Where tax and science meet part 2*

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Bathsheba Kelly
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1 Where tax and science meet part 2* How CAs can identify eligible activities for the federal government s SR&ED program *This is an expanded version of a summary that appeared in the November 2003 print edition of CAmagazine. By William Stark and Marvin Silbert As noted in last month s issue ( Where tax and science meet, ) the Scientific Research and Experimental Development program is Canada s largest tax incentive program. Yet it is also one of the most underused. One of the main reasons is that CAs, who are generally the first contact regarding tax matters, lack the background to identify and complete the technical (scientific) component of the SR&ED claim. As a result, they often fail to identify client activities that may be eligible. To solve this problem, let s outline the requirements of the SR&ED program and explain how to identify possible SR&ED activities. Program requirements The SR&ED claim consists of two components: the technical submission (often referred to as the science report), which describes and supports the eligible SR&ED activity, as well as the related tax schedules (schedule 32 and 31), which detail the qualified expenditures and calculate the resulting Investment Tax Credits (ITC). The technical submission is clearly the most important component of the claim because: If the science activities are not accepted as eligible under the program, the entire claim will be disallowed and the resulting ITCs will also be disallowed. The SR&ED expenditures stem from the eligible SR&ED activities identified in the science report. The acceptance or rejection of SR&ED activities does not always follow simple black-and-white rules. Considerable judgment may be required to interpret the merits of a complex project. Although CAs should not be expected to have the technical background of engineers and scientists which is required to complete the technical submission, they should have enough knowledge to help clients identify possible SR&ED activities and to assist in the completion of the technical submission. Defining SR&ED It is important to distinguish between Research and Development (or simply R&D) and Scientific Research and Experimental Development (SR&ED). R&D can have a variety of definitions and may encompass a wide range of activities depending on who is asked. On the other hand, SR&ED has one definition, as defined under Subsection 248(1) of the Income Tax Act, and has a much narrower scope. Since 1986, CCRA has been given the mandate to assess the eligibility of activities under this definition, and has since developed eligibility criteria through a cooperative effort with industry representatives and the accounting profession. Information Circular 86-4R3 is the culmination of this cooperative effort, and forms the cornerstone for the criteria for eligibility for all SR&ED claims under the SR&ED program. Follow-up bulletins (Information Circulars and Interpretation Bulletins) are frequently added to provide guidance for specialized applications. These are all available on the (1 of 5) [ :06:58]

2 CCRA website at The first step in the claim process is to obtain an understanding SR&ED as defined by Subsection 248 (1) of the ITA. The ITA starts by defining 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. This requires the claimant to demonstrate that a proper scientific approach was followed. While a trial-and-error approach may indeed be difficult, it is not included within the mandate of the SR&ED program. As many activities start as trial-and-error processes with no formal documentation procedures, CCRA generally allows first-time claimants some leeway in this regard. Subsequent claims should be properly executed, which means educating the claimants about the requirements and ensuring that before they engage in a possible SR&ED activity, they undertake proper planning procedures, including the development of a hypothesis and documentation procedures for all testing and results. The definition then describes the eligible fields of science: Basic research: an advancement of scientific knowledge without a specific practical application. Applied research: an advancement of scientific knowledge with a specific practical application. Experimental development: a technological advancement for the purpose of creating a new product or process. It is important to note that most people (including CAs) perceive only basic and applied research, such as the development of a cure for cancer, as eligible SR&ED. In reality, these activities account for only about 10% of all SR&ED claims. Experimental development, which has a commercial focus, accounts for approximately 90% of all eligible and allowed SR&ED claims. The definition also describes ineligible activities: Market research and sales promotion Quality control or routine testing Social sciences Prospecting, exploring or drilling for minerals, petroleum or natural gas Style changes Routine data collection. Criteria for eligibility To be eligible, the project must meet three criteria as set out in IC 86-4R3: Technological uncertainty Technological advancement Technological content. Technological uncertainty In the latest version of the T661 form, there is no longer a requirement to demonstrate technological uncertainty but claimants should not kid themselves; it's still there. Conversations with CCRA science advisers have confirmed it is still necessary to demonstrate that the project was not just a simple application of existing technologies. In a project with technological uncertainty, you don't know in advance whether the final result is attainable. Technological uncertainty may be relatively easy to demonstrate in fundamental science and engineering projects (i.e., the sort of thing that gets done in universities and major laboratories), but is not so obvious in experimental development claims. In experimental development, the project may result in a totally new concept, a new way of doing things or perhaps only an incremental improvement, all of which are eligible. Projects that fail might (2 of 5) [ :06:58]

3 also be considered eligible since that failure may indicate the final result was indeed unattainable. Perhaps one of the biggest misunderstandings with respect to the concept of technical uncertainty is the distinction between routine engineering and SR&ED. Certainly, commissioning a new process or trying to get more output from an existing process may prove to be very difficult; but if it can be achieved through standard engineering or industry practices and the outcome is predictable, it has no technological uncertainty. As well, reinventing the wheel to discover something that someone knowledgeable in the field would already have known will not qualify under this criterion. The only exception might be in industries where secrecy prevents the dissemination of information and there is no possible way of obtaining it. It is also important to differentiate between technological uncertainty and commercial uncertainty, since the latter relates to marketing and will not be eligible. To compare a project that possesses technological uncertainty with one that doesn't, consider this example. A company produces widgets. There is a need for a new widget twice the size of those currently made. Nobody in the world has ever attempted to produce such large widgets. It takes a lot of effort, but eventually the existing machinery can make the bigger ones. Alternatively, the company can buy the machinery designed to do the job. [IF THERE WAS SPECIFIC MACHINERY FOR THE JOB, WHY HASN T IT BEEN USED BEFORE?]It may take a bit of time to get it up and rolling before it does the job, [???] but there was really no doubt it would. In both cases, success was almost guaranteed. There were no technological uncertainties standing in the way of success. Consider now finding that the existing machinery could never be upgraded to do the job and no suitable machinery was available from any supplier. Even if it was, the flow of hot plastic under gravity might prevent forming a symmetrical product or perhaps it might warp or crack as it cooled. To produce that widget, they would have to design the machinery to do the job. That equipment would have to compensate for that flow under gravity and then find a route to eliminate that tendency to warp or crack. Is all this achievable? Maybe, but the larger widgets will never be produced unless all these steps work. If they don't, the whole effort is scrap. Unlike the earlier examples, this one possesses technological uncertainty. There are numerous obstacles that preclude a guaranteed success. Technological advancement The project must also contribute technological advancement to the appropriate area of science and/or engineering. It is not for projects that use existing methods to add that bit of magic that would enable a company to add new and improved to a product's label. That improvement may provide a commercial advantage to the company, but does it represent a new or improved technology? The result must lead to new or improved technologies that could benefit others. Technological content Lastly, there must be some technological content or substance to the work. The activity must be carried out using the scientific method, generally starting with a hypothesis and then setting out to follow a logical series of steps to prove it. All activities, testing and results must be properly documented since the onus of proof is on the claimant to demonstrate what was done. Many people keep everything in their heads and have no documentation to indicate that the work had the required planning component. It s easy to describe almost anything with 20/20 hindsight, but if you can't show the work was planned and organized, it wasn't. Technological content also requires that the people who do the work have the appropriate qualifications. This does not mean everyone on the team must have an advanced university degree. There is no hard-and-fast rule, but the team s efforts may not be considered as eligible SR&ED if they were unaware of what had been done before and had gone out and reinvented the wheel (e.g., to get (3 of 5) [ :06:58]

4 around a patent) by performing an extensive project to discover something that someone knowledgeable in the field would already have known. There are some obvious exceptions in industries where there is a great degree of secrecy; in those cases, the claimants would have had no access to the competitor s knowledge. Taxation has always been considered the CA s responsibility. It is important when working with the SR&ED program to realize that the scientist/engineer and CA are either going to work together as a team or both will fail, since it is the technical submission that identifies the eligible activities and therefore dictates all the eligible costs. Properly prepared technical submissions must clearly identify the activity, indicate how it meets the definition of SR&ED and fully describe how it meets the eligibility criteria. While CCRA employs science officers in many disciplines, it can't be expected to cover everything. Therefore, it makes a lot of sense to ensure that each submission will stand on its own and be totally comprehendible to someone who has a reasonable science or engineering background in that field, but might not have an in-depth knowledge of that specific area of science. Even with the most complex of projects, the description should be no more than three to four pages long. It is also extremely important that the technical submission properly identify the area of science. Recently, an improperly prepared biotech claim was assessed as a computer software claim because one minor aspect of the project involved setting up a computer database. CCRA assigned the claim to a computer engineer and rejected it because the activities did not demonstrate any advancement in the computer field. All the biotech work (the real basis of the project, which was eligible), was disallowed. Finally, each fiscal year must stand on its own merit. Many applicants assume a project that was eligible one year will continue to be eligible in subsequent years. That is certainly possible, but there is no guarantee. Identifying SR&ED activities: a CA s perspective Although CAs are not expected to have the technical knowledge to prepare the technical submission, they are expected to know enough about their client s business to see potential SR&ED activities. Here are some indicators to consider in determining whether a client may have an eligible SR&ED activity: 1. Were qualified engineers and scientists involved with the project? 2. Were applications also made for patents? 3. Does the product or process have to meet specific industry standards? 4. What is the industry? (CCRA identifies 12 technology sectors.) 5. Did the company retain the intellectual property rights to any subcontracted activities? 6. Is this company trying to develop a new process or product with no precedent elsewhere? 7. Is this an improvement to an existing process or product that requires totally new technologies before it can succeed? 8. Did the company go through many steps that failed? The CA s role As a CA, your main role in the SR&ED program is to inform clients about the program and its benefits. Start by identifying clients with eligible SR&ED activities, based on your knowledge of their business (4 of 5) [ :06:58]

5 activities. You should then recognize their need for assistance in preparing the required technical submission and advise them accordingly. Be extremely careful if the client wishes to prepare the science report in-house. It should be written in a manner that emphasizes compliance with the program. Unless all the required information is included, the science officer may see its content in a different way. Once this report has been completed, you can help with the preparation and filing of the required tax forms and return. This is the second in a three-part series on the SR&ED. Next month: Next month: Specific tax areas of the SR&ED program. (For more details on the SR&ED program, visit William Stark, CA (bill@resdev.ca) is the president of ResDev Tax Consultants Inc. in Toronto. Marvin Silbert, PhD, PEng, is senior manager of chemical and manufacturing at ResDev. (5 of 5) [ :06:58]

Maximizing Innovation Funding for Technology Development. MNP SR&ED Team. Presented by: Date:

Maximizing Innovation Funding for Technology Development Presented by: Date: MNP SR&ED Team February 27, 2018 Technological Innovation Strategy Innovation is incremental to technology advancement but it