REASONS
FOR JUDGMENT
Bocock J.
I. Introduction
and Issues
[1]
The Appellant, Highweb & Page Group Inc.
(“HPGI”), appeals the Minister of National Revenue’s (the “Minister”) disallowance
of certain scientific research and experimental development (“SR-ED”) expenditures.
The sum of $25,200 was disallowed in the 2007 taxation year (Phase I) and
$37,975 in the 2008 taxation year (Phase II). The Minister did allow SR-ED investment
tax credits (“ITCs”) of $2,704 in the 2008 taxation year (“STA2 - Phase II”).
[2]
HPGI appeals on the basis that it undertook technological
investigation or experiments to resolve identified technological uncertainties.
Specifically, HPGI asserts it conducted the required systematic investigation
which yielded 6 technological advancements in Phase I and a total of 4
technological advancements in Phase II, 3 more than the 1 allowed by the
Minister (STA2 – Phase II). There is no dispute as to the amounts, dates, or
other criteria.
[3]
Therefore the one issue before the Court is:
does the work undertaken by the Appellant beyond STA2 – Phase II constitute
SR-ED?
II. Law
[4]
To qualify for SR-ED ITCs, a taxpayer must
expend amounts on scientific research and experimental development related to
the business of the taxpayer, carried on in Canada and directly undertaken by
the taxpayer, pursuant to section 37(1)(a)(i) of the Income Tax
Act, RSC 1985, c.1 (5th Supp.) (the “Act”).
[5]
Relevant to the Appellant’s claim is the definition
of scientific research and experimental development within
subsection 248(1) of the Act which reads as follows (with relevant
emphasis added by underscoring):
…
“scientific
research and experimental development” means 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
(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;
…
[6]
The definition is broad and somewhat circuitous
in subparagraphs (a), (b), (c), and (d). Further,
that broad definition is subject to exclusions in subparagraphs (e) through (k).
Not surprisingly and appropriately then, jurisprudence
providing a methodological approach has necessarily developed.
[7]
In Northwest Hydraulic Consultants Ltd. v.
Her Majesty The Queen, [1998] 3 CTC 2520 (“Northwest Hydraulic”),
Justice Bowman outlined five criteria, summarized by this Court below, to
assist in assessing whether the “experiments” constitute SR-ED expenditures:
1.
Is there technical risk or uncertainty?
2.
Are there hypotheses which target the
uncertainty?
3.
Did the procedures employ the scientific method
bearing the usual hallmarks: trained and systematic observation, measurement
and experiment, and the iterative modification of the hypotheses?
4.
Was an advancement made; simply, was knowledge
gained?
5.
Were all of the above steps contemporaneously
recorded in detailed records?
III. The Project Generally
[8]
With any SR-ED claim, the facts related to the undertaken
experiments are critical and central to any analysis by the Court.
[9]
HPGI’s business is the marketing and design of digital
software and web-based accessibility systems. These products and services
assist small- and medium-sized businesses to manage internal server and web-based
applications, content, and business processes through the use of HPGI’s
“iFactum” software suite (“iFactum”). The program iFactum was being sold prior to
the SR-ED work being undertaken.
[10]
HPGI’s president and principal, Mr. Sarmiento,
together with one assistant undertook the work. Mr. Sarmiento testified at
the hearing. Mr. Sarmiento has a Bachelor of Science degree in electrical
engineering and many years’ experience with his company in developing and
marketing software related to business information management and integration.
He seemed sufficiently qualified to otherwise carry out the work undertaken.
[11]
Generally, and as described by the Appellant in
its initial SR-ED application, Phase I (the 2007 SR-ED) and Phase II (the 2008
SR-ED) involved enhancing the Appellant’s product by “universalizing” the
iFactum web content management system compatibility with other commercial operating
system platform programs (Phase I) and commercial web-based server platforms
(Phase II). In short, to update and modify iFactum’s utility with updated
or new third-party system server and web-based software.
[12]
In argument, the Appellant’s agent ultimately provided
the actual overriding hypothesis or proposal to the Court for each of Phase I
and II. They were as follows:
Phase I: The software design language “J#” could
achieve interoperability, communication, and/or functionality between various software
product platforms by the modification of iFactum code utilizing various
operating systems.
Phase II: That iFactum could achieve compatibility
across multiple web-based platforms or web service content by modifying iFactum
code.
[13]
Deductively, there is a targeted difference
between the proposed technological advancement in Phase I and II: the first
(Phase I) enhancements target actual operating systems on a user’s own computer
systems and the second (Phase II) target compatibility across web- or
internet-based platforms. Frequently, this is described as a business’ own
“intranet” system (Phase I) as opposed to the publically available “internet”
(Phase II). Although the targets are different, the advancement is theoretically
achieved through modifying and/or redesigning the underlying iFactum code. The
code is simply the binary sequence language embedded within the program or
operating language of iFactum which provides the commands, directions, and
scheme for the program.
IV. Specifics of the Work Undertaken
[14]
While it may be logical to look at the
technological uncertainty and experimental procedures as a whole, in light of
the overarching two hypotheses however, the most practical and common sense
analysis must occur more elementally. Since each alleged proposed technological
investigation or experiment must focus on the technological uncertainty, each
of 2007 and 2008 shall be analyzed segmentally. This is consistent with both
the analysis undertaken by the Minister in denying most of the claimed SR-ED
ITCs and with the manner in which HPGI presented its appeal at the hearing. It
is also consistent with the authorities: Les Abeilles Service de
Conditionnement Inc. c. Sa Majesté la Reine, 2014 CCI 313 at paragraph 138.
As well, such an analysis distills the otherwise insular and unique language of
software development. It is noted that two books of documents (actually
entitled “Book of Evidence” and “Book of Documents”) were entered by HPGI into
evidence. Only those documents referenced in these Reasons were described and
referenced by viva voce evidence during the hearing and therefore
comprise the documentary record before the Court. Such specific documents were
identified to the parties at the outset and clarified at the conclusion of
hearing testimony and prior to submissions.
[15]
Therefore, the chart attached hereto as Appendix
1 summarizes the Phase I and Phase II experiments and steps of the undertaking
as originally described and analyzed by the Canada Revenue Agency (the “CRA”).
The synthesized summaries are gleaned from the testimony of two witnesses: on
behalf of the Appellant, Mr. Sarmiento, the president of HPGI, and on
behalf of the Respondent, Mr. Pelissero, a research and technology advisor
with the CRA.
[16]
The onus lies with the Appellant to show more
likely than not, that the work undertaken within the experiments was SR-ED: Zeuter
Development Corporation v. Her Majesty The Queen, 2006 TCC 597 (“Zeuter
Development”) at paragraph 26. To that end, HPGI’s documentary evidence
consisted of time tracking sheets for Mr. Sarmiento and the other HPGI employee
and approximately 37 trouble ticket entries by date for Phase I and 17 trouble
ticket entries by date for Phase II. These trouble tickets were computer based
“post-its” which identified challenges and next steps in very general computer
nomenclature. On the other hand, the substantive 16-page SR-ED Technical Review
Report (the “Technical Review Report”) was prepared by Mr. Pelissero of the
CRA. An analysis of the evidence regarding compliance with the scientific
method and recordal will be determined by specific assessment of the alleged
technological uncertainty, proposed experiments, and claimed advancement, again
lifted almost entirely from the CRA’s Technical Review Report referred to above.
V. Analysis and Decision
[17]
For the following reasons the appeal is
dismissed.
(1) Technological
Uncertainty and Technological Advancement Absent
[18]
For technological uncertainty to exist there
must be a gap in knowledge. It was described by the Appellant’s agent as “a
missing piece of a jigsaw puzzle”. It cannot be that the knowledge exists, but
is merely unknown to an ITC claimant, or that the gap is soluble by the
application of another product through usual techniques applied by, in this
case, skilled and experienced software developers. Simply applying such skills
with generally available knowledge and/or other products is not scientific or
experimental development. It is product research and development. The fact that
readily available programs such as J# and JavaScript formed the bedrock of such
undertakings suggests the uncertainty was not of a technological unknown, in
the sense of a knowledge gap, but rather that of selective trial and procedural
sequencing errors: knowing which available products applied in the correct
sequence utilizing routine, standard or customary modifications would
accomplish the best enhancement to the existing, but outdated, iFactum
software.
[19]
This point is further demonstrated by the SR-ED
ITCs allowed by the Minister in STA2 - Phase II. Considerably more recordal
information was generated and referable to this technological uncertainty,
technological experiment, and technological advancement. Further, there was a
resolution of identified technological uncertainties within the differential
encoding of .NET and Java platforms. Individual testing and modification, duly
recorded, modified the functions in phased protocols. The STA2 – Phase II
undertaking generated learning around the uncertainty of reconciling data-type
mapping of QueryBeans. It had been incompatible. A technique was devised to
discover a reconciliation of shared data types between .NET and JavaScript
based platforms. The knowledge was not gained in the positive achievement of
the postulate or hypothesis, but in learning an outcome in the context of the
uncertainty proved by a negative result. No other detailed technological
experiment or technological advancement of another claimed technological
advancement in either of Phase I or Phase II was so defined, examined,
analyzed, and/or resolved. HPGI’s agent suggested that Information Circular
86-4R3 provided assistance where, at first glance, technological uncertainty
might not exist. He submitted that “system uncertainty” existed. It required
“work on combining technologies, devices, and/or processes” since “non-trivial
combinations of established (well-known) technologies and principles for their
integration carry a major element” of system uncertainty. This is factually not
apparent from the evidence. The Appellant did not tender sufficient concurrent
documentation or records to show that the challenge of system and internet incompatibility
(beyond STA2 - Phase II) was analyzed sufficiently to establish a need for
technological experiments or investigation to solve the alleged technological
gap related to iFactum.
(2) No
Clear Hypotheses or Technological Investigations Revealed in Evidence Support
the SR-ED Claim
[20]
At the conclusion of one-and-a-half days of
evidence, HPGI, through its agent, after precise questioning from the Bench,
assembled the two hypotheses referenced above: one operating system based and
the other based upon web or internet interfaces. It was also not clear from
Mr. Sarmiento’s testimony that these precise hypotheses were documented at
the time the work was undertaken. The presence of the hypotheses, at the outset,
is essential to otherwise provide the Court with demonstrable evidence that the
technological experiments/investigations existed at the outset to overcome the
uncertainty. The one exception to this existed within STA2 - Phase II of the
Technical Review Report. In STA2 – Phase II the common use by HPGI of the words
“incompatibility”, “not resolvable with existing products”, and “required
research” were hallmarks of existing technological uncertainty which
intuitively led to a developed hypothesis and undertaken detailed technological
investigations. The Minister allowed this claim, but denied the others. For the
Court, it is consistent with the authorities which logically state that for
technological uncertainty to be overcome, a “detailed record of the hypotheses
… be kept as the work progresses” (Northwest Hydraulic at paragraph 16).
This was inconsistent with HPGI’s factual record; the scant concurrently
recorded documentary evidence prepared and marshalled by the Appellant was not
sufficient to show the technological investigation/experiment to prove or
disprove the hypotheses beyond STA2 - Phase II.
[21]
Evidence was not offered to indicate that the
work undertaken was, on balance, more than HPGI’s core business of software
design and modification of its existing product. The program, iFactum, required
usual and customary updating, a task prolific in the industry. The evidence did
not show that the work undertaken went beyond applying standard practices and
procedures, albeit with newly released or updated, third-party products. Little
evidence suggested such work was more than enhancing the iFactum product, with
existing, but newly released products through computer programming manipulated
by the skills of a person suitably trained: C.W. Agencies Inc. v. Canada,
2002 DTC 6740 at paragraph 18. On balance, based upon the evidence, the
enhancement of iFactum was the deployment of steps constituting the application
of existing products and the debugging of code deficiencies and
incompatibilities between iFactum and other platforms by using usual software
design techniques. These products and skills were applied to iFactum to
commercially enhance its marketability.
(3) Insufficiency
of Relevant Record Keeping
[22]
Quite apart from anything else, the evidence of
having followed scientific procedures was simply not sufficient in the disallowed
technological investigation, experiments, and advancements. This was demonstrated
by Mr. Sarmiento’s need at the hearing to describe the technological
uncertainty, technological advancement, and work undertaken not through any
cogent, recognizable or organized technical records generated by HPGI, but
rather by extensive, and almost exclusive reference in his evidence-in-chief to
the CRA Technical Review Report. The Technical Review Report was helpful
because it referenced Mr. Sarmiento’s commentary at interviews during the CRA
audit and review phase which, notably, occurred after the work. This is not a
suitable substitute for contemporaneous record keeping. Nothing approaching
similar records or documents created by HPGI at the time the SR-ED work was undertaken
was before the Court. While evidence of the outcome is important, it is
critical to technological advancement that the rigours of adherence to the
scientific and experimental method be kept on a detailed and concurrent basis
with the conduct of the experiments. Since a negative answer to the hypothesis
is a more frequent outcome and frequently as helpful in advancing technological
knowledge, detailed step-by-step logging, analysis, and measurement is a
mandatory requirement, not an optional addendum. It is the roadmap. If one
loses the way and failure results, retracing through these accurate records
provides one with the deductive process for developing a different direction,
speed or mode to create, locate, size, and arrange the “missing piece in the
puzzle”. The “only reliable method of demonstrating that scientific research
was undertaken in a systematic fashion is to produce documentary evidence”: Zeuter
Development at paragraph 28. Factually, that necessary recordal process was
not present in this appeal.
VI. Summary and Costs
[23]
In summary, it may well be that some incremental
technological uncertainty and technological advancement occurred within
additional components of Phase II and within any of the Phase I work. However,
the precise nature of the technological uncertainty, hypotheses or experiments
on how these challenges would be solved and the advancement of knowledge gained
through the research cannot be identified from HPGI’s evidence of undertaken
work. Factually, there was manifest disregard and non-compliance with the
essential and well-known procedural requirements of the scientific method and
its fundamental requirement for detailed and current recordkeeping in order to
document the technological uncertainty, the hypotheses, the experiments, the
results, and achievements.
[24]
Since the Appellant elected to proceed with both
years under the Informal Procedure, there shall be no order as to costs.
Signed at Edmonton, Alberta, this 8th day of June 2015.
“R.S. Bocock”
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