Tuesday, 3 April 2012

Technical Uncertainty - SR&ED

The scientific research and experimental development ("SR&ED") tax incentive program is a generous program provided by the Federal Government of Canada.  It provides annually about $4 billion in investment tax credits to over 18,000 claimants.  This said - a claimant can not simply claim that the research and development carried out qualifies as SR&ED.  For research and development to qualify as SR&ED one of the hurdles that must be overcome is that of proving that the R&D was not simply routine engineering.  It is necessary to show that the focus of the R&D was to overcome a technical uncertainty.  The following was first published in the Canadian Tax Highlights, a Canadian Tax Foundation publication.

SR & ED Technical Uncertainty

Recent 2011 SR&ED cases - Soneil International (2011 TCC 391) and Jentel Manufacturing (2011 FCA 355) - illustrate the futility of claiming expenditures as SRED if it cannot be established that the research and development centered around overcoming a technical uncertainty that could not be resolved through routine engineering. In Jentel the goal of the R&D was to obtain a smaller and lighter version of its existing multi-bin product and in Soneil the goal was to improve existing switch battery technology.

SR&ED is defined in subsection 248(1) and paragraph (c) was relevant in each case. SR&ED is

... systematic investigation or search that is carried out in a field of science or technology by means of experiment or analysis and that is...
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.

When making a SR&ED claim the onus is on the taxpayer to show, on the balance of probabilities, that the expenditures it incurred were for SR&ED as defined (Zeuter Developments 2006 TCC 597.)

Paragraph (c) of the definition was also relevant in Northwest Hydraulic Consultants (3 CTC 2520), in which the TCC set out an invaluable list of five steps to determine when R&D can be considered to be SR&ED.  The first step is whether there is a technical risk or uncertainty, a step that the taxpayers in both Soneil and Jentel failed to meet. Justice Bowman elaborated on the meaning of “technical risk or uncertainty”:

 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.

In other words the taxpayer cannot simply state that a procedure is technically uncertain; the taxpayer must demonstrate that the technological uncertainty could not be solved by routine engineering.

In Soneil the taxpayer listed four technical uncertainties that needed to be overcome but failed to demonstrate why they could not be overcome by routine engineering. The TCC confirmed that the list of the four uncertainties “was the only evidence provided by the [taxpayer]…. It is simply not clear to me whether he is referring to uncertainties that could be resolved by scientific research and experimental development or if he is referring to redesign issues that could have been resolved by using techniques, procedures, and data that were generally available to competent professionals in the field”. The TCC also noted that the taxpayers not only failed to provide sufficient evidence that a technological risk or uncertainty existed, but also failed to provide sufficient evidence that testing was performed to overcome the technical uncertainties. The court quoted from its earlier decision in Zeuter Developments:

… While not absolutely necessary, it is beyond doubt that a taxpayer who creates a well-supported claim will facilitate the process in determining whether something qualifies as SR&ED. As stated in RIS-Christie, the only reliable method of demonstrating that scientific research was undertaken in a systematic fashion is to produce documentary evidence.

The taxpayer thus failed to show on a balance of probabilities that its R&D qualified as SR&ED because it failed to show that the technical uncertainties for which it was conducting R&D could not be overcome through routine engineering. 

In Jentel the taxpayer developed and manufactured thermoformed plastic products that were engineered for consumer and industrial uses.  Before its 2005 fiscal year, Jentel had developed a storage unit: Multi-Bins, a small storage system typically used in industrial and shop-floor settings. During its 2005 fiscal year the company sought to overhaul and improve the Multi-Bins concept by redesigning a smaller and significantly lighter version. The taxpayer characterized the R&D issue as technical uncertainty that arose because the properties of plastic become unknown when it was extruded. The testimony given in court and deduced from the TCC decision appears to have been centered on the testing procedures that the taxpayer undertook to achieve the final product goal. 

Similar to Soneil, the taxpayer in Jentel  failed to establish the technical uncertainties that needed to be overcome through R&D.  Jentel’s expert witness focused on the testing that was done to obtain the final result and the only technical uncertainty he mentioned was the unknown property changes of a plastic resin when extruded. However, the court concluded that the extruding of plastics was not a technical uncertainty that could not be overcome by routine engineering.

The FCA agreed. The FCA said that the activities carried out by Jentel in its fiscal 2005 year were of a routine nature. The fact that Jentel had previously used both injection moulding and thermoforming and did not just begin to use those methods in 2005 supports the reasonableness of the conclusion that the taxpayer was using an available standard manufacturing process.

Sunita Doobay
TaxChambers, Toronto
©2012, Canadian Tax Foundation

Canadian Tax Highlights
Volume 20, Number 3, March 2012

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