the knowledge base is necessary to help the reviewer compare the technological advancements sought with the technology available in the public domain. Of course, the knowledge base changes at approximately the same rate as the technological advancements, so it needs to be revisited periodically.

Experimental production The concept of experimental production as SR&ED presents a number of problems: It is hard to recognize, is often misunderstood, is difficult for the CRA to administer, makes the SR&ED claim more difficult to prepare, and is challenging to defend. Experimental

32 Progressive Solutions Inc. v. The Queen, 96 DTC 1232 (TCC). 33 This requirement existed prior to 2008.

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production is not the same as experimental development, although the terms are often mistakenly interchanged. As well, the experimental production of a product should not be confused with commercial production. In 2002, the CRA published a policy defining experimental production and outlining its administrative practices for these claims. However, many problems and challenges arose as a result of this policy, and the CRA subsequently revised it twice before replacing it in December 2012 with the SR&ED During Production Runs Policy. A clarifying update was made to the policy in July 2016. Despite the revisions and changes, challenges remain. Experimental production commonly occurs in a variety of sectors, most notably in shopfloor environments such as those found in commercial facilities and production environments. In these situations, an existing or improved commercial-scale setting may be the only means to experimentally develop and test hypotheses. Depending on the method chosen to compute SR&ED expenditures, experimental production claims may benefit from a broader scope of eligible expenditures covering most of the costs of running the production process during the experimental production. In certain industries, expenditures such as power, consumable supplies, and other overhead expenses incurred in the commercial setting where the experimental production occurs can be significant and, as a result, substantially increase the investment tax credit earned (for more information, see Chapter 4, What is eligible? – Financial aspects). When SR&ED is done in conjunction with commercial production, only SR&ED costs above and beyond those normally incurred in production may be claimed. It is often difficult to determine where the line should be drawn separating the costs normally incurred from the incremental expenditures incurred as a result of the SR&ED being performed.34

Definitions of experimental production and commercial production Experimental production may arise in projects that involve shop-floor experimentation or the use of the production process for R&D. The SR&ED During Production Runs Policy underlines that it is essential to distinguish between experimental development resulting in experimental production (ED+EP) and experimental development that occurs in conjunction or simultaneously with commercial production (ED+CP). The claimant is responsible for discerning whether the SR&ED project’s experimental trials or the production runs are conducted in the context of ED+EP or ED+CP. This determination can have a significant impact on the SR&ED expenditures claimed (see Chapter 4, What is eligible? – Financial aspects). In the SR&ED During Production Runs Policy, the CRA states that experimental production is “the production output of experimental development that is required to verify whether the objectives of the SR&ED work have been met or if a technological

34 Even using the alternative incremental cost method proposed by the CRA may prove to be difficult. Although the alternative method allows a claimant to identify an overall amount of incremental costs incurred as a result of SR&ED by comparing the actual costs incurred to the standard production costs attributable to commercial production only (instead of showing that each specific expenditure item meets the normal incremental test), the standard production costs (or comparable costs) may not be available to the claimant or may not be supported by sufficient evidence.

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advancement is achievable.” The policy then goes on to describe the purpose of a production run, in which the output is experimental production, as being “to evaluate the technical aspects of the SR&ED project.” A production run is defined as running, “[i]n a commercial environment, … processes and equipment for certain periods of time in order to achieve specific objectives … A production run could also be a period of time during which changes to the process are validated.” The SR&ED Glossary states that commercial production is “work associated with producing materials, devices, and products, intended for sale or business operations. It is expected that a profit will be made.” This definition may be problematic when a company is operating at a loss for a long time. Generally speaking, with commercial production, there is little to no technical risk or technological uncertainty relative to the product or process, and it is anticipated that saleable materials will be created as a result.

Distinguishing experimental production from commercial production in conjunction with experimental development Being the production output of experimental development, experimental production cannot exist without experimental development first taking place. As a result, even before distinguishing ED+EP from ED+CP, SR&ED — and more precisely, experimental development — must be occurring. Indeed, it is possible to conduct a “trial” or an experiment on a process line without undertaking experimental development. Another preliminary step before distinguishing ED+EP from ED+CP is to identify which production runs are part of the experimental development work, as the distinction between ED+EP and ED+CP must be made for each of these production runs (the SR&ED During Production Runs Policy refers to this as determining “the context of each necessary production run” to determine the extent of the SR&ED performed). Once it has been determined that experimental development is present and the relevant production runs have been identified, the next step in distinguishing ED+EP from ED+CP (or determining the context of a specific production run) is to determine whether experimental production is present. Note that the sale of any production output, whether at a profit or loss, should not be used as a determining factor to show that commercial production has occurred. As mentioned above, determining whether experimental production is present must be done for each production run that is part of the experimental development work. It is not uncommon in an SR&ED project to have several trials or production runs conducted, with some being in an ED+EP context and others in an ED+CP context. Experimental production is present (or the context of a production run is ED+EP) when there is a technical risk to the process or product, provided the technical risk is attributable to the technological uncertainties that the company is attempting to resolve. In essence, as stated in the SR&ED During Production Runs Policy, the technical risk arises for the most part because of “the need to test process parameters (including combinations thereof) outside normal established process, procedures, ranges, and tolerances.” The SR&ED expenditures associated with that production run can then be calculated. When the context of the production run is ED+EP, the costs associated with the production may be allowable SR&ED expenditures; however, costs relating to any production beyond that required for the SR&ED (referred to as excess production) are

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not allowable SR&ED expenditures.35 When the context of the production run is ED+CP, the costs must be apportioned between SR&ED and non-SR&ED work — costs attributable to commercial production are not allowable SR&ED expenditures. CRA literature on the subject of experimental production generally depicts production runs as being either completely carried out in an ED+EP context or completely carried out in an ED+CP context. However, it is common for a production run to start out in an ED+EP context but continue, as the experiment progresses and risk is reduced, in an ED+CP context. This may occur when the risk to the product is high at the onset of the production run, but it is determined, as the experiment or production run is carried out, that this risk is reduced. For example, it may not be reasonable to end a trial or experiment halfway through a batch or production run simply because the planned parameter changes are complete. It may make more sense to complete the batch or production run without transitioning it back to “normal” operating mode if the resulting product is acceptable and the process considered stable (a business decision). If data continue to be collected in support of the SR&ED project, the remainder of the production run would be carried out in an ED+CP context. However, if data collection in support of the SR&ED project does not continue, the costs attributable to the rest of the batch or production run are attributable straight to commercial production. Sometimes, it is easy to identify experimental production when an experimental trial puts product at risk — for example, where the changes being made during the trial create rejected product or a high risk of damage, or introduce instability to the existing process or equipment. In other cases, the judgment of the company’s technical experts is required to determine the presence of technical risk beyond that of a normal production run. A well-planned and well-documented experimental trial should provide indicators of product or process risk.

Experimental production factors An ED+EP determination is based on technical considerations as well as applicable evidence. The SR&ED During Production Runs Policy lists examples of the types of evidence (or factors) that suggest the presence of technical risks in the context of ED+EP: •

Specific experimental operating instructions and other consistent records were prepared for the production run as part of the original project plan.

•

Special tracking, classification, monitoring or recognition of the project/product occurred.

•

Meeting minutes or other relevant sources of supporting information were available to substantiate and corroborate the planning and technical risk associated with the production run.

•

Senior management gave the authorization to proceed with the production run that involved a technical risk to the product or process.

•

There was significant input and close monitoring of the work by technically qualified individuals (technical personnel or contractors).

•

Additional technical personnel or supervision were present.

•

Specific monitoring strategies and operating instructions for the experimental

35 Excess production is not considered experimental production.

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development were communicated to the operating staff. •

There was design of specific experiments, and monitoring and analyzing test data from the production runs.

•

The experimental process introduced significant changes that affect the core of the regular production process.

•

Production quantities commensurate solely with the needs of the experimental development project were used at each stage (in contrast to what was normally produced).

•

The experimental development was performed on a dedicated experimental line, separate from the commercial system or on a production line borrowed solely for this purpose.

•

A smaller quantity than normal was produced.

•

There were large incremental SR&ED costs (based on the facts of the case).

•

The SR&ED costs were significant in terms of the overall standard costs of production.

With respect to these examples or factors, the policy also states: This is not an exhaustive list nor is it intended to be used as checklist. The different forms of available evidence will depend on the technical considerations identified, as well as the particular project itself. Hence: •

the number of factors met is not relevant;

•

no one factor carries a greater weight than another; and

•

no one factor, in isolation, is determinative.

As previously mentioned, it is a combination of technical considerations, supported by evidence, that makes it possible to determine the context of a production run. If the technical considerations and the associated evidence do not support an ED+EP determination, the context of the production run is ED+CP. There is no substitute for experience and company expertise in identifying and claiming experimental production. Before proceeding further, it is important to discuss two variables that are critical when submitting a claim: the experimental development zone and experimental development duration. These variables are crucial to the proper identification of associated costs.

Identifying the experimental development zone The experimental development zone is the portion or stages of the process that are involved in the experiment or trial. When running a pilot plant or a parallel process, identifying the experimental development zone should be relatively straightforward. In a large commercial setting, however, the identification of the experimental development zone is more complex, as in these circumstances a company usually performs production runs that use multi-stage continuous processes to transform, step by step, raw materials into one or several final products. So defining the zone becomes very important when deciding which expenditures are eligible for a claim. Determining where the risk to the product or process begins and ends within an experimental development zone is often difficult, and the decision must involve input from the technical personnel. A common mistake is to assume that where a final output from the production process is needed, all

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costs that go into converting the raw materials into the finished product should be included. This “kitchen sink” approach often results in claiming ineligible work and expenditures. When identifying the experimental development zone, it is important to look at where experimentation is taking place within the process, and where inputs or process variables are being changed. It is also very important to establish where measurements are taken for evaluation of the project’s technological objectives and to facilitate analyses to address whether technological uncertainties have been resolved.

Determining the duration of experimental development When experimental development is carried out in a shop-floor environment, it is critical to identify the beginning and end stages of the trial or experiment. Most experiments have three basic stages, no matter what industry the claimant is operating in: •

the initial transition stage;

•

the experimentation stage; and

•

the final transition stage.

The initial transition stage encompasses the period it takes to convert or move from the stable “normal” operating conditions to the new experimental operating conditions. This period varies depending on the process type (continuous or discrete), the process equipment, the size of the experimental development zone, and the length of time required to go through the process before data can be collected to evaluate the experiment. This initial stage is eligible because it is required as part of the experiment. The experimentation stage begins when the changes made during the initial transition period have stabilized and reliable data can be collected. The length of this stage varies depending on the number of parameters being investigated, the number of further experimental input changes made, and the nature of the technological uncertainties that need to be resolved. A reasonable amount of time to confirm the reproducibility of experimental results may also be included. The duration of experimental production trials can range from a few hours to several weeks, and possibly longer. So, how does one determine when the experimentation stage is over? In general (and as discussed earlier), when production runs are carried out that require the normal production process to be changed or that are outside normally established ranges, procedures, or tolerances, the production runs are carried out in an ED+EP context. Some experimental trials will require that the process be put back into “normal” mode for production to resume. In these cases, it is relatively easy to isolate the start and end points of each experimental trial. However, in some cases, the experiment may be going so well that a decision is made to continue to run under the new operating parameters. At this point, there may be enough data to reach reasonable conclusions about the trial, but a decision may be made to collect data for a few more days or weeks to reduce statistical variation. In these cases, determining the end point of the experimental trial becomes a bit more difficult. Determining when experimental production ends can be established by looking at the technological objectives and planned parameter changes laid out before the trial began. Once the data have been collected, and the technological objectives have been met, the

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trial is over. However, when claiming projects using this reasoning, one must be careful to pinpoint where ED+EP ends but ED+CP continues, as the identification of SR&ED expenditures will vary significantly. The final transition stage may be part of the experiment or may be part of day-to-day business and should be claimed accordingly.

Supporting experimental production claims Claims that include experimental production will, in all likelihood, be subject to more detailed CRA audit scrutiny than other types of claims. The CRA will want to ascertain that experimental production has actually occurred and may also look for clarification of •

the severity of the risk to the product or process;

•

the amount of time needed to obtain results from the experimental trial;

•

the differentiation between ED+EP and ED+CP; and

•

the amount of dollars claimed.

When defending experimental production claims during a CRA audit, preparation is key. Ideally, this preparation includes having clear documentation demonstrating the intent, risks, objectives, methodology, schedules, data, analyses, and conclusions of all trials. Types of supporting documentation that may help in the defence of a claim are •

trial planning reports with objectives, risks, and planned sequence of events;

•

project books and spreadsheets of quantitative data from trials;

•

lab tests performed on outputs from experimental trials;

•

graphs and charts illustrating analysis done on results and conclusions;

•

photos and videos that demonstrate SR&ED was being performed (showing the process was not in “normal” operating mode but likely in experimental mode), special work instructions, and samples of experimental products; and

•

final project reports with analyses and conclusions.

While documentation such as trial records is best, sometimes the supporting information available is less than ideal. During a detailed review, the CRA normally wants to interview technical personnel, examine available documentation, and in some cases, tour the site or location where the SR&ED took place. Usually, the CRA likes to see some form of documentation prepared during the fiscal year in question. If this supporting information is lacking, there is a greater risk that the CRA will view the claim as insufficiently substantiated. For more information on supporting an SR&ED claim, see Chapter 5, SR&ED claims submission process.

For further reference Income Tax Act 248(1)

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Case law 1726437 Ontario Inc. o/a Airmax Technologies v. The Queen, 2012 TCC 376 2037625 Ontario Inc. (formerly ITC Invoice to Cash Inc.) v. The Queen, 2015 TCC 269 6379249 Canada Inc. v. The Queen, 2015 TCC 77 ACSIS EHR (Electronic Health Record) Inc. v. The Queen, 2015 TCC 263 Blue Wave Seafoods Incorporated et al. v. The Queen, 2004 TCC 553; aff’d. 2006 FCA 81 C.W. Agencies Inc. v. The Queen, 2001 FCA 393 Emotion Picture Studios Inc. v. The Queen, 2015 TCC 323 Flavor Net Inc. v. The Queen, 2017 TCC 179 Formadrain Inc. v. The Queen, 2017 TCC 42 Highweb & Page Group Inc. v. The Queen, 2015 TCC 137 Hun-Medipharma Research Inc. v. The Queen, 99 DTC 407 (TCC) Hypercube Inc. v. The Queen, 2015 TCC 65 Jentel Manufacturing Ltd. v. The Queen, 2011 TCC 261; aff’d. 2011 FCA 355 Joel Theatrical Rigging Contractors (1980) Ltd. v. The Queen, 2017 TCC 6 Lehigh Hanson Materials Limited v. The Queen, 2017 TCC 205 Les Abeilles Service de Conditionnement Inc. v. The Queen, 2014 TCC 313 Les Éditions Progitech Inc. v. The Queen, 99 DTC 672 (TCC); aff’d. 2002 FCA 19 Life Choice Ltd. v. The Queen, 2017 TCC 21 Mac & Mac Hydrodemolition Services Inc. v. The Queen, 2017 TCC 256 Murray Arlin Dentistry Professional Corporation v. The Queen, 2012 TCC 133 Northwest Hydraulic Consultants Ltd. v. The Queen, 98 DTC 1839 (TCC) Novalia Power General Research Inc. v. The Queen, 2016 TCC 81 Progressive Solutions Inc. v. The Queen, 96 DTC 1232 (TCC) R&D PRO-innovation Inc. v. The Queen, 2015 TCC 186; aff’d. 2016 FCA 152 RIS-Christie Ltd. v. The Queen, 99 DTC 5087 (FCA) Robotx Solutions Inc. v. The Queen, 2017 TCC 73

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Soneil International Limited et al. v. The Queen, 2011 TCC 391 Tacto Neuro Sensory Devices Inc./Appareils Neurosensoriels Tacto Inc. v. The Queen, 2004 TCC 341 Zeuter Development Corporation v. The Queen, 2006 TCC 597

Guides T4088

Scientific Research and Experimental Development (SR&ED) Expenditures Claim – Guide to Form T661

SR&ED program policies Eligibility of Work for SR&ED Investment Tax Credits Policy SR&ED During Production Runs Policy SR&ED While Developing an Asset Policy

Web resources Brief history of the definition of SR&ED www.canada.ca/en/revenue-agency/services/scientific-research-experimentaldevelopment-tax-incentive-program/a-brief-history-definition.html Brief history of the guidance on the eligibility of work www.canada.ca/en/revenue-agency/services/scientific-research-experimentaldevelopment-tax-incentive-program/a-brief-history-guidance-on-eligibility-work.html

Appendix Reproduced below is an excerpt from the Northwest Hydraulic Consultants decision (1998 DTC 1839 (TCC)) outlining the Tax Court’s understanding of the approach to be taken when determining whether work qualifies as SR&ED: 1. Is there a technical risk or uncertainty? (a) Implicit in the term “technical risk or uncertainty” in this context is the requirement that it be a type of uncertainty that cannot be removed by routine engineering or standard procedures. I am not talking about the fact that whenever a problem is identified there may be some doubt concerning the way in which it will be solved. If the resolution of the problem is reasonably predictable using standard procedure or routine engineering there is no technological uncertainty as used in this context. (b) What is “routine engineering”? It is this question, (as well as that relating to technological advancement) that appears to have divided the experts more than any other. Briefly it describes techniques, procedures and data that are generally accessible to competent professionals in the field. 2. Did the person claiming to be doing SRED formulate hypotheses specifically aimed at reducing or eliminating that technological uncertainty? This involves a five stage process: (a) the observation of the subject matter of the problem;

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(b) the formulation of a clear objective; (c) the identification and articulation of the technological uncertainty; (d) the formulation of an hypothesis or hypotheses designed to reduce or eliminate the uncertainty; (e) the methodical and systematic testing of the hypotheses. It is important to recognize that although a technological uncertainty must be identified at the outset an integral part of SRED is the identification of new technological uncertainties as the research progresses and the use of the scientific method, including intuition, creativity and sometimes genius in uncovering, recognizing and resolving the new uncertainties. 3. Did the procedures adopted accord with established and objective principles of scientific method, characterized by trained and systematic observation, measurement and experiment, and the formulation, testing and modification of hypotheses? (a) It is important to recognize that although the above methodology describes the essential aspects of SRED, intuitive creativity and even genius may play a crucial role in the process for the purposes of the definition of SRED. These elements must however operate within the total discipline of the scientific method. (b) What may appear routine and obvious after the event may not have been before the work was undertaken. What distinguishes routine activity from the methods required by the definition of SRED … is not solely the adherence to systematic routines, but the adoption of the entire scientific method described above, with a view to removing a technological uncertainty through the formulation and testing of innovative and untested hypotheses. 4. Did the process result in a technological advance, that is to say an advancement in the general understanding? (a) By general I mean something that is known to, or, at all events, available to persons knowledgeable in the field. I am not referring to a piece of knowledge that may be known to someone somewhere. The scientific community is large, and publishes in many languages. A technological advance in Canada does not cease to be one merely because there is a theoretical possibility that a researcher in, say, China, may have made the same advance but his or her work is not generally known. (b) The rejection after testing of an hypothesis is nonetheless an advance in that it eliminates one hitherto untested hypothesis. Much scientific research involves doing just that. The fact that the initial objective is not achieved invalidates neither the hypothesis formed nor the methods used. On the contrary it is possible that the very failure reinforces the measure of the technological uncertainty. 5. Although the Income Tax Act and the Regulations do not say so explicitly, it seems selfevident that a detailed record of the hypotheses, tests and results be kept, and that it be kept as the work progresses.

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4. What is eligible? – Financial aspects Overview [§37, §127, §127.1] — Once it has been established from a scientific point of view that eligible work has been performed — that is, that the work is considered to be scientific research and experimental development (SR&ED)1 — the next step in claiming SR&ED tax incentives is to identify and quantify the eligible SR&ED expenditures. Eligible SR&ED expenditures, which consist of current and pre-2014 capital expenditures,2 accumulate in a pool (referred to as the SR&ED expenditure pool), along with other components, and the balance of this pool is deductible from income. Section 37 of the Income Tax Act provides for the computation of the SR&ED expenditure pool, as well as the deduction from income. The expenditures that are part of the SR&ED expenditure pool are also the starting point in determining qualified expenditures, which are used to earn investment tax credits. Qualified expenditures and the investment tax credits earned on them are computed under section 127. Investment tax credits may be used to offset taxes otherwise payable. However, certain Canadian-controlled private corporations (CCPCs) may be entitled to a refund of the credits when they are not required to offset tax. Entitlement to the refundable credits is determined under section 127.1. This chapter discusses how these SR&ED tax incentives are calculated, including the various components that enter into the calculations, and is organized as follows: •

Eligible SR&ED expenditures (on page 68) identifies the expenditures that accumulate in the SR&ED expenditure pool;

•

SR&ED expenditure pool (on page 101) reviews the other components of the pool and the deduction from income;

•

SR&ED qualified expenditure pool (on page 113) discusses the link between eligible SR&ED expenditures and qualified expenditures, and reviews other elements that affect the computation of qualified expenditures;

•

Investment tax credits (on page 139) outlines how investment tax credits are earned and claimed, and reviews situations in which the credits may be recaptured (or reversed);

•

Refundable investment tax credits (on page 156) discusses the entitlement to refundable investment tax credits; and

•

Special situations (on page 158) reviews the computation of eligible SR&ED expenditures, qualified expenditures, and investment tax credits in special circumstances (e.g., where SR&ED claims are made by entities other than corporations and where there is a loss restriction event).

1

See Chapter 3, What is eligible? – Scientific and technological aspects, for more details.

2

Capital expenditures made after 2013 do not qualify for SR&ED incentives.

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Eligible SR&ED expenditures After determining what work may be claimed with respect to an SR&ED project, taxpayers must identify which of the project expenditures are eligible for a deduction under section 37 (and thus are added to the SR&ED expenditure pool). Taxpayers compute these expenditures using one of two methods (proxy or traditional). This part of the chapter begins with a brief overview of the two methods and then goes on to review in more detail the eligibility of the following categories of expenditures under each method: •

labour;

•

materials consumed or transformed;

•

subcontracts (SR&ED performed on taxpayer’s behalf);

•

lease of premises, facilities, and equipment;

•

other expenditures directly related and incremental to SR&ED;

•

third-party payments;

•

current expenditures all or substantially all attributable to SR&ED; and

•

capital expenditures.

Most current expenditures are reported on a project-by-project basis in Part 6 of Form T661, Scientific Research and Experimental Development (SR&ED) Expenditures Claim. The summary of all expenditures is reported in Section B of Part 3 of Form T661. Because some of the categories of expenditures mentioned above (in particular, expenditures all or substantially all attributable to SR&ED, as well as expenditures directly related and incremental to SR&ED) are broad enough in scope to capture many expenditures that could be eligible under other more specific categories, certain expenditures may be eligible under more than one category (although they may be deducted only once). See Expenditures deductible under more than one provision (on page 98) for more details. A table summarizing the expenditures deductible under each method and a comparison of the two methods are also provided. See Proxy and traditional methods – Summary and comparison (on page 98).

Proxy and traditional methods – Overview [§37(8)] — Subsection 37(8) provides for two methods of computing eligible SR&ED expenditures: the traditional method and the proxy method. The proxy method, introduced in 1992, allows a narrower band of eligible SR&ED expenditures than the traditional method. However, for investment tax credit purposes, a prescribed proxy amount (PPA) of 55% of labour costs3 is included in the computation of qualified expenditures as a replacement, or proxy, for some of the expenditures that

3

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For purposes of calculating the PPA, adjustments may be required to labour costs deducted under ITA s. 37; the PPA rate was reduced from 65% to 55% over a two-year period beginning in 2013. See Prescribed proxy amount (on page 115).

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would have been included in eligible SR&ED expenditures had the taxpayer chosen to claim under the traditional method. Thus, the PPA does not form part of the SR&ED expenditure pool under subsection 37(1) and is included only in the computation of SR&ED qualified expenditures under subsection 127(9). See SR&ED qualified expenditure pool (on page 113). Expenditures that are not eligible under the proxy method remain deductible as ordinary business expenses. To use the proxy method, taxpayers must make an election by checking Box 160 in Section A of Part 3 of Form T661 when filing the original SR&ED claim for a taxation year. Once made, the election is irrevocable for that taxation year,4 although a different method may be selected in another year. The Department of Finance explanatory notes regarding the introduction of the proxy method state that “[it] is anticipated that in many cases the alternative method will be simpler for taxpayers.” While this statement may be true for some taxpayers, others may be better off choosing the traditional method. Too many taxpayers elect to use the proxy method without fully understanding the two options, which may result in lost investment tax credits or difficult and protracted claim reviews by tax authorities. See Proxy and traditional methods – Summary and comparison (on page 98) for more information.

Labour Under the proxy method, the cost of salaries or wages for employees directly engaged in SR&ED (proxy method salaries) is an eligible SR&ED expenditure. Under the traditional method, the cost of salaries or wages for employees who directly undertake, supervise, or support the prosecution of SR&ED (traditional method salaries) is an eligible SR&ED expenditure. In addition, if the salaries or wages are all or substantially all attributable to the prosecution of SR&ED, they may be deductible under the traditional method as current expenditures all or substantially all attributable to SR&ED. See Current expenditures all or substantially all attributable to SR&ED (on page 93) for more information. Other salaries and wages may be eligible for deduction under the traditional method as expenditures directly related and incremental to SR&ED. See Other expenditures (on page 85).

Salaries for employees directly engaged in SR&ED (proxy method salaries) [§37(8)(a)(ii)(B)(IV)] — Under the proxy method, subclause 37(8)(a)(ii)(B)(IV) provides that the cost of eligible SR&ED labour is that portion of an expenditure made in respect of an expense incurred in the year for salary or wages of an employee who is directly engaged in scientific research and experimental development in Canada that can reasonably be considered to relate to such work having

4

See ITA ss. 37(8)(a)(ii)(B) and 37(10). See also Advanced Agricultural Testing Inc. v. The Queen, 2009 TCC 190.

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regard to the time spent by the employee thereon, and, for this purpose, where that portion is all or substantially all of the expenditure, that portion shall be deemed to be the amount of the expenditure[.] [italics added]

The term directly engaged is not defined in the Act. The SR&ED Glossary and the SR&ED Salary or Wages Policy both indicate that whether an employee is directly engaged in SR&ED is based on the tasks performed by the employee, not on the employee’s job title; it is thus a question of fact. The glossary and policy further add that the expression directly engaged in SR&ED refers to hands-on SR&ED work. Within this context, the SR&ED Salary or Wages Policy provides the following examples of tasks that would normally be performed by employees considered to be directly engaged in SR&ED: •

preparing equipment and materials for experiments, tests, and analyses (but not maintaining equipment);

•

carrying out experiments, tests, and analyses;

•

collecting data commensurate with the needs and directly in support of the experimentation and analyses; and

•

performing the following additional SR&ED support work: – recording measurements, making calculations, and preparing charts and graphs, – carrying out statistical surveys and interviews, – preparing computer programs, and – performing work with respect to engineering or design, operations research, mathematical analysis, and psychological research.

Both specialized and non-specialized employees may be considered to be directly engaged in SR&ED. However, the SR&ED Salary or Wages Policy specifies that the CRA would consider work of a non-specialized employee to be work directly engaged in SR&ED only when the following two conditions are met: •

the work is directly in support and is an integral part of the basic or applied research or experimental development work; and

•

the work is supervised by staff with scientific or technological qualifications.

Operating a machine for the purpose of an experiment that requires the use of that machine, feeding raw materials into a machine for purposes of an experiment, and constructing and testing a prototype as an integral part of an SR&ED project are three examples, provided in the SR&ED Salary or Wages Policy, of eligible work that could be performed by non-specialized employees. In addition, time spent by supervisors or managers directing the course of, or providing direct technical input into, the ongoing SR&ED work being claimed may be considered directly engaged in SR&ED. However, time spent on non-technological management activities, such as long-term strategic planning and contract administration, or on decision-making functions that do not directly influence the course of ongoing SR&ED work, is not considered time directly engaged in SR&ED, even though it may relate to SR&ED.

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Even if an employee is directly engaged in SR&ED, it does not necessarily mean that all amounts included in the employee’s salary or wages can be claimed; only the portion of the salary or wages that can reasonably be considered to relate to the employee’s SR&ED work will qualify. The SR&ED Salary or Wages Policy states that to determine whether a reasonable link exists, the underlying reasons for paying the salary or wages would have to be examined, and the taxpayer would have to demonstrate how the expenditure relates to SR&ED to be entitled to claim it. As a result, bonuses or other remuneration based on profits paid or payable to an employee who is not a specified employee — see Specified employees (on page 74) — can be claimable, provided a reasonable connection or link is demonstrated.5 However, where it is determined that an employee has spent all or substantially all (i.e., 90% or more) of his or her time directly engaged in SR&ED carried on in Canada, 100% of the individual’s salary and wages may be deducted (subject to certain exceptions, such as in the case of specified employees). Salaries and wages of Canadian residents incurred for SR&ED performed outside Canada may also be deemed to be made in respect of SR&ED carried on in Canada and thus may be deducted. See SR&ED performed in Canada (on page 103).

Salaries for employees who directly undertake, supervise, or support SR&ED (traditional method salaries) [§37(8)(a)(ii)(A)(II), Reg. 2900(2)(b)] — In addition to current expenditures all or substantially all attributable to SR&ED,6 expenditures may also be eligible under the traditional method if they are directly attributable to the prosecution of SR&ED, or to the provision of premises, facilities, or equipment for the prosecution of SR&ED, in Canada. A labour expenditure is directly attributable to the prosecution of SR&ED if •

it constitutes salary or wages of an employee (or a portion of the salary or wages) that can reasonably be considered to be in respect of the prosecution of SR&ED; and

•

the employee directly undertakes, supervises, or supports the prosecution of SR&ED.

Other labour expenditures (or portions of them) may also qualify as expenditures directly attributable to the prosecution of SR&ED if they are directly related to the prosecution of SR&ED and would not have been incurred if the prosecution had not occurred. See Other expenditures (on page 85) for more information on these labour expenditures, as well as expenditures directly attributable to the provision of premises, facilities, or equipment for the prosecution of SR&ED. The SR&ED Salary or Wages Policy provides the following guidelines for determining when an employee is directly undertaking, supporting, or supervising SR&ED: “Undertakes” means performing experimentation, analysis and other related activities in the performance of work described in paragraphs (a) to (d) of the definition of SR&ED in

5

In CalAmp Wireless Networks Inc. v. The Queen, 2013 TCC 201, the Tax Court found that no such connection or link existed in respect of a one-time bonus incentive paid to employees directly engaged in SR&ED, following the acquisition of control of the corporation that employed them. The bonus incentive was in stark contrast with the traditional bonus policy followed in the past.

6

See Current expenditures all or substantially all attributable to SR&ED (on page 93).

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paragraph 248(1) of the Income Tax Act, that is basic research, applied research, experimental development or support work. “Supervises” refers to the day-to-day management of work described in paragraphs (a) to (d) of the definition of SR&ED by an employee, not merely the supervision of employees who undertake or support SR&ED work. It is expected that the performance of such work would require a significant technological background based on the employee’s academic or work experience, or both… The term “supports” describes the performance of any of the work described in paragraph (d) of the definition of SR&ED and other technical work that relates to the prosecution of SR&ED. The other technical work could include work performed by non-specialized employees.

Salaries and wages of Canadian residents incurred for SR&ED performed outside Canada may also be deemed to be made in respect of SR&ED carried on in Canada and thus be eligible under the traditional method. See SR&ED performed in Canada (on page 103).

Labour allocation For claims made under the traditional method, it is a question of fact whether a particular labour expenditure is directly attributable to SR&ED (i.e., can reasonably be considered to be in respect of SR&ED or directly relates to SR&ED) or is all or substantially all attributable to SR&ED. Similarly, for claims made under the proxy method, it is a question of fact whether time spent is directly engaged in SR&ED. It is the taxpayer’s responsibility to support a determination that an expenditure is attributable to SR&ED or that time is spent by an employee who is directly engaged in SR&ED.7 The CRA’s research and technology advisors, not its financial reviewers, are responsible for making these determinations from the CRA’s perspective. See Chapter 1, The SR&ED program, and Chapter 5, SR&ED claims submission process, for more information on CRA reviews. Section 13 of the SR&ED Salary or Wages Policy provides guidance on these determinations. This section applies to both the proxy and traditional methods and provides specific guidance on appropriate methodologies for allocating expenditures between SR&ED labour expenditures and non-SR&ED labour expenditures where the taxpayer is not using formal time-tracking systems. The document discusses high-, medium-, and low-level information that may be available to support the labour expenditures allocation. High-level information includes corporate- or strategic-level information such as project plans. Medium-level (project level) or low-level (activity level) information may be available to support high-level directive information, or may be available on its own. Medium-level information includes project plans, timelines, and Gantt charts, and lowlevel information includes resource allocations and personal logbooks.

7

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Evidence of good conduct by a taxpayer and CRA approval of prior years’ SR&ED claims by the taxpayer do not constitute support for the validity of a new file — at best, they can be useful in establishing context. See Laboratoire Du-Var Inc. v. The Queen, 2012 TCC 366.

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Reasonable estimates are acceptable but should be based on evidence supporting the percentage of time allocations. This evidence should be produced by following a methodology that is reasonable within the context of the SR&ED environment (distinct, well-defined SR&ED projects, shop-floor SR&ED, etc.), and it should be applied effectively and consistently. The CRA may request support for the rationale or ask about the reliability of internal controls. The following are examples of evidence to support SR&ED labour estimates: •

A time-capture system with the flexibility to allocate time by project codes and an unlimited number of sub-project codes representing different stages of a project — The data retrieved may include a breakdown of hours or days by task and employee. The tasks described may be brief. For example, typical tasks performed by software developers include – requirements analysis; – functional specifications; – technology evaluation; – prototyping; – application design; – coding and unit tests; – quality assurance testing; and – maintenance and support.

•

A daily or weekly journal with dated entries describing the work performed for the period covered by the entry — Many companies’ technical employees keep such records already. For SR&ED purposes, the activity descriptions should be in terms of project tasks or phases. Ideally, the tasks described link to the SR&ED project descriptions submitted to the CRA.

•

An email archive for each project — Some companies create an email account for each project, such as [email protected]. The employees working on the project then copy all project-related emails to this email account. The project email account may also be copied when scheduling meetings or tasks, and the email account’s calendar entries may then be used to track work and tasks related to the project.

Not all front-line project managers performing eligible SR&ED record their time on a tracking system. An alternative approach is to compute eligible time by reviewing logbooks, emails, and minutes of project meetings, supplemented by discussions with the managers. Any SR&ED labour allocation system should fit with a company’s current practices and use existing data and processes as much as possible; it should not result in onerous tasks for employees. A system is only as good as the people using it, and if the tracking system is separate from existing practices, it may not be reliable. Ideally, the CRA wants to see a time-keeping record that includes a brief description of the task performed. If the CRA believes the labour allocation method is inadequate, it will normally inform the taxpayer of the need for additional supporting information. In these situations, it is advisable to work with the CRA to determine what would be reasonable supporting information and documents. The sophistication of the time-keeping system

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depends on variables such as the number of people whose time is being tracked and the number of projects. If possible, the total time available per person should be presented to the CRA, showing the allocation of time between SR&ED and non-SR&ED activities.8 The allocation of an individual’s time is based on the available-for-work time of an employee. Available-for-work time does not include sick days, statutory holidays, or vacation time. For example, if an individual works a 40-hour week, takes three weeks of vacation a year and five sick days, and is entitled to 10 statutory holidays a year, the available-for-work time on which to calculate allocations for SR&ED is 1,840 hours (2,080 – 120 – 40 – 80).

Determining the cost [§248(1) “salary or wages”] — Salaries or wages are defined in subsection 248(1) as income from an office or employment (as calculated in sections 5 to 8) and thus include taxable benefits covered under section 6, such as employer-paid life insurance premiums and taxable automobile benefits. Salary and wages do not include the employer’s share of payments for related benefits, such as Canada or Quebec pension plan contributions, employment insurance premiums, payments for workers’ compensation or to the Commission des normes, de l’équité, de la santé et de la sécurité au travail du Québec, and payments to an employee medical, dental, or optical insurance plan. Taxpayers using the traditional method may deduct these payments as expenditures that are directly related and incremental to SR&ED. See Other expenditures (on page 85).

Specified employees [§37(9), (9.1), §248(1) “specified employee”] — Special rules apply to specified employees (i.e., employees who are specified shareholders — generally, individuals owning 10% or more of the shares of any class of the outstanding shares of the corporation claiming SR&ED — or employees who do not deal at arm’s length with the corporation).9 Specifically, under subsection 37(9), bonuses10 and remuneration based on profits are excluded from salaries or wages under both the traditional and proxy methods (i.e., for the purpose of clauses 37(8)(a)(ii)(A) and (B)). Taxable benefits are not excluded, however, and should therefore remain in salaries or wages.

8

However, in AG Shield Ltd. v. The Queen, 2017 TCC 68, the Tax Court rejected the CRA’s reassessment under which a portion of the salaries and wages paid to its two 50% shareholders was treated as having been paid for non-SR&ED activities, on the basis of the percentage of the shareholders’ aggregate hours not spent on SR&ED. The court accepted the taxpayer’s argument that the two shareholders were paid salaries and wages only for their hours spent on SR&ED (they were directly engaged in SR&ED under the proxy method) and any other amounts received by them were paid as dividends. The court noted that it was the shareholders’ choice to receive dividends in lieu of additional salary or wages for performing non-SR&ED management activities for their corporation.

9

In CRA document 2012-0439781E5, the CRA indicates that a shareholder of a majority-interest partner of a partnership employing the shareholder could be considered a specified employee. In the CRA’s view, it may be argued that the shareholder does not deal at arm’s length with the partnership.

10 Remuneration referred to as a bonus in an employment contract may not necessarily be a bonus. See Oldcastle Building Products Canada Inc. c. La Reine, 2016 CCI 183.

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For both methods, the maximum amount of salary and wages deductible per specified employee in a year is limited, under subsection 37(9.1), to five times the year’s maximum pensionable earnings (YMPE).11 The YMPE is determined on a calendar-year basis and is published on the CRA website. For 2018, the YMPE is $55,900, up from $55,300 in 2017 and $54,900 in 2016. [§37(9.2)–(9.5)] — Subsections 37(9.2) to (9.5) provide rules for determining the allocation of salary and wages of an individual who is a specified employee of two or more associated corporations, and also require that an allocation agreement be filed with the CRA. Subsection 37(9.4) sets out the following filing requirements for these agreements, which are referred to in subsection 37(9.3): •

the agreement must be in prescribed form (Form T1174, Agreement Between Associated Corporations to Allocate Salary or Wages of Specified Employees for Scientific Research and Experimental Development (SR&ED)); and

•

where the taxpayer is a corporation, the agreement must be accompanied by a certified copy of either the directors’ resolution or another document that authorized the agreement.

Unpaid amounts [§37(11), (11.1), §78(4)] — Under subsection 78(4), salaries and wages that remain unpaid 180 days after the end of the taxation year are deemed not to have been incurred in that year but rather in the taxation year in which they are paid. Despite this presumption, subsection 37(11) requires any expenditures incurred under the Act, read without reference to subsection 78(4), to be reported on Form T661 on or before the day that is 12 months after the taxpayer’s filing-due date. See Fundamentals (on page 173) in Chapter 5, SR&ED claims submission process, for more details on filing requirements. In other words, taxpayers must report unpaid salaries and wages in the year the work is performed and the salary and wages are earned, even if they are not deductible for that year, and must do so within the time limit; otherwise, the salaries and wages will not be eligible for deduction in the year in which they are paid. The amendments to subsection 37(11) that were enacted in 2017 do not appear to be intended to change this reporting requirement.

Labour – Form T661 Form T661 includes the following categories under which to report labour expenditures: •

salaries or wages of employees (other than specified employees) directly engaged in SR&ED for work performed in Canada (Line 300);

•

salaries or wages of specified employees directly engaged in SR&ED for work performed in Canada (Line 305);

•

salaries or wages of employees (other than specified employees) directly engaged in SR&ED for work performed outside Canada (Line 307);

11

As determined under the Canada Pension Plan.

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•

salaries or wages of specified employees directly engaged in SR&ED for work performed outside Canada (Line 309);

•

salaries or wages deemed incurred in the year they are paid under subsection 78(4) (Line 310);

•

unpaid amounts deemed not incurred in the year under subsection 78(4) (Line 315); and

•

overhead or other expenditures (Line 360).

Table 3 in Guide T4088, Scientific Research and Experimental Development (SR&ED) Expenditures Claim – Guide to Form T661, is intended to help taxpayers report salaries and wages on Form T661. The table presents several examples of tasks and classifies them under the following three categories: •

salaries or wages for employees directly engaged in SR&ED;

•

salaries or wages for overhead and other expenditures; and

•

non-SR&ED salaries or wages.

Form T661 does not provide a specific line on which to report salaries and wages determined under the traditional method. However, from the categories provided on the form and in Guide T4088, there appears to be an expectation that taxpayers using the traditional method will report salaries of employees who are directly engaged in SR&ED (salaries computed under the proxy method) on Lines 300 to 309 and report salaries of employees who directly undertake, supervise, or support SR&ED net of the proxy method salaries on Line 360 as overhead and other expenditures. For a taxpayer choosing the traditional method, extracting proxy method salaries from traditional method salaries to comply with the categories on Form T661 may seem counterintuitive, as it is not necessary for the taxpayer to separate the expenditures into these two categories when determining eligible SR&ED expenditures. This separation may also create confusion in the application of the methods, especially given that directly undertaking, supervising, or supporting SR&ED is a different and broader concept than directly engaged in SR&ED (a concept that is exclusive to the proxy method in the income tax legislation). Reporting traditional method salaries (allowed under Regulation 2900(2)(b)) net of the proxy method salaries on the same line as other eligible salaries (allowed under Regulation 2900(2)(c)) makes it unclear which provision (or provisions) a taxpayer used as the basis for deducting salaries and wages under the traditional method. For example, Table 3 in Guide T4088 lists SR&ED contract administration under overhead and other expenditures. An in-depth review of the work undertaken might lead to the conclusion that the contract administration role includes providing technical input that directly supports the prosecution of SR&ED (which is eligible under Regulation 2900(2)(b)), and non-technical input involves incremental salary expenditures directly related to the prosecution of SR&ED (which are eligible under Regulation 2900(2)(c)).12

12 As mentioned under Salaries for employees who directly undertake, supervise, or support SR&ED (traditional method salaries) (on page 71), labour expenditures that are directly related to the prosecution of SR&ED and that would not have been incurred if the prosecution had not occurred are deductible, under the traditional method, as eligible SR&ED labour expenditures that are directly attributable to the prosecution of SR&ED. For more information, see Other expenditures (on page 85).

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A separate line on Form T661 for all salary and wage expenditures eligible under Regulation 2900(2)(b) might simplify the task for taxpayers using the traditional method and eliminate confusion during the CRA’s review of the claim. By comparison, the Quebec form (Form RD-222, Deduction Respecting Scientific Research and Experimental Development Expenditures) includes one column for reporting eligible SR&ED expenditures under the traditional method and another for reporting eligible SR&ED expenditures under the proxy method. However, it also requires the taxpayer to separate salary and wage expenditures of employees directly engaged in SR&ED from support salaries. See the table titled Labour expenditures included in SR&ED expenditure pool and PPA salary base (on page 171) in the Appendix of this chapter for examples of eligible salary and wage expenditures.

Materials consumed or transformed [§37(8)(a)(ii)(A)(II), §37(8)(a)(ii)(B)(V), Reg. 2900(2)(a)] — The cost of materials consumed or transformed in the prosecution of SR&ED is an eligible SR&ED expenditure under both the traditional and proxy methods. Neither the phrase cost of materials consumed or transformed nor the individual terms cost, materials, consumed, and transformed are defined in the Act or regulations. The Materials for SR&ED Policy outlines the CRA’s interpretation of these terms. In accordance with the general principles of statutory interpretation, the CRA states that these words must be given their ordinary meaning, taking into account the overall context of the Act, so that the interpretation adopted is consistent with the spirit of the Act and the intent of Parliament. During a CRA review, it is the responsibility of the CRA’s research and technology advisor, not its financial advisor, to determine whether materials are consumed or transformed from the CRA’s perspective.

Material According to the CRA, the term material refers to all the raw materials, substances, or other items that compose the body of a thing at a given moment in the SR&ED process. Thus, a taxpayer should consider not only whether a material forms part of the new or improved materials, devices, products, or processes being developed, but also the broader question of whether a material forms the “body of a thing” in the overall SR&ED process. For example, materials consumed could include materials scrapped as a result of tests conducted on a new or improved manufacturing line where the purpose of the taxpayer’s research was to develop a new process or improvement to an existing process rather than a new or improved product. In essence, materials, in the CRA’s view, must be physical and tangible and compose the body of either a tangible object on which SR&ED is being carried out or a tangible object that results from SR&ED being carried out. Energy sources directly related to the prosecution of SR&ED generally do not constitute materials because they are not items composing the body of a thing — a thing being a tangible object that may be an intermediate product, a by-product, or the final product.

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However, there are circumstances where water and energy sources used in performing SR&ED may meet the definitions of materials and consumed in the Materials for SR&ED Policy and thus be considered materials consumed. Section 4.3 of the Materials for SR&ED Policy clarifies how water and energy sources should be treated for SR&ED purposes. The policy states that water or energy sources may be considered materials consumed for SR&ED purposes in some circumstances, such as where the energy becomes part of the conversion or production process and is integral to the chemical reaction on which the process is based. Supplies such as cleaning products, discs used in computers, test tubes, Petri dishes, pipettes, lubricants, and solvents are generally not considered materials because they do not compose the body of a thing. Therefore, if the taxpayer has elected to use the proxy method, expenditures for these supplies are not deductible as SR&ED expenditures. However, they may be eligible under the traditional method as expenditures directly related and incremental to SR&ED. See Other expenditures (on page 85). Some observers have noted that the CRA’s interpretation of materials consumed or transformed is somewhat restrictive, as some legal dictionaries contain a much broader definition (e.g., defining material as every kind of movable property).

Cost The CRA defines cost as the net laid-down price (after trade discounts) and acquisition costs. It thus generally includes invoice costs, custom and excise duties, transportation costs, other acquisition costs, and storage costs. This definition is consistent with generally accepted accounting principles (GAAP). For SR&ED purposes, the cost of inventories of goods manufactured by the taxpayer is essentially the production cost or the industrial cost price of a product (including the laid-down cost of materials), in addition to the cost of direct labour and the applicable share of overhead expense. Inventory is defined in subsection 248(1) as a description of property whose cost or value is relevant in computing a taxpayer’s income from a business for a taxation year. The rules of valuation of inventory are set out in section 10 of the Act and in Part XVIII of the regulations. Again, GAAP would apply. With respect to timing for claiming materials in inventory, the material becomes deductible after it is removed from inventory and is consumed or transformed in the SR&ED process.

Materials consumed According to the CRA, a material is consumed when it is destroyed or rendered virtually valueless as a result of the SR&ED.

Materials transformed According to the CRA, the phrase materials transformed means that the material was changed or incorporated into another material or product as a result of the SR&ED and still has some value. If the product that includes the transformed material is later sold or converted to commercial use, investment tax credits previously claimed on the cost of property acquired and incorporated into the product (and not on the value of the material) may need to be recaptured. See Recapture of ITC (on page 147).

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Examples of materials consumed or transformed Experimental production For experimental production costs to qualify as SR&ED expenditures, the production run (or runs) or a portion of the production run (or runs) must be required to evaluate or validate the SR&ED project. The CRA’s position on experimental production is articulated in the SR&ED During Production Runs Policy. See also Experimental production (on page 56) in Chapter 3, What is eligible? – Scientific and technological aspects, for information on defining and identifying experimental production. The cost of materials consumed or transformed during the required production runs to generate experimental production is an eligible SR&ED expenditure under both the proxy and traditional methods. Once it has been determined that experimental production has occurred, the next step is to identify which materials were required for the SR&ED project, and whether these materials were consumed or transformed. It is important for financial and technical people to work together closely to identify which materials were consumed or transformed and to determine their related costs. Materials consumed in experimental production can often be very significant in terms of dollars. The CRA often has concerns with experimental production claims because of a lack of evidence. If the result or product of the experimental production is sold, the recapture rules may apply to the property acquired. Taxpayers may consider not deducting materials transformed because the investment tax credits earned on the materials will be recaptured. However, to give the CRA a better picture of the extent of the SR&ED, it may be advisable to claim the materials and recapture the cost of the property acquired. In any event, if a taxpayer decides not to claim because of recapture, this decision should be stated in the project description to provide a clearer picture of what occurred. For more information on the recapture rules, see Recapture of ITC (on page 147).

Prototypes Various definitions of the term prototype exist in industry. The Act does not define the term for SR&ED purposes, but it is defined in both the SR&ED Glossary and SR&ED While Developing an Asset Policy as “an original model on which something new is patterned and of which all things of the same type are representations or copies. It is a basic experimental model that possesses the essential characteristics of the intended product.” From a technological point of view, a prototype is normally understood to be a trial model or preliminary version whose purpose is to test a concept or hypothesis. A prototype is not constructed for commercial purposes, its sale is incidental, and it generally has no lasting material or economic value. The determination of whether an item meets the definition of prototype should be made by a person with technical knowledge. This determination involves establishing whether there is a series of prototypes or copies of prototypes and what items are eligible to be claimed as SR&ED (considering the context of the work being performed).

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Once it has been determined that an item is a prototype, the expenditures relating to its design, construction, and testing may be claimed. However, in the unusual circumstance where a prototype is sold or converted to commercial use, recapture rules may apply to the property acquired by the taxpayer that was transformed into the prototype. The SR&ED While Developing an Asset Policy provides an in-depth discussion of prototypes, including issues surrounding copies and versions of a prototype. With respect to copies of a prototype, the policy states that in certain cases, while the work itself is not considered to be SR&ED, the expenditures for the construction of several duplicate copies of a prototype to be used for testing may qualify for SR&ED purposes. When the testing is commensurate with the needs and directly in support of basic research, applied research, or experimental development prior to commercial production or use, the copies of the prototypes may be considered materials for SR&ED purposes. The cost for the construction of the copies of a prototype (including the labour, materials, and overhead) can be claimed as materials for SR&ED when the copies are consumed or transformed in the prosecution of SR&ED. This means the expenditure can be claimed as materials consumed or transformed when the tests are completed and not when the copies are constructed… The construction of several duplicate copies of a prototype — to meet a need or to establish an inventory after successful testing of the original prototype(s) — is not considered SR&ED because the construction and use of these copies are part of commercial production. Consequently, the costs related to the construction of these copies will not qualify for SR&ED tax incentives.

The policy goes on to discuss versions of a prototype: In certain situations, several different versions of a prototype may be developed, each one involving SR&ED in an attempt to improve on the previous version. In other words, each new version of the prototype utilizes the knowledge gained from the previous version. In such cases, for each version of the prototype, the expenditures associated with the identified SR&ED work will be treated as SR&ED current expenditures. In the case of any version that is developed for the purpose of its sale or subsequent use in the business, the costs associated with any non-SR&ED work performed in its development cannot be claimed for SR&ED purposes…However, if a version is developed for its technical or experimental content, the costs associated with any non-SR&ED work may be treated as part of the cost of materials for SR&ED to be used for testing.

Note that although the additional copies or versions of the prototypes used in SR&ED tests are considered materials, if the materials are sold or converted to a commercial use after the SR&ED test, only the cost of the property acquired that is incorporated into the material, not the full cost of the material, is subject to recapture. The cost of labour incurred by the taxpayer that is included in the cost of materials (and reported as the cost of materials on Form T661) does not constitute property acquired and is not subject to recapture.

Materials – Form T661 Reporting materials on Form T661 is relatively straightforward. Costs of materials are reported together on a project-by-project basis in Part 6 of Form T661. In the summary of all projects in Part 3 of the form, materials consumed are reported on Line 320 and materials transformed on Line 325. There does not appear to be a reason for reporting

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these expenditures on two separate lines, except perhaps to isolate materials transformed, as they could potentially trigger a recapture of investment tax credits at a later time. For more information, see Recapture of ITC (on page 147).

Subcontracts – SR&ED performed on behalf of the taxpayer [§37(1)(a)(i.01), §37(8)(a)(ii)(A), (B), §37(14), (15), Reg. 2900(2)(c)] — Under subparagraph 37(1)(a)(i.01), a taxpayer may deduct current expenditures incurred for SR&ED that is related to a business of the taxpayer, carried on in Canada, and directly undertaken on behalf of the taxpayer. For purposes of the following discussion, the key words in subparagraph 37(1)(a)(i.01) are “expenditures…directly undertaken on behalf of the taxpayer.” This idea is reiterated in subclause 37(8)(a)(ii)(B)(II), which provides that expenditures for the prosecution of SR&ED in Canada that is directly undertaken on the taxpayer’s behalf are deductible under the proxy method.13 Under the traditional method, expenditures for SR&ED performed on the taxpayer’s behalf are generally deducted as expenditures directly attributable to the prosecution of SR&ED under subclause 37(8)(a)(ii)(A)(II) and Regulation 2900(2)(c). See Other expenditures (on page 85). As well, if such an expenditure meets the all-or-substantially all test, it may be claimed under •

subclause 37(8)(a)(ii)(A)(I) (traditional method) — see Current expenditures all or substantially all attributable to SR&ED (on page 93); or

•

prior to its repeal, subclause 37(8)(a)(ii)(B)(I) (proxy method) — see Lease of premises, facilities, and equipment (on page 82).

Directly undertaken on behalf of the taxpayer SR&ED directly undertaken on behalf of the taxpayer is SR&ED work performed by persons other than the taxpayer for the benefit of the taxpayer. Determining whether SR&ED has been performed on a taxpayer’s behalf can be fairly complex. It is a question of fact that must be determined on a case-by-case basis. Where one party (the payer) has entered into a transaction to have SR&ED performed on its behalf by another party (the performer), both the payer and the performer are generally entitled to deduct their costs as subsection 37(1) SR&ED expenditures. It should be noted that section 127 contains provisions to prevent the two parties from claiming investment tax credits for the same work. The Assistance and Contract 13 Amendments applicable to expenditures incurred after September 16, 2016, changed the wording of ITA s. 37(8)(a)(ii)(B)(II), replacing “in respect of” the prosecution of SR&ED with the more restrictive “for” the prosecution of SR&ED. The change was in response to the decision in Feedlot Health Management Services Ltd. v. The Queen, 2015 TCC 32, in which the Tax Court found that expenditures incurred by the taxpayer and made to a sole proprietorship business for arranging for cattle to be acquired and delivered to specific third-party feedlots (where tests could be administered and relevant data collected by the feedlots for later analysis by the taxpayer) were expenditures made in respect of SR&ED.

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Payments Policy, which is useful in determining whether a taxpayer has received a contract payment for investment tax credit purposes, may cause confusion if it is used to determine whether the subsection 37(1) requirements have been met. For more information on contract payments, see Contract payments (on page 125).

Look-through rule [§37(14), (15)] — Given that expenditures of a capital nature, or for the right to use capital property, no longer qualify for SR&ED tax incentives (effective for expenditures made after 2013), subsection 37(14) provides a look-through rule to ensure that expenditures incurred by a taxpayer in respect of SR&ED performed on the taxpayer’s behalf include only current expenditures. Specifically, the taxpayer’s expenditures made to the performer must be reduced by any related expenditure of the performer that is not an expenditure of a current nature and that is made after 2013 (or before 2014 for property that became available for use after 2013). The performer is required under subsection 37(15) to inform the taxpayer in writing of the amount of the reduction no later than 90 days after the end of the calendar year in which the expenditure to be reduced was made. The information must be provided without delay if requested by the taxpayer.

Subcontract expenditures – Form T661 When reporting subcontracted SR&ED expenditures in Part 3 of Form T661, taxpayers must distinguish between arm’s length and non-arm’s length expenditures. For purposes of section 37, the law does not differentiate between the two types of subcontractors, although there are significant differences when calculating investment tax credits. In addition, taxpayers are required to disclose, in Section C of Part 2 of Form T661, the business number of all taxable suppliers paid during the taxation year to perform SR&ED on their behalf. Previously, taxpayers were required to report amounts paid to a subcontractor only when the total paid to the subcontractor was $30,000 or more; however, the current version of Form T661 requires the reporting of all amounts paid to subcontractors on a project-by-project basis.

Lease of premises, facilities, and equipment Although lease costs are not specifically identified in the legislation governing the traditional method, the pre-2014 cost of leasing premises, facilities, and equipment used in the prosecution of SR&ED may be deducted under this method if •

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[§37(8)(a)(ii)(A)(I)] — all or substantially all of the cost was attributable to the prosecution of SR&ED in Canada, or to the provision of premises, facilities, or equipment for the prosecution of SR&ED in Canada (see Current expenditures all or substantially all attributable to SR&ED (on page 93)); or

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•

[§37(8)(a)(ii)(A)(II)] — the cost is directly attributable, as determined by regulation, to the prosecution of SR&ED in Canada, or to the provision of premises, facilities, or equipment for the prosecution of SR&ED in Canada.14

[Reg. 2900(2)(c)] — Expenditures are directly attributable to the prosecution of SR&ED if they are directly related to the prosecution of SR&ED and would not have been incurred if the prosecution had not occurred. See Other expenditures (on page 85). [Reg. 2900(3)(b)] — Expenditures are directly attributable to the provision of premises, facilities, or equipment for the prosecution of SR&ED in Canada if they are directly related to that provision and would not have been incurred if the premises, facilities, or equipment had not existed. The SR&ED deduction under the traditional method is based on the actual percentage of use. In accordance with subparagraph 37(8)(d)(ii), the deduction is no longer available, effective for expenditures made after 2013 and expenditures deemed not to have been made before 2014 because the property had not yet become available for use. For taxpayers using the proxy method, the following pre-2014 expenditures may be deducted: •

[§37(8)(a)(ii)(B)(I) repealed] — a current expenditure that is all or substantially all attributable to the lease of premises, facilities, or equipment used for the prosecution of SR&ED in Canada (other than an expenditure for general-purpose office equipment or furniture); or

•

[§37(8)(a)(ii)(B)(VI) repealed] — one-half of any other current expenditure relating to the lease of premises, facilities, or equipment used primarily for the prosecution of SR&ED in Canada (other than an expenditure for general-purpose office equipment or furniture).

In other words, only half the expenditure is allowed for usage greater than 50% and less than 90% (i.e., used primarily for the prosecution of SR&ED). Under the proxy method, there are no provisions that allow the cost of leasing premises, facilities, and equipment where usage for SR&ED is 50% or less, and expenditures for the lease of general-purpose office equipment and furniture are not allowed (regardless of percentage of use). According to the SR&ED Lease Expenditures Policy, general-purpose office equipment or furniture includes all furniture (e.g., desks, chairs, lamps, filing cabinets, and bookshelves), as well as photocopiers, fax machines, telephones, pagers, typewriters, word processors, teletypes, and calculators. Computers, including hardware, software, and ancillary equipment, are not considered to be general-purpose office equipment or furniture.

14 Although the words lease and equipment may have a broad meaning, subscription fees for real-time stock-trading data transmitted via the internet (Inflection Analytics Ltd. v. The Queen, 2015 TCC 129) and the use of cattle without exclusive possession (Feedlot Health Management Services Ltd. v. The Queen, 2015 TCC 32) are two examples that the Tax Court has considered not to be a lease of equipment or even a lease.

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As under the traditional method, the deduction under the proxy method is no longer available, effective for expenditures made after 2013 and expenditures deemed not to have been made before 2014 because the property had not yet become available for use. The following table summarizes the percentage of lease payments that may be included (depending on the election made) in the SR&ED expenditure pool. Portion deductible depending on election made (%)

SR&ED usage (%)1

Proxy2

Traditional

90% or more

100%

100%

More than 50% but less than 90%

50%

Actual usage

Nil

Actual usage

50% or less 1 2

For taxation years that straddle January 1, 2014, the SR&ED usage is determined as a percentage of the total operating time for the period that relates to 2013. Excluding general-purpose office equipment or furniture.

Buildings [§37(8)(d)]15 — Generally, pre-2014 expenditures in respect of buildings and leasehold interests in buildings are not eligible SR&ED expenditures. However, there is an exception for pre-2014 expenditures in respect of special-purpose buildings. See Buildings (on page 95).

Lease costs of equipment – Form T661 There are two separate lines for reporting the pre-2014 cost of leasing equipment in Part 3 of Form T661: •

Line 350 is used to report expenditures where the equipment is used all or substantially all (90% or more) in the prosecution of SR&ED; and

•

Line 355 is used to report expenditures where the equipment is used primarily (more than 50% but less than 90%) in the prosecution of SR&ED.

These lines are used when claiming under the proxy method. For taxpayers claiming under the traditional method, despite the guidance provided on Form T661 and in Guide T4088, it would seem more logical to claim the cost of leasing equipment used in the prosecution of SR&ED on Line 360 (although it would still be correct to identify the cost of leasing equipment that meets the all-or-substantially-all test on Line 350).

15 ITA s. 37(8)(d) as it formerly applied.

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Other expenditures [§37(8)(a)(ii)(A)(II)] — As noted under the various categories of eligible SR&ED expenditures earlier in this chapter, a current expenditure may be deducted under the traditional method if the expenditure is directly attributable to the prosecution of SR&ED in Canada, or to the provision of premises, facilities, or equipment for the prosecution of SR&ED in Canada. This broad provision captures specific expenditures such as the cost of salaries or wages for employees who undertake, supervise, or support SR&ED (see Labour (on page 69)), as well as general ones. In the context of these other expenditures, the following expenditures are directly attributable to the prosecution of SR&ED (as defined under Reg. 2900(2)(c)), or directly attributable to the provision of premises, facilities, or equipment for the prosecution of SR&ED (as defined under Reg. 2900(3)(b)): •

[Reg. 2900(2)(c)] — other expenditures (or portions of them) that are directly related to the prosecution of SR&ED and that would not have been incurred if the prosecution had not occurred; and

•

[Reg. 2900(3)(b)] — other expenditures (or portions of them) that are directly related to the provision of premises, facilities, or equipment for the prosecution of SR&ED and that would not have been incurred if the premises, facilities, or equipment had not existed.

In other words, current expenditures must meet two tests to be considered directly attributable to the prosecution of SR&ED:16 •

the expenditures must be directly related to carrying out the SR&ED; and

•

the expenditures must be expenses that would not have been incurred if the SR&ED had not occurred.

These expenditures are often referred to as overhead expenses. However, the description in Regulations 2900(2)(c) and 2900(3)(b) captures much more than what would typically be considered an overhead expense from an accounting point of view. Therefore, so as not to confuse the accounting term with the expenditures described in Regulations 2900(2)(c) and 2900(3)(b), we refer to the latter as expenditures directly related and incremental (DRAI) to SR&ED, a much broader term that is tied to the legislation.

Directly related to SR&ED The SR&ED Overhead and Other Expenditures Policy, SR&ED Salary or Wages Policy, and SR&ED Glossary discuss the meaning of the expression directly related, and the SR&ED Overhead and Other Expenditures Policy refers to the following dictionary definition: “in a direct manner; without an intervening step or intermediary.” The example provided in the SR&ED Salary or Wages Policy is that of a vice-president required to hire a personnel manager who is then required to hire SR&ED personnel. Because the personnel manager has direct contact with SR&ED personnel during the recruitment process, the portion of the manager’s salary relating to this direct contact is directly

16 These two tests are similar to the ones current expenditures must meet to be considered attributable to the provision of premises, facilities, or equipment for the prosecution of SR&ED.

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related to SR&ED. The vice-president, however, deals directly only with the personnel manager, not the SR&ED personnel, and therefore the vice-president’s salary is not directly related to SR&ED. The SR&ED Overhead and Other Expenditures Policy further indicates that to determine what constitutes eligible SR&ED expenditures, there “must be a direct linkage of the expenditure to specific SR&ED work, staff, or machinery/equipment.” The SR&ED Salary or Wages Policy adds, in the context of an administrative employee’s salary or wages, that to “make this determination in respect of a particular employee, it is necessary to examine the duties performed by the employee.” The SR&ED Overhead and Other Expenditures Policy provides examples of activities or tasks that may be directly related to the prosecution of SR&ED and activities or tasks that are generally not directly related to the prosecution of SR&ED. Activities or tasks that may be directly related to SR&ED work include •

evaluating, recruiting, and hiring SR&ED personnel when the work is performed by human resources staff;

•

services provided by clerical and administrative staff to SR&ED employees;

•

financing of funds used to perform SR&ED;

•

direct purchasing of material or SR&ED equipment; and

•

shipping and distribution of experimental products for internal or customer testing.

Activities or tasks that are generally not directly related to SR&ED work include •

general administration of the business (e.g., the functions of planning (nontechnological), direction, control, coordination, and systems);

•

finance activities (other than the financing activities listed above);

•

human resources activities (other than the activities of evaluating, recruiting, and hiring listed above);

•

bidding;

•

purchasing (other than the purchasing exception listed above);

•

taxation and legal services activities;

•

sales, marketing, and advertising activities;

•

shipping and distribution (other than the shipping and distribution activities listed above);

•

employee relations activities;

•

development of benefits program for SR&ED personnel;

•

corporate secretary and reporting to shareholders;

•

initiating and closing of licensing agreements;

•

non-technological feasibility studies leading to potential SR&ED collaborations and assessing the commercial feasibility of a given technology;

•

commercialization of existing intellectual property;

•

review and approval of SR&ED budgets and cost control;

•

patent application (including legal work);

•

preparation of user manuals;

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•

administrative training;

•

putting products into a saleable state; and

•

preparation of claims for ISO 9000 registration.

Generally, a direct link between a task and SR&ED can be identified with little controversy, but establishing the link between the expenditure and SR&ED appears to pose a greater problem. One approach is to first identify the tasks that are directly linked to SR&ED and then determine the costs of performing these tasks. Consider again the example of the personnel manager who recruits an employee directly engaged in SR&ED. Expenditures for this task consist of the salary, employee benefits, and several other expenditures, and a reasonable portion of these expenditures could be attributed to tasks with direct links to SR&ED. However, the CRA generally takes a much more restrictive approach. A taxpayer may end up having all expenditures other than salary disallowed because they are considered “overhead on overhead” (i.e., expenditures with no direct link to SR&ED) or, as commonly referred to, support on support. Indeed, the CRA considers such expenditures incurred for clerical and administrative staff to be indirectly linked to SR&ED work, staff, or machinery or equipment. In such cases, the taxpayer and the CRA usually work out a mutually acceptable solution without specifically resolving the overhead-on-overhead issue; the taxpayer must nevertheless be able to demonstrate that a reasonable, rational method for linking the expenses to the prosecution of SR&ED was used and that the expenditures were not simply arbitrarily connected with the SR&ED work. There are very few legal precedents concerning SR&ED, and nothing in the case law appears to address this precise point.

Incremental to SR&ED As mentioned earlier, an expenditure that is directly related to SR&ED (or a portion of it) is deductible under the traditional method if the expenditure would not have been incurred had the prosecution not taken place. Similarly, an expenditure (or a portion of it) that is directly related to the provision of premises, facilities, or equipment for the prosecution of SR&ED is deductible if the expenditure would not have been incurred had the premises, facilities, or equipment not existed. Such an expenditure is referred to as an incremental expenditure. For example, a taxpayer may deduct the cost of a pencil bought for the sole purpose of documenting SR&ED research notes and used exclusively for SR&ED. But if the taxpayer buys a box of 100 pencils and only 30 are used solely for SR&ED, may the taxpayer deduct 30% of the cost of the box of pencils? Is the expenditure a pencil, the box, or the entire stationery expense for the year? Regulation 2900(2)(c) removes the necessity of arguing this point, as it indicates that a portion of an expenditure may be incremental and thus deductible. Determining incrementality is relatively simple when reviewing variable expenditures (i.e., expenses that increase proportionately with the volume of work).

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The concept of incrementality becomes more complicated when dealing with fixed costs. In reality, businesses have very few purely fixed costs; costs are either variable or semi-fixed. A semi-fixed cost is stable for a certain level of production and grows incrementally once production passes a certain level. For example, a business might have only one employee when it starts up, with SR&ED representing 10% of his or her workload. When the employee performs clerical duties, such as paying supplier invoices for the purchase of materials consumed in SR&ED, it might be difficult to prove that the expenditure would have been less if SR&ED had not occurred. As the business grows, it may hire more staff, and the percentage of time spent on SR&ED will likely be influenced by the workload of all the employees, including the 10% SR&ED employee. This means that costs that are generally considered to be fixed (but are actually semi-fixed) may increase incrementally as a result of SR&ED. In a large business, activities related to SR&ED may be distributed among various individuals. The accounts payable clerk, payroll clerk, buyers, and other employees might all process transactions related to SR&ED, but they are generally not limited to processing these transactions only. It would be logical to assume that if SR&ED represents 10% (on average) of the transactions for a team of 10 such people, the team might be reduced to nine if SR&ED did not occur. In this specific scenario, the CRA will allow the salary or wages of one clerk to be treated as incremental (see the SR&ED Overhead and Other Expenditures Policy). It is important to remember that one person often does all the jobs in a startup. Considering all the potential scenarios for building a team of full-time and part-time people to carry out work related to SR&ED, incrementality often boils down to determining a reasonable allocation of expenditures. The available options for hiring part-time staff must also be factored in to determine what constitutes an incremental expenditure. Accordingly, a reasonable approach for determining what constitutes incremental expenditures is to step into the shoes of a manager who prepares two annual budgets: one assuming SR&ED work will be done, and the second assuming it will not. Would the business have accounting, human resources, maintenance, and support departments of the same size or credentials? Taxpayers often spend a considerable amount of time during claim reviews discussing what constitutes an incremental expenditure. If each expenditure element is reviewed in detail to determine what constitutes an incremental expenditure, taxpayers can easily arrive at a different conclusion from that of the authorities (i.e., one that does not reflect the same economic reality). The reality for many businesses is that the total expenditures that would not have been incurred if SR&ED had not occurred often approximates the total expenditures incurred for performing tasks directly linked to SR&ED. This interpretation appears to better reflect the incentive nature of the SR&ED program and recognizes the true cost of SR&ED.

Labour deductible as DRAI expenditure As discussed under Labour (on page 69), labour costs eligible under the traditional method comprise a broader scope of work than those eligible under the proxy method. There are also additional labour-related expenditures (beyond traditional method salaries) that are eligible as DRAI expenditures.

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For example, Guide T4088, Scientific Research and Experimental Development (SR&ED) Expenditures Claim – Guide to Form T661, states that the salary or wages cost of the following work may be deducted as a DRAI expenditure: •

technological staffing carried on by human resources staff; and

•

accounting, maintenance or repairs, purchasing, and other functions carried on by clerical and administrative staff that are not technological and aid the ongoing SR&ED.

Additional items deductible as DRAI expenditures Examples of additional items, listed in Guide T4088 or in the SR&ED Overhead and Other Expenditures Policy, that may be deducted as DRAI expenditures include •

non-taxable benefits paid in respect of eligible salaries and wages,17 such as – employer’s share of Canada and Quebec pension plan contributions, employment insurance premiums, and workers’ compensation payments, – pension plan contributions, and – medical and dental plan contributions;

•

retiring allowances that meet the DRAI criteria outlined in the SR&ED Overhead and Other Expenditures Policy;

•

pre-2014 lease costs that do not meet the all-or-substantially-all threshold;

•

travelling and lodging costs (e.g., to do testing);

•

training costs;

•

supplies;

•

long-distance telephone and internet charges;

•

utilities (e.g., electricity, fuel, oil);

•

property taxes;

•

insurance;

•

health and safety; and

•

contract costs (e.g., electricians, welders, and mechanics), other than SR&ED contracts.

DRAI expenditures – Form T661 The total of all DRAI expenditures is reported on Line 360 in Part 3 of Form T661. As noted under Labour – Form T661 (on page 75), Form T661 does not provide a specific line on which to report traditional salaries, which may cause some confusion, as there appears to be an expectation that taxpayers using the traditional method will extract proxy method salaries that are embedded in their traditional method salaries, reporting them separately on Lines 300 to 309, with the remaining traditional method salaries reported on Line 360.

17 Excluding salaries or wages of clerical and administrative staff providing a service to SR&ED employees. As discussed in the SR&ED Overhead and Other Expenditures Policy, the CRA does not consider the related benefits granted to these employees to be DRAI expenditures. See Directly related to SR&ED (on page 85) for more information.

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Third-party payments Third-party payments (for SR&ED undertaken by third parties) are also eligible SR&ED expenditures. The legislative provisions relating to these payments are not affected by a taxpayer’s choice of the proxy or traditional method.

Eligible payments [§37(1)(a)(i.1), (ii)] — Under subparagraph 37(1)(a)(i.1), taxpayers may deduct certain third-party payments made to a corporation resident in Canada. A deduction may also be available, under subparagraph 37(1)(a)(ii), for third-party payments made to •

an approved association that undertakes SR&ED;

•

an approved university, college, research institute, or other similar institution;

•

a corporation resident in Canada and exempt from tax under paragraph 149(1)(j); or

•

an approved organization that makes payments to an association, institution, or corporation described in any of the above bullets.

Third-party payments under subparagraphs 37(1)(a)(i.1) and (ii) must be for SR&ED performed in Canada that is related to a business of the taxpayer, and the taxpayer must be entitled to exploit the results of that SR&ED. A payment to an approved university may also qualify under subparagraph 37(1)(a)(i.01) as an expenditure for SR&ED performed on behalf of the taxpayer, in which case the payment would not be a third-party payment. See Third-party payments versus expenditures for SR&ED performed on taxpayer’s behalf (on page 92). [§37(1)(a)(iii)] — Under subparagraph 37(1)(a)(iii), eligible third-party payments are payments for basic or applied research that may have applications in other types of businesses unrelated to the business of the taxpayer. Payments for this type of research must be made by the taxpayer to a corporation that is exempt from tax under paragraph 149(1)(j). Such a corporation (referred to as a non-profit SR&ED corporation) must carry on SR&ED that is directly undertaken by or on behalf of the corporation or by payment to another institution. Subparagraph 37(1)(a)(iii) permits the formation of consortiums to perform pre-competitive research that would have applications in more than one type of business. It does not impose the requirement that the taxpayer have the right to exploit the results of the SR&ED. Third-party payments to corporations were separated from other third-party payments (applicable to payments made after 1995) because they are subject to different treatment with respect to prepaid expenses. Under subsection 18(9), third-party payments to corporations for SR&ED that will be carried on after the end of the taxation year cannot be deducted in the year, but thirdparty payments covered under subparagraphs 37(1)(a)(ii) and (iii) may still be deducted, as long as the taxpayer deals at arm’s length with the entity receiving the payment.18

18 See ITA s. 18(9)(d).

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Payments (or portions of them) made for a research chair may also be considered thirdparty payments for SR&ED. Section 7 of the Third-Party Payments Policy discusses the conditions for allowing a portion of a payment as a third-party payment for SR&ED, as well as the industrial contribution to the Natural Sciences and Engineering Research Council industrial research chairs.

Look-through rule [§37(14), (15)] — Given that expenditures of a capital nature, or for the right to use capital property, no longer qualify for SR&ED tax incentives (effective for expenditures made after 2013), subsection 37(14) provides a look-through rule to ensure that expenditures incurred by a taxpayer as third-party payments for SR&ED include only current expenditures. This rule is the same as the rule discussed earlier that applies to subcontracts. Specifically, the taxpayer’s expenditures made to the third-party performer must be reduced by any related expenditure of the third-party performer that is not an expenditure of a current nature and that is made after 2013 (or before 2014 for property that became available for use after 2013). The third-party performer is required under subsection 37(15) to inform the taxpayer in writing of the amount of the reduction no later than 90 days after the end of the calendar year in which the expenditure to be reduced was made. The information must be provided without delay if requested by the taxpayer.

Approved institution The Third-Party Payments Policy (section 11.1) explains what the term approved means and requires: The term “approved” (as used for SR&ED purposes) refers only to the approval, by the Minister of National Revenue, of: •

institutes

•

associations

•

other organizations

The term “approved” does not apply to SR&ED claims or programs. To determine whether an institution or association has been “approved” by the Minister of National Revenue for purposes of section 37 of the Income Tax Act, a claimant should check the list of approved entities in appendix A, or if the name is not indicated there, contact the entity in question.

For purposes of clause 37(1)(a)(ii)(B), all Canadian universities and affiliated colleges are considered to be approved. Approved organizations, for purposes of clause 37(1)(a)(ii)(E), include the Canadian Institutes of Health Research, the Natural Sciences and Engineering Research Council, and the Social Sciences and Humanities Research Council. To apply for approved status, an institution or association should write to the following address:

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Income Tax Rulings Directorate Policy and Legislation Branch Canada Revenue Agency 16th Floor, Tower A Place de Ville 320 Queen Street Ottawa ON K1A 0L5 The Third-Party Payments Policy provides the requirements that an applying entity needs to meet to obtain approval, as well as the documentation that it needs to submit. It should be noted that the confidentiality provisions of the Act prevent the CRA from publicly listing entities that have been granted approved status unless the entities have consented to public identification. So the lists of approved entities provided by the CRA, such as in Appendix A of the Third-Party Payments Policy, are incomplete and may not be up to date.

Meaning of entitled to exploit Whether a taxpayer is entitled to exploit the results of SR&ED is a question of fact that is determined on a case-by-case basis. The guiding principle is that the taxpayer must have gained the right to use the SR&ED results as a direct result of the payments. The ThirdParty Payments Policy provides some examples: If the SR&ED results in a product or patent, then this requirement could be satisfied if the claimant has the right to use a resulting patent (even for a royalty), or where the claimant is entitled to distribute or market any resulting product. If the claimant cannot use the patent or can only obtain the product through normal commercial channels, this requirement would not be satisfied. If the SR&ED does not result in a product or patent, but results in a gain of knowledge (such as by publication of a scientific paper), then one way this requirement could be satisfied is if the claimant has, as a consequence of the payment, been granted a preferential right to use the results of the SR&ED (the knowledge gained) in its business. A preferential right could be access to unpublished results, or early access to results. If results are presented at a conference or published in a journal, this requirement could be met if the sponsor received a prepublication print of the paper. If the results of the SR&ED are in the public domain before the sponsor receives them, then that would not be considered to be a preferential right.

When determining whether there is an entitlement to exploit, the terms and conditions of the contract agreement between the taxpayer and the corporation or institution undertaking the SR&ED should be reviewed.

Third-party payments versus expenditures for SR&ED performed on taxpayer’s behalf The key difference between third-party payments and expenditures for SR&ED performed on a taxpayer’s behalf is the amount of control the payer has over the SR&ED being performed. Third-party payments are contributions to the SR&ED efforts of entities described in subparagraphs 37(1)(a)(i.1), (ii), and (iii), when these efforts are related to the taxpayer’s business and the taxpayer is entitled to exploit the results. On the other hand, SR&ED performed on the taxpayer’s behalf generally means that the subcontractor is performing the SR&ED at the direction and for the benefit of the payer.

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Third-party payments – Form T661 Taxpayers that make third-party payments for SR&ED must complete Form T1263, ThirdParty Payments for Scientific Research and Experimental Development (SR&ED), for each payment and attach it to Form T661. The total of all third-party payments for SR&ED reported on Form(s) T1263 is reported on Line 370 in Part 3 of Form T661. On Form T1263, the taxpayer must briefly explain •

what the payment is for;

•

how the SR&ED is related to a business carried on by the taxpayer; and

•

how the taxpayer is entitled to exploit the results of the SR&ED.

Current expenditures all or substantially all attributable to SR&ED [§37(8)(a)(ii)(A)(I)] — Under the traditional method, a taxpayer may deduct any current expenditure, regardless of type, that is all or substantially all attributable to •

the prosecution of SR&ED in Canada;19 or

•

the provision of premises, facilities, or equipment for prosecuting SR&ED in Canada.

The proxy method provides only for pre-2014 expenditures all or substantially all attributable to the lease of premises, facilities, or equipment for prosecuting SR&ED in Canada, not for the broader category of expenditures all or substantially all attributable to the prosecution of SR&ED. Although the legislation does not define all or substantially all, the SR&ED Capital Expenditures Policy and other SR&ED policies state that the phrase is generally accepted to mean 90% or more. The SR&ED Capital Expenditures Policy also provides an example, using subclause 37(8)(a)(ii)(A)(III) as it applied prior to its repeal, of a situation in which an all-or-substantially-all test is applied to capital expenditures:20 For SR&ED capital property, the [all-or-substantially-all] test will be met where it is determined that, the property’s anticipated use for other purposes during its operating time in its expected useful life does not exceed 10%, or if it is intended that not less than 90% of the value of the property is to be consumed in the prosecution of SR&ED carried on in Canada.

The all-or-substantially-all test applies to many income tax provisions. In some court cases, taxpayers have been able to satisfy the test at thresholds lower than 90% (e.g., at 80%), but these cases did not relate to SR&ED.21 It should be noted that under paragraph 37(8)(d), expenditures of a current nature exclude expenditures for the acquisition of capital property of the taxpayer, effective for expenditures made after 2013 or deemed not to have been made before 2014 because

19 See SR&ED performed in Canada (on page 103) for an expanded definition of Canada for SR&ED purposes. 20 ITA s. 37(8)(a)(ii)(A)(III) [repealed] is discussed under Capital expenditures (on page 94). 21 See, for example, Watts v. The Queen, 2004 TCC 535. See also the Tax Court’s discussion on the elasticity of the 90% threshold in VLN Advanced Technologies Inc. v The Queen, 2018 TCC 33.

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the property had not yet become available for use. Similarly excluded are expenditures for the use of, or the right to use, property that would be capital property of the taxpayer if it were owned by the taxpayer.

Capital expenditures [§37(1)(b) repealed] — Expenditures of a capital nature made after 2013 cannot be claimed as eligible SR&ED expenditures. However, pre-2014 expenditures of a capital nature may generally be claimed under both the traditional and proxy methods, as further explained below. [§37(8)(a)(ii)(A)(III) repealed] — Under subclause 37(8)(a)(ii)(A)(III) (as it applied prior to its repeal), a taxpayer using the traditional method may claim a pre-2014 capital expenditure for SR&ED if, at the time it was incurred, the expenditure was made for the provision of premises, facilities, or property and it was intended that •

it would be used during all or substantially all its operating time in its expected useful life for the prosecution of SR&ED in Canada; or

•

all or substantially all its value would be consumed in the prosecution of SR&ED in Canada.

[§37(8)(a)(ii)(B)(III) repealed] — For taxpayers using the proxy method, subclause 37(8)(a)(ii)(B)(III) (as it applied prior to its repeal) indicates that a pre-2014 capital expenditure may be claimed for SR&ED if it •

is an expenditure described in (pre-repeal) subclause 37(8)(a)(ii)(A)(III); and

•

is not general-purpose office equipment or furniture.

The intended use of the property in the year it was acquired and became available for use and its subsequent actual usage will provide evidence that the SR&ED intent test is met. See Demonstrating intent (on page 95). If depreciable property does not meet the all-or-substantially-all test, the property will be treated as any other capital asset and should be reported under the appropriate capital cost class. However, for investment tax credit purposes, the asset may qualify as shared-use equipment as defined in subsection 127(9). See Shared-use equipment (on page 117). The deduction under both traditional and proxy methods is no longer available, effective for expenditures made after 2013 and expenditures deemed not to have been made before 2014 because the property had not yet become available for use.

Cost of capital asset The effect of government and non-government assistance and federal investment tax credits on the cost of capital assets is reviewed under SR&ED expenditure pool (on page 101).

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Timing of capital expenditure [§37(1.2)] — Under subsection 37(1.2), a pre-2014 capital expenditure for SR&ED is deemed not to have been made until the property is considered to be available for use by the taxpayer, as determined under subsections 13(26) to (32).

Used assets Many taxpayers believe that pre-2014 used capital assets cannot be deducted as eligible SR&ED expenditures. However, the provisions in section 37 do not exclude used assets. For a discussion on the exclusion of used capital assets as qualified expenditures for purposes of the investment tax credit, see Used depreciable property (on page 122).

Buildings [§37(8)(d),22 Reg. 2903 repealed] — Under former paragraph 37(8)(d), pre-2014 expenditures in respect of buildings and leasehold interests in buildings are generally not eligible SR&ED expenditures. However, there is an exception for special-purpose buildings, as defined in (pre-repeal) Regulation 2903: 2903. For the purposes of…paragraph 37(8)(d) of the Act, a special-purpose building is a building the working areas of which are designed and constructed to have a displacement in any direction of not more than .02 micrometre and to have, per .028 cubic metre of interior airspace, (a) not more than 350 airborne particles of a size less than or equal to .1 micrometre in diameter and no airborne particles of a size greater than .1 micrometre in diameter, (b) not more than 75 airborne particles of a size less than or equal to .2 micrometre in diameter and no airborne particles of a size greater than .2 micrometre in diameter, (c) not more than 30 airborne particles of a size less than or equal to .3 micrometre in diameter and no airborne particles of a size greater than .3 micrometre in diameter, or (d) not more than 10 airborne particles of a size less than or equal to .5 micrometre in diameter and no airborne particles of a size greater than .5 micrometre in diameter.

A building meeting this description is generally referred to as a clean room. Obviously, the specifications of this description are very stringent. It is our understanding that there are very few buildings in Canada that would qualify, although the possibility should not be discarded outright.

Demonstrating intent The SR&ED Capital Expenditures Policy provides the CRA’s view on establishing intent. The factors the CRA recommends taxpayers use in determining intent are summarized below. This summary is not exhaustive, and it is important to reiterate that intent can be determined only by examining all the relevant facts on a case-by-case basis.

22 ITA s. 37(8)(d) as it formerly applied.

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Reason for purchase To determine intent, it is necessary to look at all the reasons for the purchase at the time the property was acquired. This is obviously the key factor. The remaining factors may be useful in determining intent when it cannot be categorically demonstrated by reviewing the reason for the purchase.

Potential use of property It may be helpful to consider the potential use of the property. Where the property has a potential commercial use, the taxpayer should consider whether there was an intention to use the asset for that commercial purpose and how much commercial use was intended. In most cases, the intent test is not met where property is acquired with the intent of using it for both SR&ED and commercial purposes. To establish whether a property could have a potential commercial use, the taxpayer should determine if it uses similar property for commercial use in its business.

Actual use of property In most cases, the actual use of property should substantiate intent. However, actual use is not conclusive evidence of intent. It is possible for the intent test to be met even where a property was acquired with the intent of being used all or substantially all in SR&ED but was later sold or used for other activities. The taxpayer will have to be able to support its contention that the intent test was met. The investment tax credit recapture rules may apply to capital expenditures if the property was subsequently sold or converted to commercial use. See Recapture of ITC (on page 147). If the intent test is not met at the time of acquisition but the property was destroyed or rendered valueless during the prosecution of SR&ED, the property would still not be considered an eligible SR&ED capital expenditure. In such a case, the property may qualify as shared-use equipment for investment tax credit purposes. See Shared-use equipment (on page 117).

Development of a commercial asset or custom product Where the SR&ED involves the construction of a custom product or commercial asset, it is necessary to determine whether the property acquired is an integral part of the end product or is used to perform SR&ED. Where it is intended that the property will be part of the end product, the intent test will generally not be met and thus the expenditure to acquire the property will generally not be allowed for SR&ED purposes. Where the development of the custom product or commercial asset requires SR&ED, the taxpayer may have a position for deducting some of the costs of developing the end product under the various cost categories (labour, material consumed or transformed, etc.), as discussed earlier in this chapter.

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SR&ED environment Generally, the intent test is met where property is acquired for use by a dedicated SR&ED corporation or is used in a dedicated SR&ED facility. Note that neither the legislation nor the CRA provides a definition of dedicated SR&ED facility; as a result, it may be more difficult to support the intent test in these circumstances.

Length of SR&ED project In determining whether the intent test has been met, the length of a research project should be compared with the expected useful life of the property. Where the length of the project is less than the expected useful life of the capital property, it may indicate the intent test was not met. On the other hand, if the taxpayer intends to use the asset in subsequent SR&ED projects, this intent helps demonstrate that the test was met. Where it is intended that all or substantially all the value of the property will be consumed in the prosecution of SR&ED because of changing technologies or obsolescence, or because the property will be destroyed in the SR&ED process, the length of the SR&ED project may be irrelevant in determining intent.

Taxpayer’s past practices If a taxpayer acquired and claimed similar property in prior years, the taxpayer may have already analyzed the relevant facts in determining intent.

Planning documents Planning documents that describe the planned use of capital property before the property was acquired or at the time the property was acquired should demonstrate intent. Examples of planning documents are a request for funding for an SR&ED project, a project plan, and a business case report.

Rights to SR&ED [§37(4), Reg. 2902] — Under subsection 37(4), no SR&ED deduction is allowed for an expenditure made to acquire rights in, or arising out of, SR&ED. Also, under Regulation 2902, no investment tax credits are allowed for these expenditures. These provisions are in place so that the same work is not subject to the incentives more than once. The acquisition of a right to use software (which may derive from SR&ED on the part of its developer) is generally not considered a right to SR&ED, particularly if the software is used as a tool in performing SR&ED.

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Expenditures deductible under more than one provision As noted under the various categories of eligible SR&ED expenditures discussed in this part of the chapter, certain expenditures may be deductible under more than one provision of the Act. However, a particular expenditure may be deducted only once.23 For example, in Consoltex Inc. v. The Queen,24 the Tax Court reviewed the various provisions that allowed the taxpayer to claim yarn as a raw material used in experimentation in a commercial setting (because the finished product — the fabric — had been sold). At the time, Regulation 2900(2)(a) allowed only materials consumed to be claimed for the taxation year in question.25 The court indicated that the expenditure for the materials might qualify as an expenditure incurred all or substantially all for the prosecution of SR&ED (under clause 37(7)(c)(ii)(A)26 at the time), and further stated that it would put a strained interpretation on the word “consumed” to say that the yarn that is turned into product that is sold was “consumed”. It is precisely because it was not consumed, but was sold, that the matter is before the court. The yarn is a material that is not consumed within the meaning of paragraph 2900(2)(a). Does this exclude it from paragraph 2900(2)(c), on the theory that paragraph (a) deals with materials and if the cost of materials is to be treated as an SR&ED expenditure it must fall within paragraph (a)? Such a conclusion…has no basis as a matter of statutory construction. The cost of yarn is directly related to the prosecution of SR&ED and would not have been incurred if such prosecution had not occurred. Therefore…the cost of yarn used in the SR&ED falls within both clause 37(7)(c)(ii)(A) of the Act and paragraph 2900(2)(c) of the Regulations.

It is thus necessary to understand the nature of the SR&ED and related expenditures and to specify the provision (or provisions) of section 37 that may entitle a taxpayer to a deduction. For example, under the traditional method, a labour expenditure for an employee devoting all or substantially all of his or her time to SR&ED could be deductible under •

subclause 37(8)(a)(ii)(A)(I), as a current expenditure all or substantially all attributable to SR&ED; or

•

subclause 37(8)(a)(ii)(A)(II) and Regulation 2900(2)(b), as salary of an employee who directly undertakes, supervises, or supports SR&ED.

Proxy and traditional methods – Summary and comparison The following table provides a simplified comparison of the eligible SR&ED expenditures discussed in the previous sections.

23 See ITA s. 248(28). 24 Consoltex Inc. v. The Queen, 97 DTC 724 (TCC). 25 Reg. 2900(2)(a) has since been amended to allow the costs, incurred after February 23, 1998, of materials consumed or transformed. 26 Now under ITA s. 37(8)(a)(ii)(A).

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Expenditures deductible under traditional and proxy methods Traditional method Proxy method Legislative Legislative Expenditure provisions Specifications provisions Specifications Labour

ITA s. Undertake, 37(8)(a)(ii)(A)(II) supervise, and Reg. 2900(2)(b) support

ITA s. 37(8)(a)(ii)(B)(IV)

Directly engaged

Materials

ITA s. Consumed or 37(8)(a)(ii)(A)(II) transformed Reg. 2900(2)(a)

ITA s. 37(8)(a)(ii)(B)(V)

Consumed or transformed

Subcontracts1

Not specifically mentioned2

ITA s. 37(8)(a)(ii)(B)(II)

For SR&ED performed on behalf of taxpayer

Pre-2014 current expenditure for lease of premises or equipment

Not specifically mentioned3

ITA s. 37(8)(a)(ii)(B)(I) [repealed]4 ITA s. 37(8)(a)(ii)(B)(VI) [repealed]

All or substantially all

n/a

Other current expenditures directly attributable to SR&ED

Directly related ITA s. 37(8)(a)(ii)(A)(II) and incremental Regs. 2900(2) and (3)

n/a

Third-party payments5

ITA ss. 37(1)(a)(i.1)–(iii)

ITA ss. 37(1)(a)(i.1)–(iii)

ITA s. Current expenditures all 37(8)(a)(ii)(A)(I) or substantially all attributable to SR&ED Pre-2014 capital expenditures intended to be used all or substantially all in SR&ED 1 2 3 4 5

Any current expenditure

ITA s. 37(8)(a)(ii)(A)(III) [repealed]

n/a

50%

n/a

ITA s. 37(8)(a)(ii)(B)(III) [repealed]

Reduced by any related expenditure of the performer that is not an expenditure of a current nature. These expenditures may be claimed as current expenditures that are all or substantially all attributable to SR&ED or as other expenditures directly attributable to SR&ED. These expenditures may be claimed as current expenditures that are all or substantially all attributable to SR&ED or as other expenditures directly attributable to SR&ED. Other than general-purpose office equipment and furniture. Reduced by any related expenditure of the third-party performer that is not an expenditure of a current nature.

As mentioned under Proxy and traditional methods – Overview (on page 68), too many taxpayers choose the proxy method (because they believe it is simpler) without having a sufficient understanding of both methods. For example, the difference between salaries

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for employees who are directly engaged in performing SR&ED (directly engaged salaries, claimed under the proxy method) and salaries for employees who undertake, supervise, or support SR&ED (traditional salaries, claimed under the traditional method) is commonly misunderstood. Because the phrase directly undertakes, supervises, or supports is broader than directly engaged in, traditional salaries cover a wider range of activities and expenses than directly engaged salaries. The gap between traditional method salaries and proxy method salaries can vary significantly from one taxpayer to another, and the size of the gap may be influenced by factors such as •

the industry;

•

the inner workings of the business and the management of the project; and

•

the nature of the project (e.g., does the project require greater support than other projects?).

A taxpayer that fails to properly recognize proxy method or traditional method salaries may significantly underestimate SR&ED expenditures (which will also result in lost investment tax credits) or overestimate the expenditures (potentially resulting in a difficult CRA review).

Accounting versus tax – Direct and indirect salaries Perhaps the most significant cause of lengthy claim reviews is the failure to make a distinction between categories of expenditures for accounting versus tax purposes. For example, labour expenditures are categorized in one way for accounting purposes but may need to be categorized in a different way to determine which labour expenditures are deductible under section 37 as eligible SR&ED expenditures. Taxpayers that do not track labour costs using a project-based accounting system tend to correctly allocate salaries for the prosecution of SR&ED to employees directly engaged in the prosecution (if they elect to use the proxy method) or to employees who directly undertake, supervise, or support the prosecution (if they choose the traditional method). On the other hand, taxpayers that do track labour costs using a project-based accounting system may encounter problems when trying to correctly allocate salaries for tax purposes. For example, for businesses that track project costs using a timesheet system, the time worked by “direct employees” is charged to either the project (direct labour) or overhead accounts according to the tasks undertaken. “Indirect employees” charge their time to overhead accounts or do not prepare timesheets (in which case, accounting systems generally record their time in overhead accounts). The following problems may arise when these types of accounting classifications are used for tax purposes.

Direct labour for accounting purposes Direct labour, as defined for accounting purposes, cannot necessarily be equated with work of an employee directly engaged in the prosecution of SR&ED (for tax purposes).

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For accounting purposes, management has a lot of latitude with respect to which tasks are considered to be direct. Contract administrators assigned a contract portfolio might charge their time directly to the contracts’ project codes for technical and non-technical input. In certain businesses, even the administrative support staff assigned to a specific project charge their time to the project. Where a taxpayer elects to use the proxy method, direct labour expenditures for accounting purposes must be reviewed to ensure that all labour expenditures deducted meet the test for this method (employees directly engaged in SR&ED). A similar review is required where a taxpayer chooses the traditional method, although the scope of the eligible labour under this method is much broader, and direct labour expenditures for accounting purposes should logically be allowed as salaries of employees who directly undertake, supervise, or support SR&ED (assuming all work under the project meets the definition of SR&ED). Nevertheless, to comply with the expenditure categories on Form T661, it appears that the taxpayer must analyze the time charged to a project to separately report the salaries of employees directly engaged in SR&ED. See Labour – Form T661 (on page 75).

Indirect labour for accounting purposes Taxpayers using a project-based accounting system must also review the indirect labour accounts to identify any eligible SR&ED expenditures. Taxpayers choosing the traditional method generally do complete this step, but it is often overlooked by taxpayers that elect the proxy method (which may lead to a significant loss of investment tax credits). For instance, it is generally recognized that first-line supervisors often qualify as employees directly engaged in SR&ED. These supervisors may not charge their time directly to projects. As a result, other methods must be used to determine the eligible salaries (see section 13 of the CRA’s SR&ED Salary or Wages Policy). Work performed by departments considered to be “indirect departments” by certain businesses (i.e., departments where none of the employees charges his or her time directly to the project) is often omitted on SR&ED claims. The following are some common examples: •

certain scientific work undertaken by the purchasing department, particularly if the department includes engineers conducting research on issues related to component equivalencies;

•

the testing of materials to be consumed or transformed in SR&ED that often falls under the responsibility of the quality assurance department; and

•

the calibration of research equipment often carried out by the quality assurance department.

SR&ED expenditure pool This part of the chapter discusses the calculation of the SR&ED expenditure pool (including a review of its major components) and the deduction of SR&ED expenditures from income.

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The SR&ED expenditure pool is computed in Section C of Part 3 of Form T661, Scientific Research and Experimental Development (SR&ED) Expenditures Claim. First, the total eligible SR&ED expenditures (from Section B of Part 3) are reported on Line 420. This amount is then reduced by government and non-government assistance (Lines 429 to 432) and investment tax credits claimed in the previous taxation year (Line 435). Other adjustments are made to reflect changes to the pool for the current taxation year (including adjustments related to the sale of SR&ED capital assets and the recapture of tax credits in the previous taxation year). The opening balance of the SR&ED expenditure pool at the beginning of the taxation year (Line 450) is added to the changes to the pool for the current taxation year to arrive at the amount available for deduction for the current taxation year (Line 455). Although the structure of the form does not follow the structure of subsection 37(1), it provides the same result. Subsection 37(1) is structured to provide for a pool of SR&ED expenditures that accumulates over time and that is recomputed taking into consideration all relevant transactions and adjustments over the years. For example, paragraph 37(1)(a) provides for the accumulation of all current expenditures for taxation years ending after 1973, and paragraph 37(1)(b) (as it applied prior to its repeal) provides for the accumulation of all capital expenditures made before 2014 for taxation years ending after 1958. A taxpayer’s expenditure pool under subsection 37(1) is made up of the following components. Additions to the pool: •

[§37(1)(a)] — current expenditures incurred on SR&ED carried out in Canada in taxation years ending after 1973;

•

[§37(1)(b) repealed] — capital expenditures made before 2014 incurred on SR&ED carried out in Canada in taxation years ending after 1958;

•

[§37(1)(c)] — repayments of government and non-government assistance that had previously reduced the pool;

•

[§37(1)(c.1)] — amounts included in a taxpayer’s income in previous taxation years under paragraph 12(1)(v) (resulting from a negative balance in the SR&ED expenditure pool at the end of a taxation year); and

•

[§37(1)(c.2), (c.3)] — the amount of investment tax credits recaptured in preceding taxation years.

Reductions to the pool: •

[§37(1)(d)] — government or non-government assistance;

•

[§37(1)(d.1)] — superallowance benefit amount;27

•

[§37(1)(e)] — SR&ED investment tax credit claimed in previous taxation years;

•

[§37(1)(f)] — amounts deducted from income under subsection 37(1) in preceding taxation years; and

•

[§37(1)(f.1)] — certain amounts that may apply to corporations that were subject to an income inclusion for debt forgiveness and claimed a deduction under section 61.3.

27 See Superallowance (on page 145).

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Adjustments in special circumstances: •

[§37(1)(g)] — certain amounts relating to Part VIII tax (from the scientific research tax credit program, which no longer exists); and

•

[§37(1)(h)] — the SR&ED expenditure pool prior to a loss restriction event.28

Some of these components are reviewed in more detail below.

Previous year’s balance – Line 450 of Form T661 As mentioned above, the way in which expenditures are reported on the lines of Form T661 differs from the way the components are described in the legislation. Unlike subsection 37(1), Form T661 keeps components from the current taxation year separate from those of previous years. The net result of all components of the SR&ED expenditure pool up to the start of the current taxation year is reported on Line 450 as the opening balance.

Current expenditures [§37(1)(a)] — As mentioned in the introduction to this section, current expenditures incurred after 1973 are accumulated in the SR&ED expenditure pool. [§37(1)(a)(i)] — Current expenditures on SR&ED that is directly undertaken by a taxpayer are added to the pool, provided the expenditures are for SR&ED performed in Canada and are related to the business of the taxpayer. These expenditures are described in detail under Eligible SR&ED expenditures (on page 68). [§37(1)(a)(i.01)] — Current expenditures on SR&ED that is directly undertaken on behalf of a taxpayer are also added to the pool, provided the expenditures are for SR&ED performed in Canada and are related to the business of the taxpayer. These expenditures are discussed under Subcontracts – SR&ED performed on behalf of the taxpayer (on page 81). [§37(1)(a)(i.1)–(iii)] — Third-party payments are also included in the pool. For a detailed discussion, see Third-party payments (on page 90).

SR&ED performed in Canada To be eligible under subsection 37(1), current expenditures must be for SR&ED performed in Canada. [§255] — Canada is defined in section 255: 255. For the purposes of this Act, “Canada” is hereby declared to include and to have always included (a) the sea bed and subsoil of the submarine areas adjacent to the coasts of Canada in respect of which the Government of Canada or of a province grants a right, licence or privilege to explore for, drill for or take any minerals, petroleum, natural gas or any related hydrocarbons; and

28 See Loss restriction event (on page 165).

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(b) the seas and airspace above the submarine areas referred to in paragraph (a) in respect of any activities carried on in connection with the exploration for or exploitation of the minerals, petroleum, natural gas or hydrocarbons referred to in that paragraph.

[§37(1.3)] — SR&ED expenditures incurred by a taxpayer in the exclusive economic zone of Canada (as identified by the Oceans Act) in the course of a business otherwise carried on in Canada by the taxpayer are considered to have been incurred by the taxpayer in Canada. Thus, the geographical area of Canada is extended for SR&ED purposes. [§37(1.4), (1.5)] — Expenditures incurred after February 25, 2008, for salaries and wages paid to Canadian residents for SR&ED performed outside Canada are deemed to be made in respect of SR&ED carried on in Canada, as long as the work is directly undertaken by the taxpayer, related to a business of the taxpayer, and solely in support of SR&ED carried on by the taxpayer in Canada. The amount that may be added to the SR&ED expenditure pool (and that will earn investment tax credits) is limited to 10% of the total of all expenditures made for the salaries and wages paid in respect of SR&ED that is related to a business of the taxpayer and carried on in Canada by the taxpayer during the taxation year, prorated to reflect the number of days in the taxation year after February 25, 2008. Although subsection 37(1.5) refers to salaries and wages paid for purposes of calculating the limit, the SR&ED Salary or Wages Policy states that the CRA uses expenditures incurred, in the same way that eligible SR&ED expenditures are determined. Permissible salaries and wages exclude salaries or wages subject to an income or profits tax imposed by a foreign country because of the employee’s presence or activity in that country. In addition, although the 2008 federal budget documents proposed to exclude from the permissible salaries and wages remuneration based on profit and bonuses, this proposal was not reflected in the implementing legislation or in any subsequent amendment to the Act. Finally, even if the calculation of the limit takes place outside subsection 37(8), it nevertheless applies to taxpayers using either the proxy or traditional method. It should be noted that taxpayers that have elected to use the proxy method would use the salary or wages of employees directly engaged in SR&ED, whereas taxpayers using the traditional method would use the salary or wages of employees who directly undertake, supervise, or support SR&ED. The SR&ED Salary or Wages Policy specifically excludes any DRAI salaries or wages from the calculation for taxpayers using the traditional method.

SR&ED performed outside Canada [§37(2)] — A taxpayer may deduct from income current expenditures for •

SR&ED that is carried on outside Canada, directly undertaken by or on behalf of the taxpayer, and related to the business of the taxpayer; or

•

payments to approved associations, universities, colleges, research institutions, or other similar institutions to be used for SR&ED carried on outside Canada, as long as the SR&ED is related to the taxpayer’s business and the taxpayer is entitled to exploit the results.

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However, except for salaries and wages deemed, under subsections 37(1.4) and (1.5), to be made in respect of SR&ED carried on in Canada (see SR&ED performed in Canada (on page 103)), these expenditures are not added to the SR&ED expenditure pool, and they do not earn investment tax credits. The expenditures must be deducted in the year incurred.

Exceptions In addition to the salaries and wages described in subsections 37(1.4) and (1.5), the CRA does allow, in practice, certain expenditures incurred outside Canada to be included in the SR&ED expenditure pool. For example, the following expenditures, including foreign travel expenditures, can be included in the pool, provided they are DRAI expenditures for SR&ED in Canada: •

expenditures for training hands-on employees in respect of SR&ED carried out in Canada; and

•

expenditures for visits to foreign customers in respect of SR&ED carried out in Canada to update the customer on the SR&ED project status.

These expenditures are included only for taxpayers using the traditional method. Section 6.2 of the SR&ED Overhead and Other Expenditures Policy discusses these rules in some detail.

Case law In The Queen v. Tigney Technology Incorporated,29 the issue on appeal from the Tax Court of Canada was whether the respondent (taxpayer) was entitled to investment tax credits for SR&ED expenditures associated with work done outside Canada. The disputed expenditures were the direct costs of data collection and allocable overhead for experiments conducted in Kentucky. The Tax Court accepted, as a matter of fact, that it was necessary to conduct the experiments in Kentucky. The court held that the amounts connected with the work in Kentucky were eligible SR&ED expenditures under subparagraph 37(1)(a)(i) — and therefore were qualified expenditures — because “the portion of the research which did not physically take place in Canada was an isolated and relatively small part of the systemic investigation which was on-going in Canada.” However, the Federal Court of Appeal reversed this decision. According to the appeal court, the language of paragraph 37(1)(a) could not support the Tax Court’s interpretation because [t]he words “aggregate of all amounts each of which is an expenditure of a current nature” in paragraph 37(1)(a) in relation to the words “on scientific research and experimental development carried on in Canada” as used in subparagraph 37(1)(a)(i) are clear. In cases where part of [an] SR&ED project is carried on inside Canada and another part is carried on outside Canada only those expenditures made in respect of the SR&ED inside Canada will be eligible for the refundable investment tax credit.

29 The Queen v. Tigney Technology Incorporated, 2000 DTC 6112 (FCA); rev’g. 97 DTC 414 (TCC).

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Similar reasons were given by the Federal Court of Appeal in LGL Ltd. v. The Queen,30 which was heard in tandem with the Tigney case. In LGL, the appellant had carried on four separate SR&ED projects relating to the environmental effects of offshore oil and gas development on whales, birds, and fish. Although the four projects were designed, managed, and based in Canada, observations had been made and data collected in Alaska. The data was then brought back to the appellant’s premises in Canada and analyzed. The Tax Court did not consider the direct cost of the data collection and allocable overhead for the work done outside Canada to be an eligible SR&ED expenditure within the meaning of subparagraph 37(1)(a)(i). The Federal Court of Appeal agreed that expenditures for SR&ED carried on outside Canada were not contemplated by subparagraph 37(1)(a)(i) and, therefore, were not qualified expenditures. The court dismissed the appeal, noting that the words “all amounts” in paragraph 37(1)(a) suggest that “the focus of the provision is on individual SR&ED expenditures, not on the project as a monolithic whole.” In the court’s view, the words “carried on in Canada” must be read in the context of subsection 37(1), which clearly contemplates the assessment of individual expenditures.

Property acquired outside Canada Property acquired outside Canada but used for SR&ED performed in Canada may be eligible for deduction. For example, materials purchased outside Canada that are either consumed or transformed in the prosecution of SR&ED in Canada would be eligible.

Related to the business For a taxpayer to deduct an expenditure, the SR&ED performed must be related to the business of the taxpayer. This determination depends on the facts of each particular case. [§37(8)(b), (c)] — For SR&ED to be related to a business carried on by a taxpayer, the taxpayer must demonstrate that there is an interconnection or link between the SR&ED and the taxpayer’s business. SR&ED that may lead to or facilitate an extension of a business is considered to be related to that business. On the other hand, carrying out SR&ED, in and by itself, is not considered to be related to the business of a taxpayer unless all or substantially all of the taxpayer’s revenue is derived from carrying on SR&ED.31 For more information on this topic, see Related to the business of the claimant (on page 28) in Chapter 2, Tax benefits of SR&ED.

30 LGL Ltd. v. The Queen, 2000 DTC 6108 (FCA); aff’g. 99 DTC 675 (TCC). 31 See PSC Elstow Research Farm Inc. v. The Queen, 2008 TCC 694, for an example of the application of this provision.

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Current expenditures – Form T661 Current expenditures for the current taxation year are reported on Lines 300 to 360 and on Line 370 (for third-party payments) of Form T661. Any adjustments to prior-year amounts are reflected in the previous year’s ending balance on Line 450. See Eligible SR&ED expenditures (on page 68) for more details on reporting the various categories of current expenditures.

Capital expenditures Under paragraph 37(1)(b) (as it applied prior to its repeal), a taxpayer may deduct the lesser of •

[§37(1)(b)(i) repealed] — the total pre-2014 capital expenditures made by the taxpayer in the year, or in a preceding taxation year ending after 1958, on SR&ED that is carried on in Canada, is directly undertaken by or on behalf of the taxpayer, and is related to a business of the taxpayer, where the capital expenditures were made to acquire property (other than land or a leasehold interest in land) that would be depreciable property of the taxpayer if section 37 did not apply; and

•

[§37(1)(b)(ii) repealed] — the undepreciated capital cost to the taxpayer of the acquired property at the end of the taxation year (before making any deduction under this paragraph in computing the taxpayer’s income for the taxation year).

The undepreciated capital cost (UCC)32 is another pool that is recalculated on a cumulative basis, taking into consideration transactions and adjustments covering all taxation years leading up to the time of calculation. Capital expenditures are no longer added to the SR&ED expenditure pool, effective for expenditures that are made after 2013 or are made before 2014 for property that became available for use after 2013.

Capital expenditure amount deemed to be capital cost allowance [§37(6)] — A depreciable property deducted as an SR&ED capital expenditure is deemed to be an asset of a separate class whose entire amount was allowed as capital cost allowance (CCA).

Investment tax credit reduces capital cost [§13(7.1)(e)] — Investment tax credits claimed before the current taxation year in respect of a depreciable property reduce the capital cost of that property as computed for the current taxation year.

Computing the amount of a capital expenditure The following example illustrates the computation of pre-2014 capital expenditures under (pre-repeal) paragraph 37(1)(b).

32 ITA s. 13(21) “undepreciated capital cost.”

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Example Facts and assumptions: In 2012, Company A acquired a capital asset for $1,000, intending to use all or substantially all its value in the prosecution of SR&ED.33 The company deducted the entire amount of the SR&ED expenditure pool, earned a 20% investment tax credit,34 and used all the investment tax credits available to offset taxes otherwise payable in the year.35 Tax consequences and analysis: The deduction allowed in 2012 was the lesser of •

the amount under (pre-repeal) subparagraph 37(1)(b)(i) ($1,000); and

•

the UCC, under (pre-repeal) subparagraph 37(1)(b)(ii) ($1,000).

Therefore, the amount deducted (added to the SR&ED expenditure pool) was $1,000, and the investment tax credit claimed was $200 ($1,000 x 20%). The SR&ED expenditure pool must be recalculated every year, on a cumulative basis. Therefore, in 2013, the SR&ED expenditure pool includes an amount equal to the lesser of •

the amount under (pre-repeal) subparagraph 37(1)(b)(i), which is – the original $1,000, less – the $200 investment tax credit claimed; and

•

the UCC, under (pre-repeal) subparagraph 37(1)(b)(ii), which is – the capital cost (now $800),36 less – the CCA allowed ($1,000).37

Therefore, the amount allowed (included in the SR&ED expenditure pool at the end of 2013) is the lesser of $800 and nil.38 Because the amount of the capital expenditure computed in the SR&ED expenditure pool at the end of 2012 was $1,000, the expenditure pool will decrease by $200 for 2013.39

33 See Capital expenditures (on page 94) for more details on the requirements that must be met for a capital expenditure to be eligible. 34 As was then available. For taxation years ending after 2013, the base investment tax credit rate has been reduced from 20% to 15%. 35 See Investment tax credits (on page 139) for more information on how these credits are calculated. 36 See variable A in the formula in ITA s. 13(21) “undepreciated capital cost.” 37 See variable E in the formula in ITA s. 13(21) “undepreciated capital cost.” 38 UCC is calculated using an algebraic formula. ITA s. 257 deems the negative result of an algebraic formula to be nil unless specifically stated otherwise. 39 This $200 otherwise negative UCC will be included in Company A’s 2013 income as recaptured CCA under ITA s. 13(1). However, if Company A acquires additional capital expenditures in 2013, this otherwise negative UCC would be absorbed by the new investment in capital expenditures, rather than coming into income via the CCA recapture rules.

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Sale of SR&ED capital assets Guide T4088, Scientific Research and Experimental Development (SR&ED) Expenditures Claim – Guide to Form T661, provides the following instructions on reporting the sale of SR&ED and other assets on Line 440 of Form T661: If, during the tax year, you sold a capital asset for which you had previously claimed an SR&ED expenditure, and the amount on line 450 includes undeducted expenditures for the asset sold, enter on line 440 the lesser of: (a) the proceeds of disposition; and (b) the amount of unclaimed expenditures included on line 450 for the asset.

The SR&ED Capital Expenditures Policy adds: If the sale proceeds are more than the unclaimed balance of SR&ED expenditures for the capital property, the difference is generally included in income up to the amount of recapture of CCA (the claimed deduction for the SR&ED capital property). If the sale proceeds are more than the original cost of the capital property, the excess is either a capital gain or income, depending on the facts of each case.

The proceeds of disposition reduce the UCC of a depreciable property, up to the original capital cost.40 Example Facts and assumptions: In 2016, Company A (from the example under Computing the amount of a capital expenditure (on page 107)) sells the asset for $100. The company deducted the entire amount of the SR&ED pool against income prior to 2016. Tax consequences and analysis: The application of subsection 37(6) results in a UCC of nil at the end of 2012 (and 2013), as the amount of the deduction of the capital expenditure is deemed to be CCA allowed for that asset. Subsection 13(1) requires recaptured depreciation (CCA) to be taken into income.41 Because the UCC is nil,42 the proceeds of $100 on the sale of the asset equal the amount of recaptured CCA. In this case, the proceeds would be reported on Schedule 1, Net Income (Loss) for Income Tax Purposes, of the T2 corporate return as recaptured depreciation. If Company A had not deducted the capital expenditure, the UCC would have been $800 prior to the disposition ($1,000 original cost less $200 investment tax credit), and the proceeds of $100 on the sale of the asset would have reduced the UCC to $700.43 In this case, the proceeds would be reported as a reduction of the SR&ED expenditure pool on Line 440 of Form T661.

40 See variable F in the formula in ITA s. 13(21) “undepreciated capital cost.” 41 The recapture is defined as the amount by which variables E to K exceed variables A to D.1 of the formula in ITA s. 13(21) “undepreciated capital cost.” 42 Although the UCC after the disposition would have been negative, ITA s. 257 deems it to be nil. 43 See variable F in the formula in ITA s. 13(21) “undepreciated capital cost.”

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Amounts deducted in preceding taxation years [§37(1)(f)] — Because the expenditures in the pool accumulate over many taxation years, to reflect the remaining balance available for deduction, the taxpayer must reduce the pool by the amount of SR&ED deductions that reduced taxable income in all previous taxation years.

Negative SR&ED expenditure pools taken into income [§12(1)(v), §37(1)(c.1)] — A negative SR&ED expenditure pool must be taken into income under paragraph 12(1)(v). For the same reason that amounts deducted from income under subsection 37(1) reduce the SR&ED expenditure pool, any amount previously taken into income under paragraph 12(1)(v) is added back to the pool. When a negative balance is taken back into income, the closing balance on Line 470 of Form T661 is zero, and the carryforward balance on Line 450 in the following taxation year will also be zero.

Amount available for deduction in current taxation year [§37(1)] — A taxpayer may deduct all or any portion of the balance remaining in the SR&ED expenditure pool at the end of a taxation year. This deduction is optional. Any portion not deducted remains available in the pool for deduction in subsequent taxation years. [§37(5)] — Where an amount in respect of SR&ED is potentially deductible under either section 37 or section 110.1 or 118.1 (as a gift), the amount cannot be deducted from taxable income under section 110.1 or claimed as a tax credit under section 118.1. Thus, the deduction is available only under section 37.

ITCs claimed in prior years [§37(1)(e)] — A taxpayer’s SR&ED expenditure pool must be reduced by the amount of investment tax credits (ITCs) claimed in prior years that can reasonably be attributed to •

a prescribed proxy amount for a preceding taxation year;

•

a current expenditure that was incurred in a preceding taxation year and was a qualified expenditure in that year; or

•

an amount included because of paragraph 127(13)(e) in the taxpayer’s qualified expenditure pool at the end of a preceding taxation year (where there was a transfer of qualified expenditures between related parties).

ITCs claimed consist of ITCs used to offset Part I taxes otherwise payable and ITCs refunded to a taxpayer. The prescribed proxy amount, qualified expenditures, and the qualified expenditure pool are discussed in more detail under SR&ED qualified expenditure pool (on page 113) and Investment tax credits (on page 139). Because the SR&ED expenditure pool is reduced by ITCs claimed for a preceding taxation year, an ITC claimed in a taxation year reduces the pool only in the following taxation year.

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ITCs claimed on capital assets [§13(7.1)(e)] — Although paragraph 37(1)(e) does not provide for a reduction in the SR&ED expenditure pool for ITCs claimed on pre-2014 capital expenditures, the undepreciated capital cost of a capital expenditure is reduced, under paragraph 13(7.1)(e), by the amount of ITCs claimed in respect of that expenditure. See Capital expenditures (on page 107) for more details. Shared-use equipment is not included in the capital expenditures added to the SR&ED expenditure pool under (pre-repeal) paragraph 37(1)(b). As explained under Shared-use equipment (on page 117), shared-use equipment is subject to the same capital cost treatment as any other capital asset. ITCs claimed on shared-use equipment are also captured by paragraph 13(7.1)(e) in computing the capital cost of the asset.

ITCs allocated by a partnership or trust [§127(12.1)] — The SR&ED expenditure pool of a partnership or trust is reduced by ITCs earned in the year on current expenditures and allocated by the partnership to its partners or by the trust to its beneficiaries. For more information, see Partnerships (on page 158) and Trusts (on page 164).

ITCs claimed included in income [§12(1)(t)] — The ITCs claimed by a taxpayer for a preceding year and in respect of a property acquired or an expenditure made in a preceding taxation year must be included in the taxpayer’s income where the ITCs do not reduce the undepreciated capital cost (UCC) of the property (under paragraph 13(7.1)(e) or variable I in the definition of UCC in subsection 13(21))44 or the SR&ED expenditure pool (under paragraph 37(1)(e)). The ITCs are included in the taxpayer’s income for the taxation year that follows the later of •

the taxation year in which the ITCs are claimed; and

•

the taxation year in which the property was acquired or the expenditure was made.

No inclusion in income under paragraph 12(1)(t) is necessary for a taxation year if the ITCs are included in income for a preceding taxation year, or if the ITCs have reduced the adjusted cost base of an interest in a partnership or of a capital interest in a graduated rate estate or a communal organization.

Prior-year ITCs claimed – Form T661 Prior-year ITCs claimed relating to a prescribed proxy amount, current expenditures, or qualified expenditures transferred by a related party under subsection 127(13) are reported on Line 435 of Form T661. ITCs claimed relating to pre-2014 capital expenditures are also reported on Line 435.

44 ITA s. 13(7.1)(e) provides for a reduction in the capital cost of the property, and therefore in its UCC, where the ITC is claimed prior to the disposition of the property, whereas variable I in the UCC definition in s. 13(21) reduces the UCC where the ITC is claimed after the disposition of the property.

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ITCs claimed relating to shared-use equipment are reported under the applicable class on Schedule 8, Capital Cost Allowance, of the T2 corporate return.

Assistance [§37(1)(d)] — The SR&ED expenditure pool is reduced by any assistance (both government and non-government) a taxpayer has received, is entitled to receive, or can reasonably be expected to receive at the taxpayer’s filing-due date. For a description of each type of assistance, see Government and non-government assistance (on page 123). Only assistance in respect of current and pre-2014 capital expenditures reduces the SR&ED expenditure pool (assistance is treated in a different way when computing qualified expenditures). Assistance in respect of SR&ED but not in respect of a current or pre-2014 capital expenditure does not reduce the SR&ED expenditure pool. Such assistance is generally included in income under paragraph 12(1)(x). ITCs received from the federal government are not considered assistance.

Assistance relating to prescribed proxy amount The amount of provincial or territorial tax credits that relates to the prescribed proxy amount is not included as assistance to be applied against the SR&ED deductible expenditure pool. Instead, this assistance must be included in income under paragraph 12(1)(x) in the year received.45

Assistance relating to depreciable property [§13(7.1)(f)] — Assistance relating to depreciable property, including shared-use equipment, reduces the capital cost of the depreciable property.

Repayment of assistance [§37(1)(c)] — A repayment of assistance that reduced the SR&ED expenditure pool in a previous year must be added back to the pool in the year the repayment is made.

Assistance no longer expected to be received If a taxpayer had, in a taxation year, a reasonable expectation that assistance would be received but, in a later year, that assistance can no longer reasonably be expected to be received, the amount is added back to the SR&ED expenditure pool in that later year. As the pool is cumulative and recomputed at the end of each taxation year, assistance that is no longer expected to be received essentially ceases to form part of the SR&ED expenditure pool. For a discussion on determining whether a taxpayer can reasonably expect to receive assistance, see Amount entitled or expected to be received (on page 129).

45 See CRA document 2014-0522541E5 for more details on the timing of an income inclusion under ITA s. 12(1)(x).

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Recapture of SR&ED ITC ITCs previously earned on acquired property may be recaptured if the property is sold or converted to commercial use. For a more detailed discussion of the recapture rules, see Recapture of ITC (on page 147). [§37(1)(c.2), (c.3)] — A recapture of ITCs increases the SR&ED expenditure pool, thereby reversing the reduction of the pool that occurred when the ITCs were originally claimed.

SR&ED qualified expenditure pool [§127] — Section 127 of the Act allows the deduction of many types of tax credits, including SR&ED investment tax credits. Subsection 127(5) allows a taxpayer to deduct investment tax credits from Part I taxes otherwise payable. [§127(9) “investment tax credit”] — The SR&ED investment tax credit of a taxpayer for taxation years ending after 2013 includes •

15% of the taxpayer’s SR&ED qualified expenditure pool;46 and

•

for certain CCPCs, an additional 20% on all or part of the corporation’s SR&ED qualified expenditures.47

For taxation years ending prior to 2014, the base credit rate available to all claimants was 20%, and the additional credit rate for eligible CCPCs was 15% (so no change in the total credit rate of 35% for eligible CCPCs).48 [§127(9) “SR&ED qualified expenditure pool”] — The SR&ED qualified expenditure pool is determined by the following formula: A+B–C where A is the taxpayer’s qualified expenditures for the year; B is any qualified expenditures transferred to the taxpayer by another taxpayer; and C is any qualified expenditures transferred to another taxpayer by the taxpayer. The transfers referred to in variables B and C occur when one taxpayer (the performer or transferor) performs SR&ED on behalf of the other taxpayer (the payer or transferee) and the transferor and transferee do not deal with each other at arm’s length. This part of the chapter discusses how qualified expenditures are computed, how these expenditures are determined in non-arm’s length transactions, and the transfer of qualified expenditures between non-arm’s length parties.

46 ITA s. 127(9) “investment tax credit” (a.1). 47 ITA s. 127(9) “investment tax credit” (e), which makes reference to s. 127(10.1). 48 For taxation years straddling January 1, 2014, the applicable credit rates are prorated for the number of days in the taxation year before 2014 and after 2013.

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Qualified expenditures [§127(9) “qualified expenditure”] — A qualified expenditure incurred by a taxpayer in a taxation year is •

an amount incurred in the year by the taxpayer in respect of SR&ED where the amount is – a current expenditure described in subparagraph 37(1)(a)(i) (i.e., a current expenditure included in the SR&ED expenditure pool for SR&ED directly undertaken by the taxpayer — see Current expenditures (on page 103) and Eligible SR&ED expenditures (on page 68) for more details on the various categories of current expenditures), – 80% of a current expenditure described in subparagraphs 37(1)(a)(i.01) to (iii) (i.e., a current expenditure included in the SR&ED expenditure pool for SR&ED directly undertaken on behalf of the taxpayer or third-party payments) — see Subcontracts – SR&ED performed on behalf of the taxpayer (on page 81) and Third-party payments (on page 90) for more details on these expenditures),49 – prior to February 1, 2017, and under certain circumstances, an expenditure for firstor second-term shared-use equipment (i.e., certain depreciable property acquired prior to 2014), or – a pre-2014 capital expenditure described in (pre-repeal) subparagraph 37(1)(b)(i) (i.e., a capital expenditure included in the SR&ED expenditure pool — see Capital expenditures (on page 107) in the SR&ED expenditure pool section of this chapter and Capital expenditures (on page 94) in the Eligible SR&ED expenditures section); or

•

the taxpayer’s prescribed proxy amount for the year.

However, qualified expenditures do not include •

prescribed expenditures;

•

an expenditure (other than employee salary or wages) incurred by the taxpayer for SR&ED performed by a non-arm’s length person or partnership; or

•

a current expenditure described in paragraph 37(1)(a) that is paid or payable by the taxpayer to or for the benefit of a person or partnership that is not a taxable supplier in respect of the expenditure, unless the expenditure is for SR&ED directly undertaken by the taxpayer.

In addition, many provisions in section 127 require adjustments to be made to the amount of qualified expenditures, including adjustments for •

[§127(11.5)–(11.8)] — the cost of goods and services purchased from related parties;

•

[§127(13)–(17)] — qualified expenditures transferred to or received from related parties;

•

[§127(18)–(25)] — assistance and contract payments; and

•

[§127(26)] — unpaid amounts.

49 For an expenditure made prior to 2013, 100% of the expenditure could be categorized as a qualified expenditure.

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Eligible SR&ED expenditures and qualified expenditures [§127(9) “qualified expenditure” (a)(i), (ii)] — To compute its qualified expenditures for a taxation year, the taxpayer begins with the eligible SR&ED expenditures (current and pre-2014 capital expenditures) incurred in the year that were included in its SR&ED expenditure pool. So, the amounts reported on Lines 380 (current expenditures) and 390 (pre-2014 capital expenditures) of Form T661 (Part 3, Section B) are re-entered on Lines 492 and 496 (Part 4). However, given that only 80% of current expenditures made after 2012 for arm’s length contracts or third-party payments are considered qualified expenditures, the taxpayer must subtract, on Line 529 (Part 4), 20% of the expenditures included on Lines 340 (arm’s length contract expenditures for SR&ED performed on the taxpayer’s behalf) and 370 (third-party payments) (Part 3, Section B). As indicated in the 2012 federal budget documents, the government established the 20% reduction for simplicity, to represent the profit element (on which investment tax credits can no longer be earned) of these arm’s length and third-party contracts. See Current expenditures (on page 103) and Capital expenditures (on page 107), as well as Eligible SR&ED expenditures (on page 68), for more details.

Prescribed proxy amount [§127(9) “qualified expenditure” (b), Reg. 2900(4)] — The prescribed proxy amount (PPA), which is defined in Regulation 2900(4) as 55%50 of the proxy salary base of the taxpayer, is included as an addition in the computation of qualified expenditures of taxpayers that elect to use the proxy method. The PPA is designed to compensate for the difference in the amount of current and pre2014 capital eligible SR&ED expenditures added to the SR&ED expenditure pool by taxpayers using the proxy method (the proxy method allows a narrower band of eligible SR&ED expenditures than the traditional method). The PPA is not an eligible SR&ED expenditure and, therefore, does not form part of the SR&ED expenditure pool. Notional overheads calculated using the PPA are used only to calculate qualified expenditures for investment tax credit purposes. The differences between the proxy and traditional methods and the eligible expenditures for each method are described under Eligible SR&ED expenditures (on page 68).

Proxy salary base The proxy salary base is the total salary and wages of employees directly engaged in SR&ED carried on in Canada (directly engaged salaries) as well as outside Canada (where the expenditure is deemed made in respect of SR&ED carried on in Canada, under subsection 37(1.4)).51 See Labour (on page 69) for a description of directly

50 The PPA rate was reduced from 65% to 55% over a two-year period beginning in 2013. The rate was reduced to 60% for the 2013 calendar year and to 55% for 2014 and subsequent calendar years. The applicable rate is prorated for the number of days in the taxation year that straddle January 1, 2013, or January 1, 2014. 51 See CRA document 2009-0325831I7.

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engaged salaries and SR&ED performed in Canada (on page 103) for details on the deemed expenditures under subsection 37(1.4). [Reg. 2900(9)] — The proxy salary base excludes •

remuneration based on profits or bonuses52 paid to any employee;

•

taxable benefits described in sections 6 and 7 of the Act; and

•

salaries and wages deemed not to have been incurred under subsection 78(4) (unpaid amounts).

For examples of what to include in the salary base under the proxy method, see the table titled Labour expenditures included in SR&ED expenditure pool and PPA salary base (on page 171) in the Appendix of this chapter. [§248(1) “specified employee,” “specified shareholder,” Reg. 2900(7)] — In calculating the PPA, Regulation 2900(7) limits the SR&ED portion of the salary and wages of a specified employee to the lesser of •

the year’s maximum pensionable earnings53 multiplied by 2.5; and

•

75% of the employee’s total salary and wages.

A specified employee of a taxpayer is an employee who is a specified shareholder of the taxpayer or who does not deal at arm’s length with the taxpayer. An individual is a specified shareholder of a corporation in a taxation year if, at any time in that year, the individual owns (directly or indirectly) at least 10% of the issued shares of any class of the capital stock of the corporation or of any other corporation that is related to the corporation. The limit in Regulation 2900(7) applies to the total of salaries and wages received by a specified employee from all corporations of an associated group of corporations. The exclusions to the proxy salary base listed in Regulation 2900(9) also apply to the salary and wages limitation for specified employees. Example Facts and assumptions: The following information applies to Company B’s 2017 taxation year: Salary of specified employee (includes taxable benefits of $2,000) Non-taxable benefits re salary

$8,000

Cost of materials

$15,000

Subcontracts Other 1

$122,000

$60,000

expenditures1

$50,000

See Other expenditures (on page 85) for a description of these expenses.

52 Remuneration referred to as a bonus in an employment contract may not necessarily be a bonus. See Oldcastle Building Products Canada Inc. c. La Reine, 2016 CCI 183. 53 The year’s maximum pensionable earnings (YMPE) are $55,900 for 2018, up from $55,300 in 2017. The YMPE is determined on a calendar-year basis and is published on the CRA website.

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Tax consequences: Depending on whether the corporation chooses the traditional or proxy method, qualified expenditures would be calculated as follows: Traditional method

Proxy method

Salaries

$122,000

$122,000

Benefits

$8,000

0

Materials

$15,000

$15,000

Subcontracts

$60,000

$60,000

Other expenditures

$50,000

0

$255,000

$197,000

0

$49,500

$243,0001

$234,5002

Eligible SR&ED expenditures PPA (see below) Qualified expenditures 1 2

$255,000 – (20% x $60,000) = $243,000. $197,000 – (20% x $60,000) + $49,500 = $234,500.

If the company chooses the proxy method, the PPA is calculated by multiplying the proxy salary base by 55%. The proxy salary base is the lesser of •

[Salaries ($122,000) – Taxable benefits ($2,000)] x 75% = $90,000; and

•

Year’s maximum pensionable earnings ($55,300) x 2.5 = $138,250.

Thus, the PPA is $90,000 x 55% = $49,500.

Overall cap on PPA [Reg. 2900(6)] — The PPA is limited to the amount of business expenditures deducted by the taxpayer less specified adjustments. These adjustments include amounts deducted in computing income for the year from a business under any of sections 20, 24, 26, 30, 32, 37, 66 to 66.8, and 104 of the Act. Specific examples are rent or lease costs for a building, expenses already deducted as SR&ED, interest, and capital cost allowance. This limit prevents taxpayers from earning an investment tax credit on an amount that would exceed all business expenses incurred in the year (other than the specifically excluded amounts).

Shared-use equipment [§127(9) “qualified expenditure” (a)(iii) repealed] — Prior to February 1, 2017, and under certain circumstances,54 a portion of the capital cost of certain depreciable properties acquired before 2014 may be included in the computation of qualified expenditures. These properties are referred to as shared-use equipment because their use may be “shared” between SR&ED and other purposes.

54 For example, when depreciable property does not meet the all-or-substantially-all test. See Capital expenditures (on page 94).

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Where the property is used primarily (more than 50% but less than 90%) in the prosecution of SR&ED, up to 50% of the cost of shared-use equipment may qualify as a qualified expenditure and thus be eligible for an investment tax credit — generally over a period of one to three years from the date of acquisition (as discussed below). [§127(9) “first term shared-use-equipment,” §127(11.2)] — First-term shared-use equipment is depreciable property of the taxpayer (other than prescribed depreciable property) that is acquired before 2014 and used by the taxpayer during the property’s operating time in a specified period (known as the first period) primarily for the prosecution of SR&ED in Canada. The first period •

begins at the time the taxpayer acquired the property; and

•

ends at the taxpayer’s first taxation year-end that is at least 12 months after the time the property was acquired by the taxpayer (not 12 months after the date of acquisition, which is a common misconception).

For example, if a property was acquired on January 15, 2013, by a corporation with a December 31 taxation year-end, the first period would end on December 31, 2014 (not January 15, 2014). To qualify as first-term shared-use equipment, the property would have to be used for more than 50% of its operating time in the prosecution of SR&ED from January 15, 2013, to December 31, 2014 (23.5 months). Under subsection 127(11.2), first-term shared-use equipment is deemed not to have been acquired until it has become available for use. Shared-use equipment does not include general-purpose office equipment or furniture. According to the SR&ED Lease Expenditures Policy, general-purpose office equipment or furniture includes all furniture (e.g., desks, chairs, lamps, filing cabinets, and bookshelves), as well as photocopiers, fax machines, telephones, pagers, typewriters, and word processors. It does not include computers, hardware, software, or ancillary equipment. [§127(9) “second term shared-use-equipment”] — Second-term shared-use equipment is property of the taxpayer that •

was first-term shared-use equipment of the taxpayer; and

•

is used by the taxpayer during its operating time in a specified period (known as the second period) primarily for the prosecution of SR&ED in Canada.

The second period begins at the time the taxpayer acquired the property and ends at the taxpayer’s first taxation year-end that is at least 24 months after that time. So, for the first-term shared-use equipment described above (acquired on January 15, 2013), the second period would run from January 15, 2013, to December 31, 2015 (35.5 months). Although the determination of whether a depreciable property is an eligible SR&ED expenditure depends on the property’s intended use (i.e., intended to be used all or substantially all in the prosecution of SR&ED), the test for determining whether a property is first- or second-term shared-use equipment depends on the property’s actual use. The onus is on the taxpayer to substantiate the percentage of time claimed. For example, evidence may be provided by tracking

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•

machine hours;

•

operating labour hours;

•

the number of trial runs versus the number of production runs;

•

commercial production output versus experimental production output; or

•

the timeline of usage.

[§127(11.5)]55 — One-quarter of the capital cost of first-term shared-use equipment is added to the amount of qualified expenditures that generate investment tax credits, and one-quarter of the capital cost of second-term shared-use equipment is also added to the amount of qualified expenditures. [§13(21) “undepreciated capital cost”] — Because shared-use equipment is a qualified expenditure but not an eligible SR&ED expenditure, the portion of capital cost is not included in the subsection 37(1) SR&ED expenditure pool. Instead, the full capital cost is included in the undepreciated capital cost of the appropriate class and is depreciated in accordance with the regular capital cost allowance rules at the regular rates. Paragraph 13(7.1)(e) requires that the capital cost of depreciable property be reduced by the amount of any investment tax credit claimed in a preceding year in respect of the property. See Capital expenditures (on page 107). Example Facts and assumptions: Company A has an August 31 year-end. On March 15, 2013, Company A acquired and made available for use a new server that cost $200,000. The company intended to eventually use the server in commercial production, but its immediate use was for the prosecution of SR&ED (a test server to simulate a production environment). Gradually, the server was transitioned to production (introduction of production data with an eventual phase-out of test data). The following is a timeline of the server’s usage in SR&ED: •

March 15, 2013, to September 30, 2013 – 100% utilized in SR&ED.

•

October 1, 2013, to December 31, 2013 – 50% utilized in SR&ED.

•

January 1, 2014, to August 31, 2014 – 25% utilized in SR&ED.

•

September 1, 2014, to August 31, 2015 – 10% utilized in SR&ED.

Tax consequences: The percentage of SR&ED usage for Company A’s first- and second-term shared-use equipment is calculated as follows:

55 ITA s. 127(11.5) as it formerly applied.

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Number of days (A) 199

% utilized in SR&ED (B) 100%

Usage factor (A x B) 199

Oct. 1 to Dec. 31, 2013

92

50%

46

Jan. 1 to Aug. 31, 2014

243

25%

61

Total

534

Sept. 1, 2014, to Aug. 31, 2015

365

Total

899

Period Mar. 15 to Sept. 30, 2013

306 10%

37 343

First-term shared-use equipment % usage (March 15, 2013, to August 31, 2014) = 306/534 = 57% Second-term shared-use equipment % usage (March 15, 2013, to August 31, 2015) = 343/ 899 = 38% The property meets the usage test (greater than 50% actual usage for SR&ED) for firstterm shared-use equipment, but not for second-term shared-use equipment. Therefore, Company A may claim $50,000 in qualified expenditures ($200,000 x 25%) in the taxation year ending August 31, 2014, as first-term shared-use equipment. It cannot make a claim for second-term shared-use equipment in the taxation year ending August 31, 2015.

Prescribed depreciable property [Reg. 2900(11)] — Prescribed depreciable property (not to be confused with the prescribed expenditures described below) cannot qualify as first-term shared-use equipment. These prescribed properties, which are listed in Regulation 2900(11), are as follows: •

a building of the taxpayer;

•

a taxpayer’s leasehold interest in a building; and

•

a property (or part of a property) of a taxpayer if, at the time the property (or part) was acquired, the taxpayer (or a related person) intended that the property (or part) would be used in the prosecution of SR&ED during the assembly, construction, or commissioning of a facility, plant, or line for commercial manufacturing, commercial processing, or other commercial purposes (other than SR&ED) and intended – that the property (or part) would be used during its operating time in its expected useful life primarily for non-SR&ED purposes, or – that the value of the property (or part) would be consumed primarily in nonSR&ED activities.

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Pilot plants — The SR&ED Shared-Use-Equipment Policy states that equipment used in pilot plants will not be considered prescribed depreciable property. Both the SR&ED While Developing an Asset Policy and the SR&ED Glossary define a pilot plant as “a noncommercial scale plant in which processing steps are systematically investigated under conditions simulating a full production unit.” Capital costs relating to equipment purchased or developed for a pilot plant are exempt from the prescribed depreciable property rules and may be claimed as shared-use equipment, provided the SR&ED-use requirements for first- and second-term shared-use equipment are met. It is the responsibility of the taxpayer to determine if a plant qualifies as a pilot plant. The SR&ED Shared-Use-Equipment Policy provides additional guidance.

Prescribed expenditures [§127(9) “qualified expenditure” (c), Reg. 2902(a)–(e)] — The definition of qualified expenditure in subsection 127(9) specifically excludes prescribed expenditures. These expenditures, which are listed in Regulation 2902, are •

certain prescribed current expenditures (see below);

•

certain prescribed expenditures generally of a capital nature (see below);

•

an expenditure made to acquire rights in, or arising out of, SR&ED;

•

an expenditure on SR&ED for which an amount is deductible as a gift under section 110.1 or section 118.1; and

•

an expenditure that is reimbursed by – a resident of Canada (other than certain public entities, such as the federal government, a provincial or territorial government, a corporation controlled directly or indirectly by any of these governments, or a Canadian municipality), or – a non-resident, where the reimbursement is deductible from the non-resident’s taxable income earned in Canada.

[Reg. 2902(a)] — The prescribed current expenditures listed under Regulation 2902(a) are expenditures in respect of •

the general administration or management of a business, which includes – administrative salary or wages and related benefits of a person whose duties are not all or substantially all directed to the prosecution of SR&ED, unless the expenditure is considered directly attributable to the prosecution of SR&ED under Regulation 2900(2) or directly attributable to the provision of premises, facilities, or equipment for the prosecution of SR&ED under Regulation 2900(3), – a legal or accounting fee, – an amount described in any of paragraphs 20(1)(c) to (g) (i.e., generally, interest and other financing costs), – an entertainment expense, – an advertising or selling expense, – a conference or convention expense, – a due or fee for membership in a scientific or technical society or organization, and

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– a fine or penalty; or •

if the expenditure is not attributable to the prosecution of SR&ED, the maintenance and upkeep of premises, facilities, or equipment.

[Reg. 2902(b)] — The prescribed expenditures listed under Regulation 2902(b) are •

capital expenditures incurred before 2014 in respect of the acquisition of property unless, at the time the expenditure was incurred, it was for – first- or second-term shared-use equipment, or – the provision of premises, facilities, or equipment if it was intended, at the time of acquisition, -

that the premises, facilities, or equipment would be used during all or substantially all its operating time in its expected useful life for the prosecution of SR&ED in Canada, or

-

that all or substantially all the value of the premises, facilities, or equipment would be consumed in the prosecution of SR&ED in Canada;

•

expenditures56 in respect of the acquisition of qualified property or qualified resource property, as defined in subsection 127(9); or

•

expenditures57 in respect of the acquisition of property that was used or acquired for use or lease for any purpose whatsoever before it was acquired by the taxpayer (see Used depreciable property (on page 122)).

Used depreciable property [Reg. 2902(b)(ii)] — Used depreciable property cannot be claimed as a qualified expenditure under subsection 127(9). As mentioned under Used assets (on page 95), pre-2014 used depreciable property may be included in the SR&ED expenditure pool (and thus benefit from a full tax deduction in the year of acquisition). However, used property must be excluded from qualified expenditures (as a prescribed expenditure under Regulation 2902) and consequently will not earn investment tax credits. In addition, property that was acquired for use or lease for any purpose (either SR&ED or non-SR&ED) before being acquired by the taxpayer is a prescribed expenditure even if it was not actually used by the previous owner. New equipment that has been used in a demonstration for a prospective buyer or that has been tested by the buyer is not usually considered used equipment and therefore is not a prescribed expenditure. However, equipment used regularly for demonstration purposes is considered to be a prescribed expenditure. See section 10.2.1 of the Total Qualified SR&ED Expenditures for Investment Tax Credit Purposes Policy.

56 Reference should be made to capital expenditures for expenditures incurred prior to 2014. 57 Reference should be made to capital expenditures for expenditures incurred prior to 2014.

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Assistance and contract payments [§127(9) “qualified expenditure” (h), §127(18)] — In general, assistance (either government or non-government) and contract payments received or receivable by a taxpayer reduce the amount of the taxpayer’s qualified expenditures if the assistance or contract payments •

are in respect of SR&ED; and

•

are received or receivable, or are reasonably expected to be received, on or before the filing-due date of the taxpayer’s income tax return for the taxation year (i.e., for corporations, six months after their taxation year-end).

Government and non-government assistance [§127(9) “government assistance”] — Government assistance is defined as assistance from a government, municipality, or other public authority, whether as a grant, subsidy, forgivable loan, deduction from tax, investment allowance, or any other form of assistance.58 Specifically excluded from the definition are •

investment tax credits deducted under subsection 127(5) from Part I tax otherwise payable (see Investment tax credits (on page 139)); and

•

investment tax credits deducted by a cooperative corporation under subsection 127(6) against patronage dividend taxes withheld at source (see Cooperative corporations (on page 163)).

Therefore, federal investment tax credits59 are not considered government assistance for purposes of sections 37 and 127. Aside from this specific exclusion, the definition makes no distinction between Canadian governments or public authorities and foreign governments or public authorities, so government assistance potentially includes assistance from governments outside Canada, as well as from provincial governments (including provincial SR&ED tax credits). Examples of government assistance include the Quebec refundable tax credit for SR&ED salaries and wages, the Ontario innovation tax credit, the Ontario business research institute tax credit, and assistance from the industrial research assistance program. In addition, in Immunovaccine Technologies Inc. v. The Queen,60 the Tax Court of Canada found that interest-free advance payments made to a taxpayer by a federal government regional economic development agency were government assistance. Since the advances were repayable as a percentage of future revenues, the taxpayer had argued that the advances constituted an ordinary loan made on reasonable commercial terms for business purposes of the federal agency and, accordingly, did not constitute

58 The definition in ITA s. 127(9) contains a number of terms not defined in the Act, such as assistance, grant, forgivable loan, and subsidy. However, the Assistance and Contract Payments Policy, section 4.2, provides general considerations in interpreting some of these terms (e.g., factors used to determine whether an amount is assistance, and an example of what the CRA considers a forgivable loan). 59 Includes all investment tax credits covered by ITA s. 127, not just credits for SR&ED. 60 Immunovaccine Technologies Inc. v. The Queen, 2013 TCC 103; aff’d. 2014 FCA 196.

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government assistance.61 The Federal Court of Appeal upheld the Tax Court’s decision and dismissed the taxpayer’s argument that, in accordance with the ejusdem generis principle of statutory interpretation,62 the amounts received from the federal agency should not be characterized as “any other form of assistance” under the definition of government assistance in subsection 127(9) — the taxpayer’s position being that each item in the list represented a transfer of funds advanced with no expectation of repayment. The Federal Court of Appeal instead found that the definition provides “a broad meaning to the word ‘assistance,’ capable of encompassing a variety of forms of government assistance not necessarily limited to the said enumeration,” and that the agreement was not an ordinary business arrangement because it did not have the attributes of a commercial venture. Leave to appeal the decision to the Supreme Court of Canada was dismissed. Section 4.2.1 of the Assistance and Contract Payments Policy describes factors that may be used to determine whether an amount is assistance.63 [§12(1)(x), §127(9) “non-government assistance”] — Non-government assistance is defined in subsection 127(9) as an amount that would be included in income under paragraph 12(1)(x) if it were read without reference to subparagraphs 12(1)(x)(v) to (vii). Paragraph 12(1)(x), read without reference to subparagraphs 12(1)(x)(v) to (vii), states: 12. (1) There shall be included in computing the income of a taxpayer for a taxation year as income from a business or property such of the following amounts as are applicable… (x) any particular amount (other than a prescribed amount) received by the taxpayer in the year, in the course of earning income from a business or property, from (i) a person or partnership (in this paragraph referred to as the “payer”) who pays the particular amount (A) in the course of earning income from a business or property, (B) in order to achieve a benefit or advantage for the payer or for persons with whom the payer does not deal at arm’s length, or (C) in circumstances where it is reasonable to conclude that the payer would not have paid the amount but for the receipt by the payer of amounts from a payer, government, municipality or public authority described in this subparagraph or in subparagraph (ii), or (ii) a government, municipality or other public authority, where the particular amount can reasonably be considered to have been received (iii) as an inducement, whether as a grant, subsidy, forgivable loan, deduction from tax, allowance or any other form of inducement, or (iv) as a refund, reimbursement, contribution or allowance or as assistance, whether as a grant, subsidy, forgivable loan, deduction from tax, allowance or any other form of assistance, in respect of (A) an amount included in, or deducted as, the cost of property, or (B) an outlay or expense,

61 Thereby following the test established in The Queen v. CCLC Technologies Inc., 96 DTC 6527 (FCA). 62 According to this principle, where a general word or phrase follows a list of specific words or phrases, the general word or phrase must be interpreted to include only items of the same type as those listed. 63 See also CRA document 2012-0459731I7.

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to the extent that the particular amount … (viii) may not reasonably be considered to be a payment made in respect of the acquisition by the payer or the public authority of an interest in the taxpayer, an interest in, or for civil law a right in, the taxpayer’s business or an interest in, or for civil law a real right in, the taxpayer’s property[.]

Essentially, paragraph 12(1)(x) provides that inducements, refunds, reimbursements, contributions, allowances, and assistance (such as grants, subsidies, forgivable loans, deductions from tax, and allowances) received by a taxpayer in the course of earning income from a business or property must be included in income under that provision.64 The language of paragraph 12(1)(x) is echoed in the Assistance and Contract Payments Policy (section 4.1.2), which outlines the CRA’s administrative position on nongovernment assistance: [N]on-government assistance is an amount that can reasonably be considered to have been received as an inducement, reimbursement, contribution, allowance or as assistance for the cost of a property or for an outlay or expense. Non-government assistance may be in the form of a grant, subsidy, forgivable loan, deduction from tax, allowance or any other form of inducement or assistance.

Neither paragraph 12(1)(x) nor the policy appears to distinguish between amounts received from Canadian sources and amounts received from foreign sources. [§12(1)(x)(viii)] — If an amount may reasonably be considered to be a payment made in respect of a payer’s or public authority’s acquisition of an interest in the taxpayer, its business, or its property, the amount does not need to be included under paragraph 12(1)(x). Subparagraph 12(1)(x)(viii) also applies, under civil law, to a right in the taxpayer’s business or a real right in the taxpayer’s property. Thus, amounts described in paragraph 12(1)(x) do not need to be included in income if they are made in return for an interest in the taxpayer’s business or property. To illustrate what might constitute an interest in the taxpayer’s business or property, Interpretation Bulletin IT-273R2, Government Assistance – General Comments (paragraph 8), gives as an example an entitlement to share in the profits of the taxpayer’s business.

Contract payments The purpose of reducing otherwise qualified expenditures by the amount of a contract payment is to avoid having two parties claim an investment tax credit for the same SR&ED. The definition of contract payment contained in the Act assists in determining whether the payee (the contractor performing the SR&ED) or the payer is entitled to claim the credit. The Department of Finance explanatory notes concerning the definition of contract payment in subsection 127(9) state: There are a number of ways in which SR&ED can be performed. Taxpayers can perform SR&ED in-house, have someone else perform the SR&ED on their behalf (contract-SR&ED),

64 See CRA document 2014-0522541E5 for more details on the timing of an income inclusion under ITA s. 12(1)(x). With respect to provincial tax credits, the CRA took the position that a provincial tax credit is considered to be received for purposes of ITA s. 12(1)(x) when it is applied to reduce tax payable (or included in a refund), not necessarily when it is deemed under the provincial law to have been received.

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or make payments for SR&ED to be carried on by certain third-party entities (third-party SR&ED). A taxpayer is entitled to claim ITCs [investment tax credits] in respect of a “qualified expenditure” as defined in subsection 127(9). In the case of contract-SR&ED and third-party SR&ED, qualified expenditures of a performer are reduced by the amount of a payor’s contract payment to the performer. This ensures that both the payor and the performer cannot claim ITCs on the same qualified expenditure.

[§127(9) “contract payment”] — For purposes of section 127, a contract payment is defined as •

an amount paid or payable to a taxpayer by a taxable supplier for SR&ED performed – for or on behalf of a person or partnership entitled to a deduction for the amount as a current expenditure because of subparagraph 37(1)(a)(i.01), or as a third-party payment to a corporation because of subparagraph 37(1)(a)(i.1) (i.e., as an eligible SR&ED expenditure under those subparagraphs), and – at a time when the taxpayer is dealing at arm’s length with the person or partnership; or

•

an amount for a current expenditure65 of the taxpayer (other than a prescribed amount) payable by a Canadian government, municipality, or other Canadian public authority, or payable by a person fully or partly exempt from Part I tax under section 149, for SR&ED to be performed for it or on its behalf.

Amount paid by a taxable supplier — When determining whether an amount received (or receivable) by a taxpayer qualifies as a contract payment, the first issue to consider is whether the amount was paid (or payable) to the taxpayer by a taxable supplier (taxable supplier is defined in subsection 127(9)). An amount is considered paid (or payable) by a taxable supplier if •

the amount was paid (or payable) by a person resident in Canada or a Canadian partnership; or

•

the amount was paid (or payable) by a non-resident person, or by a partnership that is not a Canadian partnership, in the course of carrying on a business through a permanent establishment in Canada.

In other words, amounts received for SR&ED from a non-resident person or nonCanadian partnership that does not carry on business in Canada through a permanent establishment are not considered contract payments. However, certain payments received from non-taxable suppliers may be deemed to be contract payments under the anti-avoidance rule in subsection 127(25). An amount received is deemed to be a contract payment when •

a person or partnership pays a non-taxable supplier for SR&ED to be performed by another entity; and

•

one of the main purposes of doing so may reasonably be considered to be to prevent the amount from being characterized as a contract payment.

65 Within the meaning assigned by ITA s. 37(8)(d). The reference to a current expenditure generally applies in respect of expenditures made after 2013.

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The character of the original payment made by the first entity is not changed by the application of subsection 127(25). Example Facts and assumptions: Company A, a Canadian resident, hires Company B, a foreign corporation with no permanent establishment in Canada, to perform SR&ED. Company B then hires Company C, a Canadian resident, to perform the SR&ED. Tax consequences and analysis: Because Company B is a foreign corporation with no permanent establishment in Canada, it is not a taxable supplier in respect of the payment it made to Company C, and therefore Company C would not be considered to have received a contract payment. However, if one of the main reasons for the arrangement may reasonably be considered to be to prevent the amount received by Company C from being characterized as a contract payment, subsection 127(25) will apply to deem the amount received by Company C to be a contract payment. As a result, Company C’s qualified expenditures would be reduced by that amount. It should be noted that the payment made by Company A would likely still be excluded as a qualified expenditure of that company because the amount was paid to a nontaxable supplier (i.e., Company B).66 Entitlement to 37(1) deduction — Another issue to consider in determining whether an amount received or receivable by a taxpayer qualifies as a contract payment is whether the amount was for SR&ED performed for or on behalf of a taxpayer that is entitled to a deduction for that SR&ED under subsection 37(1). This provision is highly unusual in that a taxpayer is not typically required or allowed to determine whether, as a matter of law, another taxpayer is entitled to a deduction (or any other tax-related item). The Assistance and Contract Payments Policy states that the following four criteria should be considered when determining whether an amount is a contract payment: •

contractor performance requirements;

•

pricing versus risk assumed;

•

intellectual property; and

•

contract for services versus contract for the sale of goods.

According to the policy, the party that is entitled to claim the investment tax credits generally directs the SR&ED work, bears the risk that the work will yield the desired outcomes, and owns the intellectual property in the work. It is important to note that the criteria outlined in the policy are guidelines only, and none of the four criteria is determinative on its own. Nevertheless, in practice, the CRA often considers the intellectual property criterion to be the most critical, even though there is no legislative support for this emphasis.

66 ITA s. 127(9) “qualified expenditure” (g).

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Payments from Canadian government, municipality, public authority, or tax-exempt persons — An amount (other than a prescribed amount)67 may also be considered a contract payment if it is payable by a Canadian government, municipality, or other Canadian public authority, or by a tax-exempt person, for SR&ED to be performed for it or on its behalf. The key again is that the amount must be paid for SR&ED. The amount must also be in respect of a current expenditure of the taxpayer, if the expenditure is made after 2013 or is made before 2014 for property that became available for use after 2013. These current expenditures exclude expenditures for the acquisition of capital property of the taxpayer, as well as expenditures for the use of, or the right to use, property that would be capital property of the taxpayer if it were owned by the taxpayer. Jurisprudence — The only reported case in which a court has considered whether an amount constituted a contract payment is Com Dev Ltd. v. The Queen.68 In this case, the appellant argued that the amount it received from another corporation did not constitute a contract payment and, as a result, it was entitled to claim investment tax credits in respect of its SR&ED qualified expenditures. Specifically, the appellant argued that, contrary to what was determined by the Crown, the amount received had not been paid for SR&ED, and it had not been received from the Canadian government (the Crown had argued that the project on which the appellant was working and for which it received an amount from the other corporation was ultimately funded by the government of Canada). Although the court held that a contract payment, within the meaning of paragraph (b) of the definition of that term in subsection 127(9), had not been received by the appellant because no amount had been payable to the appellant by the Canadian government (which was in itself sufficient to allow the appeal), it also considered the second criterion under paragraph (b) of the definition (i.e., whether the payments received by the appellant were payable for SR&ED). In this regard, the court considered the intellectual property provisions in the contract, along with many other factors, and concluded that “the contractual relationship based on a fixed firm price for the purchase of the components did not include the purchase of SRED.” Thus, the appeal was allowed, and the appellant was entitled to claim the investment tax credits.

Amount in respect of SR&ED An amount of assistance or contract payment may cover expenditures that are not qualified expenditures. For example, a government grant may fund part of the cost of acquiring used equipment that is intended to be used for all or substantially all its useful life in the prosecution of a particular SR&ED project. As discussed under Used depreciable property (on page 122), the cost of used depreciable property is not a

67 Under Reg. 4606, a prescribed amount is an amount received from the Canadian Commercial Corporation (CCC) in respect of an amount it received from a foreign government, foreign municipality, or other foreign public authority. The CCC is a Crown corporation of the Canadian government that acts as Canada’s international contracting and procurement agency. 68 Com Dev Ltd. v. The Queen, 99 DTC 775 (TCC).

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qualified expenditure. Nevertheless, the grant in this case will reduce the recipient’s qualified expenditures for that specific project because the amount is in respect of the SR&ED.

Amount entitled or expected to be received In the Assistance and Contract Payments Policy, the CRA provides guidance on determining whether a taxpayer is entitled to receive, or can reasonably be expected to receive, assistance. According to the policy, the CRA considers a taxpayer to be entitled to receive an amount if •

a particular event must occur or the taxpayer must fulfill some condition before receiving the assistance, and this event has occurred or the condition has been met; or

•

the taxpayer has an enforceable right to receive the assistance.

The CRA’s view is that an amount can reasonably be expected to be received by a taxpayer if the taxpayer •

has applied for assistance and it is reasonable to believe, under the circumstances, that the assistance will be received;

•

has received information advising that it will receive assistance; or

•

has earned the current year’s provincial research-and-development tax credit and has added the amount to the provincial research-and-development tax credit pool to be applied to future years.

Reduction on project-by-project basis [§127(18)] — Amounts received as assistance or contract payments reduce qualified expenditures on a project-by-project basis; therefore, an amount received for a particular project does not reduce the qualified expenditures of another project. For each project, qualified expenditures are reduced by the lesser of •

the total of all amounts of assistance and contract payments less any amounts of assistance and contract payments applied in preceding taxation years; and

•

the project’s qualified expenditures incurred in the year.

The total of all amounts of assistance and contract payments means amounts received or receivable, as well as amounts that can reasonably be expected to be received, on or before the taxpayer’s filing-due date. As a result, if any part of this amount is not applied to the particular project in the current year, it is carried forward to reduce the qualified expenditures of that project in future years.

Assistance and contract payments of a related party [§127(19), (20)] — Where the amount of assistance or contract payment that is received, receivable, or reasonably expected to be received exceeds the amount of qualified expenditures incurred by the recipient and non-arm’s length entities, subsection 127(19)

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applies to reduce the qualified expenditures incurred by the non-arm’s length entities. See the third example under Examples from Department of Finance (below) for an illustration of this reduction.69 Where the amount of assistance or contract payment that is received, receivable, or reasonably expected to be received does not exceed the total amount of qualified expenditures incurred by the recipient and non-arm’s length entities (referred to as the related group), the members of the related group may agree, under subsection 127(20), to allocate among themselves the amount of assistance or contract payment that reduces qualified expenditures.

Examples from Department of Finance The following three examples from the Department of Finance’s explanatory notes, released in 1995 with the introduction of subsections 127(18) to (20), illustrate how assistance and contract payments may affect qualified expenditures: EXAMPLE 1 Aco receives $300 of assistance for SR&ED from a government in its 1997 taxation year. It incurs $500 of qualified expenditures before any reduction under subsection 127(18) for the 1997 taxation year. Subsection 127(18) requires that Aco’s qualified expenditures be reduced to $200. As a result, Aco can only claim an ITC based on the $200 amount. EXAMPLE 2 Bco receives $300 of government assistance for SR&ED in its 1997 taxation year. Bco contracts with its resident subsidiary, Cco, for the latter to perform part of that SR&ED. Bco and Cco have the same December 31 taxation year-end. Cco completes its portion of the SR&ED in its 1997 taxation year and incurs $480 of qualified expenditures in respect of the SR&ED before any reduction due to assistance. Bco also completes the other part of the SR&ED in its 1997 taxation year and incurs qualified expenditures of $600 for the SR&ED in the year before any assistance reduction. Under subsection 127(18), Bco’s qualified expenditures otherwise incurred in the year, $600, would be reduced by the $300 of assistance received. Therefore, Bco would have only $300 of qualified expenditures. Cco’s $480 of qualified expenditures remain unaffected in this case. EXAMPLE 3 Dco receives a contract payment of $1200 for SR&ED from an arm’s length party in its 1997 taxation year. Dco contracts out part of this SR&ED to its subsidiary, Eco, which has the same December 31 taxation year-end. Eco completes its portion of the SR&ED in its 1997 taxation year and incurs $480 of qualified expenditures in respect of the SR&ED before any reduction due to assistance. Dco incurs qualified expenditures of $200 for the SR&ED in its 1997 taxation year and $400 for the SR&ED in its 1998 taxation year before any assistance reduction. All of the SR&ED is completed by the end of 1998. Under subsection 127(18), Dco’s qualified expenditures otherwise incurred in its 1997 year, $200, would be reduced to nil. Under subsection 127(19), Eco’s $480 of qualified expenditures otherwise incurred in 1997 will also be reduced to nil because of the contract payment received by Dco.

69 See also PSC Elstow Research Farm Inc. v. The Queen, 2008 TCC 694.

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In 1998, subsection 127(18) requires that the difference between $1,200 and $680 (the sum of $200 and $480 that was applied to reduce the qualified expenditures of Dco and Eco for their 1997 taxation years) be applied to reduce the qualified expenditures of Dco otherwise incurred in 1998 in respect of the SR&ED to nil. Since Dco incurs only $400 more qualified expenditures in 1998 before completing the SR&ED, it would have no qualified expenditures in respect of the SR&ED in 1998. The unapplied amount of the contract payment, $120 or ($1,200 – $680 – $400) would not affect the amount of qualified expenditures of Dco or Eco incurred in respect of other SR&ED.

Repayments of assistance or contract payments Although contract payments and assistance received by a taxpayer reduce the taxpayer’s qualified expenditures, a repayment of an amount received does not increase the taxpayer’s qualified expenditures. Instead, an amount may be claimed as an investment tax credit when the contract payment or assistance is repaid. See Repayments of assistance or contract payments (on page 145). It should also be noted that assistance and contract payments that have reduced a taxpayer’s qualified expenditures because they were receivable or were reasonably expected to be received by the taxpayer are deemed to be repaid where they are not received or where they can no longer reasonably be expected to be received. As with contract payments or assistance actually repaid, the deemed repayment does not increase the taxpayer’s qualified expenditures.

Unpaid amounts [§78(4), §127(26)] — As noted under Labour (on page 69), any salaries, wages, or other remuneration that remains unpaid 180 days after the end of the taxation year is deemed, under subsection 78(4) and for purposes of the entire Act, not to be incurred as an expense until the year in which it is paid. The application of subsection 78(4) thus results in an adjustment to the SR&ED expenditure pool and also affects the computation of qualified expenditures. Other expenditures (i.e., not salary, wages, or other remuneration) that are incurred in a taxation year but remain unpaid 180 days after the end of that taxation year continue to be deductible SR&ED expenditures in the year incurred. However, for purposes of computing qualified expenditures and investment tax credits, these other unpaid amounts are deemed by subsection 127(26) to be incurred only at the time they are paid. Even though unpaid amounts do not earn investment tax credits until the year they are paid (because of the application of either subsection 78(4) or subsection 127(26)), they must be reported in the year the expenditure was incurred. If the amounts are not included on Form T661 within the reporting deadline,70 they are not included in calculating the SR&ED qualified expenditure pool in the year they are paid.

70 For a corporation, 18 months after its taxation year-end.

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Administration All unpaid amounts for SR&ED current expenditures other than unpaid salaries, wages, or other remuneration are reported and deducted on Line 520 of Part 4 of Form T661 in the year the expenditures are incurred. The amounts are added in the year in which they are paid (on Line 500 of Form T661). Salaries, wages, and other remuneration not paid within 180 days are excluded from the amounts on Lines 300, 305, 307, and 309 of Section B of Part 3 of Form T661. The unpaid amount for the year is reported on Line 315, even though the expense is not deductible for that year. In the year the amount is paid, it is included on Line 310. Example Facts and assumptions: During its taxation year ended June 30, 2015, Company A incurs a $50,000 expenditure for SR&ED performed on its behalf by a person with which Company A deals at arm’s length. The amount is paid in March 2016. The contractor informs Company A that it incurred $5,000 in related capital expenditures. Tax consequences: On Form T661 for the year ended June 30, 2015, Company A includes the arm’s length contractor expenses ($50,000) less the related capital expenditures incurred by the contractor ($5,000) in its SR&ED expenditure pool, and so reports $45,000 on Line 340.71 The $45,000 must be reduced by 20%, given that only 80% of current expenditures made after 2012 for arm’s length contracts are considered qualified expenditures. See Eligible SR&ED expenditures and qualified expenditures (on page 115). The resulting $36,000 ($45,000 x 80%) is reported on Line 520, thereby reducing the company’s qualified expenditures for the year ended June 30, 2015.72 For the year ended June 30, 2016, Company A adds the $36,000 back to its qualified expenditures (on Line 500). The amount does not affect the company’s SR&ED expenditure pool in that year (no amount is reported on Line 340 for that year).

Non-arm’s length transactions Taxpayers must distinguish between arm’s length and non-arm’s length subcontractors. Although section 37 does not differentiate between the two types of subcontractors, there are significant differences when calculating qualified expenditures and investment tax credits.

71 See Look-through rule (on page 82) for a discussion on this reduction, which stems from the fact that expenditures of a capital nature, or for the right to use capital property, no longer qualify for SR&ED tax incentives, effective for expenditures made after 2013. 72 Note that for unpaid amounts in respect of arm’s length contracts for SR&ED performed on behalf of a taxpayer, Guide T4088, Scientific Research and Experimental Development (SR&ED) Expenditures Claim – Guide to Form T661, instructs taxpayers to report directly on Line 520 the contract expenditures included on Line 340 net of the 20% reduction, rather than reporting the 20% reduction separately on Line 529.

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Income Tax Folio S1-F5-C1, Related Persons and Dealing at Arm’s Length, outlines the criteria the CRA considers when determining whether taxpayers are dealing with each other at arm’s length. Non-arm’s length transactions include •

non-arm’s length contracts for SR&ED services; and

•

the purchase of properties and services from non-arm’s length suppliers.

Persons, including taxpayers, are deemed not to deal at arm’s length with each other for purposes of the Act if they are related to each other under the Act.

Purchase of properties or services from non-arm’s length suppliers [§127(11.6), (11.8)] — If a taxpayer purchases a property or services from a non-arm’s length supplier (including a partnership), the taxpayer’s qualified expenditures are computed as follows: •

in the case of the purchase of property, the lesser of – the cost (or capital cost)73 to the taxpayer of the property otherwise determined, and – the adjusted selling cost to the supplier of the property; and

•

in the case of the purchase of a service, the lesser of – the actual expenditure incurred by the taxpayer, and – the adjusted service cost of rendering the service incurred by the supplier.

As discussed in further detail below, the purpose of these limits in computing the amount of qualified expenditures is to eliminate non-eligible expenditures and any markup taken by the supplier and any of its non-arm’s length sub-suppliers. Given that expenditures of a capital nature, or for the right to use capital property, no longer qualify for SR&ED tax incentives, these expenditures should not be taken into consideration when made after 2013 (or before 2014 for property that became available for use after 2013). [§127(11.7), (11.8)] — The terms adjusted selling cost (for the purchase of property) and adjusted service cost (for the purchase of services) are defined in subsection 127(11.7). In essence, these definitions require the taxpayer to adjust its qualified expenditures to reflect only the cost of the property or services incurred by the non-arm’s length supplier that would have been recognized as an eligible SR&ED expenditure had the taxpayer performed the same work (i.e., the provision of the property or services) itself. The definitions are further complicated by a “look through” from the non-arm’s length supplier to any other supplier that is not dealing at arm’s length with the supplier. Appendix B of the Total Qualified SR&ED Expenditures for Investment Tax Credit Purposes Policy provides examples of determining the adjusted service cost and adjusted selling cost.

73 In respect of capital expenditures made prior to 2014.

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Administration Because it may not be feasible for the taxpayer to obtain sufficient information to calculate the adjusted selling or service cost, the CRA generally accepts reasonable estimates. The adjusted selling and service costs for the purchase of properties or services from non-arm’s length suppliers are entered on Lines 543 (for pre-2014 capital expenditures) and 542 (for current expenditures) of Form T661 (both in Part 4). For shared-use equipment, the adjusted selling cost is entered on Line 504.

Non-arm’s length SR&ED contracts Generally, where two parties are Canadian taxable suppliers and deal with each other at arm’s length, the payer incurs eligible SR&ED expenditures for SR&ED performed on its behalf (the SR&ED contract), which results in a qualified expenditure, and the performer also incurs eligible SR&ED expenditures that result in qualified expenditures. As discussed under Contract payments (on page 125), the qualified expenditures of the performer must generally be reduced by the amount of the contract payment received. However, in non-arm’s length situations (i.e., where the payer and the performer do not deal with each other at arm’s length), these rules do not apply.

SR&ED contract An SR&ED contract is an arrangement whereby work that falls within the scope of the definition of SR&ED in subsection 248(1) is performed by one party on behalf of another (see Chapter 3, What is eligible? – Scientific and technological aspects, for more information on the definition of SR&ED). It is important to note that certain work (referred to as linked work) may not be considered SR&ED in the hands of the performer when contracted out on its own by an arm’s length taxpayer. However, under subsection 37(13), such work is deemed to be SR&ED (for purposes of sections 37, 127, and 127.1) if the work •

is performed by the taxpayer for a person or partnership not dealing at arm’s length with the taxpayer; and

•

would be SR&ED if it were performed by the person or partnership.

So, if a taxpayer performs work that in itself would not be SR&ED when performed by the taxpayer but would be SR&ED had it been performed by a non-arm’s length party, that work will be considered SR&ED when determining the taxpayer’s eligible SR&ED expenditures, qualified expenditures, investment tax credits, and refundable investment tax credits. Thus, in the context of work undertaken by a non-arm’s length party, SR&ED contracts include linked work.

Rules The SR&ED rules relating to non-arm’s length contracts for SR&ED services can be summarized as follows: •

the rules apply to expenditures incurred in taxation years beginning after 1995;

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•

an expenditure (other than an expenditure for salary or wages) that is paid or payable to a non-arm’s length party is not a qualified expenditure to the payer;

•

the expenditure forms part of the performer’s qualified expenditures;

•

the amount received by the performer (payee) is not a contract payment and therefore does not reduce its qualified expenditures;

•

the performer and the payer may jointly elect to transfer the qualified expenditures from the performer’s qualified expenditure pool to the payer’s qualified expenditure pool; and

•

the nature of the expenditures being transferred to the payer (current or pre-2014 capital) is preserved.

The rules are meant to prevent non-arm’s length parties from structuring SR&ED agreements in a way that allows the parties to claim more tax credits than they would be entitled to if the work had been performed by only one of the parties.

Comparison of non-arm’s length contracts under sections 37 and 127 [§37(1)(a)(i.01)] — As discussed under Subcontracts – SR&ED performed on behalf of the taxpayer (on page 81), subparagraph 37(1)(a)(i.01) allows a taxpayer to deduct expenditures for SR&ED undertaken on behalf of the taxpayer. There are no provisions in section 37 that treat these expenditures differently when they are paid to a non-arm’s length party. Therefore, the payer may deduct the amount paid to the performer (as long as the expenditures meet the requirements of section 37). Subparagraph 37(1)(a)(i) allows a taxpayer to deduct expenditures for SR&ED undertaken by the taxpayer. Therefore, the taxpayer (the performer) may deduct the expenditures it incurs in performing SR&ED on behalf of a non-arm’s length party. Section 37 thus allows for the duplication of eligible SR&ED expenditures (i.e., both the payer and performer may incur eligible SR&ED expenditures). [§127(9) “qualified expenditure” (f)] — In contrast, under subsection 127(9), expenditures incurred by a taxpayer for SR&ED performed by another party with which the taxpayer is not dealing at arm’s length are excluded as qualified expenditures of the taxpayer. Only the expenditures incurred by the performer are qualified expenditures and may earn investment tax credits, and thus the duplicate SR&ED expenditures do not result in duplicate investment tax credits. It should be noted that under paragraph (a) of the definition of contract payment in subsection 127(9) (see Contract payments (on page 125)), a payment received or receivable by a taxpayer from a taxable supplier for SR&ED performed for or on behalf of a person or partnership entitled to a deduction for the amount because of subparagraph 37(1)(a)(i.01) or (i.1) (i.e., as an eligible SR&ED expenditure under those subparagraphs) is considered a contract payment only if the SR&ED is performed at a time when the taxpayer is dealing at arm’s length with the person or partnership. This requirement ensures that the contract amount paid to a non-arm’s length performer is not a contract payment to the performer, and thus that its qualified expenditures are not reduced by the amount.

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Example Facts and assumptions: Company B is a subsidiary of Company A, and both are taxable suppliers. In 2016, Company B performs SR&ED for Company A (the payer) under contract. Company B incurs eligible SR&ED expenditures of $90 and charges Company A $125 to cover the eligible SR&ED expenditures, other non-eligible SR&ED expenditures, and a certain amount of profit. Company B does not incur any related expenditures that are not current in nature. Tax consequences and analysis: In the absence of the non-arm’s length rule in paragraph (f) of the definition of qualified expenditure in subsection 127(9) and non-arm’s length requirement in paragraph (a) of the definition of contract payment in subsection 127(9), Company A would have eligible SR&ED expenditures of $125 and qualified expenditures of $100 ($125 x 80%).74 Company B would have eligible SR&ED expenditures of $90 and a contract payment amount of $125 and therefore would have no qualified expenditures. The qualified expenditures of the related group (i.e., Company A and Company B together) would be $100, consisting of $90 in eligible SR&ED expenditures and $10 in non-eligible SR&ED expenditures (the 20% reduction being intended to disallow the profit element). As a result, the group could potentially earn investment tax credits on amounts that would not otherwise qualify as eligible SR&ED expenditures had the SR&ED work been performed by only one entity. Applying the non-arm’s length rule and arm’s length requirement reduces Company A’s eligible SR&ED expenditures of $125 by the non-arm’s length contract amount of $125, which results in no qualified expenditures for that work. Company B, on the other hand, has eligible SR&ED expenditures of $90, and the $125 received is not a contract payment. Therefore, Company B has qualified expenditures of $90 (as does the related group).

Administration For the purpose of computing eligible SR&ED expenditures, the payer’s expenditures for non-arm’s length contracts are entered on Line 345 of Section B of Part 3 of Form T661. This amount is then entered on Line 541 (Part 4) of the form (expenditures for non-arm’s length SR&ED contracts) and is used to calculate qualified expenditures. Expenditures incurred by the performer are reported on the appropriate lines in Section B of Part 3 (allowable SR&ED expenditures) of Form T661 and are reflected in Lines 492 and 496 in Part 4 (qualified expenditures). The contract amount is not a contract payment and thus is not included on Line 517 or 518.

74 Only 80% of current expenditures made after 2012 for SR&ED contracts are considered qualified expenditures. See Eligible SR&ED expenditures and qualified expenditures (on page 115).

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Transfer of qualified expenditures [§127(13)] — Subsection 127(13) provides a mechanism for the transfer of qualified expenditures between non-arm’s length taxpayers.75 The transferor is the non-arm’s length party that performed the SR&ED. The transferee is the non-arm’s length party that paid the transferor for SR&ED work performed under contract. The parties may jointly elect to transfer qualified expenditures from the performer to the payer by filing an agreement with the CRA. The amount of the transfer will be the least of •

the amount specified by the parties in the agreement filed with the CRA;

•

the amount of the transferor’s SR&ED qualified expenditure pool at the end of the year (before deducting the transfer of qualified expenditures to the transferee, which must be paid by the transferor within 180 days of the relevant taxation year-end); and

•

the total of all amounts that would generally be contract payments (had the parties been dealing at arm’s length) in respect of qualifying expenditures incurred by the transferor for the performance of SR&ED for or on behalf of the transferee (the amount must be paid by the transferee to the transferor within 180 days of the end of the transferor’s taxation year in which the transferor is entitled to receive or can reasonably be expected to receive the amount).

The amount of the transfer reduces the SR&ED qualified expenditure pool of the performer and increases the SR&ED qualified expenditure pool of the payer. If the amount specified in the agreement exceeds the amount of the transferor’s SR&ED qualified expenditure pool before taking into consideration the transfer, the agreement is ineffective and there is no transfer. [§127(26)] — The rules under subsection 127(26) regarding unpaid amounts (see Unpaid amounts (on page 131) for more details) do not affect non-arm’s length SR&ED contracts. Subsection 127(26) does not affect the payer’s deduction under section 37,76 and the amount paid to a non-arm’s length party for SR&ED contracts does not form part of the payer’s qualified expenditures. Therefore, subsection 127(26) also has no effect on the payer’s qualified expenditures. The unpaid amount represents an uncollected amount for the performer and does not change the deductibility of the expenditures incurred by the performer or their eligibility as qualified expenditures. [§127(15)] — Subsection 127(15) sets out the conditions for the transfer: •

the transferor and transferee must jointly file an agreement in prescribed form (Form T1146, Agreement to Transfer Qualified Expenditures Incurred in Respect of SR&ED Contracts Between Persons Not Dealing at Arm’s Length);

•

the agreement must be filed

75 Partnerships cannot be party to an ITA s. 127(13) transfer because partnerships are not taxpayers under the Act and s. 127(8) specifically excludes s. 127(13) from the rule that allows a partnership to compute its tax credits as if it were a person (a taxpayer) in calculating investment tax credits allocable to a partner. For more information on partnerships, see Partnerships (on page 158). 76 The application of ITA s. 127(26) is limited to ss. 127 and 127.1. ITA s. 78(4) denies a deduction, but only for unpaid salaries, wages, and other remuneration.

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– by the transferor’s filing-due date for the taxation year to which the agreement relates,77 – during the period in which the transferor may object (by serving a notice of objection) to an assessment of Part I tax payable for that particular taxation year, or – during the period in which the transferee may object (by serving a notice of objection) to an assessment of Part I tax payable for the transferee’s first taxation year ending at or after the end of the transferor’s particular taxation year; and •

where the transferor or transferee is a corporation, the agreement must be accompanied by a certified copy of the directors’ resolution from the transferor or transferee (or both, if applicable) authorizing the agreement (if the directors are not legally entitled to administer the agreement, the certified copy of the document authorizing the agreement must come from the legal administrator of the corporation).

Anti-avoidance rules [§127(15), (16)] — If taxpayers do not deal at arm’s length with each other principally for the purpose of allowing them to enter into a transfer agreement under subsection 127(13), the anti-avoidance rule in subsection 127(16) deems the amount transferred to the transferee’s SR&ED qualified expenditure pool to be nil. However, the reduction of the transferor’s SR&ED qualified expenditure pool by the amount of the attempted transfer is not adjusted. The result is that none of the related parties earns investment tax credits on the amount of qualified expenditures in question. Subsection 127(15) prevents taxpayers from filing amended agreements when subsection 127(16) is applicable. [§127(24)] — Subsection 127(24) prevents non-arm’s length parties from using an intermediate arm’s length party (unrelated party) to get around the non-arm’s length SR&ED rules. Specifically, if two non-arm’s length parties (the first party and the second party) structure an arrangement so that the first party pays an amount to an arm’s length third party who then pays the second party, the amount is deemed not to be a qualified expenditure of the first party if one of the main purposes of the arrangement can reasonably be considered to be to cause the amount paid by the first party to be a qualified expenditure. Example Facts and assumptions: Company A (parent of Company B) ↓ Company Z (arm’s length party) ↓ Company B (subsidiary of Company A)

77 For corporations, six months after the year-end (by comparison, Form T661 must be filed within 18 months).

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Company A contracts with Company Z to perform SR&ED on its behalf. Company Z contracts with Company B to perform all or some of the same work. Tax consequences: If one of the main purposes of this arrangement is to allow Company A to treat the payment to Company Z as a qualified expenditure, the amount paid by Company A to Company Z is deemed not to be a qualified expenditure.

Timing of transfer [§127(13)(d), (e)] — When the parties agree to transfer the qualified expenditures (and comply with all the conditions set out above) in a particular taxation year, the transferred expenditures are excluded from the transferor’s SR&ED qualified expenditure pool for that year and are included in the transferee’s SR&ED qualified expenditure pool for the transferee’s first taxation year that ends at (or after) the end of the particular taxation year in which the transfer is made.

Administration The transferee includes transferred qualified expenditures on Lines 508 (for current expenditures) and 510 (for pre-2014 capital expenditures) in Part 4 of Form T661. The transferor reports the qualified expenditures it transferred on Lines 544 (for current expenditures) and 546 (for pre-2014 capital expenditures) on Part 4 of the form.

Investment tax credits [§127] — Section 127 contains rules governing many types of investment tax credits (ITCs), including ITCs for SR&ED. Subsection 127(5) allows a taxpayer to deduct ITCs from taxes otherwise payable at the end of the year. The definition of investment tax credit in subsection 127(9) is lengthy and complex.78 Specifically, subsection 127(9) states that79 “investment tax credit” of a taxpayer at the end of a taxation year means the amount, if any, by which the total of… (a.1) 15% of the amount by which the taxpayer’s SR&ED qualified expenditure pool at the end of the year exceeds the total of all amounts each of which is the super-allowance benefit amount for the year in respect of the taxpayer in respect of a province… (b) the total of amounts required by subsection (7) or (8) to be added in computing the taxpayer’s investment tax credit at the end of the year, (c) the total of all amounts each of which is an amount determined under any of paragraphs (a) to (b) in respect of the taxpayer for any of the 10 taxation years immediately preceding or the 3 taxation years immediately following the year…

78 A simplified description that focuses on SR&ED ITCs is provided under Investment tax credits (on page 139). 79 Paragraphs not relevant for SR&ED ITC purposes are omitted from this quotation. In addition, the transitional application provisions in ITA ss. 127(9.01) and (9.02) must also be referred to while reading the definition. See ITC carryback and carryforward (on page 146).

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(e) the total of all amounts each of which is an amount required by subsection (10.1) to be added in computing the taxpayer’s investment tax credit at the end of the year or at the end of any of the 10 taxation years immediately preceding or the 3 taxation years immediately following the year, (e.1) the total of all amounts each of which is the specified percentage of that part of a repayment made by the taxpayer in the year or in any of the 10 taxation years immediately preceding or the 3 taxation years immediately following the year that can reasonably be considered to be a repayment of government assistance, non-government assistance or a contract payment that reduced (i) the capital cost to the taxpayer of a property under paragraph (11.1)(b), (ii) the amount of a qualified expenditure incurred by the taxpayer under paragraph (11.1)(c) for taxation years that began before 1996, (iii) the prescribed proxy amount of the taxpayer under paragraph (11.1)(f) for taxation years that began before 1996, (iv) a qualified expenditure incurred by the taxpayer under any of subsections (18) to (20)…and (e.2) the total of all amounts each of which is the specified percentage of 1/4 of that part of a repayment made by the taxpayer in the year or in any of the 10 taxation years immediately preceding or the 3 taxation years immediately following the year that can reasonably be considered to be a repayment of government assistance, non-government assistance or a contract payment that reduced (i) the amount of a qualified expenditure incurred by the taxpayer under paragraph (11.1)(e) for taxation years that began before 1996, or (ii) a qualified expenditure incurred by the taxpayer under any of subsections (18) to (20), in respect of first term shared-use-equipment or second term shared-use-equipment, and, for that purpose, a repayment made by the taxpayer in any taxation year preceding the first taxation year that ends coincidentally with the first period or the second period in respect of first term shared-use-equipment or second term shared-use-equipment, respectively, is deemed to have been incurred by the taxpayer in that first taxation year, exceeds the total of (f) the total of all amounts each of which is an amount deducted under subsection (5) from the tax otherwise payable under this Part by the taxpayer for a preceding taxation year in respect of property acquired, or an expenditure incurred, in the year or in any of the 10 taxation years immediately preceding or the 2 taxation years immediately following the year, or in respect of the taxpayer’s SR&ED qualified expenditure pool at the end of such a year, (g) the total of all amounts each of which is an amount required by subsection (6) to be deducted in computing the taxpayer’s investment tax credit (i) at the end of the year, or… (iii) at the end of any of the 9 taxation years immediately preceding or the 3 taxation years immediately following the year, (h) the total of all amounts each of which is an amount required by subsection (7) to be deducted in computing the taxpayer’s investment tax credit (i) at the end of the year, or… (iii) at the end of any of the 10 taxation years immediately preceding or the 3 taxation years immediately following the year… (j) if the taxpayer is subject to a loss restriction event at any time before the end of the year, the amount determined under subsection (9.1) in respect of the taxpayer, and

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(k) if the taxpayer is subject to a loss restriction event at any time after the end of the year, the amount determined under subsection (9.2) in respect of the taxpayer, except that no amount shall be included in the total determined under any of paragraphs (a) to (e.2) in respect of an outlay, expense or expenditure that would, if this Act were read without reference to subsections (26) and 78(4), be made or incurred by the taxpayer in the course of earning income in a particular taxation year, and no amount shall be added under paragraph (b) in computing the taxpayer’s investment tax credit at the end of a particular taxation year in respect of an outlay, expense or expenditure made or incurred by a trust or a partnership in the course of earning income, if (l) any of the income is exempt income or is exempt from tax under this Part, (m) the taxpayer does not file with the Minister a prescribed form containing prescribed information in respect of the amount on or before the day that is one year after the taxpayer’s filing-due date for the particular year[.]

This part of the chapter outlines how ITCs are earned and how they are claimed, with reference to the relevant portions of the ITC definition. The recapture rules for ITCs are also described.

Claiming ITCs [§127(5), (9)] — As mentioned above, subsection 127(5) allows taxpayers to deduct ITCs from their tax otherwise payable.80 The amount that may be deducted is determined by the accumulation of many items listed in the ITC definition in subsection 127(9). The definition also provides for the carryback and carryforward of ITCs, which is why it is often referred to as the ITC pool. The ITC carryback and carryforward are discussed under ITC carryback and carryforward (on page 146). [§127.1(3)] — ITCs that are refunded to a taxpayer are deemed to have been deducted from taxes otherwise payable. See Refundable investment tax credits (on page 156) for more information on these credits.

Earning SR&ED ITCs [§127(9) “investment tax credit” (a.1), (e)] — Section 127 allows a 15% tax credit for all taxpayers and an additional 20% for certain CCPCs.81 Paragraph (a.1) of the definition of

80 However, for an individual, ITCs cannot reduce tax otherwise payable below minimum tax as calculated under ITA s. 127.51. 81 A detailed review of what constitutes a CCPC (in particular, when a corporation is controlled for purposes of the Act) is beyond the scope of this publication. However, for recent court decisions on corporate structures that were set up with CCPCs to qualify for the 35% ITC, see Solutions MindReady R&D Inc. v. The Queen, 2015 TCC 17, and Lyrtech RD Inc. v. The Queen, 2013 TCC 12; aff’d. 2014 FCA 267. In these decisions, the courts established that “a form of determinative economic influence that enables a corporation to be in a position to impose its will on the affairs of another corporation is sufficient to constitute de facto control.” It should be noted that amendments enacted in 2017 introduced ITA s. 256(5.11) to reverse the effect of the 2016 Federal Court of Appeal decision in McGillivray Restaurant Ltd. v. The Queen, 2016 FCA 99, where it was held that the factors that may be used to determine the presence of de facto control are limited to a legally enforceable right and ability to effect a change in the board of directors or its powers, or to exercise influence over the shareholders who have that right or ability, by opposition to operational control. See Aeronautic Development Corporation v. The Queen, 2018 FCA 67, for an example of a case applying the McGillivray decision prior to the application of s. 256(5.11) for taxation years beginning after March 21, 2017.

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ITC in subsection 127(9) refers to the 15% ITC for the current taxation year. Paragraph (e) provides for the additional 20% by referring to the ITC added by subsection 127(10.1), which specifies that a CCPC may earn the additional ITC on expenditures, up to the CCPC’s expenditure limit. Thus, a CCPC may claim a total credit of 35% on its qualified expenditures, up to its expenditure limit. For taxation years ending prior to 2014, the base credit rate available to all claimants was 20%, and the additional credit rate for eligible CCPCs was 15% (so no change to the total credit rate of 35% for eligible CCPCs).82

Expenditure limit for 35% ITC [§127(10.2)] — Generally, the expenditure limit is $3 million. However, this amount may be reduced as a result of the formula in subsection 127(10.2) (for 2010 and subsequent taxation years): ($8 million – 10A) x [($40 million – B)/$40 million] For taxation years that ended between February 26, 2008, and December 31, 2009, the first amount in the formula was $7 million rather than $8 million.83 The formula provides for two “size” tests designed to ensure the enhanced 35% ITC is available only to small and medium-sized CCPCs. The first part of the formula represents a taxable income test, and the second part a taxable capital test.

Taxable income test [§127(10.2)] — Variable A in the above formula is the corporation’s taxable income for the immediately preceding taxation year, up to $500,000 ($400,000 for taxation years that ended before January 1, 2010). For 2010 and subsequent taxation years, a CCPC with taxable income of $500,000 or less in its preceding taxation year generally has a $3-million expenditure limit. A CCPC with taxable income of $800,000 or more in its preceding taxation year has no expenditure limit. A CCPC with taxable income between $500,000 and $800,000 in its preceding taxation year generally has an expenditure limit between zero and $3 million, adjusted by $10 for every $1 of taxable income above $500,000.84 For taxation years that ended between February 26, 2008, and December 31, 2009, the $3-million expenditure limit was reduced to nil when the preceding year’s taxable income was $700,000 or more. A CCPC with taxable income between $400,000 and

82 For taxation years straddling January 1, 2014, the applicable credit rates are prorated for the number of days in the taxation year before 2014 and after 2013. 83 For 2010 taxation years that straddled January 1, 2010, any increase in the expenditure limit resulting from this formula change was prorated on the basis of the number of days in the taxation year that were in 2010. 84 For 2010 taxation years that straddled January 1, 2010, the phase-out limit was prorated on the basis of the number of days in the taxation year that were in 2010.

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$700,000 in its preceding taxation year generally had an expenditure limit between zero and $3 million.85 Where the CCPC is associated with other corporations, variable A comprises the total of the associated corporations’ taxable incomes for the last taxation year of each corporation that ends in the preceding calendar year.86 A corporation’s taxable income for the immediately preceding taxation year is the taxable income before taking into consideration specified future tax consequences for that preceding taxation year. Specified future tax consequence is defined in subsection 248(1): “specified future tax consequence” for a taxation year means (a) the consequence of the deduction or exclusion of an amount referred to in paragraph 161(7)(a), (b) the consequence of a reduction under subsection 66(12.73) of a particular amount purported to be renounced by a corporation after the beginning of the year to a person or partnership under subsection 66(12.6) or (12.601) because of the application of subsection 66(12.66), determined as if the purported renunciation would, but for subsection 66(12.73), have been effective only where (i) the purported renunciation occurred in January, February or March of a calendar year, (ii) the effective date of the purported renunciation was the last day of the preceding calendar year, (iii) the corporation agreed in that preceding calendar year to issue a flow-through share to the person or partnership, (iv) the particular amount does not exceed the amount, if any, by which the consideration for which the share is to be issued exceeds the total of all other amounts purported by the corporation to have been renounced under subsection 66(12.6) or (12.601) in respect of that consideration, (v) paragraphs 66(12.66)(c) and (d) are satisfied with respect to the purported renunciation, and (vi) the form prescribed for the purpose of subsection 66(12.7) in respect of the purported renunciation is filed with the Minister before May of the calendar year; and (c) the consequence of an adjustment or a reduction described in subsection 161(6.1)[.]

Paragraph 161(7)(a) refers to many types of losses incurred in a taxation year that may be carried back to reduce tax payable under Parts I, I.3, VI, and VI.1 of the Act, including losses deductible under subsection 111(1).87 Losses under subsection 111(1) include noncapital losses and net capital losses carried back up to three taxation years. Therefore, a CCPC that incurs a loss in one taxation year and carries back the loss to the preceding taxation year cannot reduce the taxable income of that preceding year for the purpose

85 For taxation years that included February 26, 2008, the phase-out limit was prorated on the basis of the number of days in the taxation year that were after February 25, 2008. 86 See CRA document 2011-0417971E5 for an example of this rule. 87 A detailed review of each of these specified future tax consequences is beyond the scope of this publication.

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of calculating its expenditure limit. In such a situation, it would be advisable to consider various options for carrying losses forward to subsequent taxation years to help preserve the expenditure limit in future years. The following table lists the applicable taxable income thresholds by taxation year. Expenditure limit reduction Taxation year

Threshold

2010 and subsequent taxation years

$500,000

2007, 2008, and 2009

$400,0001

2005 and 2006

$300,000

2004

$250,000

2003

$225,000

2002 and prior years

$200,000

1

The threshold was $300,000 for a 2007 or 2008 taxation year that immediately followed a taxation year ending before 2007. Generally, this would be the first taxation year ending in 2007, unless a taxation year of 53 weeks for a corporation began in late 2006 and ended in early 2008.

Taxable capital test [§125(2), (3), (5), (5.1), §127(10.2)] — The second part of the formula — “($40 million – B)/ $40 million” — reduces the expenditure limit when a CCPC and all its associated corporations have combined taxable capital employed in Canada88 of more than $10 million for the previous year, and it is nil when this taxable capital reaches $50 million.89 Variable B in the formula refers to the taxable capital employed in Canada of the CCPC and of all its associated corporations for the preceding taxation year. Where this taxable capital is $10 million or less, variable B is deemed to be nil; in any other case, variable B is the lesser of $40 million and the amount by which the taxable capital exceeds $10 million.

Expenditure limit and total ITC earned – Scenarios The following table illustrates various scenarios for a CCPC that •

has a taxation year ending December 31, 2017;

•

is not associated with any other corporations; and

•

has $3 million of qualified expenditures.

88 Defined in ITA s. 181.2, and also in s. 181.3 for taxation years ending after February 25, 2008. A discussion of the composition of taxable capital employed in Canada is beyond the scope of this publication. 89 For taxation years that include February 26, 2008, the phase-out limit is prorated on the basis of the number of days in the taxation year that are after February 25, 2008 (previously, the phase-out limit was $15 million rather than $50 million).

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2016 taxable capital ($M)

2017 expenditure limit ($M)

Total ITC earned in 2017

$400,000

$10.0

$3

$1,050,000

$500,000

$10.0

$3

$1,050,000

$600,000

$10.0

$2

$850,000

$700,000

$10.0

$1

$650,000

$800,000

$10.0

Nil

$450,000

$500,000

$12.5

$2.81

2016 taxable income

$500,000

$15.0

$2.63

$500,000

$50.0

Nil

1 2

1

$1,012,500 $975,0002 $450,000

[$8 million – (10 x $500,000)] x [$40 million – ($15 million – $10 million)]/$40 million = $2,625,000. (15% x $3 million) + (20% x $2,625,000).

Superallowance [§127(9) “investment tax credit” (a.1), §127(9) “super-allowance benefit amount”] — Previously, the provinces of Quebec and Ontario allowed taxpayers to deduct SR&ED expenditures in excess of the amount of expenditures incurred. The tax savings resulting from the deduction of these additional amounts were not considered assistance. In 2001, the Act was amended to assign a value, defined as a superallowance benefit amount in subsection 127(9), to these provincial tax savings and treat them in a way similar to how government assistance was treated. The superallowance benefit amount reduces the amount on which the ITC is calculated. Shortly after these amendments were introduced, Quebec and Ontario repealed the legislation allowing the extra deductions. Given the current provincial SR&ED regimes, the superallowance provisions, while still law, are not currently applicable.

Repayments of assistance or contract payments [§127(9) “investment tax credit” (e.1), (e.2), §127(10.7)] — Paragraph (e.1) of the definition of ITC in subsection 127(9) provides that if a taxpayer repays government or non-government assistance or a contract payment, the taxpayer is entitled to an ITC for the repayment to the extent that the repaid assistance or contract payment had previously reduced the amount of the taxpayer’s •

capital cost of a property under paragraph 127(11.1)(b);

•

qualified expenditures under any of subsections 127(18) to (20); or

•

for taxation years that began before 1996, the taxpayer’s – qualified expenditures on SR&ED under (pre-repeal) paragraph 127(11.1)(c), or – prescribed proxy amount under (pre-repeal) paragraph 127(11.1)(f).

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Paragraph (e.2) of the definition provides that if a taxpayer repays government or nongovernment assistance or a contract payment that had reduced the amount of the taxpayer’s qualified expenditures under any of subsections 127(18) to (20)90 in respect of first-term shared-use equipment, the taxpayer is entitled to an ITC of one-quarter of the amount repaid. The same treatment applies to repayments of assistance or contract payments that reduced qualified expenditures in respect of second-term shared-use equipment. See Shared-use equipment (on page 117) for a description of first- and second-term shared-use equipment. Repayments made during the period in which the asset qualified as first- or second-term shared-use equipment require special consideration. For example, assume a taxpayer acquires a depreciable asset in a year (Year 1) and the asset is used primarily in the prosecution of SR&ED from the time of acquisition to the end of the following year (Year 2) (so the asset qualifies as first-term shared-use equipment). If the taxpayer received assistance in respect of the asset when it was acquired (i.e., in Year 1) and repaid the assistance in that same year, the repayment is deemed to have been made in Year 2 because the amount for the first-term shared-use equipment is not added to qualified expenditures until the end of Year 2. The repayment with respect to the amount for second-term shared-use equipment (provided the assets qualify as such at the end of Year 3) would be deemed to have been made at the end of Year 3. The ITC resulting from the repayment of assistance or a contract payment is earned at the ITC rate used for that amount in the year the assistance or contract payment was originally applied against qualified expenditures. The repayment of assistance does not increase the qualified expenditures in the year, and therefore the ITC earned on the repayment is not refundable in the year the repayment is made or deemed to be made.

Assistance or contract payment no longer expected to be received [§127(10.8)] — An amount of assistance or contract payment that a taxpayer expected to receive but that was not received, and that can no longer reasonably be expected to be received, is deemed to be repaid by the taxpayer in the year it ceased to be expected to be received. Because this amount would have been used to reduce the taxpayer’s qualified expenditures when it was expected to be received, subsection 127(10.8) allows the taxpayer to claim an ITC for the amount deemed to be repaid.

ITC carryback and carryforward Unused ITCs in a current year may be carried back three years or forward 20 years to be deducted from tax otherwise payable in those years. The legislative mechanism that allows for this carryover is somewhat complex and is incorporated into the definition of ITC in subsection 127(9), as well as in the transitional application provisions in subsections 127(9.01) and (9.02), which must be read in conjunction with the definition.

90 Also under ITA s. 127(11.1)(e) [repealed] for taxation years that began before 1996.

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ITC definition [§127(9) “investment tax credit” (a.1), (b), (e), (f)] — The current-year basic SR&ED ITC of 15% is included in the ITC pool under paragraph (a.1) of the definition of ITC in subsection 127(9). Also included in the pool at a particular taxation year-end, under paragraph (c) of the definition, is the SR&ED ITC computed under paragraphs (a.1) and (b) for any of the 10 preceding taxation years (which allows an ITC to be carried forward 10 years) and for any of the three following taxation years (which allows an ITC to be carried back to that particular taxation year in any of the subsequent three years). The additional 20% ITC allowed for CCPCs under subsection 127(10.1) is included in the ITC pool under paragraph (e) of the definition. For the 20% credit, the amounts for the current year, 10 preceding years, and three following years are all included under the same paragraph. The ITC pool is then reduced, under paragraph (f) of the definition, by the ITC claimed in the year, in any of the 10 preceding years, or in the two years immediately following the year, thereby keeping the carryforward and carryback windows to 10 and three years, respectively. For taxation years ending prior to 2014, the basic credit rate available to all claimants was 20%, and the additional credit rate for eligible CCPCs was 15%.91

Transitional application provisions [§127(9.01), (9.02)] — Subsection 127(9.01) is a transitional provision that effectively provides for the extension of the carryforward period, from 10 taxation years to 20, for ITCs earned in 2006 and subsequent taxation years.92 In addition, the carryforward period for unused ITCs between 1998 and 2005 has been extended from 10 to 20 taxation years. This amendment generally allows ITCs earned in 1998 to be carried forward to 2018; however, where a taxpayer has more than 10 taxation years after 1997 and before 2008 (because of short taxation years), the ITCs that expired after 10 taxation years before 2008 are not afforded a 20-taxation-year carryforward.

Recapture of ITC [§127(27)–(36)] — The recapture rules, contained in subsections 127(27), (28), and (29) to (36), provide for the recapture of ITCs previously claimed when property acquired is subsequently disposed of or converted to commercial use. Guidance on the application of the rules is provided in the Recapture of SR&ED Investment Tax Credit Policy.

91 For taxation years straddling January 1, 2014, the applicable credit rates are prorated for the number of days in the taxation year before 2014 and after 2013. 92 A similar provision applies to the carryforward of ITCs for cooperative corporations — ITA s. 127(9.02) extends the carryforward period from 10 taxation years to 20 taxation years for 2006 and subsequent taxation years.

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Rather than decreasing the ITC pool, the recaptured ITC is added to the taxpayer’s Part I tax otherwise payable for the taxation year in which the property is disposed of or converted to commercial use. The SR&ED expenditure pool is increased in the following year. The taxpayer’s Part I tax otherwise payable for the year is increased by the lesser of •

the ITCs earned on the property (qualifying expenditures multiplied by the historical ITC rate); and

•

one of the following amounts: – in the case of a property disposed of to an arm’s length party, the proceeds of disposition multiplied by the historical ITC rate, or – in any other case (i.e., the property is converted to commercial use or disposed of to a non-arm’s length party), the fair market value of the property at the time of conversion or disposal multiplied by the historical ITC rate (see Shared-use equipment (on page 150) for the special rules applicable where the property is first-term or second-term shared-used equipment).

The historical ITC rate is the rate that applied in calculating the ITC earned on the cost of the property for the taxation year in which it became a qualified expenditure. Generally, that rate is 15% (20% if the ITC was earned prior to 2014). For CCPCs that claimed a 35% ITC, it is generally acceptable to recapture ITCs earned at 15% (20% if the ITC was earned prior to 2014) before recapturing ITCs earned at 35%. There is an assumption that, in the case of expenditures that are within the expenditure limit, current expenditures are computed first, as they give rise to a fully refundable tax credit (see section 8.3 of the Recapture of SR&ED Investment Tax Credit Policy).

Purpose The recapture rules exist to ensure taxpayers earn ITCs on the net cost of performing SR&ED in respect of property acquired. For example, at the start of an SR&ED project, a taxpayer may not know whether a property will be fully consumed during the SR&ED project or whether it will have residual value at the end of the project. In this situation, the taxpayer may claim ITCs on the eligible cost of the property at the start of the SR&ED project. If the property is subsequently disposed of or converted to commercial use, the recapture rules will deal with any residual value. Recapture also applies where a taxpayer acquires a depreciable asset intending to use all or substantially all its value in the prosecution of SR&ED (and therefore deducts the cost of the asset as a pre-2014 capital expenditure), but the asset is later converted to another use. Some of the concepts used in the application of the recapture rules, such as property, disposition, and conversion to commercial use, as well as some particularities (e.g., disposition of equipment to a non-arm’s length party) are discussed below.

Requirements Recapture applies when all four of the following requirements are met:

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•

[§127(27)(a)] — The taxpayer acquired a property from a person or partnership in the year, or in any of the 10 preceding taxation years. See Timing of the acquisition (on page 150) for more details, including a discussion of the transitional application provision that takes into account the change in the ITC carryforward period from 10 taxation years to 20.

•

[§127(27)(b)] — The cost (or a portion of the cost) of the property was a qualified expenditure to the taxpayer, or would be a qualified expenditure if not for the application of the 180-day-unpaid rule in subsection 127(26). See Unpaid amounts (on page 131) for a description of this rule.93 The cost cannot exceed the amount paid by the taxpayer to acquire the property and does not include amounts paid by the taxpayer to maintain, modify, or transform the property.94

•

[§127(27)(c)] — The cost (or the portion of the cost) of the property was included, or would be included if not for the application of the 180-day-unpaid rule in subsection 127(26), in an amount on which the taxpayer earned ITCs.95

•

[§127(27)(d)] — The property (or another property that incorporates that property) is disposed of or converted to commercial use after February 23, 1998.

Salaries and contracts for services are not property acquired and therefore are not subject to recapture. Example Facts and assumptions: Company A builds a sub-assembly required in the prosecution of SR&ED. The company purchases parts from a third party for $10 and incurs a labour expense of $5 to build the sub-assembly. Tax consequences: Company A deducts $15 as eligible SR&ED expenditures. If the sub-assembly is subsequently disposed of or converted to commercial use, only the $10 spent to acquire the parts would be subject to recapture. If the company had purchased the sub-assembly from the third party (instead of building it) for the same $15 (i.e., all $15 was for property acquired), the full invoice cost of $15 would be subject to recapture. Livestock born as a result of SR&ED are not subject to recapture because they are not considered property acquired by the taxpayer. However, animals purchased by the taxpayer and used in SR&ED would be subject to the recapture rules. When items in inventory are used in an SR&ED project, the cost of the property subject to recapture is the laid-down cost of the property acquired that is incorporated into that inventory. If the property was manufactured by the taxpayer, the cost includes the cost

93 The references in ITA s. 127(27)(b) to a portion of the cost and to unpaid amounts under s. 127(26) are applicable to dispositions and conversions occurring after December 20, 2002. 94 ITA s. 127(32). 95 The references in ITA s. 127(27)(c) to a portion of the cost and to unpaid amounts under s. 127(26) are applicable to dispositions and conversions occurring after December 20, 2002.

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of the materials originally purchased plus manufacturing salary and overheads. Only the cost of the materials originally purchased and the overhead costs representing property acquired that is incorporated into the inventory are subject to recapture.

Timing of the acquisition For the recapture rules to apply in a particular taxation year, the taxpayer must have acquired the property in that year or in any of the 10 preceding taxation years. This requirement ensures that there is no recapture when property is disposed of or converted to commercial use after the related ITCs have expired. Even property acquired by the taxpayer before February 23, 1998, is subject to recapture if it is disposed of or converted to commercial use after that date, provided all four requirements discussed above are met. [§127(36)] — Subsection 127(36) is a transitional provision applicable to ITCs earned in 2006 and subsequent taxation years. The provision takes into account the change in the ITC carryforward period from 10 taxation years to 20 taxation years. It is worded in a fashion similar to subsection 127(9.01), which is discussed under ITC carryback and carryforward (on page 146). As mentioned under ITC carryback and carryforward (on page 146), the carryforward period for unused ITCs between 1998 and 2005 has been extended from 10 to 20 taxation years. The recapture rules have also been amended to reflect this change.

Shared-use equipment When determining whether shared-use equipment has been converted to commercial use, the CRA’s position (see the Recapture of SR&ED Investment Tax Credit Policy) is that a conversion occurs only when the usage of the equipment for SR&ED becomes incidental. Thus, an ITC in respect of shared-use equipment will be recaptured only if the property has been disposed of or has been all or substantially all converted to commercial use. Because only a percentage of the cost of shared-use equipment (25% or 50%) is claimed as a qualified expenditure, only that percentage of the proceeds of disposition or fair market value, not the full cost of the property, is used in determining recapture under subsection 127(27), for disposals and conversions occurring after December 20, 2002. Example Facts and assumptions: In Year 1, Company A acquired equipment for $100. The expenditure qualifies as firstand second-term shared-use equipment. The ITC rate is 15%, and the company earns ITCs of $3.75 on each of the first- and second-term shared-use equipment ($100 x 15% x 25%). The total ITCs earned are $7.50. In Year 4, Company A sells the equipment to an arm’s length party for $80.

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Analysis: Under the current wording of the Act, the amount recaptured is the lesser of •

$7.50 (the ITCs earned); and

•

$6 (Proceeds of disposition x Historical ITC rate = $80 x 15% x 50%).

If the equipment had met only the test for first-term shared-use equipment, the amount would be $3 (calculated using 25% of the proceeds).

Definition of property Subsection 248(1) defines property as property of any kind, whether real or personal, immovable or movable, tangible or intangible, or corporeal or incorporeal. The types of property most commonly subject to ITC recapture include •

materials transformed in the SR&ED project;

•

capital (shared-use equipment or capital used all or substantially all in SR&ED);

•

animals and growing things used in an SR&ED project; and

•

property acquired through a contract.

An exception to this last item is the acquisition of intellectual property through a services contract. In such a case, it is the CRA’s view, expressed in the Recapture of SR&ED Investment Tax Credit Policy, that “[w]here the IP [intellectual property] belongs to the payer under the terms of a contract, the payer is not acquiring the IP. The IP always belonged to the payer. It simply accrues to the payer as it is generated.”

Definition of disposition Subsection 248(1) defines disposition to include any transaction or event that entitles a taxpayer to proceeds of disposition of a property. The following events may give rise to a disposition: •

sale of an SR&ED prototype;

•

sale of a custom product;

•

sale of experimental production; and

•

receipt of insurance proceeds for property that is damaged or destroyed.

Proceeds of disposition The term proceeds of disposition is not defined in the Act for the purpose of the recapture rules.96 For recapture, the common meanings of the term may include •

the sale price of a property that has been sold; or

•

insurance compensation for the loss or destruction of property.

96 The term is defined, for example, in ITA s. 54 for the purpose of the capital gains provisions (i.e., ss. 38 to 55).

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It is important to note that the sale price should not be allocated to individual cost elements of the property. Example Facts and assumptions: The cost of a property to Company A is $10 ($7 for raw materials and $3 for SR&ED labour). The company sells the property to an arm’s length party for $8. Tax consequences: The proceeds of disposition used to calculate the ITC recapture are $8 (not the percentage of $8 that applies to the raw-material component of the property being sold).

Conversion to commercial use It is a question of fact whether a property has been converted to commercial use. Generally, such a conversion is associated with a revenue-generating activity. There is no clear guidance or jurisprudence regarding the amount of commercial activity that may trigger recapture. However, recapture is not usually triggered by an incidental commercial use of a given property.

Deemed fair market value When a property is converted to commercial use or is sold to a non-arm’s length party, the fair market value (FMV) of the property must be calculated. FMV includes the value of materials, labour, and overhead used to develop the property. Where equipment used all or substantially all in SR&ED is sold to a non-arm’s length person or converted to commercial use, the Recapture of SR&ED Investment Tax Credit Policy recommends using a notional undepreciated capital cost, calculated using the capital cost allowance rate that would have applied had the equipment not been an SR&ED capital expenditure, as an estimate of FMV. However, the FMV may be lower than this notional undepreciated capital cost. In such a case, it would be advisable for the taxpayer to be able to support a lower amount.

Disposition of equipment to non-arm’s length party [§127(33)] — ITC recapture is deferred when the property is transferred to a non-arm’s length party and the property •

is a pre-2014 capital expenditure used all or substantially all for SR&ED; and

•

continues to be used all or substantially all for SR&ED after the transfer.

Essentially, subsection 127(33) provides that recapture does not apply on non-arm’s length transfers if the cost would have been an SR&ED pre-2014 capital expenditure that would have met the all-or-substantially-all test for the acquirer (as the test read prior to

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its repeal). This excludes non-arm’s length transfers to non-taxable Canadian suppliers. The main purpose of this provision is to avoid the ITC recapture in the context of nonarm’s length reorganizations within Canada. Subsection 127(33) does not technically apply to shared-use equipment. The CRA’s administrative policy (see the Recapture of SR&ED Investment Tax Credit Policy) is that recapture will not occur for shared-use equipment that is transferred to a non-arm’s length person unless the usage of the equipment for SR&ED becomes only incidental. Thus, an ITC in respect of shared-use equipment that has been transferred to a nonarm’s length person will be recaptured only if the property has been all or substantially all converted to commercial use, or is subsequently disposed of by the non-arm’s length person to an arm’s length person (as discussed below). This is consistent with the CRA’s policy with respect to the change in use of shared-use equipment. See Shared-use equipment (on page 150).

Recapture of ITC on property previously transferred to a non-arm’s length party [§127(34)] — ITC recapture applies to property described in subsection 127(33) when the property is subsequently disposed of to an arm’s length party or converted to commercial use. The non-arm’s length purchaser is required to apply a recapture rule similar to the recapture rule in subsection 127(27) (discussed above). The ITC rate to be applied is the rate at which the original ITC was generated on the property. Accordingly, it is advisable for the transferor to communicate the original ITC rate to the transferee at the time of transfer.

Recapture of ITC on qualified expenditures transferred to a related party [§127(29)] — Where qualified expenditures have been transferred between non-arm’s length parties under subsection 127(13) and recapture subsequently applies in respect of property acquired that represented qualified expenditures transferred to the payer, the ITC is nevertheless recaptured in the hands of the SR&ED performer (the transferor). The recapture is the lesser of •

the amount that can reasonably be considered to have been included in computing the transferee’s ITC in respect of the eligible SR&ED expenditures transferred by the transferor; and

•

the amount determined by the formula (A x B) – C, where – A is the transferee’s ITC rate, – B is either -

the proceeds of disposition (if sold to an arm’s length party), or

-

the FMV (for conversions to commercial use or sales to non-arm’s length parties), and

– C is the amount, if any, that has been recaptured under subsection 127(27) in respect of that particular property.

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Example Facts and assumptions: Company A and Company B are non-arm’s length parties. Company A incurs eligible SR&ED expenditures of $300,000 to develop a property ($200,000 for the purchase of raw materials plus $100,000 of eligible labour). Company A transfers qualified expenditures of $100,000 to Company B under subsection 127(13). Both companies earn ITCs at the 15% rate. The property is then sold to an arm’s length party for $400,000. Tax consequences: Company A ITCs earned = ($300,000 – $100,000) x 15% = $30,000 Company B ITCs earned = $100,000 x 15% = $15,000 When the property is sold, Company A is subject to recapture. For ITCs earned by Company A, the ITC recapture under subsection 127(27) is $20,000, calculated as the lesser of •

ITC earned on property acquired = $20,000 [15% x ($200,000 for raw materials x $200,000/$300,000)];97 and

•

ITC rate x Proceeds of disposition = $60,000 [15% historical ITC rate x Proceeds of disposition of $400,000].

For ITCs earned by Company B, the ITC recapture for Company A under subsection 127(29) is $10,000, calculated as the lesser of •

ITC earned = $10,000 [15% x ($200,000 for raw materials x $100,000/$300,000)]; and

•

(A x B) – C = $40,000 [(15% Company B ITC rate x $400,000 proceeds of disposition) – $20,000 recapture of ITC under subsection 127(27)].

Therefore, the total recapture for Company A is $20,000 + $10,000 = $30,000.

De minimis rule By administrative policy (see the Recapture of SR&ED Investment Tax Credit Policy), ITC recapture does not apply to •

scrap sales (proceeds of sale less than 10% of the total cost of the property);

•

a conversion to commercial use or disposition to a non-arm’s length person where the FMV at the time of conversion or disposition is less than 10% of the total cost of the property; and

•

the cost of materials consumed (e.g., not incorporated into an SR&ED product) where the proceeds received are less than 10% of the cost of the materials.

97 The proportion of the qualified expenditures retained in Company A (i.e., not transferred to Company B).

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This de minimis rule is consistent with the CRA’s policy that all or substantially all should generally be interpreted to mean at least 90%. In essence, the de minimis policy extends the all-or-substantially-all concept to the recapture rules.

Incorporeal property As noted under Definition of property (on page 151), the recapture rules cover both corporeal and incorporeal property. However, recapture on incorporeal property is rare, as the expenditures are not usually eligible for ITCs. Where there has been a claim for eligible expenditures relating to incorporeal property, the recapture rules will apply. To illustrate how the recapture rules apply to incorporeal property, the Recapture of SR&ED Investment Tax Credit Policy gives two examples related to software: An example of the recapture rules applying to incorporeal property would be the purchase of an existing software application for SR&ED purposes, where the software is directly incorporated into a larger experimental software application (the purchased software is incorporated into the end product) which is eventually perfected and sold (or leased). This would be the case as long as the expenditure was allowable in the first place (for example, if subsection 37(4) of the Act did not apply to disallow the expenditure). Another situation where the recapture rules apply to incorporeal property is where a performer acquires, before 2014, an off-the-shelf product (for example, software) and subsection 37(4) was not applied because the property was used as an SR&ED tool (the purchased software is not incorporated into the end product). In such a case, the recapture rules will apply when the property is sold or converted to commercial use.

The above examples do not consider all the factors that must be considered in determining whether the recapture rules apply to a given expenditure. For example, in many cases, an SR&ED performer will purchase time-limited software licences for a product to be used as an SR&ED tool, frequently on an annual basis. Each annual licence should be considered as a separate property. In the case of an application to be incorporated into a larger application under development, many SR&ED performers purchase multiple licences. These may consist of, for example, a development licence, an off-site backup licence, and a production licence. This scenario may be further complicated by annual licensing. Again, each licence should be considered as a separate property. When the rights to intellectual property arising out of an SR&ED project are sold, there is no recapture.

Unpaid amounts As discussed above, where property is sold or converted to commercial use after December 20, 2002, the ITC recapture rules in subsection 127(27) apply to expenditures that would have been qualified expenditures in the taxation year had it not been for the application of the 180-day-unpaid rule in subsection 127(26).

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Recapture – Forms For corporations, the amount of ITC recapture is calculated on Schedule 31, Investment Tax Credit – Corporations, of the T2 income tax return. It is included on Line 602 of the return as an addition to Part I tax payable. For individuals, ITC recapture is calculated on Form T2038(IND), Investment Tax Credit (Individuals). This includes ITC recapture that results from the disposition of property or a conversion to commercial use of property by a partnership. In the year following the recapture, all amounts added to tax payable are included on Line 453 of Form T661, Scientific Research and Experimental Development (SR&ED) Expenditures Claim.

Refundable investment tax credits [§127.1] — Section 127.1 contains rules that entitle certain CCPCs, individuals, and trusts to refundable ITCs. This part of the chapter reviews the refundable credits for CCPCs. See ITC for other claimants – 15% credit (on page 22) in Chapter 2, Tax benefits of SR&ED, for information on the refundable credits available to other taxpayers. CCPCs may be eligible for a 100% refund of ITCs earned at the rate of 35% on qualified expenditures not exceeding the CCPC’s expenditure limit. A CCPC that is a qualifying corporation and that is not an excluded corporation may also be entitled to a refund of part of the ITCs earned at the rate of 15%. For taxation years ending prior to 2014, the basic credit rate available to all claimants was 20%, and the additional credit rate for eligible CCPCs was 15%.98

Qualifying corporations [§127.1(2) “qualifying corporation,” “qualifying income limit”] — A corporation is a qualifying corporation if it is a CCPC in the taxation year and its taxable income for the previous year does not exceed its qualifying income limit for the taxation year. If the corporation is associated with one or more other corporations in the year, the taxable income of each corporation for its last taxation year ending during the previous calendar year cannot exceed the corporation’s qualifying income limit. For 2010 and subsequent taxation years, the qualifying income limit is $500,000 ($400,000 for taxation years ending between February 26, 2008, and December 31, 2009). However, like the expenditure limit for the 35% ITC, the qualifying income limit is reduced where the taxable capital employed in Canada of the corporation (and of all its associated corporations) exceeds $10 million for the previous year, and it is nil when this taxable capital reaches $50 million.99

98 For taxation years straddling January 1, 2014, the applicable credit rates are prorated for the number of days in the taxation year before 2014 and after 2013. 99 For taxation years that include February 26, 2008, the phase-out limit is prorated on the basis of the number of days in the taxation year that are after February 25, 2008 (previously, the phase-out limit was $15 million rather than $50 million).

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The taxable income used in determining whether a corporation is a qualifying corporation (whether reference is made to the qualifying income limit or the business limit) is the taxable income of the corporation (and the taxable income of all associated corporations) before factoring in any specified future tax consequences. See Taxable income test (on page 142). Three sets of transitional rules thus surround the application of the qualifying corporation determination: •

for taxation years straddling February 26, 2008, any excess amount obtained by applying the $400,000 qualifying income limit test instead of the business limit test is prorated on the basis of the number of days in the taxation year that are after February 25, 2008;

•

for taxation years beginning after February 26, 2008, and ending before 2010, the qualifying income limit is $400,000 before any reduction; and

•

for 2010 taxation years straddling January 1, 2010, the qualifying income limit, before any reduction, is as follows: $400,000 + [$100,000 x (Days in 2010/Days in the taxation year)].

Excluded corporations [§127.1(2) “excluded corporation”] — Section 4.3 of the SR&ED Investment Tax Credit Policy paraphrases the definition contained in subsection 127.1(2) as follows: An excluded corporation is a corporation that is, at any time in the year, either controlled by (directly or indirectly, in any manner whatever), or is related to: •

one or more persons exempt from tax under section 149;

•

Her Majesty in right of a province, a Canadian municipality or any other public authority; or

•

any combination of the above persons.

Refund for CCPC that is not a qualifying corporation For a CCPC that is not a qualifying corporation and that is not an excluded corporation, ITCs are refundable as follows: •

100% of the current expenditures that earned ITCs at the 35% rate (i.e., expenditures up to the expenditure limit); and

•

40% of the pre-2014 capital expenditures100 that earned ITCs at the 35% rate.

Expenditures exceeding the expenditure limit earn ITCs at the base rate of 15% (or 20% for taxation years before 2014),101 and these ITCs are not refundable.

100 Capital expenditures are no longer added to the SR&ED expenditure pool or considered qualified expenditures, effective for expenditures that are made after 2013 or made before 2014 for property that became available for use after 2013. 101 For taxation years ending prior to 2014, the basic credit rate available to all claimants was 20%, and the additional credit rate for eligible CCPCs was 15%.

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Refund for CCPC that is a qualifying corporation A CCPC that is a qualifying corporation and that is not an excluded corporation is entitled to the refund described above (refund for a CCPC that is not a qualifying corporation) plus 40% of the ITCs earned on qualified expenditures beyond the expenditure limit (i.e., ITCs earned at the base rate of 15% (or 20% for taxation years before 2014)). It is interesting to note that unlike the provisions that allow CCPCs to earn an additional 20% ITC (or an additional 15% ITC for taxation years before 2014) where the taxable income of the preceding year exceeds the $500,000 threshold and gradually reduce the expenditure limit when this taxable income is between $500,000 and $800,000,102 the provisions dealing with refunds on ITCs do not provide a similar phase-out and completely eliminate entitlement to ITCs earned on qualified expenditures beyond the expenditure limit when the taxable income of the preceding taxation year exceeds the business limit by any amount. See Taxable income test (on page 142) for more information on the phase-out.

Special situations This part of the chapter discusses •

specific rules for partnerships, cooperative corporations, sole proprietorships, and trusts;

•

the transfer of the SR&ED expenditure pool and ITC carryforward pool on an amalgamation or windup; and

•

the effect of a loss restriction event on the treatment of section 37 expenditures and ITCs carried forward.

Partnerships SR&ED deduction [§96(1)(e.1)] — In calculating a partner’s share of the income or loss of a partnership for a taxation year, SR&ED expenditures must be deducted in the year incurred. This provision overrides subsection 37(1), which allows SR&ED expenditures to be deducted in the year or in any subsequent taxation year. The partnership’s SR&ED expenditures are part of the regular partnership income; if a net loss results from the deduction of expenditures from income, the loss is subject to the general rule for partnership losses. [§248(1) “specified member”] — The deductibility of losses that result from the deduction of SR&ED expenditures is restricted for limited partners and other specified members of the partnership (e.g., inactive partners). A specified member of a partnership is

102 For 2010 and subsequent taxation years.

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•

any member of the partnership who is a limited partner (as defined in subsection 96(2.4)) of the partnership at any time during the partnership’s fiscal period or taxation year; and

•

any partner (including a general partner) except a partner who was, while a partner and during the partnership’s operating year, – actively engaged (on a regular, continuous, and substantial basis) in activities of the partnership business other than its financing, or – carrying on (on a regular, continuous, and substantial basis) a business similar to that carried on by the partnership in its taxation year (otherwise than as a member of the partnership).

To be considered actively engaged in the activities of a partnership, a partner would normally be expected to contribute time, labour, and attention to the business of the partnership to a sufficient extent that these contributions would be a determinant in the successful operation of the business.103 [§96(1)(g)] — In calculating the share of a partnership loss that is deductible by a limited partner, the partnership loss is reduced by any SR&ED expenditures deducted by the partnership in that year. For example, if a partnership’s income for the 2016 taxation year is $100,000 before deducting SR&ED expenditures of $150,000, the loss that may be allocated to a limited partner is nil, despite the fact that the partnership’s net loss for the year is $50,000. The loss restricted by paragraph 96(1)(g) is not deductible by other members of the partnership and does not reduce the amount of the adjusted cost base of the limited partner’s partnership interest.

Allocation of ITC to a partner [§127(8)] — Subsection 127(8) contains the general rule for the allocation from a partnership to a partner of an ITC in respect of SR&ED expenditures. The ITC on SR&ED qualified expenditures must be computed at the partnership level on the basis of amounts that would be determined under paragraph (a.1) of the definition of ITC in subsection 127(9). In other words, the partnership is required to calculate the ITC as 15% of the SR&ED qualified expenditures (or 20% for taxation years before 2014),104 even if the partners are CCPCs eligible for the enhanced 35% refundable credit. The partnership must allocate an ITC amount that can reasonably be considered to be the partner’s share of ITCs. An ITC amount is generally considered to be the partner’s reasonable share if the amount is allocated to the partner in the same proportion as the partner’s share of the partnership’s income or loss (as agreed by the partners), after considering any adjustments required under section 103.105

103 SR&ED Claims for Partnerships Policy. 104 For taxation years ending prior to 2014, the basic credit rate available to all claimants was 20%, and the additional credit rate for eligible CCPCs was 15%. 105 Under ITA s. 103, a partner’s share of income determined under a sharing formula may be changed to a reasonable allocation if the sharing formula is designed principally to reduce or postpone taxes otherwise payable.

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Under paragraph 127(8)(b), the ITC pool of a specified member of a partnership does not include any ITC earned by the partnership in respect of SR&ED expenditures. [§127(8.3), (8.31)] — Subsection 127(8.3) provides for the allocation of unallocated partnership ITCs to members of the partnership who are not specified members. The amount available for such an allocation is determined under subsection 127(8.31) and is summarized in the Department of Finance explanatory notes issued in October 2006:106 The amount determined under new subsection 127(8.31) is the amount, if any, by which •

the partnership’s total ITCs for its fiscal period

exceeds the total of •

the partnership ITCs allocated to general partners who are not specified members,

•

the amount of non-SR&ED ITCs allocated to specified members of the partnership. This amount does not include SR&ED ITCs because such amounts cannot be allocated to specified members. In addition, this amount does not include other ITCs (e.g., apprenticeship expenditure ITCs) that cannot be allocated to limited partners because of the constraint in subsection 127(8.1)…

Essentially, partnership ITCs that cannot be allocated to specified members of a partnership may be added – for the purpose of subsection 127(8) – to the investment tax credits allocated to members of the partnership who were not specified members of the partnership at any time in its fiscal period. This additional allocation under subsection 127(8) is to be based on what is reasonable in the circumstances (having regard to the investment in the partnership, including debt obligations of the partnership, of each such member of the partnership).

The reallocation of SR&ED ITCs to non-limited partners who are not specified members does not remedy the loss of SR&ED expenditure deductions under paragraph 96(1)(g).

Expenditure reduction resulting from allocation of ITCs [§127(12.1)] — ITCs allocated to a partner under subsection 127(8) for SR&ED current expenditures that are qualified expenditures reduce the current SR&ED expenditures the partnership may deduct at the end of the fiscal period in which the allocation was made. This rule is different from the one applicable to corporations (corporations are required to reduce the SR&ED expenditure pool by the ITC earned in the preceding year). [§127(12)] — ITCs allocated to a partner under subsection 127(8) for SR&ED pre-2014 capital expenditures107 that are qualified expenditures reduce the capital cost of the relevant property at the end of the fiscal period in which the allocation was made. Again, this rule is different from the one applicable to corporations (corporations are required to reduce the cost of the property by the ITC earned in the preceding year).

106 See also CRA document 2010-0357461I7. 107 Capital expenditures are no longer added to the SR&ED expenditure pool or considered qualified expenditures, effective for expenditures that are made after 2013 or made before 2014 for property that became available for use after 2013.

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Election to renounce ITCs [§127(8.4)] — A partner who has received an ITC allocation under subsections 127(8) and (8.3) may elect to have any portion of that amount deemed not to have been required to be added in computing the partner’s ITC for the year. The prescribed form for this election is Form T932, Election by a Member of a Partnership to Renounce Investment Tax Credits Pursuant to Subsection 127(8.4). In such circumstances, the ITCs are extinguished and a cost-base reduction of partnership property is not required. Generally, a partner renounces ITCs to avoid reducing the cost base of the partnership’s property or to avoid reducing its SR&ED expenditure pool by the amount of the ITC in situations where the partner cannot use the ITC to offset taxes otherwise payable.

Non-arm’s length SR&ED work performed for or on behalf of a partnership [§127(8)(a)] — Paragraph (f) of the definition of qualified expenditure in subsection 127(9) excludes payments to non-arm’s length SR&ED performers. The performer uses its SR&ED expenditures to compute its qualified expenditures and may elect to transfer the qualified expenditures under subsection 127(13). However, this election is not available to partnerships because, under paragraph 127(8)(a), a partnership is not considered a person for the purpose of subsection 127(13). A performer is therefore not allowed to transfer qualified expenditures.

Recapture [§127(8), (28), (30), (31), (34), (35)] — The ITC recapture rules for partnerships are contained in subsections 127(8), (28), (30), (31), (34), and (35). The four requirements that apply to corporations and individuals — see Recapture of ITC (on page 147) — also apply to partnerships. The amount recaptured is deducted from ITCs otherwise available (i.e., on the expenditures incurred by the partnership) in the year in which the property was disposed of or converted to commercial use. If the ITCs otherwise available are insufficient (less than the amount of the recapture), each partner reports its share of the difference as an addition to Part I taxes payable. If a taxpayer is a member of a tiered partnership (i.e., is a member of a partnership that is a member of another partnership), subsection 127(31) directs partnerships and their members to continue allocating these amounts down through their members until reaching a level at which the members are taxpayers and not partnerships.

Filing requirements The filing requirements for partnerships are summarized in the SR&ED Filing Requirements Policy, the SR&ED Claims for Partnerships Policy, and Guide T4088, Scientific Research and Experimental Development (SR&ED) Expenditures Claim – Guide to Form T661. More details are provided in Guide T4068, Guide for the Partnership Information Return (T5013 Forms).

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If the partnership is not required to file a partnership information return (T5013 forms),108 each partner should file •

Form T661, Scientific Research and Experimental Development (SR&ED) Expenditures Claim, for the partnership;

•

financial statements for the partnership; and

•

schedules showing the calculation and allocation of the ITC of the partnership.

A corporate partner should file this information with Schedule 31, Investment Tax Credit – Corporations, of its T2 income tax return by the applicable reporting deadline. If the partnership is required to file a partnership information return (T5013 forms), and it is filed on time with the documents listed above, along with a copy of Form T5013, Statement of Partnership Income, for all the partners, each partner should file Form T5013 with Schedule 31 (for corporate partners) by the applicable reporting deadline. A partner can file Form T661 on behalf of the partnership, but the SR&ED claim will not be processed unless a partnership information return, which agrees with Form T661, has been filed. Note that the expenditures listed in Part 3 of Form T661 are the total SR&ED expenditures at the partnership level, not just a particular partner’s share of those expenditures. According to the CRA guidance listed above, to facilitate processing where a partnership information return (T5013 forms) is required to be filed, Form T661 should be filed with the return no later than 12 months after the earliest of all filing-due dates for the income tax returns of the partners for the year in which the partnership’s fiscal period ends, so that each member can meet its deadline to claim the SR&ED ITC allocated to it. Schedule 31 must be filed by each corporate partner no later than 12 months after the filing-due date of the partner’s return for the year. It is the partner’s (not the partnership’s) taxation year that is to be considered in determining filing deadlines.

Partnership summary The implications of performing SR&ED at the partnership level can be summarized as follows: •

SR&ED deductions must be deducted in the current year (no carryforward provision);

•

ITCs are computed at the partnership level using the rate of 15% (or 20% for taxation years before 2014), even if the partners receiving the ITCs are eligible for the enhanced refundable credit;

•

limited partners cannot deduct losses created by the deduction of SR&ED expenditures;

•

a specified member of a partnership cannot include in its ITC pool ITCs earned by the partnership in respect of SR&ED qualified expenditures;

108 Form T5013 FIN, Partnership Financial Return, and related schedules; Form T5013SUM, Summary of Partnership Income; and Form T5013, Statement of Partnership Income.

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•

a limited partner may be prevented from adding ITCs from SR&ED expenditures that exceed the partner’s expenditure base or at-risk amount; and

•

ITCs that cannot be included in the ITC pool of a specified member or a limited partner may, in certain circumstances, be allocated to a non-specified partner that is not a limited partner.

Cooperative corporations [§127(6)] — Interpretation Bulletin IT-362R, Patronage Dividends (paragraph 17), states: Subsection 135(3) provides that where the amount, or the total of two or more amounts, paid by a taxpayer in respect of patronage payments to a customer resident in Canada in a particular calendar year exceeds $100 and that resident is not exempt from tax under section 149, the taxpayer is required to deduct and withhold a tax of 15 percent on the excess and remit it to the Receiver General on account of the customer’s tax liability. If the taxpayer is a cooperative corporation that had an unused investment tax credit at the end of its previous taxation year, pursuant to subsection 127(6) this requirement to remit tax in the current taxation year may be met to the extent that the unused investment tax credit is applied against the tax otherwise required to be remitted. The amount deemed to have been remitted on account of the customer will be the same, regardless of the manner in which the requirement to remit was met.

ITCs used to offset the remittance of a patronage-dividend withholding are deemed to have been remitted on account of the taxes of the person receiving the dividend. Therefore, there is no impact on the member. The ITC used to offset the remittance reduces the cooperative corporation’s ITC pool. This, in effect, allows a cooperative corporation to transfer ITCs to its members.

Individuals operating a business as a sole proprietorship There are no SR&ED provisions that apply only to individuals operating a business as a sole proprietorship. The general provisions as they apply to these individuals are reviewed briefly below.

Filing-due dates [§37(11), (11.1)] — The filing deadline for SR&ED claims is 12 months after the filing-due date for the taxpayer’s income tax return for the year. Under subparagraph 150(1)(d)(ii), individuals who carry on a business must file their tax returns for a taxation year by June 15 of the following calendar year. So, while corporations have 18 months after the taxation year-end to file their SR&ED claims, individuals have only 17.5 months. However, because paragraph 249.1(4) allows an individual to select a year-end other than December 31 (subject to adjusting his or her business income in accordance with subsection 34.1), certain individuals may have more than 17.5 months to complete their claims. For example, the deadline for filing an SR&ED claim for an individual operating a business as a sole proprietor with a January 1 taxation year-end would be 29.5 months after the business’s taxation year-end.

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ITCs Individuals may benefit from the 15% ITC on qualified expenditures (or 20% ITC for taxation years before 2014) but are not eligible for the enhanced 35% credit. See ITC for other claimants – 15% credit (on page 22) in Chapter 2, Tax benefits of SR&ED, for more information on this credit.

Refundable ITCs Individuals (other than trusts) are entitled to a refund of 40% of ITCs earned in a year that are not used to offset taxes otherwise payable in the year or in a preceding taxation year. Subsection 127.1(3), which deems refundable ITCs to have been used to offset taxes otherwise payable, is disregarded when calculating the amount of refundable ITC. Individuals may first use ITCs earned in a previous year to offset taxes otherwise payable, preserving the current year’s ITC for a greater refund.

Trusts Under subsection 104(2), trusts are deemed to be individuals for purposes of the Act. Therefore, a trust that carries on business is subject to the SR&ED provisions of the Act that apply to all taxpayers. Certain provisions also address trusts specifically.

Graduated rate estates and communal organizations [§127(7)] — Trusts that are graduated rate estates109 and communal organizations110 may allocate to their beneficiaries a reasonable share of their ITCs. Unlike partnerships, trusts are not obliged to do so. However, if a trust allocates ITCs to a beneficiary, the beneficiary does not have the option to renounce the ITCs. Beneficiaries add the ITCs to their ITC pool,111 and the trust deducts them from its ITC pool. [§127(12), (12.1)] — ITCs reduce the SR&ED expenditures of a trust in the same way they do for partnerships. Subsection 127(12) requires that ITCs allocated to beneficiaries as depreciable property are deemed received as government assistance in the year they are allocated. Paragraph 127(12.1) requires that ITCs allocated to beneficiaries as current expenditures be deducted from a trust’s SR&ED expenditures in the year of allocation.

Refundable ITCs Only trusts whose beneficiaries are individuals or qualifying corporations are entitled to refundable ITCs. The refund is 40% of the ITCs earned in a year that have not been allocated to beneficiaries.

109 For 2016 and subsequent taxation years. ITA s. 127(7) previously referred to testamentary trusts. A graduated rate estate of an individual at any time is the estate that arises on and as a consequence of the individual’s death, if that time is no more than 36 months after the individual’s death and certain conditions are met. See s. 248(1) “graduated rate estate” for more details. 110 ITA s. 143(1) deems communal organizations to be trusts. 111

164

Under ITA s. 127(9) “investment tax credit” (b).

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Reporting deadlines [§37(11), (11.1)] — Because trusts are deemed to be individuals for purposes of the Act, they must file their SR&ED claims within the reporting deadlines stated in subsection 37(11). Under paragraph 150(1)(c), the filing-due date for trust tax returns is 90 days after the taxation year-end. So, trusts have 12 months and 90 days to file their ITC claims (compared with 18 for corporations, and 17.5 for sole proprietors).

Transfer from amalgamation or windup Amalgamation [§87(2)(l)] — For purposes of section 37, where there is an amalgamation of two or more corporations (as defined in section 87), the new corporation is deemed to be the same corporation as, and a continuation of, each of the predecessor corporations. Consequently, the SR&ED pool of each predecessor corporation is included in the SR&ED opening pool of the newly amalgamated corporation. ITCs claimed by each predecessor corporation in the year before amalgamation reduce the amalgamated corporation’s SR&ED expenditure pool in the taxation year following the amalgamation.

Windup [§88(1)(e.2)] — Where a taxable Canadian corporation (the subsidiary) winds up, and at least 90% of its shares were owned by another taxable Canadian corporation (the parent), the parent corporation is deemed to be the same corporation as, and a continuation of, its subsidiary. Consequently, in the year of the windup, the parent corporation must include the SR&ED pool of its subsidiary in the same manner as provided for under paragraph 87(2)(l) (see Amalgamation (above)), which deems the parent to be the same corporation as, and a continuation of, each predecessor corporation. ITCs claimed by the wound-up subsidiary in the year before the windup reduce the parent corporation’s SR&ED expenditure pool in the taxation year following the windup.112

Loss restriction event Where a taxpayer is subject to a loss restriction event (LRE) (e.g., where the control of a corporate taxpayer is acquired by a person dealing at arm’s length with the taxpayer),113 the use of the taxpayer’s losses and other benefits, such as unclaimed ITCs and the

112 For more details on the availability of the SR&ED pool and unutilized ITCs of a wound-up subsidiary, in particular with respect to the carryback of the subsidiary’s ITCs to years prior to its winding-up and the impact of an acquisition of control of the subsidiary prior to its winding-up, see CRA document 2010-0391291E5. 113 ITA s. 251.2(2) sets out the circumstances in which a taxpayer (i.e., corporation or trust) is subject to an LRE.

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SR&ED expenditure pool, may be restricted. In addition, subsection 249(4) generally deems the taxpayer’s taxation year to end immediately prior to the time the taxpayer is subject to the LRE.

SR&ED expenditure pool [§37(1)(h), §37(6.1)] — Paragraph 37(1)(h) reduces the SR&ED expenditure pool for certain SR&ED expenditures incurred by a taxpayer that was subject to an LRE. The amount of the reduction is specified in subsection 37(6.1). Essentially, the SR&ED expenditure pool that remains at the taxation year-end is isolated in a pre-LRE SR&ED expenditure pool at the time the taxpayer is subject to the LRE. That pre-LRE SR&ED expenditure pool is added back to the post-LRE SR&ED expenditure pool to the extent required to reduce taxable income earned from the same business in which the pre-LRE SR&ED expenditures were incurred. The business must be carried on by the taxpayer for profit (or with a reasonable expectation of profit) throughout the year. Where the business carried on by the corporation prior to the LRE involved the sale, lease, rental, or development of properties, or the rendering of services, the pre-LRE SR&ED pool may be applied to the extent of income from another business, provided the income is substantially derived from the sale, lease, rental, or development of similar properties or the rendering of similar services.

ITCs [§127(9.1)] — Subsection 127(9.1) outlines the requirements that must be met to carry forward pre-LRE ITCs to taxation years ending after the LRE. Pre-LRE ITCs may be carried forward only to the extent required to offset a Part I tax liability arising on income from the same business that earned the ITCs pre-LRE, to the extent that the income for the year has not already been offset by a non-capital-loss carryforward. The similar-business rule applicable to the pre-LRE SR&ED expenditure pool also applies to the pre-LRE ITC pool. See SR&ED expenditure pool (above).

For further reference Income Tax Act 37(1)

SR&ED – Deduction from income

37(1.2)

Deemed time of capital expenditure

37(1.4), (1.5)

Salary or wages for SR&ED outside Canada

37(2)

Research outside Canada

37(6)

Expenditures of a capital nature

37(6.1)

Loss restriction event

37(8)

Interpretation

37(8)(a)(ii)

Traditional and proxy methods

37(9)

Salary or wages

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37(9.1)

Limitation re specified employees

37(9.2)–(9.5)

Associated corporations

37(10)–(12)

Filing requirements (proxy method election, information return, etc.)

37(13)

Non-arm’s length contract – Linked work

37(14), (15)

Look-through rule

127(5)

Investment tax credit

127(6)

Investment tax credit of cooperative corporation

127(7)

Investment tax credit of certain trusts

127(8)–(8.5)

Investment tax credit of partnership

127(9)

Definitions

127(9.01), (9.02)

Transitional application of investment tax credit definition

127(9.1), (9.2)

Loss restriction event

127(10.1)

Additions to investment tax credit

127(10.2)–(10.6)

Expenditure limit

127(10.7), (10.8)

Further additions to investment tax credit

127(11.2)

Time of expenditure and acquisition

127(11.5)–(11.8)

Adjustments to qualified expenditures

127(12.1)

Reduction of SR&ED expenditure pool of partnership or trust

127(13)–(17)

Agreement to transfer qualified expenditures

127(18)–(23)

Reduction of qualified expenditures re assistance

127(24)

Exclusion from qualified expenditure

127(25)

Deemed contract payment

127(26)

Unpaid amounts

127(27)–(36)

Recapture of investment tax credit

127.1

Refundable investment tax credit

Case law Advanced Agricultural Testing Inc. v. The Queen, 2009 TCC 190 Aeronautic Development Corporation v. The Queen, 2018 FCA 67 AG Shield Ltd. v. The Queen, 2017 TCC 68 Bois Aisé De Roberval Inc. v. The Queen, [1999] 4 CTC 2161 (TCC) CalAmp Wireless Networks Inc. v. The Queen, 2013 TCC 201 The Queen v. Canada Safeway Limited, [1998] 1 CTC 120 (FCA) The Queen v. CCLC Technologies Inc., 96 DTC 6527 (FCA); rev’g. 95 DTC 5685 (FCTD)

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Com Dev Ltd. v. The Queen, 99 DTC 775 (TCC) Consoltex Inc. v. The Queen, 97 DTC 724 (TCC) Feedlot Health Management Services Ltd. v. The Queen, 2015 TCC 32 GTE Sylvania Canada Limited v. The Queen, 74 DTC 6315 (FCTD); aff’d. 74 DTC 6673 (FCA) Hun-Medipharma Research Inc. v. The Queen, 99 DTC 407 (TCC) Immunovaccine Technologies Inc. v. The Queen, 2013 TCC 103; aff’d. 2014 FCA 196 Inflection Analytics Ltd. v. The Queen, 2015 TCC 129 Iron Ore Company of Canada v. The Queen, 2001 DTC 5411 (FCA) The Queen v. Johnson & Johnson Inc., 94 DTC 6125 (FCA) Laboratoire Du-Var Inc. v. The Queen, 2012 TCC 366 Les Éditions Progitech Inc. v. The Queen, 99 DTC 672 (TCC); aff’d. 2002 FCA 19 LGL Ltd. v. The Queen, 2000 DTC 6108 (FCA); aff’g. 99 DTC 675 (TCC) Lyrtech RD Inc. v. The Queen, 2013 TCC 12; aff’d. 2014 FCA 267 Attorney General of Canada v. MacDonald, 94 DTC 6262 (FCA) McGillivray Restaurant Ltd. v. The Queen, 2016 FCA 99 Northwest Hydraulic Consultants Ltd. v. The Queen, 98 DTC 1839 (TCC) Oldcastle Building Products Canada Inc. c. La Reine, 2016 CCI 183 Ottawa Valley Power Company v. MNR, 69 DTC 5166 (Ex. Ct.); aff’d. 70 DTC 6223 (SCC) Progressive Solutions Inc. v. The Queen, 96 DTC 1232 (TCC) PSC Elstow Research Farm Inc. v. The Queen, 2008 TCC 694 Ransom v. MNR, 67 DTC 5235 (Ex. Ct.) Rio Tinto Alcan Inc. v. The Queen, 2017 TCC 67 Solutions MindReady R&D Inc. v. The Queen, 2015 TCC 17 The Queen v. The Consumers’ Gas Company Ltd., 87 DTC 5008 (FCA) The Queen v. Tigney Technology Incorporated, 2000 DTC 6112 (FCA); rev’g. 97 DTC 414 (TCC) VLN Advanced Technologies Inc. v. The Queen, 2018 TCC 33

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CRA rulings and interpretations 58719

SR&ED – Non-government assistance

9833526

Vertical amalgamation – Government assistance

2001-0078855

SR&ED – Contract payment

2004-0078161I7 and 2010-0391291E5

Winding-up – R&D expenses and ITCs

2008-0269721I7

SR&ED expenditures and joint ventures

2009-0325831I7

SR&ED proxy method – Overhead outside Canada

2010-0357461I7

SR&ED ITC – Specified member

2010-0389611E5

SR&ED – Partnerships

2011-0417971E5

Associated corporations – ITC

2011-0423671E5

Expenditure limit

2012-0439781E5

Specified employee for SR&ED credits

2012-0459731I7

Government assistance

2014-0522541E5

Application of paragraph 12(1)(x)

Forms T1145

Agreement to Allocate Assistance for SR&ED Between Persons not Dealing at Arm’s Length

T1146

Agreement to Transfer Qualified Expenditures Incurred in Respect of SR&ED Contracts Between Persons Not Dealing at Arm’s Length

T1174

Agreement Between Associated Corporations to Allocate Salary or Wages of Specified Employees for Scientific Research and Experimental Development (SR&ED)

T1263

Third-Party Payments for Scientific Research and Experimental Development (SR&ED)

T2SCH1 (Schedule 1)

Net Income (Loss) for Income Tax Purposes

T2SCH31 (Schedule 31)

Investment Tax Credit – Corporations

T2SCH49 (Schedule 49)

Agreement Among Associated Canadian-Controlled Private Corporations to Allocate the Expenditure Limit

T2038(IND)

Investment Tax Credit (Individuals)

T661

Scientific Research and Experimental Development (SR&ED) Expenditures Claim

T932

Election by a Member of a Partnership to Renounce Investment Tax Credits Pursuant to Subsection 127(8.4)

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Guides T4068

Guide for the Partnership Information Return (T5013 Forms)

T4088

Scientific Research and Experimental Development (SR&ED) Expenditures Claim – Guide to Form T661

Income tax folios S1-F5-C1

Related Persons and Dealing at Arm’s Length

Interpretation bulletins IT-273R2

Government Assistance – General Comments

IT-362R

Patronage Dividends

IT-364

Commencement of Business Operations

SR&ED program policies Assistance and Contract Payments Policy Contract Expenditures for SR&ED Performed on Behalf of a Claimant Policy Materials for SR&ED Policy Pool of Deductible SR&ED Expenditures Policy Prescribed Proxy Amount Policy Recapture of SR&ED Investment Tax Credit Policy SR&ED Capital Expenditures Policy SR&ED Claims for Partnerships Policy SR&ED During Production Runs Policy SR&ED Filing Requirements Policy SR&ED Investment Tax Credit Policy SR&ED Lease Expenditures Policy SR&ED Overhead and Other Expenditures Policy SR&ED Salary or Wages Policy SR&ED Shared-Use-Equipment Policy SR&ED While Developing an Asset Policy

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Third-Party Payments Policy Total Qualified SR&ED Expenditures for Investment Tax Credit Purposes Policy Traditional and Proxy Methods Policy

Other publications SR&ED Glossary

Web resources Claiming SR&ED tax incentives www.canada.ca/en/revenue-agency/services/scientific-research-experimentaldevelopment-tax-incentive-program/claiming-tax-incentives.html

Appendix The following table is adapted from the 1997 Canadian Tax Foundation Ontario Tax Conference roundtable (Question 15). See also the SR&ED Salary or Wages Policy and the Prescribed Proxy Amount Policy. Labour expenditures included in SR&ED expenditure pool and PPA salary base Type of expenditure

Traditional method

Proxy method

Salary and wage expenditures

Salary and wage expenditures

Salary base

Yes

Yes

Yes

Yes (amount is restricted)

Yes (amount is restricted)

Yes (amount is restricted)

Vacation pay

Yes

Yes

Yes

Statutory holiday pay

Yes

Yes

Yes

Sick leave pay

Yes

Yes

Yes

Employee stock option benefit

No

No

No

Standby charge and operating benefits re automobile

Yes

Yes

No

Group term insurance

Yes

Yes

No

Salary and wages Non-specified employee (other than benefits) Specified employee (other than benefits) Benefits

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Labour expenditures included in SR&ED expenditure pool and PPA salary base Type of expenditure

Traditional method

Proxy method

Salary and wage expenditures

Salary and wage expenditures

Salary base

Interest-free loan and low-interest loan benefit

No

No

No

Benefit re board and lodging paid by employer

Yes

Yes

No

Allowances re personal or living expenses (with exceptions)

Yes

Yes

No

Allocations under employee profitsharing plans

No

No

No

Forgiveness of employee debt

No

No

No

Employee benefit plan benefits (excluding death benefits)

No

No

No

Specified employees

No

No

No

Non-specified employees

Yes

Yes

No

Employer share of payments to CPP, QPP, EI, WCB; approved employee pension plan; and employee medical, dental, or optical insurance plans

Yes

No

No

Management fees

Yes

Yes

No

Benefits (cont’d)

Bonuses

Related benefits

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5. SR&ED claims submission process Overview This chapter describes the steps involved in claiming tax benefits for SR&ED carried on in Canada — from identifying eligible work within an organization to preparing and submitting a claim. The chapter begins by discussing some basic administrative information a claimant must be aware of, such as what forms to use, the deadlines for making claims, and how to submit them. From there, the chapter goes on to examine some of the more technical aspects of claims submissions, first exploring the ways in which organizations may set up and manage their SR&ED processes to ensure eligible work is accurately identified and documented, and then discussing the completion of Form T661, Scientific Research and Experimental Development (SR&ED) Expenditures Claim. Finally, the last sections of the chapter consider what happens after a claim has been filed (i.e., how the CRA reviews and processes claims and how claimants can object to a CRA decision).

Fundamentals What to file To make an SR&ED claim, claimants must submit the following: •

Form T661, Scientific Research and Experimental Development (SR&ED) Expenditures Claim;

•

Form T2SCH31 (Schedule 31), Investment Tax Credit – Corporations, or Form T2038(IND), Investment Tax Credit (Individuals);1

•

where there is an agreement to allocate SR&ED qualified expenditures between associated corporations, any of the following forms (along with required attachments) that apply: – Form T1145, Agreement to Allocate Assistance for SR&ED Between Persons Not Dealing at Arm’s Length, – Form T1146, Agreement to Transfer Qualified Expenditures Incurred in Respect of SR&ED Contracts Between Persons Not Dealing at Arm’s Length, and – Form T1174, Agreement Between Associated Corporations to Allocate Salary or Wages of Specified Employees for Scientific Research and Experimental Development (SR&ED);

•

where there is an agreement to allocate the SR&ED expenditure limit among a group of associated corporations performing SR&ED, Form T2SCH49 (Schedule 49),

1

Although both corporations and self-employed individuals may claim SR&ED, this chapter generally focuses on corporate claimants. However, the general principles and issues discussed apply equally to individual claimants.

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Agreement Among Associated Canadian-Controlled Private Corporations to Allocate the Expenditure Limit; and •

where a third-party payment is made, Form T1263, Third-Party Payments for Scientific Research and Experimental Development (SR&ED).

Schedule 31 is used by corporations and is filed with a corporation’s income tax return (T2 return) for its taxation year. Form T2038(IND) is used by individuals and is filed with an individual’s T1 personal income tax return (T1 return) for the year.2 In the SR&ED Filing Requirements Policy, the CRA specifies that Form T661 is the prescribed form3 for purposes of determining the pool of deductible SR&ED expenditures under section 37 of the Act, with Forms T1145, T1146, T1174, and T1263 supplementing Form T661. Schedule 31 and Form T2038(IND) are the prescribed forms4 for purposes of determining the investment tax credit under section 127 of the Act, with Schedule 49 supplementing Schedule 31. Accordingly, the SR&ED Filing Requirements Policy states that no investment tax credit can be claimed without Schedule 31 or Form T2038(IND) being filed on time (even if Form T661 is filed), and no SR&ED incentives (i.e., the SR&ED expenditures income deduction and the investment tax credit) can be claimed without Form T661 being filed on time (even if Schedule 31 or Form T2038(IND) is filed). See below for more information on when to file. The current version of Form T661 was released in 2015 and, as of January 1, 2016, must be used for all taxation years. The forms must be completed for each fiscal period for which expenditures are incurred and investment tax credits are earned, even if an investment tax credit is not being refunded or used in that period to offset taxes otherwise payable. A claimant that has earned tax credits but is not entitled to a full refund may apply the credits to offset taxes otherwise payable in •

the current taxation year;

•

the prior three taxation years; or

•

future fiscal periods (up to 20 taxation years).

Claimants may use the CRA’s preprinted or fillable forms and schedules to file their submissions. A claimant that uses a commercial software package to prepare its T2 return may also file its SR&ED claim electronically over the internet with the T2 return (the claim must be filed using CRA-certified software). It is important to note that for taxation years ending in 2010 or later, corporations that meet the criteria for mandatory internet filing of their T2 return (i.e., having gross revenues in excess of $1 million)5 must

2

An SR&ED claim relates to a business (proprietorship or partnership) of the individual and is therefore filed on a fiscal-year basis and reported in the T1 return for the calendar year in which the business income is reported. For more information on taxation year-ends of unincorporated businesses, see EY’s Guide to Preparing Personal Tax Returns.

3

Under ITA s. 37(11).

4

Under ITA s. 127(9) “investment tax credit” (m).

5

However, some corporations with gross revenues in excess of $1 million are exempt from the mandatory internet filing requirement for T2 returns (e.g., insurance corporations, non-resident corporations, corporations reporting in functional currency, and corporations that are exempt from income tax under ITA s. 149).

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file their SR&ED claim online. For more information on completing Form T661, see Preparing the claim (on page 183).

When to file Claimants must file the prescribed forms — Form T661 and Schedule 31 (for corporations) or Form T2038(IND) (for individuals) — with all the relevant prescribed information by the reporting deadline. See Preparing the claim (on page 183) for more details on prescribed information. A claimant’s reporting deadline is 12 months after the filing-due date of the return for the year or fiscal period in which the expenditures were incurred. Therefore, a corporation has 18 months, and an individual has 17.5 months,6 after the end of the taxation year in which the expenditures were incurred to claim these costs as SR&ED expenditures.7 The CRA no longer has discretion to extend this deadline under any circumstances. On or before the reporting deadline, claimants may submit amendments to the forms and related schedules. Sometimes, a claimant may not have filed the applicable tax return by the deadline for filing the SR&ED claim. In such circumstances, the claimant must submit the prescribed forms with the prescribed information on or before the relevant SR&ED filing deadline to ensure the claim can be considered for SR&ED benefits. However, the CRA will not process the SR&ED claim until it receives the completed tax return.

How and where to file To file a claim, the claimant must send the completed prescribed forms, usually with the applicable income tax return, to the appropriate CRA tax centre. According to the SR&ED Filing Requirements Policy, claims delivered by first-class mail or daily service are considered filed on the date of the postmark, which is not necessarily the day the claim was mailed. If the reporting deadline falls on a Saturday, Sunday, or statutory holiday, the claim is considered to be filed on time if it is postmarked on the first working day after the deadline. Claimants may choose to use registered mail so that they have their own record of the postmark on file. If submitting a claim close to the deadline, it is advisable to send it via registered mail; doing so gives the claimant documented proof that the claim was submitted on time. However, it is important to note that the documented proof does not provide evidence of what the envelope contained. Therefore, it is advisable to list the prescribed forms and project descriptions filed with the SR&ED claim and have two people sign that they have reviewed the contents of the envelope sent by registered mail (in case the claimant is required to prove that it had mailed the prescribed forms). As mentioned previously, internet filing is available to corporations involved in SR&ED activities. Corporations may transmit their SR&ED claims electronically with their T2 6

In their T1 returns for the calendar year, individuals must report the taxable income of all their businesses with a fiscal period ending in that calendar year. The reporting deadline for SR&ED claims refers to the fiscal year-end of the individual, not the business.

7

The filing-due date for the T2 return is six months after the end of the corporation’s taxation year. For self-employed individuals and their spouses or common-law partners, the filing-due date for the T1 return is June 15 of the year following the taxation year.

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returns, using CRA-certified software. For claims received through the CRA’s corporation internet filing service, the filing date is the date the confirmation number is issued. Corporations filing SR&ED claims for taxation years ending in 2010 or later that meet the criteria for mandatory internet filing must file their T2 returns through the internet. Because the filing requirements for provincial or other programs may differ from the federal requirements described above, SR&ED claimants should determine the specific requirements for their particular province or program and ensure they are met.

Reducing the claimant’s processing risks The importance of submitting a complete claim cannot be overemphasized. A complete claim is one that contains Form T661, with all prescribed information, as well as Schedule 31 of the T2 return (for corporations) or Form T2038(IND) (for individuals). See Preparing the claim (on page 183) for more details on prescribed information. Failure to file a complete claim for a fiscal period can have significant negative consequences for a claimant, including the outright rejection of the entire claim without any legal recourse to refile it for that fiscal period. Also, as noted under When to file (on page 175), the CRA will not process an SR&ED claim until it receives the claimant’s completed tax return. Generally, if a claim is filed 90 days or more before the filing deadline, the CRA should have sufficient time to conduct an initial review and will issue a “request for information” letter or otherwise advise the claimant of any deficiencies in the claim before the deadline, if a submission is incomplete or otherwise non-compliant. The claimant may then provide the CRA with the missing information before the deadline. Time permitting, the claimant may also provide the missing information through an amended claim. Once the filing deadline has passed, the CRA will not accept any additional information to complete or increase the claim, even if it is in response to a request for information sent to the claimant by the CRA. Guide T4088, Scientific Research and Experimental Development (SR&ED) Expenditures Claim – Guide to Form T661, provides claimants with some guidelines that, if followed, can reduce the risk that a claim will be rejected or take a long time to process. Specifically, claimants •

must use the most recent version of Form T661;

•

must file the claim by the reporting deadline;

•

must ensure that all the prescribed information is included in Form T661 and in Schedule 31 (for corporations) or Form T2038 (IND) (for individuals);

•

must check Boxes 231 and 232 on page 2 of the T2 return to indicate that Form T661 and Schedule 31 are included (for corporations);

•

must retain all technical and financial information that supports the SR&ED claim;

•

should file the claim and tax return at the appropriate tax centre, not at the local tax services office; and

•

should respond to any CRA requests for more information in a timely manner.

As discussed in previous chapters, all claims must be in accordance with the definition of SR&ED in subsection 248(1) of the Act (as opposed to any generic definition of research

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and development) and must comply with sections 37, 127, and 127.1 of the Act, as well as the applicable regulations. The definition of SR&ED is discussed in Chapter 3, What is eligible? – Scientific and technological aspects. Sections 37, 127, and 127.1 are covered in Chapter 4, What is eligible? – Financial aspects.

Investigating SR&ED within an organization To facilitate the preparation of an SR&ED claim, a business must be able to clearly identify its SR&ED projects. Indeed, integrating an SR&ED claims management process into a business’s normal operating procedures is considered a best practice. In the absence of an integrated process, companies often find themselves communicating with department heads close to the filing deadline to ask about the research and development that has been done. Such a process relies heavily on staff members’ memories and may be incomplete in identifying SR&ED projects and finding evidence to support them. In contrast, a useful approach is to assemble a core team of senior technical people to consider the operations of the business, as well as how management has decided to invest in changes and improvements needed to compete, prosper, or perhaps just survive. SR&ED requires extending capability beyond what is proven, available, and applicable to the company’s technological objectives. In other words, what is the company trying to improve scientifically or technologically, and what is holding it back? When deciding which personnel to involve in the SR&ED claims process, it is a best practice to consider people who understand how the company operates and how priorities are established. The way in which a company operates and manages its priorities is usually reflected in the SR&ED that is needed to achieve technological objectives. The people contemplating an SR&ED claim must know, or be able to determine, what activities aimed at obtaining new scientific or technological knowledge are going on in the organization, and what is being done to improve the company’s technological capabilities. These people may include senior technical personnel from all areas of the organization who regularly manage the company’s technical business risks. This core team must understand how the company applies financial resources towards the resolution of technological issues, and how the expenditure of these resources is documented. The financial staff members involved in the submissions process are often from operation control or the central finance group within a company. There are many reasons why a company might seek scientific knowledge that was previously unavailable or unproven, or attempt to achieve a technological advancement. The need for SR&ED is generally created by •

the need to investigate new basic or applied scientific knowledge relevant to the organization;

•

the drive for better and more innovative products (including resolving prior limitations);

•

the need to improve the operating efficiency of manufacturing or other technological processes;

•

the need to make better use of energy and resources or to address environmental constraints; or

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•

the requirement to enhance information flow, increase speed, and manage greater amounts of data to provide better information services.

The approach described in this publication investigates from two directions. The initial viewpoint is a “top-down” investigation that starts with the core business functions and works down to the resources deployed towards enabling those business goals. A second “bottom-up” investigation reviews major costs and resources deployed. This second direction of investigation seeks to understand the nature of these investments and how they may ultimately lead to achieving the desired goals.

Companies with established products and processes Sometimes, an organization’s strategy is to minimize investments in improving products or processes, and it chooses to maintain the technical status quo. In this case, it may be difficult to identify work that meets the legislative requirements. A company that normally operates to maintain the status quo might not have a basis for an SR&ED claim. However, given that companies face challenges in keeping older technologies functioning, and most customers today demand price reductions for, and increased quality of, existing products, it is questionable whether any company can truly maintain the status quo. In many cases, companies develop new operating methods and enhancements of their existing technologies to survive under this pressure. They determine a means to alter or extend their technology to get more capability and output from what they have in place. The creative low-capital incremental developments that help to keep a company alive and moving forward might then be the core of their SR&ED projects.

What are the science and technology improvement drivers? There is a relentless push in the world’s business sectors for better products and improved efficiencies. This drive is evidenced by •

the transfer of development and production work to low-cost countries;

•

the consolidation of sales and distribution through mega-retailers and distribution networks;

•

networks of information-sharing systems linking business to business and business to consumer in real time;

•

more variety, smaller lot sizes, and quicker evolution and obsolescence of products and services; and

•

customized products and services enabled through direct internet links to the final retailer and customers.

Numerous factors complicate how a company decides to invest in science and technology changes. Emerging technology and technological trends often create a need to revisit past practices and approaches. Many organizations operate in complex development and delivery structures. The need for improvement might originate with customers, suppliers, or subcontractors, or through input from a company’s retail and distribution network.

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Competitors, investors, and customers often add to the urgency to upgrade technological knowledge and abilities. With that in mind, it is important for a business to consider the following: •

the nature of current and planned business operations in Canada;

•

the products or services that are currently provided or under development; and

•

the challenges that arise from any (or all) of the following: – the function and features of the current or planned product or services, – the targeted operating environment in which the products must operate, – the materials or components from which products are made, and – the process improvements, including support processes, required for the manufacture, maintenance, or operation occurring at the company.

Eligible work often results from the need for developmental and investigation work to •

create new knowledge with or without practical application;

•

make products in less time and using less energy; or

•

overcome technological constraints that hold back the ability to create new or improved products or processes.

In addition to the eligible work described above, claims may include a significant amount of related technical support work and costs.

What development plans already exist? An internal SR&ED review identifies and evaluates improvement plans for a variety of needs in the organization relative to the SR&ED program requirements. These plans may relate to work already under way or under consideration and may include •

product development plans;

•

manufacturing process development plans;

•

information technology plans; and

•

infrastructure process development plans.

Many companies in the service industry rely on the development of enhanced capital equipment, as well as computer science and information technology development. This is why it is important to look at the key underlying technologies that enable retail, distribution, and service industry organizations to satisfy customer needs and achieve operating efficiencies. SR&ED claims in this area would be made for the advancement of science and technology. While it is important to understand the business context of all technical needs, the investigation must ensure that it is clear what technologies are required to support the business imperatives. During the top-down portion of the SR&ED investigation, it often becomes evident why the existing technology is insufficient, or why obstacles presented by materials, equipment, methods, or operating environment prevent the use of the currently proven forms of a particular technology.

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Conducting the initial SR&ED scan The insight gained from the top-down view of the company’s technology strategy, objectives, and environment is meant to prepare the team for the initial scan of technical work planned, completed, or under way for the improvement initiatives. The initial bottom-up scan looks at what work was done and what is planned. A comprehensive bottom-up scan examines the organization using different screening criteria from more than one viewpoint. Multiple scans provide different ways of viewing the initiatives that are under way and uncover links to other work that might then be noted as eligible. Multiple scans reduce the risk of missing work and costs that are worth considering for a claim. In some cases, the individuals working on isolated tasks may not be aware that what they are doing is a key part of SR&ED occurring elsewhere in the organization. The following table provides some examples of questions that might be answered through multiple, overlapping scans. Product-based scans •

What products or services are produced, planned for development, or planned to be improved?

•

What information technology changes must be addressed to enable the product or service to function?

People-based scans •

What people or departments are responsible for new developments, improvements, and investigations?

•

Who are the technical consultants and advisors?

Process-based scans •

What changes are occurring in manufacturing processes?

•

What changes to information technology are needed to enable these processes to change?

•

What changes are happening to support processes (environmental, regulatory, ergonomics, waste management, energy, distribution, logistics, administration, sales, inventory management, etc.)?

Cost-based scans •

What capital items have been acquired or are planned for acquisition?

•

What cost-reduction programs are under way for products, processes, or support activities?

•

What are the large expenditures in repair and maintenance accounts?

Market-based scans •

What is changing in the market?

•

How does the company react to these changes?

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For most companies, change initiatives are connected to a wide range of different products and processes, often with overlapping and possibly conflicting improvement objectives. Prior to the scan, it may not be clear how these initiatives relate to the technical goals of the department, operating unit, or division and, ultimately, to the organization as a whole. In addition to helping identify SR&ED, the scan may provide individuals who perform SR&ED with a broader and very valuable business perspective. In the Eligibility of Work for SR&ED Investment Tax Credits Policy, the CRA notes that a project involves a set of interrelated activities that collectively are needed in attempting to achieve a specific scientific or technological advancement and overcome scientific or technological uncertainty. After the scan has been performed, it may be clearer why the company needs to improve something, and what work is likely needed to reach the desired result. The topdown and bottom-up inquiries into the company’s activities and costs help to clarify the reasons for the costs; as a result, an SR&ED claim for a project and its required eligible expenditures is easier to understand and support.

Defining the entire project Industry sees many investigative and improvement projects as long-term undertakings with interim and, occasionally, ultimate goals. These large projects often consist of interrelated technical activities that are geared towards the development of the solution, and other activities that are directly needed as support for the development approach undertaken. The definition of SR&ED in subsection 248(1) of the Act states that the experimental development work must be “undertaken for the purpose of achieving technological advancement, for the purpose of creating new, or improving existing materials, devices, products, or processes, including incremental changes thereto.” There are two “for the purpose” requirements. It is important that there be a clear reason why work undertaken within a business project (work that may indeed result in a new or improved product or process) is required to achieve the technological advancement. The link between the work and the associated cost claimed must also be clearly presented. A further cause for difficulty in defining a project is that the need for research and development tends to migrate through an organization. When a technical problem emerges in a particular area, it is common for its effect to spread elsewhere in the organization as obstacles present themselves in various elements of the technological change required. It may be difficult to confirm the full extent of the technological issues related to the project. Parts of the organization may have worked to solve one aspect of the problem, others may have provided inputs to that solution, and others may have participated in analyzing the consequences of the change. The SR&ED scan assists in understanding the work linkages within the organization and helps determine the technical extent of a project.

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Claiming a project at the right level – Managing risk Claiming a project at the wrong level can be problematic. The challenge is to keep the focus on the science and technology and away from the non-technical and business drivers. Part of claiming at the “right” level is getting a full perspective of what is happening technologically within a company. The claimant must show how scientific or technological uncertainties are linked to each other and to a higher level of scientific or technological advancement. This would then provide justification for claiming that the related direct and supporting work is required for that advancement. Otherwise, the claimant may inadvertently present the solution to a scientific or technological challenge as several small independent projects. A claimant may not see the value of filing a claim if it believes it must substantiate the scientific and financial merits of a large number of small independent projects. As well, it may be more difficult to adequately support the eligibility of many small independent projects during a CRA review. If the work is presented to the CRA at a low level (e.g., as a specific technical task), the description of the project may lead the reviewer to conclude that the work is routine. It would be difficult to see the overall advance being sought when some of the important challenges to the affected underlying technology are described in other projects. An organization may have claimed several small projects that collectively contribute to the resolution of a technological challenge. Aggregating these smaller projects in a single higher-level project that demonstrates the deficiencies in the existing underlying technology would then highlight the technological challenges. Claiming at too low a level may therefore introduce risk in describing work in several ways. The lowest level or grouping of technical work is at the individual technical task. Claiming at the task level is time consuming and often leads to incorrect categorizations of the basis for eligibility (e.g., work that is in support of other eligible work may not be seen as eligible in its own right and so is viewed as being unrelated to SR&ED). Support work that is associated with several of these small independent projects may also be misunderstood. Without clarity in how the work is required for the scientific or technological advancement and the overall scientific or technological objectives, it may be difficult to express how this support work is commensurate with the needs and directly in support of these smaller projects. In this situation, the basis for eligibility becomes unclear, and a CRA reviewer may consider this work to be routine commercial work and therefore ineligible. Conversely, claiming at a high level (e.g., at the product or business-initiative level) may create the perception that the SR&ED project being claimed is the entire business or enterprise project. This may result in audit discussions that focus on the business risks or market issues rather than the scientific or technological advances. For example, consider a company whose technological objective is to have a low-cost, high-efficiency, quick-changeover steel mill that produces small lots of many different grades of high-quality steel while adhering to all environmental regulations. The work involved in developing such a mill may include many routine technical and commercial tasks, as well as many changes beyond standard technological practice for •

the individual components of the factory;

•

the chemical formulations;

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•

the process equipment;

•

the environmental and power systems;

•

the process controls and material-handling systems;

•

construction and construction issues resolution; and

•

commissioning combined with process prove-outs.

In such a situation, the company would need to answer the following questions: •

Does each change have a technological advancement and is it a distinct and separate SR&ED project?

•

At what level of the overall business project should the company claim its SR&ED?

In most scientific fields, technological innovations rarely start with a blank slate. For example, many steel mills already exist, and several may have addressed challenges similar to those faced by the company described above; approach methods may now be evident and available to the company. Similarly, information technology projects build upon other projects that used comparable architectures, and they often use some elements of proven operating code. Prior existing technology abounds, and it is often difficult to precisely identify technological advancement in a large project where multiple technologies apply. When claiming large projects that encompass many technological issues, added effort is required to define the technology base and the required advancement needed to attain the technological objectives. With these larger projects, the claimant must take particular care to demonstrate the scientific and technological barriers. If the claimant describes the enterprise project instead of the SR&ED aspects of the project in the claim submission, the challenges that need to be overcome to address non-technological business issues may dominate the discussion. The work to address the non-technological challenges should not be claimed or included in the project description. Indeed, including business factors as part of the project description frequently leads to additional validation work during the CRA’s review process to confirm that only the work related to resolving the technological uncertainties was included in the claim.

Preparing the claim If a company has identified its SR&ED projects during the investigation stage and understands what work was needed to overcome the scientific or technological uncertainties to achieve the advancement, as well as what work was done and what is planned, it should have the information it needs to prepare a clear and concise claim. The claim is prepared using Form T661, Scientific Research and Experimental Development (SR&ED) Expenditures Claim, and its accompanying guide (Guide T4088, Scientific Research and Experimental Development (SR&ED) Expenditures Claim – Guide to Form T661).

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The information requested in the 10 parts of Form T661 (discussed in more detail below) is prescribed information, as are any attachments or schedules necessary to provide the information requested on the form (e.g., Form T1145, Agreement to Allocate Assistance for SR&ED Between Persons Not Dealing at Arm’s Length). Therefore, the information must be present and viewed as complete for the claim to be accepted. If the submission is incomplete, the CRA will not process it. If the claimant fails to provide all prescribed information by the filing deadline, the entire claim (or part of it) may be rejected.8 For a corporate claimant, prescribed information includes the corporation’s name, business number, and taxation year-end and the relevant information requested in Parts 2, 3, 8 to 17, 29, and 30 of Schedule 31 of the T2 return (Form T2SCH31, Investment Tax Credit – Corporations), as well as Schedule 49 of the T2 return (Form T2SCH49, Agreement Among Associated Canadian-Controlled Private Corporations to Allocate the Expenditure Limit) where necessary to provide the information requested on Schedule 31.9

Form T661 Part 1 – General information In Part 1 of Form T661, the claimant provides general information about the business making the claim. This includes the span of the taxation year claimed, business identification numbers, and the number of projects claimed. For claims filed for a partnership, this part of the form asks for the names, percentages involved, and business numbers or social insurance numbers of partners. The claimant is asked to list a contact person for the financial aspects of the overall claim, as well as a contact person for the technical information. This may be easier for smaller companies where the claim relates to one location. Larger companies with multiple sites may not have a centralized person who is familiar with the financial or technical information across the entire organization. Nevertheless, all information on the form is prescribed information and should be answered.

Form T661 Part 2 – Project information Claimants must file a separate Part 2 of Form T661 for each project claimed for the taxation year. Alternatively, a claimant may choose to submit this part for only the 20 largest projects in dollar value at the time of filing. However, given that the CRA may request Part 2 for some, or all, of the remaining projects at a later time, a claimant should keep the relevant information available.

8

See, for example, Westsource Group Holdings Inc. v. The Queen, 2018 FCA 57, where the Federal Court of Appeal dismissed the claimant’s appeal from a decision of the Tax Court of Canada upholding the minister’s denial of the claimant’s SR&ED tax credit claim. The claim was denied because the claimant had failed to complete the boxes on Form T661 describing the technological advancements, technological uncertainties, and work performed to overcome these uncertainties, in respect of its SR&ED activity. The appeal was dismissed even though the claimant submitted that the minister was already in possession of the relevant information because the minister had approved the SR&ED claims of a related corporation that had participated in the same project.

9

For a claimant that is an individual or trust, the relevant information requested in Parts A to F of Form T2038(IND), Investment Tax Credit (Individuals), is prescribed information.

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The CRA stresses that clear, concise, and to-the-point narratives are desired. There are specified limits on the number of words a claimant can use when responding to certain questions in this part of the form. There are three sections in Part 2: •

Section A – Project identification: This section asks for general information on the project, including name, timing, and the field of science or technology in which the project attempts to achieve an advancement.

•

Section B – Project descriptions: This section helps establish the nature of the SR&ED work that was undertaken and thus asks for technical details on the basic research, applied research, or experimental development performed. Section B specifically asks for a description of the scientific or technological uncertainties encountered, what work was performed to overcome these uncertainties, and the scientific or technological advancements achieved or attempted as a result of the work performed.

•

Section C – Additional project information: This section indicates who prepared the report, who the key participants in the project were (internal and contractors), and what forms of evidence have been retained.

Section A – Project identification In Section A, the claimant enters a title and a project code. Project codes are helpful if there are multiple projects with similar words in their titles, which could cause confusion. As well, a project code might help when projects extend to multiple years. Claimants are advised to maintain a log of codes to ensure that the same code is used for work that spans multiple years. The identification step also asks for the dates on which the project starts and ends. A project essentially starts when scientific or technological uncertainties are identified and the work to resolve them commences.10 Once the scientific or technological advancement is achieved and the associated scientific or technological uncertainties are resolved, the project is complete. The end of an SR&ED project may also occur when it is determined that the uncertainties cannot be resolved or when the project is terminated for any reason. An expected end date must be provided if the specific end date is not known at the time of filing. Stating that the project is “ongoing” or “continues” is not deemed to be an acceptable end date. The claimant must identify the primary field of science or technology in which the SR&ED project is attempting to achieve a scientific or technological advancement. To help with this identification, the CRA has published a list of science and technology fields (see Appendix 1 of Guide T4088). The list appears to be based on the fields of science and technology published in the OECD’s Frascati Manual. Correctly identifying the field of science or technology is important because it helps to ensure the CRA assigns staff with the appropriate background to the technical review, should the CRA decide to conduct one.

10 For further discussion, see Scientific or technological uncertainty (CRA’s methodology – Step 1, Question 1) (on page 36) in Chapter 3, What is eligible? – Scientific and technological aspects.

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Only one field of science or technology may be listed for a project. During public sessions where this topic was discussed, the CRA advised claimants to pick the most relevant field of science when more than one field is involved — for instance, medical research that involves a solution involving the neuroscience of brain disorders, electronic sensing development to detect brain waves, and software algorithms to interpret patterns. This example involves multiple and quite disparate fields of science and technology. If the work involves all three fields of science moving towards a single advancement, the claimant would list one field of science as the core field and explain how the others are involved in the context of that work in Section B of Part 2. In Section A, the claimant must indicate whether this is the first claim for the project or a continuation of a previously claimed project. The claimant must also indicate whether the work in the project was done jointly or in collaboration with other businesses and provide the names and business numbers of those collaborators. The CRA guidance clearly indicates that this is not in reference to contract arrangements (e.g., where contractors are performing some or all of the work on behalf of the claimant, or where the claimant has been contracted to do work on behalf of another party), which are declared elsewhere on the form. Although joint ventures may be one such type of collaboration, the CRA is unclear what forms of working relationships are expected to be reported in this section. Collaborations can occur in several industries where multiple participants jointly take on a challenge. Software and hardware developers, auto parts companies, and tool shops may work on a project together without contract payments when an ultimate benefit will occur on completion of their respective tasks. It is unclear how the CRA intends to use this data to review the cost and eligibility of a claim for projects undertaken within these networks.

Section B – Project descriptions In Section B, the claimant must describe the technical details and context of the basic research, applied research, or experimental development project. There are strict word limits, and all information must be in text form. Guide T4088 stresses focusing on the technical facts and using the technical language and style of those who are familiar with the work or who did the work. Drafting the text requires a good understanding of the project, as well as a comprehensive understanding of the SR&ED program. The claimant must ensure that the people involved in the claim preparation who understand the eligibility criteria for expenditures have sufficient access to and dialogue with the technical managers who understand the work required in a project. The scientific or technological basis for the SR&ED claim can then be appropriately described in the claim and supported with evidence. The technical description must answer all the questions on Form T661. The description is not expected to provide sufficient information to give a layperson an expert understanding of the technology. On Line 242, the claimant is allowed 350 words to describe the scientific or technological uncertainties it encountered and attempted to overcome, given the shortcomings or limitations in the current state of standard or proven technologies, practices, methodologies, or techniques (also referred to as the scientific or technological knowledge base). The uncertainties described must be related to the research or technology under development; uncertainties relating only to business or logistical issues, for example, should not be considered. Guide T4088 suggests that a claimant should describe, on Line 242, how the uncertainties could not be resolved on the basis of

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the existing scientific or technological knowledge base, after having described the objective of the project, the scientific knowledge or improved capability sought, and the existing scientific or technological knowledge base and its limitations. For more information on uncertainties, see Scientific or technological uncertainty (CRA’s methodology – Step 1, Question 1) (on page 36) in Chapter 3, What is eligible? – Scientific and technological aspects. On Line 244, the claimant must describe the work performed in the taxation year to overcome the scientific or technological uncertainties described on Line 242. The description is limited to 700 words or less. The claimant should describe only work related to overcoming the scientific or technological uncertainties for which expenditures in the taxation year are claimed. The systematic nature of the work conducted, along with the results obtained, their interpretation, and the conclusions drawn, should be summarized in chronological order. If contractors are involved, the claimant must clearly state which part of the work was performed by contractors. For more information on the formulation of hypotheses, and systematic investigations or searches, see Hypotheses formulation (CRA’s methodology – Step 1, Question 2) (on page 38) and Systematic investigation or search (CRA’s methodology – Step 1, Question 3) (on page 38) in Chapter 3, What is eligible? – Scientific and technological aspects. On Line 246, the claimant describes how the work described on Line 244 advanced, or was attempting to advance, the scientific or technological knowledge base that existed at the onset of the project, as described on Line 242. The description of this newly gained scientific knowledge or achieved (or attempted-to-be-achieved) technological advancement is limited to 350 words or less. Failure to achieve objectives or goals does not necessarily mean that there is no advancement; the rejection of a hypothesis can be considered an advancement, given that it eliminates a possible solution. For more information on advancement, see Scientific or technological advancement (CRA’s methodology – Step 1, Question 4) (on page 39) in Chapter 3, What is eligible? – Scientific and technological aspects.

Section C – Additional project information In Section C, the claimant must disclose the names of internal staff involved in the preparation of the project report, and the names of external consultants engaged on the claimant’s behalf. In addition, the claimant must provide the names of up to three key individuals involved in the project, along with their qualifications or experience and position title. If any of the individuals are contractors, use contractor for their position title. The CRA has indicated that the purpose of this information is to assist with the logistics and efficiency of scheduling audit review. Section C includes declarations regarding whether any work was claimed for salary or wages outside Canada, and whether any expenditures being claimed are for work performed on behalf of other parties or by contractors on behalf of the claimant. The names of contractors working on the claimant’s behalf (whether individuals or companies) must be disclosed, along with their business numbers (or GST/HST numbers for individuals). The claimant must also disclose the evidence that supports the technical facts, work performed, and costs presented in the claim. Although the claimant does not need to submit this evidence with the claim, all records and other evidence should be kept so

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that they are available for CRA review. An “Others” box is included to specify forms of evidence not listed on the form. There is a 15-word limit on this field. The abbreviated method using tick boxes should not be viewed as a reduction in the emphasis placed by the CRA on having comprehensive documentation. Technical records, photos, trial parts, and documents generated over the course of the project are invaluable in supporting the costs claimed. The evidence list might include items such as project plans, records of trials, test results, progress and final reports, minutes of meetings, prototypes, and new products. Documents may cross fiscal years; however, they should focus on supporting the eligibility case (advance, uncertainties, and technological base) and substantiate the fiscal period being claimed. Appendix 2 of Guide T4088 provides additional information on substantiating evidence.

Form T661 Part 3 – Calculation of SR&ED expenditures The claimant identifies eligible expenditures in Part 3 of Form T661. It is also where the claimant elects to claim its expenditures using the proxy method or chooses the traditional method. The proxy method election may be made on a year-by-year basis; however, once the claim is filed for a particular year, the choice of method is irrevocable for that year. Section B of Part 3 summarizes the allowable SR&ED expenditures related to the claimant’s SR&ED projects, as well as third-party payments reported on Form T1263, Third-Party Payments for Scientific Research and Experimental Development (SR&ED). Form T1263 must be completed for each third-party payment. Section C of Part 3 provides for deductions and other adjustments in computing the pool of deductible SR&ED expenditures. Eligible expenditures, deductions, and adjustments to the SR&ED pool are discussed in Chapter 4, What is eligible? – Financial aspects.

Form T661 Part 4 – Calculation of SR&ED expenditures for investment tax credit (ITC) purposes Part 4 of Form T661 is used to compute qualified expenditures, which are the basis for calculating investment tax credits (ITCs) earned in the year. This calculation is discussed in Chapter 4, What is eligible? – Financial aspects. The following forms are used to make related-party transfers of specific amounts relating to qualified expenditures: •

Form T1145, Agreement to Allocate Assistance for SR&ED Between Persons Not Dealing at Arm’s Length; and

•

Form T1146, Agreement to Transfer Qualified Expenditures Incurred in Respect of SR&ED Contracts Between Persons Not Dealing at Arm’s Length.

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Form T661 Part 5 – Calculation of prescribed proxy amount (PPA) The prescribed proxy amount (PPA) provides an alternative approach for claiming overheads and other costs attributable to SR&ED. Claimants may claim the PPA only if they elect to do so in Section A of Part 3 of Form T661 (on Line 160) for the year in question. The PPA, which is calculated in Part 5 of Form T661, is equal to 55%11 of the salaries and wages of employees directly engaged in SR&ED, after certain remunerations under sections 6 and 7 and unpaid amounts under subsection 78(4) of the Act have been subtracted. Wages and the PPA for specified employees are limited to a multiple of the year’s maximum pensionable earnings (see section 18 of the Canada Pension Plan). See Chapter 4, What is eligible? – Financial aspects, for more information.

Form T661 Part 6 – Project costs In Part 6 of Form T661, the claimant enters, on a project-by-project basis, the amount of project expenditures claimed in the year for salary or wages, materials consumed or transformed, and SR&ED contracts. The total reported for these expenditures should align with the amounts reported in Part 3 of Form T661 (e.g., the total cost of materials reported under Column 754 in Part 6 should equal the total of the cost of materials reported on Lines 320 and 325 in Part 3).

Form T661 Part 7 – Additional information Part 7 of Form T661 gathers background information on sources of funds for SR&ED, as well as the number and types of SR&ED personnel deployed by the claimant’s organization. The information provided should align with what was presented in aggregate in the project descriptions. Like information requested in other parts of Form T661, the information requested in Part 7 is prescribed, so the claimant must complete this section as accurately as possible. The CRA has indicated that this information assists in determining the efficacy of the program, as it provides some insight into resources deployed and the funding sources for SR&ED.

Form T661 Part 8 – Claim checklist Part 8 of Form T661 contains a checklist to verify the completeness of the claim. Claimants are advised to ensure that all elements are in place to expedite the processing of the claim. As stated earlier, claims that are incomplete at the filing deadline may be rejected in full or in part, without recourse.

11

The PPA rate was reduced from 65% to 55% over a two-year period beginning in 2013. See Prescribed proxy amount (on page 115) in Chapter 4, What is eligible? – Financial aspects.

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Form T661 Part 9 – Claim preparer information In Part 9 of Form T661, the claimant must provide the following information for each claim preparer that has accepted consideration to prepare or assist in the preparation of the SR&ED claim, but excluding any employee who has prepared or provided assistance in the course of performing his or her duties of employment: •

name and business number of the claim preparer (the GST/HST number of the claim preparer may be used if the claim preparer is an individual);

•

type of billing arrangement (hourly rate, flat fee, etc.) and the corresponding billing rate — if the type of billing arrangement does not correspond to one of the four types listed on the form, the arrangement must be described in 10 words or less (mixed types of billing arrangements used by the same claim preparer must be entered on separate lines of the form); and

•

total fee paid or expected to be paid to the claim preparer for each billing arrangement.

Part 9 of Form T661 must be signed by the claimant (for individuals) or its authorized signing officer (for corporations) to certify that the information provided in this part of the form is complete and accurate. The certification must be provided even if no claim preparer was engaged. No signature is required if the SR&ED claim is submitted electronically. A $1,000 penalty may be assessed under subsection 162(5.1) of the Act if the requested information in Part 9 of Form T661 is missing, incomplete, or inaccurate. The claimant and the claim preparer may be jointly and severally, or solidarily, liable for the penalty; however, failure to provide the required claim preparer information will not result in the disallowance of the SR&ED claim.12 To address claim preparers’ concerns about the confidentiality of their information, the CRA allows, as an administrative measure, Part 9 of Form T661 to be filed separately. The CRA instructs claimants using this administrative measure to •

complete all parts of Form T661, but without the billing arrangements and total fees information in Part 9 (i.e., leave Lines 950, 955, 960, and 965 blank but provide the identification of the claim preparer and the certification); and

•

for each claim preparer, complete a separate T661 that contains only the requested information in Part 1 and Part 9, with both parts completed in their entirety.

Form T661 Part 10 – Certification Part 10 of Form T661 must be signed by the claimant (for individuals) or its authorized signing officer (for corporations). The person certifies that he or she has examined the information provided, including attachments, and that it is true, correct, and complete. The name of the person, firm, or representative that helped to complete the form is included in this section (if applicable). This may be different from the person engaged to assist with specific responses listed on Line 257 in Section C of Part 2 of Form T661.

12 ITA s. 37(11.1).

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No signature is required if the SR&ED claim is submitted electronically, as other identification items, such as the claimant’s business number, taxation year-end, and web access code, make up its electronic signature.

Gathering documentation and supporting information – A year-round process Searching for new knowledge and improving products and processes are year-round activities. Preparing an SR&ED submission should also be treated as a year-round project. Recent interpretations and trends concerning claims and the evidence that supports the technical work and the costing methods employed, as well as recent court rulings, reinforce the benefits of having a submission process that is aligned with an organization’s business needs and integrated with daily business processes. CRA reviewers regularly request information prepared throughout the SR&ED project to justify claims. Project descriptions prepared at the time of filing may be subject to greater scrutiny during a review. CRA reviewers have called for claimants to demonstrate a consistent system that identifies and retains evidence and documentation of the SR&ED and that spans the entire length of the project. Such a system supports the project descriptions and costing summaries prepared for the actual filing. CRA reviewers prefer documents that are prepared contemporaneously (e.g., documents prepared when trials are conducted or test results received, rather than documents prepared at a later time). However, there is no requirement for contemporaneous documents and evidence under the Act. Appendix 2 of Guide T4088 states that “the lack of detailed documentary information should not discourage [potential claimants] from making an SR&ED claim or be considered as an indication that SR&ED did not take place.” Supporting information and documentation for SR&ED was a major issue in the 1990s and is re-emerging as a controversial issue. Knowing the various ways in which a claim can be substantiated using testimony and corroborating business documents and evidence is important when defending a submission during a CRA review, although one can understand why the existence of documentation and evidence specifically addressing the SR&ED scientific and technological issues is of utmost importance to the CRA in its review. Some CRA reviewers have emphasized the need for evidence based on dated documents that support •

the limits to base technology and knowledge;

•

the technological objectives at the onset;

•

timelines;

•

technological risks;

•

experiments;

•

analyses; and

•

why labour was required and how it was used during the period.

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Claimants are advised to retain as much information as is reasonable to demonstrate the work undertaken by individual people during a specific period or phase of a project. Appendix 2 of Guide T4088 provides a list of the types of supporting information that may be useful in substantiating the work undertaken in a period: •

project planning documents;

•

records of resources allocated to the project, and timesheets;

•

design of experiments;

•

design documents, computer-aided design (CAD), and technical drawings;

•

project records and laboratory notebooks;

•

design, system architecture, and source code (software development);

•

records of trial runs;

•

project progress reports;

•

minutes of project meetings;

•

test protocols, test data, and test results;

•

analysis of test results and conclusions;

•

final project report or professional publications;

•

photographs and videos;

•

prototypes and samples;

•

scrap and scrap records; and

•

contracts.

Appendix 2 of Guide T4088 also provides a non-exhaustive list of documents claimants should keep to support the SR&ED expenditures claimed. Section 5.4.3 of the CRA’s Financial Claim Review Manual – Review Procedures for Financial Reviewers also lists documents a financial reviewer may request from a claimant. One of the most problematic aspects of an SR&ED claim is supporting resource allocations, especially in cases where detailed contemporaneous time records have not been maintained. It is beneficial to understand what other documents from the period can support •

the work that was done and the amount of effort claimed;

•

the resource or pool of resources by which the work was performed; and

•

the reason for which the work was performed.

This documentation may involve separate documents or sources of evidence that can be used in combination to provide the required proof. The claimant may consider a wide variety of normal business information — for example, shipping records, invoices, standard crewing tables, individual day planners or calendars (including electronic versions), quality department requests, engineering change notices, or other documents that relate resources to a period. Gathering such information can be a monumental task, but it must be considered as a viable cross-check in situations where the claimant is otherwise relying strictly on estimates of resource allocations that are gathered after the period and supported only by records of oral testimony. Further information about how to demonstrate the contributions of staff to SR&ED is available in section 13 of the CRA’s SR&ED Salary or Wages Policy. This section describes

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how to use event-based documents and documents that define the roles of staff, the project, and process controls to adequately support labour allocation for SR&ED.

CRA review process Service standards When processing SR&ED claims, the CRA strives to meet specific service standard objectives. These standards are intended to be achieved at least 90% of the time. For refundable claims submitted with the tax filing for the year, the CRA does not generally assess the associated tax return until the SR&ED review has been completed.13 The service standard for these claims is to complete the process within 120 days of receiving a complete claim. For non-refundable claims, the service standard is to complete the review and assessment process within one year of receiving a complete claim. SR&ED tax credits are processed as filed with the assessment of the initial tax return for non-refundable claims filed for the year. Any adjustments resulting from a review of the SR&ED claim will result in a reassessment of the tax return. There is also a one-year service standard for non-refundable claims submitted with amended tax returns, and no assessment action is taken until the SR&ED review has been completed. The service standard for refundable claimant-requested adjustments (amended claims) is 240 days.

Completeness checks When a claim arrives at a tax centre, the CRA endeavours to identify the SR&ED claim as quickly as possible and performs a completeness check as the first step in processing the claim. If, in the view of the tax centre, the claim is incomplete, the claimant will be informed of the deficiencies, usually by a letter requesting that additional information be submitted within 30 days. If the tax centre does not receive the information requested, it will disallow the claim at that point. However, a company should still be allowed to resubmit its claim, as long as the 18-month deadline has not passed. After the deadline (or “too close” to the deadline), the CRA will not issue a letter requesting additional information and will not accept information provided by the claimant. Again, an incomplete claim would generally be denied with no recourse to file an amended claim.

Risk assessment Once a claim is determined to be complete, it proceeds to risk assessment, which is also performed at the tax centre. Risk assessment may result in the claim being

13 Certain Canadian-controlled private corporations may be entitled to a refund of all or part of their investment tax credits exceeding their income tax liability.

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•

accepted as filed; or

•

referred to the coordinating tax services office (CTSO) for further review.

See Chapter 1, The SR&ED program, for further discussion of the CRA’s risk assessment. The depth of a review is at the CRA’s discretion, and the level of detail may change as the CRA gathers more information: •

When only one reviewer (financial or technical) decides to conduct a detailed review, the other reviewer reserves the right to do a detailed review on the basis of the new information that surfaces.

•

When only a scientific or technical review is performed, and the CRA decides it has insufficient evidence to accept all the work claimed, a financial reviewer also performs an analysis to determine the dollar amount of any adjustments.

•

Even when the CRA has no problems with the scientific or technical aspects of a claim, it may still question the claimant’s substantiation for all or some of the expenditures.

It should be noted that the CRA has, over the years, made efforts to alleviate stakeholders’ concerns regarding accessibility, predictability, and consistency in the administration of the SR&ED program. The CRA has also reviewed the program’s policies and procedures to ensure they are aligned with current business practices and are applied consistently across Canada. For more details on these efforts and others, see Chapter 1, The SR&ED program.

First-time claimant advisory service Following the risk assessment described above, first-time claimants may be selected by the CRA to receive its first-time claimant advisory service (FTCAS). If a claimant is selected, it will be notified by a letter from the CTSO. Although the FTCAS is not labelled a review, the CRA will visit the selected claimant to discuss the claimant’s current project (or projects) and SR&ED work, and educate the claimant in terms of eligibility and documentation requirements. More specifically, the CRA will provide advice to the claimant on how to identify potential eligible work in the context of its business, as well as guidance on allowable expenditures, the types of documentation and other evidence that could support a claim, and completing and filing future SR&ED claims. After the visit, the CTSO will issue a report containing what was discussed and recommendations on improving future claims. If a refund is expected as a result of filing a claim, it will be processed after the site visit, and no detailed review of the kind described below will be performed for that claim.

Site visit and detailed review If, following the risk assessment described above, the CRA decides to conduct a detailed review of an SR&ED claim, a CRA technical reviewer — also referred to as a research and technology advisor (RTA) — may need to conduct a site visit of the claimant’s premises to resolve issues identified during the development of the RTA’s review plan or during

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the course of the review itself (e.g., if the scientific or technological advancement is not clear to the RTA, or appears to the RTA to be standard practice for the industry within the claimant’s business context). These issues, which will be discussed with the claimant prior to the site visit, may concern the eligibility of claimed work, the extent of the SR&ED, supporting evidence, or joint scientific-financial issues. A CRA financial reviewer may conduct a site review in conjunction (if possible) with the site visit by the RTA, if the issues cannot be resolved over the phone or by requesting additional information in writing. More specifically, as the CRA states in The SR&ED Technical Review: A Guide for Claimants, a site visit will help an RTA to •

understand the process that supports SR&ED claims within the claimant’s organization. For example, if the claimant’s process for identifying SR&ED projects to be included in the claim results in projects that are in agreement with the CRA’s understanding of SR&ED, then there is a greater certainty that the projects being claimed will be compliant;

•

understand the business context in which the claimed SR&ED was done;

•

understand why the claimant thinks their work represents a scientific or technological advancement, and the claimant’s views on the scientific or technological uncertainties faced;

•

work with the claimant to establish the key facts and understand the factors that support their position;

•

understand the work and the qualifications of the personnel who worked on the project;

•

determine how the claimant documents their work. The availability of contemporaneous documentation of the claimed work is important since it is the best kind of substantiation for an SR&ED claim; and

•

understand how the project’s start and end dates relate to the scope of the project.

To help claimants prepare for a site visit by an RTA, The SR&ED Technical Review: A Guide for Claimants provides the following points to consider: •

Do not focus only on the final results of the claimed work. Break the work into chronological order. Identify the scientific or technological uncertainties faced, as well as any hypotheses that were formulated to overcome these. Also, describe the experimentation and analysis that was done, as well as any conclusions reached. These kinds of facts will help to provide insight into the answers to the five questions and the requirements of the definition of SR&ED in subsection 248(1) of the Income Tax Act that will be used to determine if the claimed work is SR&ED.

•

Use the tool in Appendix 2 of the Guide T4088, Guide to Form T661, to collect and organize the supporting evidence that will substantiate what work was done and demonstrate how the work followed the basic scientific method described above. Be prepared to explain how the work described in Part 2 of Form T661 is documented, and have this supporting evidence readily available during the site visit.

•

Meet with the people who are best able to address the issues or questions raised by the RTA. If these people want more information about their role during the review, SR&ED Program policies, or the review process, contact the RTA to ask for help. Make sure that these people are available for consultation during the site visit. It is a best practice to remind these people of the scope of the SR&ED claim and its difference from the business project. That way they will answer questions within the scope of the SR&ED claim, not the business project.

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•

Make sure that key people meeting the RTA have read and reviewed descriptions of the project and the claimed work subject to the technical review. It may also be helpful for them to read past SR&ED technical reports.

Both The SR&ED Technical Review: A Guide for Claimants and Appendix A.8 of the Claim Review Manual for Research and Technology Advisors discuss what the claimant and the RTA can expect from each other during the SR&ED review, including the site visit. Mutual expectations of the claimant and the financial reviewer are discussed in Appendix 3 of the Financial Claim Review Manual – Review Procedures for Financial Reviewers. In addition, Appendix A.7 of the Claim Review Manual for Research and Technology Advisors outlines a series of questions RTAs should have in mind following their on-site interviews with claimants. To prepare for the site visit and give their SR&ED claims a better chance of being accepted, claimants should be aware of these questions and ensure they can provide satisfactory information to the CRA to address them:

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•

Is any of the review information unclear or inconsistent with other information obtained before or during the interview?

•

Are the claimed labour, materials, capital equipment, supplies and other SR&ED costs realistic and reasonable for the activities claimed in the project?

•

For the type and scale of projects of this claim, what kind of evidence would reasonably be expected to be present and would be useful towards establishing the project eligibility and work undertaken by the claimant?

•

Can the information obtained by way of the interview(s) be substantiated by the actual evidence and supporting documentation provided by the claimant? Is the evidence consistent?

•

What assumptions, if any, might now be necessary to support the analyses, and do the assumptions need validation?

•

Did each of the individuals claimed as involved in each project make a direct contribution to the SR&ED? What was the nature and extent of their contributions (for example, directly engaged, technical support, service support, general labour, clerical)?

•

What factors and considerations need to be taken into account to establish the “business context” of the claimant in relation to their claimed SR&ED?

•

Has the claimant claimed only SR&ED projects? That is, does each project as claimed reasonably represent all and only the work required to resolve a clearly defined Scientific or Technological (S/T) uncertainty and to seek a related and clearly defined Scientific or Technological Advancement (S/TA) by way of a systematic experimental and/or analytical investigation?

•

What field of science or technology is the SR&ED claimed in? Is it a multi-disciplinary area of science or technology? Is it in an excluded field? Is the SR&ED in the identified field?

•

For work that is SR&ED, what is the best way to describe the actual (as identified by the RTA) S/T uncertainty or research question posed by the claimant for each project?

•

Does the RTA think that the Scientific or Technological Uncertainty (S/TU) provided by the claimant is correctly and accurately identified, rather than being a business or other uncertainty? If given as the latter, does the claimant’s stated uncertainty have a direct link to an apparent or identifiable underlying S/TU (that is, identifiable by the RTA)? If this is the case, did the interview bring out the important relationship(s) between the technological development goals and specific S/T research objectives? Note that there is a distinction between a technological uncertainty, which relates to

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a technological obstacle or barrier, and a technical uncertainty, which relates to questions as to the results or outcome of the work, such as the commercial objectives. •

Does the RTA think that the S/TA provided by the claimant is correctly and accurately identified, and not a business or other goal, achievement or desired outcome? If given as the latter, does this goal or desired achievement have a direct link to an apparent or identifiable underlying S/TA (that is, identifiable by the RTA) in a field of science or technology which is not excluded by the definition of SR&ED? and

•

Is there a clear relationship between the claimed S/TU and the claimed S/TA? When the S/TU and the S/TA are about different issues or topics, it is possible that the project as claimed is too broad, or includes work that lies outside the goals of a specific SR&ED project.

When possible, at the end of the site visit, the RTA will give the claimant a preliminary verbal indication of the RTA’s eligibility decisions or outstanding concerns.

Research and technology review report and CRA proposal package If the CRA decides, on the basis of the RTA’s technical review, that all or some of the work claimed is not eligible, published policy states that the CRA may issue a draft copy of the research and technology review report (referred to as an SR&ED review report) as soon as the preliminary opinion has been established, to facilitate the early resolution of potential issues. The report must give the reason for ineligibility. The report may also include, where appropriate, recommendations to the claimant on necessary improvements to future SR&ED claims. A report does not appear to be required if the claim is to be processed as filed. However, in some cases, an SR&ED review report is prepared even if the claim is accepted as filed, and it may help the claimant understand why the CRA views the work as meeting the eligibility criteria. Before the technical and financial reviews are concluded, the financial reviewer will issue a 30-day proposal letter reflecting the financial results of the science and technology review, along with any other adjustments resulting from the financial review. The purpose of this letter is twofold: •

it enables the CRA to articulate, in writing, the reasons for its concerns and the impact of these concerns on the qualified expenditures and resulting investment tax credits; and

•

it allows the claimant a reasonable amount of time (usually 30 days) to provide additional information, clarification, or other support for its position.

Alternatively, and particularly if a separate draft SR&ED review report has not been presented earlier, the financial reviewer and the RTA will work to prepare a joint CRA proposal package that includes •

the proposal letter from the financial reviewer;

•

a copy of the RTA’s SR&ED review report; and

•

recommendations and requests for future claims, in particular concerning books and records.

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The claimant will benefit from the same reasonable amount of time to ask for further explanations, give new information, or rebut the CRA’s position. The CRA proposal package should not contain any surprises though, as the CRA’s policy is to communicate any concerns to the claimant as they arise. The SR&ED Technical Review: A Guide for Claimants, the Claim Review Manual for Research and Technology Advisors, and the Financial Claim Review Manual – Review Procedures for Financial Reviewers all make it clear that an open two-way dialogue is desired during the review process. If a claimant agrees with the proposal outlined in the package, it can expedite the processing of the claim by advising the CRA of its decision as soon as possible; otherwise, the CRA will wait until the 30-day response time has expired before processing the claim. If the claimant does not agree, it is incumbent on the claimant to respond to the CRA within 30 days (however, reasonable extensions of the 30-day period can usually be arranged). Both the claimant and the CRA should work together to finalize the claim. As mentioned above, The SR&ED Technical Review: A Guide for Claimants suggests that the RTA is expected to be in a position to provide a verbal preliminary opinion at the end of the site visit, when possible. If that cannot occur, it is recommended that the claimant ask •

when the preliminary opinion will be provided;

•

what concerns remain with respect to the eligibility of the work; and

•

when the report or other communication outlining the eligibility and the reasons for the decision will be available.

Disagreements between the claimant and the CRA When there are disagreements during a review, it is important for claimants to clearly communicate their position to the CRA. At the same time, it is important for claimants to work with the RTA or financial reviewer to understand the CRA’s position. According to the CRA’s published policy, RTAs and financial reviewers have an obligation to communicate their concerns to claimants or their representatives as early in the review as possible (normally as soon as the concern is identified). Although claimants have an obligation to substantiate their claims, RTAs and financial reviewers also have a responsibility to provide a full explanation and support for their position. The CRA’s policy, as stated in The SR&ED Technical Review: A Guide for Claimants, is that the position of the RTA must be supported by the facts of the case. Where disputes occur between the CRA and a claimant, the CRA’s longstanding policy is that the claimant has the right to discuss the issue with the reviewer’s manager. With respect to the SR&ED program, the CRA has taken this policy one step further, as outlined in the Guidelines for Resolving Claimants’ SR&ED Concerns. Although the CRA hopes that the majority of review issues can be resolved through clear communication between claimants and RTAs and financial reviewers, in situations where an agreement cannot be reached, claimants have the right to talk to CRA SR&ED management. Such discussions are not uncommon. In fact, they are easily arranged (ideally, as soon as possible) and encouraged by CRA management. As a courtesy, a claimant should inform the RTA or financial reviewer prior to speaking to his or her manager. If the RTA or

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financial reviewer is anticipating disagreement, he or she has likely already informed management, so a call from the claimant may not be a surprise. Claimants also have the right to contact CRA SR&ED management if they are concerned that due process has not occurred. It is incumbent on RTAs and financial reviewers to provide claimants with the name and contact information of their managers. CRA SR&ED management prefers claimants to come forward early in the process, when problems are noted. It is more difficult for CRA management to resolve issues when a lot of time and effort have been put into dealing with the issue prior to management’s involvement. CRA SR&ED management should allow claimants opportunities to discuss their concerns and provide whatever information claimants consider useful. If a claimant and the RTA’s or financial reviewer’s manager are still unable to reach an agreement, the claimant has the right to request an administrative review — that is, to bring the issues to the manager’s supervisor, who is the assistant director of SR&ED for the CTSO. The administrative review is not a second technical review; it is instead a review of the information available to the CRA to ensure that the SR&ED technical and financial reviews were consistent with current SR&ED legislation and policies, and that the claimant was given due process. A phone call to the assistant director is generally the best way to initiate contact (or at the very least, to ensure the file has not yet been closed by the CTSO). The assistant director may be willing to start discussing the situation at that point, without waiting for or requiring a formal submission. However, in most cases, the claimant must complete Form RC532, Request for Administrative Review, and send it to the National SR&ED Administrative Review Intake Centre in Ottawa, which will forward it to the assistant director within three business days. In its request, the claimant should indicate why it wants an administrative review (due process, communications, eligibility, etc.), describe the nature of its concerns in detail, provide its view on how both the review and management teams handled its concerns, and provide relevant facts and documentation to support its case. The Guidelines for Resolving Claimants’ SR&ED Concerns and Form RC532 both stress that an administrative review can be requested only after the claimant has received the proposal package from the CRA. However, Form RC532 must be submitted before the claimant’s file is closed by the CTSO (i.e., before the RTA and financial reviewer conclude their reviews and issue a final SR&ED review report and final financial review report). The Guidelines for Resolving Claimants’ SR&ED Concerns describe the administrative review process once the request is received by the assistant director:14 When conducting an Administrative Review, the Assistant Director will determine whether: •

The claimant was given due process, and

•

The SR&ED technical and financial reviews were consistent with the current SR&ED legislation, policies and procedures …

Based on the Assistant Director’s determination, there are two possible outcomes of the Administrative Review: Decision Maintained or Decision Reconsidered.

14 Although the administrative review is usually conducted by the assistant director, it may be delegated to another person not previously involved in the case.

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i. Decision Maintained If the Administrative Review reveals that the SR&ED technical and/or financial review was consistent with the current SR&ED legislation, … policies and [procedures], and that the claimant was given due process, then the technical and/or financial review will proceed in the usual manner. The claimant will be advised of this outcome in a letter from the Assistant Director. ii. Decision Reconsidered If the Administrative Review indicates that the SR&ED technical or financial review was not consistent with the current SR&ED legislation and policies, or the claimant was not given due process, then further action will be taken to address the Assistant Director’s findings. For example: •

if the claimant was not given a reasonable opportunity to provide additional information to support their claim, then the opportunity to do so may be provided; or

•

the Assistant Director may decide that a second technical and/or financial review is warranted. In this situation, another person not involved in the original review will conduct the review and write a report.

The Administrative Review will be documented in a memo to the Assistant Director, which summarizes the issues, process, findings, conclusion, and action taken. This memo needs to be produced only if the Assistant Director has delegated the Administrative Review. The claimant will be advised of the outcome of the Administrative Review in a letter from the Assistant Director. This letter will be written by the Assistant Director and include relevant information from the memo noted above.

In summary, once the administrative review has been requested, the assistant director decides how to bring the file to closure from the CRA SR&ED perspective. Agreement may have been reached or disagreements may still exist between the claimant and the CRA. Regardless, once the CRA believes the review process to be complete, it issues a final letter detailing all adjustments to be made in the assessment or reassessment of the tax return. For more information on the administrative review, see the Guidelines for Resolving Claimants’ SR&ED Concerns, and for more information on the detailed review, see The SR&ED Technical Review: A Guide for Claimants; the Claim Review Manual for Research and Technology Advisors; and the Financial Claim Review Manual – Review Procedures for Financial Reviewers. A summary of the detailed technical review process from a CRA perspective is provided in the table below. CRA’s detailed review process Research and technology review Step 1 – Preparing and planning

Financial review

RTA receives the claim

Financial reviewer (FR) receives the claim

RTA reviews the information received

FR reviews the information received

RTA contacts the FR to initiate coordination

FR contacts the RTA to initiate coordination (continued)

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CRA’s detailed review process Research and technology review Step 1 – Preparing and planning (cont’d)

Step 2 – Conducting a site visit

Financial review

RTA plans the review:

FR plans the review:

•

Identification of the issues

•

Identification of the issues

•

Assessment of the risk

•

Assessment of the risk and materiality

RTA determines scope of the review and develops a review plan

FR determines scope of the review and develops a review plan

First contact with the claimant:

First contact with the claimant:

•

RTA communicates with • the claimant

FR communicates with the claimant

•

RTA gathers information • by letter or phone (or both)

FR gathers information by letter or phone (or both)

RTA visits the claimant on site

FR visits the claimant on site

RTA interviews the SR&ED performers

FR interviews the SR&ED performers

RTA reviews documents and supporting evidence

FR reviews documents and supporting evidence

RTA analyzes all information received, requests additional information if necessary, and adjusts review plan if required

FR analyzes all information received, requests additional information if necessary, and adjusts review plan if required

RTA resolves issues

FR resolves issues

RTA communicates preliminary decisions on site, if possible Step 3 – Communicating, reporting, and finalizing results

RTA prepares an SR&ED review report RTA communicates the review results to the FR

FR prepares proposal letter

RTA and FR work together to prepare the CRA proposal, which includes the RTA’s SR&ED review report and the FR’s proposal letter (continued)

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CRA’s detailed review process Research and technology review Step 3 – Communicating, reporting, and finalizing results (cont’d)

Financial review

CRA proposal is communicated to the claimant RTA addresses any representation from the claimant on the SR&ED review report

FR addresses any representation from the claimant on the proposal letter

If the claimant’s concerns cannot be resolved with the RTA, the research and technology manager (RTM) reviews the facts of the case in an attempt to resolve the claimant’s concerns

If the claimant’s concerns cannot be resolved with the FR, the financial review manager (FRM) reviews the facts of the case in an attempt to resolve the claimant’s concerns

If the claimant’s concerns cannot be resolved with the RTM or the FRM, an administrative review is launched if requested by the claimant CTSO assistant director makes a determination (decision maintained or reconsidered) and communicates it to the claimant If the CTSO assistant director determines that the decision should be reconsidered, relevant further actions are taken to address the assistant director’s findings (e.g., reasonable opportunity to provide additional information is given to the claimant, initiation of the second technical or financial review) RTA and FR conclude their reviews and issue a final SR&ED review report and final financial review report CRA issues a notice of assessment or reassessment of the T2 tax return, with the resulting SR&ED-related adjustments, if any

Objections and appeals If, after going through the steps outlined above, the claimant still disagrees with the CRA’s proposed adjustments, and these adjustments are subsequently reflected in a notice of assessment or reassessment, the claimant may decide to file a notice of objection (objection) with the Appeals Branch of the CRA. An objection by a corporate claimant (using either a letter or Form T400A, Objection – Income Tax Act) must be served on the chief of appeals of an appeal intake centre within 90 days (not three months) of the date of sending of the CRA’s notice of assessment or reassessment. It is also possible to file an objection, within this 90-day period, using the online “Register a formal dispute” service available through My Business Account on the CRA website.

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CRA Appeals Branch The Appeals Branch promises to provide a fair and impartial review of the issues identified in the objection to determine whether the CRA has correctly applied the law to the claimant’s particular facts. Claimants should be aware that the appeals process can be quite lengthy. [§165(1)] — As noted above, once the CRA issues a notice of assessment, a corporate claimant has 90 days to file an objection. The objection must be in writing and set out the reasons for the objection and all relevant facts. [§165(1.11), (1.13)] — However, if the objection is for a large corporation, as defined in subsection 225.1(8) of the Act, the claimant must reasonably describe each issue to be decided, specify the relief sought in respect of each issue, and provide the facts and reasons the claimant is relying on in respect of each issue. The content of the objection is particularly important for a large corporation because the issues raised in the objection circumscribe the issues that may be raised subsequently in a notice of appeal to the Tax Court of Canada, as well as the relief that may be obtained with respect to those issues. If the notice of assessment or reassessment also contains adjustments with respect to issues not related to SR&ED, and the claimant wishes to object to those adjustments in addition to the SR&ED adjustments, the notice of objection must include facts and reasons relating to those adjustments as well. In other words, the claimant should file one objection that addresses all the adjustments to which the claimant objects. If the objection concerns a scientific or technological issue, as opposed to an interpretive issue (e.g., concerning the nature of an expenditure), the objection will be referred to CRA headquarters for review by the SR&ED Directorate. As noted in Pamphlet P148, Resolving Your Dispute: Objection and Appeal Rights Under the Income Tax Act, a claimant that has filed an objection has the right to access the audit report (the T20 report), as well as working papers and other information in the CRA’s audit file. Obtaining this information before filing an objection may give the claimant a better understanding of the CRA’s position and thus assist in preparing the objection. Upon receipt of the claimant’s objection, the Appeals Branch is obligated to reconsider the assessment and vacate, confirm, or vary the assessment. In other words, the Appeals Branch must choose to •

accept the objection in its entirety and vacate the assessment;

•

reject the objection in its entirety and confirm the assessment; or

•

accept a portion of the objection and vary the assessment.

Tax Court of Canada [§169] — If a claimant believes its objection will not receive adequate consideration by the CRA’s Appeals Branch and wishes to go to court, the claimant may file a notice of appeal (appeal) in the Tax Court of Canada at any time 90 days after the objection has been filed, as long as the Appeals Branch has not notified the claimant that the assessment has been vacated or confirmed. Alternatively, the claimant may file an

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appeal with the Tax Court after the Appeals Branch has considered the objection and confirmed the assessment or reassessed the claimant within 90 days of the date of the confirmation or reassessment. The Tax Court, which has the status of a superior court, has exclusive jurisdiction to hear appeals of assessments under the Income Tax Act. An appeal before the Tax Court is similar to other types of civil litigation in that issues are tried, witnesses are called, documents are tendered into evidence, and oral submissions are made supported by a memorandum of fact and law (a factum). In an income tax appeal, the taxpayer (claimant) is called the appellant, and the minister is called the respondent. The Tax Court of Canada Rules require the appellant and the respondent to provide each other with a list of all documents they intend to rely on at trial, and each party must grant access to these documents to counsel for the other party. In some cases, the appellant and the respondent may be required to file affidavits describing all the documents in their possession, control, or power that relate to any matter in issue, rather than just the documents they intend to rely on. After the exchange of lists (or affidavits) of documents and, typically, the documents themselves, the appellant and the respondent have the opportunity to examine for discovery a representative of the opposing party. The purpose of the examinations for discovery is to obtain information and documents from one party that are useful to the other party’s case, and to obtain admissions from the other party to narrow the number or scope of the issues. At trial, the parties call and cross-examine witnesses (including expert witnesses, if necessary), tender documents into evidence, and make representations based on the evidence and the law. The Tax Court judge considers the evidence placed before him or her and the applicable law, and renders a judgment that is binding on the parties unless it is overturned or varied on appeal.15 Either party may appeal from the judgment rendered by the Tax Court to the Federal Court of Appeal.16 Appeals to the Supreme Court of Canada from judgments rendered by the Federal Court of Appeal are permitted only if leave to appeal is granted by the Supreme Court. Thus, appeals to the Supreme Court are relatively rare.

15 A less stringent form of appeal procedure may be available to a claimant that chooses to file its appeal under the Tax Court’s informal procedure (as opposed to the default general procedure described above). However, for a claimant to qualify for the informal procedure, the disputed amount of federal tax and penalties cannot be more than $25,000 (or the claimant must restrict its appeal to this limit). 16 However, the Federal Courts Act restricts the grounds for an appeal from a judgment heard by the Tax Court under the informal procedure. See Federal Courts Act s. 27(1.3).

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For further reference Income Tax Act 37(11)

Filing requirement re pool of deductible SR&ED expenditures

37(11.1)

Failure to file re pool of deductible SR&ED expenditures

127(9)

Definition of investment tax credit (paragraph (m)) – Filing requirement re SR&ED investment tax credit

162(5.1)–(5.3)

Penalty for failure to provide claim preparer information

165(1)

Objections to assessments

165(1.11)

Objections by large corporations

165(1.13)

Limitation on objections by large corporations

169

Appeals to Tax Court and Federal Court of Appeal

Case law AFD Petroleum Ltd. v. Attorney General of Canada, 2016 FC 547 Easy Way Cattle Oilers Ltd. v. The Queen, 2016 FCA 301 Westsource Group Holdings Inc. v. The Queen, 2018 FCA 57

Forms RC532

Request for Administrative Review

T1145

Agreement to Allocate Assistance for SR&ED Between Persons Not Dealing at Arm’s Length

T1146

Agreement to Transfer Qualified Expenditures Incurred in Respect of SR&ED Contracts Between Persons Not Dealing at Arm’s Length

T1174

Agreement Between Associated Corporations to Allocate Salary or Wages of Specified Employees for Scientific Research and Experimental Development (SR&ED)

T1263

Third-Party Payments for Scientific Research and Experimental Development (SR&ED)

T2SCH31 (Schedule 31)

Investment Tax Credit – Corporations

T2SCH49 (Schedule 49)

Agreement Among Associated Canadian-Controlled Private Corporations to Allocate the Expenditure Limit

T2038(IND)

Investment Tax Credit (Individuals)

T400A

Objection – Income Tax Act

T661

Scientific Research and Experimental Development (SR&ED) Expenditures Claim

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Guides, manuals, and pamphlets 2000-02R3

Guidelines for Resolving Claimants’ SR&ED Concerns

Guide

The SR&ED Technical Review: A Guide for Claimants

Manual

Claim Review Manual for Research and Technology Advisors

Manual

Financial Claim Review Manual – Review Procedures for Financial Reviewers

P148

Resolving Your Dispute: Objection and Appeal Rights Under the Income Tax Act

T4012

T2 Corporation – Income Tax Guide

T4088

Scientific Research and Experimental Development (SR&ED) Expenditures Claim – Guide to Form T661

SR&ED program policies Eligibility of Work for SR&ED Investment Tax Credits Policy SR&ED Filing Requirements Policy SR&ED Salary or Wages Policy

Other publications OECD Frascati Manual

Web resources Claiming SR&ED tax incentives www.canada.ca/en/revenue-agency/services/scientific-research-experimentaldevelopment-tax-incentive-program/claiming-tax-incentives.html SR&ED program service standards www.canada.ca/en/revenue-agency/services/scientific-research-experimentaldevelopment-tax-incentive-program/program-service-standards.html SR&ED T661 claim form – Revised optional filing measure for Part 9 www.canada.ca/en/revenue-agency/services/scientific-research-experimentaldevelopment-tax-incentive-program/whats-new-program/t661-claim-form-revisedoptional-filing-measure-part-9.html

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