Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CCRA.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.

Principal Issues: Whether certain development costs incurred in respect of XXXXXXXXXX are included in Class 14 of Schedule II of the Regulations as part of the cost of a license.

Position: Question of fact.

Reasons: A license for a limited period is included in Class 14. Certain costs may be deemed to have been allowed under paragraph 20(1)(a) of the Act. Certain costs are SR&ED.

		March 28, 2003

R. C. (Bob) Neville	HEADQUARTERS
	Industry Specialist Services	A. Seidel, CMA
	Technical Applications &	(613) 957-2058
	   Valuations Division

	Attention: Bob Seney
		2003-000063

Capital Cost Allowance

This is in reply to your January 28, 2003 memorandum concerning the proper tax treatment of development costs related to XXXXXXXXXX.

Background

XXXXXXXXXX.

Issue#1

Are the amounts paid for the XXXXXXXXXX license/authorization fees on account of capital or a current expense?

Our Comments

The determination of whether an outlay is on account of capital or a current expense is discussed in Interpretation Bulletin IT-128R ("IT-128R"). Paragraph 4 of IT-128R sets out the criteria that are to be considered in determining whether an expenditure is on account of capital or a current expense. These criteria have been developed by the courts. The courts have generally taken the position that there is no rigid test to be used to determine whether an outlay is capital in nature or a current expense and that it is very much a question of fact. The circumstances specific to each case will be determinative of the issue. The four criteria that the courts have identified as being relevant to the determination are "enduring benefit", "maintenance or betterment", "integral part or separate asset" and "relative value".

In Marklib Investments II-A Limited v. Her Majesty the Queen, 2000 DTC 1413 (TCC), (hereinafter referred to as "Marklib"), Brulé, T.C.C.J. stated that the determination depends "not upon the nature of the property acquired but upon the nature of the expenditure". He then went on to state that:

"The classic description of what constitutes a capital expenditure is in British Insulated and Helsby Cables Limited and Atherton, [1926] AC 205 (H.L.) at 213:

... when an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, I think that there is very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such an expenditure as properly attributable not to revenue but to capital."

In Rainbow Pipe Line Company Limited v. Her Majesty the Queen, 99 DTC 1081 (TCC), Mogan, T.C.C.J. reviewed the "enduring asset test" and the "accurate picture approach" enumerated in Her Majesty the Queen v. Canderel Limited, 95 DTC 5101 (FCA) to conclude that the replacement of 44 kilometres of pipeline was a capital expense. The decision was based on the fact that the expense was non-recurring, was a major repair, brought into existence assets for the enduring benefit of the business, that the amount of the expenditure was substantial in relation to the book value of the whole pipeline and that capitalizing the amount provided a more accurate picture of the taxpayer's income.

The Corporation was granted a XXXXXXXXXX license in XXXXXXXXXX. The license had a specific term and expired on XXXXXXXXXX. Of the $XXXXXXXXXX deferred start-up costs that were deducted for tax purposes, $XXXXXXXXXX is specifically attributable to the XXXXXXXXXX license/authorization fee.

Applying the jurisprudence and the general guidelines in paragraph 4 of IT-128R to the facts of this particular situation, it is reasonable to conclude that the amount paid in respect of the license/authorization fee is on account of capital.

The courts have generally considered an outlay to be on account of capital in those situations where the expenditure is made "with a view to bringing into existence an asset or advantage for the enduring benefit of a trade". "Enduring benefit" is determined by the useful life of the asset. In this case, there is an enduring benefit to the Corporation. The license covers a XXXXXXXXXX-year period during which time the Corporation has unrestricted access to provide the XXXXXXXXXX in the license area.

The courts have generally considered an outlay to be on account of capital in those situations where the expenditure results in the acquisition of a separate asset. In this particular case, it is our view that the license to have access to a specific market is a separate asset from XXXXXXXXXX.

The courts have generally considered an outlay to be on account of capital in those situations where the quantum of the outlay is substantial. In Le Sous-Ministre du Revenu du Québec c. Denise Goyer, (1987 Carswell Que 122), it was determined that "as long as one is not creating new capital property, or causing the normal value of the property to be inflated, or replacing a property that has disappeared" the expenditure is of a current nature. In this particular case, the license is a new property that accounts for almost one-third of the total deferred start-up costs and therefore would be considered to be on account of capital.

The "maintenance expense or a betterment" criteria is not relevant in this particular case.

Conclusion

The XXXXXXXXXX license/authorization fee brings into existence a separate asset of substantial relative value and that is for the enduring benefit of the Corporation. Accordingly, it is our view that the $XXXXXXXXXX incurred by the Corporation was incurred for the acquisition of a capital property.

Issue #2

Based upon the conclusion that the $XXXXXXXXXX expenditure is on account of capital, is the property included in Class 14 of Schedule II of the Regulations?

Our Comments

Class 14 of Schedule II of the Regulations includes, among other things, "property that is a license for a limited period in respect of property".

Paragraph 11 of Interpretation Bulletin IT-477 ("IT-477") discusses the meaning of "franchise, concession or licence". It states that these expressions are not capable of easy definition and that they must generally be given the meaning or sense in which they are normally employed by businessmen. They include certain kinds of rights, privileges or monopolies conferred by, or pursuant to, legislation or by governmental authority. Generally, these words are used to refer to some right, privilege or monopoly that enables the holder to carry on his business or earn income from property, or that facilitates the carrying on of his business or the earning of income from property.

The license provided to the Corporation enables the Corporation to provide XXXXXXXXXX to its customers. Without the license, the Corporation would not be able to carry on their business.

The license is for a limited period of XXXXXXXXXX years such that it meets the limited period test.

Conclusion

It is our view that it is reasonable to conclude that the amounts described in the "deferred start-up costs" that relate to the XXXXXXXXXX license/authorization fee are in respect of a "license" and therefore included in Class 14 of Schedule II of the Regulations.

Issue #3

Would any of the remaining $XXXXXXXXXX of deferred start-up costs be considered to be on account of capital and, if so, what is the appropriate tax treatment of such amounts (treated as an "eligible capital expenditure", within the meaning of subsection 14(5) of the Act, included in Class 14 of Schedule II of the Regulations or included in some other Class of Schedule II of the Regulations)?

Our Comments

Paragraph 8 of Interpretation Bulletin IT-285R2 discusses the term "capital cost of property" and states that the capital cost of property generally means the full cost to the taxpayer of acquiring the property and includes legal, accounting, engineering or other fees incurred to acquire the property.

Paragraph 19 of IT-477 reiterates this for the capital cost of a property included in class 14. It states that the cost of the property includes the purchase price, if any, and any legal fees and disbursements, registration fees and representation expenses laid out to acquire the property.

As discussed in paragraph 20 of IT-477, where expenses related to the acquisition of a class 14 property are incurred in a year prior to the year in which the property is acquired, they will be added to the capital cost of the property in the year of its acquisition. No claim for capital cost allowance may be made in a year prior to the year of the actual acquisition of the relevant property.

Notwithstanding the above comments, expenses paid in a year in making a representation, relating to a business being carried on by a taxpayer, to a government, government agency or other body referred to in paragraph 20(1)(cc) of the Act, including any representation for the purpose of obtaining a licence, are deductible under paragraph 20(1)(cc) of the Act (or, if an election is made, under subsection 20(9) of the Act). However, if the representation expense was laid out to acquire a class 14 property, it will also form part of the capital cost thereof. To avoid a further deduction under paragraph 20(1)(a) of the Act in respect of the same amount and to permit recapture of the expenditure, subsection 13(12) of the Act deems the amount deducted under paragraph 20(1)(cc) of the Act (or in respect of which an election has been made under subsection 20(9) of the Act), to the extent that it forms part of the capital cost of the property, to have been allowed as capital cost allowance.

Conclusion

The statement of deferred start-up costs includes expenditures for "consulting", "legal", "marketing studies", "brand development", "regulatory documents/studies", "XXXXXXXXXX application costs" and a category described as "other". To the extent that any of these expenditures are laid out to acquire the XXXXXXXXXX license from XXXXXXXXXX, these amounts would be included in the capital cost of the class 14 property or deductible under paragraph 20(1)(cc) or subsection 20(9) of the Act. In any case, the proceeds received on the disposition of these costs would be considered to be recapture of amounts deducted, or deemed to have been deducted, pursuant to paragraph 20(1)(a) of the Act.

Issue #4

The question also arises as to the proper tax treatment of the significant costs incurred relating to the development of the XXXXXXXXXX. Some of these costs would be directly related to the purchase of fixed assets, such as XXXXXXXXXX. Presumably, these costs would be included in the appropriate CCA class, in the normal fashion. In addition, the taxpayer incurred substantial costs in relation to testing the XXXXXXXXXX. The XXXXXXXXXX was under development at the time and significant technical challenges were encountered. The taxpayer claimed some of these costs pursuant to its SR&ED claims for XXXXXXXXXX. Evidently, some of this work relates to the license application itself while other parts relate to the XXXXXXXXXX development. In the subsequent sales agreement, whereby XXXXXXXXXX sold the XXXXXXXXXX licenses and XXXXXXXXXX to XXXXXXXXXX, the "intellectual property" was described as follows:

"Intellectual Property" means all XXXXXXXXXX;"

While some of these costs may have been claimed as SR&ED, that fact should not really affect the end result. Pursuant to subsection 37(6) of the Act, amounts claimed as capital SR&ED would be deemed to be a separate class under section 1100 of the Regulations for purposes of the recapture provisions.

Should the remaining XXXXXXXXXX development costs identified in the "Statement of Deferred Start-up Costs" be included in Class 14, as part of the licence? Alternatively, do they relate to the patented process that qualified for SR&ED treatment and are part of a patent cost or an industrial design cost? Are they something else? Can the XXXXXXXXXX be separated from the license?

Our Comments

The "Science Consultant's" review of the Corporation's SR&ED claims indicated that $XXXXXXXXXX relates to capital expenditures. As you have pointed out, subsection 37(6) of the Act deems this amount, for purposes of section 13 of the Act, to be an amount allowed to the taxpayer as capital cost allowance of a separate prescribed class. Accordingly, any of the proceeds that are attributable to these capital assets would be included in income as recapture of capital cost allowance pursuant to subsection 13(1) of the Act.

Paragraphs 21 and 22 of IT-477 state that the capital cost to the original owner of a patent or industrial design includes the research and development expenses incurred in discovering, designing or developing the property to the extent that such expenses have not already been deducted as scientific research expenditures or ordinary operating expenses in the computation of income and that once the invention or design has been developed to the point where a patent or an industrial design registration can be obtained, subsequent expenses for the purpose of turning the property to account no longer form part of its capital cost.

Although the disposition of the XXXXXXXXXX license and related XXXXXXXXXX includes "intellectual property", it is not clear whether anything other than the XXXXXXXXXX license was actually disposed of by the Corporation. To the extent that the Corporation disposed of any other properties enumerated as "intellectual property", each such property would have to be reviewed to determine whether it is included in Class 14 of Schedule II of the Regulations. Nevertheless, it is our view that the XXXXXXXXXX being developed by the Corporation is distinguishable from the license itself and would not be considered to be "intellectual property".

Interpretation Bulletin IT-475 ("IT-475") discusses "Expenditures on Research and for Business Expansion" that are other than scientific research expenditures that are deductible pursuant to section 37 of the Act. To the extent that the "deferred start-up costs" are not included in Class 14 of Schedule II of the Regulations, were not deductible under section 37, subsection 20(9) or paragraph 20(1)(cc) of the Act and are not capital in nature, the following comments in IT-475 would be relevant to the remaining expenditures. Paragraph 2 of IT-475 states that expenses incurred in respect of research, which do not qualify under the Regulations as scientific research expenditures, may nevertheless be deductible if they are laid out to earn income from a business or property, they are not on account of capital and they are reasonable in the circumstances. Paragraph 3 of IT-475 states that a research program may be undertaken to determine whether a particular course of action be taken or certain capital assets acquired and that the taxpayer may use his own expertise and facilities in carrying out such a program or may contract to have it done by outside experts in the field. Although the aim of such programs is to create a lasting advantage for the business entity's profit-making operations, the expenses are treated as current operating expenditures. Finally, paragraph 5 of IT-475 states that expenditures made as part of a taxpayer's ordinary business operations in respect of research to determine whether a capital asset should be created or acquired, but which themselves are not directly linked to the creation or acquisition of a capital asset, are current operating expenses which are deductible in the year incurred. The amounts included in the schedule of "deferred start-up costs" that are not included in Class 14 of Schedule II of the Regulations, are not on account of capital, are not deductible pursuant to section 37, subsection 20(9) or paragraph 20(1)(cc) of the Act and are not depreciable property of a prescribed class, as discussed in Issues #1, #2 and #3 above, would be the types of expenditures described in IT-475. Accordingly, it is our view that such expenditures would be deductible as a current expense in computing income for tax purposes.

Conclusion

For tax purposes, the Corporation deducted $XXXXXXXXXX as "capitalized expenses deductible for tax purposes". This amount consists of many components, not all of which are to be treated equally for tax purposes.

The expenditures for the XXXXXXXXXX license, the XXXXXXXXXX license and the authorization fees in respect of the XXXXXXXXXX license are amounts that are described in Class 14 of Schedule II of the Regulations. Accordingly, for tax purposes, such amounts are not deductible as a current expense.

Similarly, any expenditures that relate to "intellectual property", as described in the sales agreement, which are on account of capital, would not be deductible, for tax purposes, as a current expense. These expenditures may, for tax purposes, be treated as "eligible capital expenditures" within the meaning thereof in subsection 14(5) of the Act.

The expenditures for "consulting", "legal", "marketing studies", "brand development", "regulatory documents/studies", "XXXXXXXXXX application costs" and included in the category described as "other" that specifically relate to the acquisition of the XXXXXXXXXX license, the XXXXXXXXXX license or any "intellectual property" that is on account of capital would form part of the capital cost of those properties. Accordingly, for tax purposes, such amounts are not deductible as current expenses.

The SR&ED claims filed by the Corporation indicate that $XXXXXXXXXX relates to capital expenditures. Subsection 37(6) of the Act deems this amount, for purposes of section 13 of the Act, to be an amount allowed to the taxpayer as capital cost allowance of a separate prescribed class. To the extent that any of the $XXXXXXXXXX proceeds received in XXXXXXXXXX is in respect of these capital expenditures, subsection 13(1) of the Act will apply to include such amount in the Corporation's income for tax purposes.

Where the Corporation has deducted any amount under subsection 20(9) or paragraph 20(1)(cc) of the Act, such amounts are deemed, for tax purposes, to be amounts deducted pursuant to paragraph 20(1)(a) of the Act. To the extent that any of the $XXXXXXXXXX proceeds received in XXXXXXXXXX is in respect of these amounts, subsection 13(1) of the Act will apply to include such amount in the Corporation's income for tax purposes.

The XXXXXXXXXX is not part of the property that is the XXXXXXXXXX license. Any expenditures that do not relate to the specific costs identified above would, for tax purposes, be deductible in the year they are incurred.

We hope our comments are of assistance. If you wish to discuss any of the above further, or if we can be of any further assistance, do not hesitate to contact us at the above number.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Customs and Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the electronic library version, or they may request a copy severed using the Privacy Act criteria which does not remove client identity. Requests for this latter version should be made by you to Mrs. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.

John Oulton, CA
Section Manager
Business and Individual Section
Business and Partnerships Division
Income Tax Rulings Directorate

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