REASONS
FOR JUDGMENT
D’Auray J.
[1]
The appellant, Flavor Net Inc., is appealing reassessments
issued by the Minister of National Revenue, disallowing the amounts claimed by
the appellant as expenditures for scientific research and experimental
development (“SR&ED”), as defined in subsection 248(1) of the Income Tax
Act (the “Act”),
for its taxation years ending June 30, 2010 and October 31, 2010.
[2]
In computing its income, the appellant claimed
qualified SR&ED expenditures of $225,136 and investment tax credits
(“ITCs”) of $78,798 for the taxation year ending June 30, 2010 and qualified
SR&ED expenditures of $45,638 and ITCs of $15,973 for the taxation year ending
October 31, 2010.
[3]
The amounts initially claimed by the appellant
were in respect of seven projects. Some of these projects continued over both of
the taxation years in dispute. The projects were identified at the hearing by
the project identification numbers given to them by the appellant. The projects
originally at issue were projects 705, 801, 802, 803, 804, 805 and 806.
However, since the appellant elected to proceed under the informal procedure, it decided to narrow the scope of the appeal to two of the
projects, 705 and 806. The appellant thus chose to waive any amount exceeding
$25,000 for each taxation year at issue.
[4]
The sole issue in this appeal is whether the
appellant’s activities with respect to projects 705 and 806 constituted
SR&ED within the meaning of the definition of SR&ED in subsection
248(1) of the Act.
If so, the appellant is entitled to ITCs in respect of the amounts claimed as
expenditures for SR&ED.
II. FACTS
[5]
The appellant was incorporated in 2000.
Initially, its business consisted of selling flavours to the baking industry
and salty snack seasonings to the snack food industry. Later, that portion of the corporation was sold to third parties,
and the company entered the energy drink business. It was this later development that led to the appellant’s work on
developing a beverage with plant sterols and other health-food ingredients.
[6]
Gregory Schmalz is the appellant’s founder,
president and sole shareholder. Mr. Schmalz holds a Bachelor of Science degree
from the University of Waterloo. He has had a lengthy career in the flavour and
fragrance industries. Mr. Schmalz testified that the work in question was
performed by him and his assistant, Chris Melling. Mr. Schmalz was unable to confirm whether Mr. Melling had any
educational background in science. However, he testified that he did not
believe this to be the case.
[7]
At the hearing, Mr. Schmalz was the only witness
for the appellant. Ms. Azza Hassanein—a research and technology manager with the Canada
Revenue Agency (the “CRA”) who evaluated the SR&ED claims made by the
appellant—testified as the
sole witness for the respondent. No experts were called by either party to
testify at the hearing.
[8]
Mr. Schmalz explained that the appellant’s
purpose with respect to project 705 (the “Plant Sterols Beverage Project”) was
to develop a beverage containing a mixture of 800 milligrams of plant sterols
in a two-ounce format. Plant sterols are a natural cholesterol-reducing
substance found in plant cell membranes. The U.S. Food and Drug Administration
recognizes that a daily dose of 800 milligrams of sterols may reduce
cholesterol and lessen the risk of heart disease, and it permits products to
advertise their cholesterol‑reducing properties if they contain the
prescribed amounts of sterols. The appellant’s intention was that the two-ounce
beverage be marketed for its cholesterol-reducing properties.
[9]
With respect to project 806 (the “Partial Hot
Fill System Project”), Mr. Schmalz explained that the appellant developed
a pasteurization system that focused on pasteurizing only the active
ingredients by pumping these ingredients in a side kettle and then pumping back
the mixture into a larger tank. This method, according to Mr. Schmalz, was novel
in that it was different from the hot fill method used by the industry. The two
projects were interrelated in the sense that they were components of the same
beverage production process and in the sense that the appellant hoped that the Partial
Hot Fill System’s pasteurization process would aid in the dispersion of the
desired amount of sterols in the two‑ounce format, as required for the
success of the Plant Sterols Beverage Project.
[10]
Before starting my analysis of the appellant’s
SR&ED projects, I would immediately emphasize that, as noted by the
respondent, there is a discrepancy between the testimony of Mr. Schmalz with
respect to the appellant’s SR&ED projects 705 and 806 and the description
of these projects by the appellant in its T661 form for both years under appeal. The T661 is a compulsory form
that a taxpayer is required to file with its income tax return when claiming
SR&ED expenditures and related ITCs. The T661 requires a taxpayer to
describe the purpose of the SR&ED project, the activities undertaken, the
technological risks, the uncertainties and advancements, and the approach followed.
The CRA relies on the T661 to determine whether the activities of a taxpayer
constitute SR&ED within the meaning of the definition of SR&DE in subsection
248(1) of the Act.
[11]
With respect to project 705—the Plant Sterols
Beverage Project—the respondent noted that the T661 of the appellant does not
mention that the appellant was to develop a two-ounce shot in which the mixture
would contain 800 milligrams of plant sterols. I agree with the respondent that
the description in the T661 is vague. It is stated that the appellant’s aim is
to develop a health supplement in the form of a beverage using plant sterols.
That said, since Ms. Hassanein, the technical reviewer at the CRA, stated
in her testimony that she was aware at the time of her review that the purpose
of project 705 was to develop a two-ounce beverage which would include 800
milligrams of sterols, I do not have any concerns in analyzing project 705 as
it was described by Mr. Schmalz during the hearing.
[12]
With respect to project 806, at the hearing, Mr.
Schmalz testified that the appellant’s purpose was to develop a Partial Hot
Fill System. However, the description in the appellant’s T661 with respect to project
806 for both years is focussed on the filling of a dual-chambered bottle. In
the T661 for the year ending June 2010, project 806 is described as follows:
A dual chambered bottle with twin caps had
never before been attempted to be filled by Flavour.Net Inc. Syncronization [sic]
of the twin tank, pump, piping, filler reservoirs and filling heads was of the
utmost importance. Through our trials it was shown that such a filling system
can be designed that enables the benefits of the dual chambered bottle to be
used in a variety of applications. By integrating a steam kettle as a mixing
vessel for liquid concentrates success was achieved in duplicating hot fill
results from the system. Significant effort was expended on the design of this
unique filling system which is currently in use filling health supplement
products. Further uses will be tested in the future.
[13]
In addition, in the appellant’s submissions to the
CRA, dated and signed by Mr. Schmalz, project 806 is described by the
appellant as relating to the dual‑chambered bottle:
Never before has Flavor.Net Inc. undertook [sic]
to design a filling unit that can simultaneously fill two separate liquids into
a dual chambered bottle and heat treat the liquid.
[14]
At the hearing, Ms. Hassanein testified with
respect to project 806 that the appellant had described that project, as the filling
of the dual-chambered bottle. Accordingly, it was the filling of the dual-chambered
bottle that Ms. Hassanein reviewed for SR&ED purposes. Her written reports
on project 806 confirm her testimony. In the report dated August 19, 2011 with respect to the taxation year ending June 30, 2010, Ms. Hassanein
wrote as follows regarding project 806:
This project was to design a filling unit
that can simultaneously fill two separate liquids into a dual chambered bottle
and heat-treat liquid. Natural health supplements can require twice daily
dosing. Flavor Net needs to determine if it can develop a unique filling system
to fill a single bottle with two chambers and two caps creating a physical
reminder to take a dose from each side. As well a capability for heat treating
of the liquid to ensure microbial safety will need to be designed.
[15]
The filling of the dual-chambered bottle and the
Partial Hot Fill System are distinct projects; this was confirmed by Mr. Schmalz
during the hearing.
[16]
Furthermore, the respondent submitted that I
should not allow project 806 since it was far from clear from the documents
filed in evidence at the hearing that the Partial Hot Fill System was developed
by the appellant during the taxation years under appeal.
[17]
As I have stated, the appellant’s purpose was to
develop a health supplement beverage. Since shots tend to be popular and are trendy,
the appellant decided to develop a two-ounce health beverage containing 800
milligrams of plant sterols that could be taken as a shot. Plant sterols are recognized
as reducing cholesterol and as having other health benefits.
[18]
The issue, however, is that sterols are hydrophobic
in nature, meaning that they do not dissolve well in water. The difficulty
presented by the project was the development of a method of dispersing in two ounces
of liquid an 800‑milligram concentration of plant sterols. The appellant
was aware that Cargill Corporation had a patent and had succeeded in dispersing
plant sterols in orange juice, but Cargill was only able to disperse 400 milligrams
in an eight‑ounce serving. Therefore, the appellant was trying to develop a beverage in which
the concentration of sterols was eight times higher than the concentration
found in the orange juice product developed by Cargill.
[19]
The appellant conducted various tests. For
example, it used different heating temperatures, mixed the sterols with different
ingredients to determine if the sterols would disperse better and completely, and
tested different emulsifiers in conjunction with NutraFlora, which is a soluble
fibre. As the project evolved, other health food ingredients (“nutraceuticals”)—such as cocoa, green tea
extract, and berries—were
added to the mixture, both to enhance the health properties of the overall product and to aid in the dispersion of the sterols.
[20]
Mr. Schmalz also explained that the appellant tested
different mixing methods, for example, high-shear mixing, and mixing with a mechanical
pump. Although, it is difficult to completely disperse 800 milligrams of
sterols in two ounces of liquid, the appellant succeeded in dispersing 85% of
the plant sterols; but there were still sediments that made the beverage unacceptable
for market purposes.
[21]
At the hearing, Mr. Schmalz explained that the
objective of the Partial Hot Fill System Project was to develop a system that
has the capability of pasteurizing two different liquid concentrates,
subsequently diluting them and then filling them into a dual-chambered bottle at
25 degrees Celsius. According to Mr. Schmalz, the appellant’s system
differs from the industry-standard “hot fill” pasteurization system, which
involves packaging the liquid when hot in special heat‑resistant plastic
or glass bottles.
[22]
Mr. Schmalz explained that the process in the
Partial Hot Fill System begins with the addition of a small amount of
sterilized water to the plant sterols and other nutraceutical ingredients—which produces what he described
as a “slurry”. That mixture is then pasteurized by being pumped into the small
side kettle, which is connected to the main tank, and heated to 50 degrees
Celsius. The
next step is to pump back the pasteurized mixture from the side kettle into the
larger tank and to dilute it with sterile water, at which point the product is
at room temperature and ready for bottling.
[23]
According to Mr. Schmalz, he was seeking to
develop an alternative to the traditional hot fill process in order to save
energy and packaging costs, since plastic bottles are less expensive than glass
bottles. In
addition, it was also hoped that the heating process used in the Partial Hot
Fill System would assist with the dispersion of the sterols and other
nutraceuticals in the two ounces of water, thereby contributing to the realization
of the Plant Sterols Beverage Project (i.e., the dispersal of the prescribed
dosage of sterols in the two-ounce format).
[24]
The appellant’s position is that the
expenditures relating to the Plant Sterols Beverage Project and Partial Hot
Fill System Project were made as part of “experimental development” within the meaning
of the definition of SR&ED found in subsection 248(1) of the Act and
thus the claimed SR&ED expenditures were qualified SR&ED expenditures and
entitled the appellant to the related ITCs. The appellant argues that the Cargill
patent represents the standard practice. In Mr. Schmalz’s view, no one had been
able to disperse such a large quantity of plant sterols in two ounces of
liquid. Therefore, there was technological uncertainty as to whether 800
milligrams of plant sterols could be dispersed in such a small quantity of
liquid.
[25]
The appellant further argues that there was
technological uncertainty with respect to the Partial Hot Fill System as an
alternative to the traditional hot fill process. The appellant further argues
that both projects were undertaken through technological advancement.
[26]
Finally, the appellant claims that it
demonstrated its use of a systematic approach consisting of the formulation of
hypotheses, the testing of those hypotheses using established techniques of
measurement and experimentation, and the recording of data.
[27]
The respondent argues that the activities
undertaken by the appellant do not constitute eligible SR&ED within the
meaning of the definition of SR&ED in subsection 248(1) of the Act.
[28]
With respect to project 705, the Plant Sterols
Beverage Project, the respondent argues that there were no technological
uncertainties and no technological advancements since the appellant was using a
methodology and techniques that were based on existing technology.
[29]
In addition, the respondent argues that the
evidence established that the appellant did not understand the concept of a
hypothesis. Therefore, no clear hypothesis was formulated and the overall
procedure followed by the appellant did not accord with the established
principles of the scientific method.
[30]
With respect to project 806, the Partial Hot
Fill System Project, the respondent argues that the evidence did not establish
that the project was developed during the years under appeal. In addition, she
argues that the documents submitted by the appellant at trial generated even
more confusion, relating to what project was under review for SR&ED
purposes.
[31]
The relevant portions of the definition of the
term “scientific research and experimental development,” as set out in
subsection 248(1) of the Act, are as follows:
“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
. . .
(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 . . . (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.
[32]
In determining whether the work undertaken by
the appellant in respect of the projects constituted SR&ED, it is necessary
to consider the five criteria set out by Justice Bowman (as he then was) in Northwest
Hydraulic Consultants Ltd. These
criteria have been repeatedly confirmed and adopted by the Federal Court of
Appeal in numerous decisions, including RIS-Christie and C.W. Agencies Inc.
[33]
In Northwest Hydraulic Consultants Ltd.,
Justice Bowman set out the approach to be taken in assessing a taxpayer’s
activities against the requirements of the statutory definition of SR&ED.
Justice Bowman’s approach is based on five criteria, which he described as
follows (at paragraph 16):
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;
(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 in section 2900 of the Regulations 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 self-evident that a detailed
record of the hypotheses, tests and results be kept, and that it be kept as the
work progresses.
[34]
With these principles in mind, I will now
proceed to consider the eligibility of both projects undertaken by the
appellant during the period at issue.
[35]
To constitute SR&ED, a project must address
a technological uncertainty that cannot be resolved by routine engineering or
standard procedures.
[36]
Mr. Schmalz described the overall objective of
the Plant Sterols Beverage Project as the development of a product containing
the prescribed dose of plant sterols in a two-ounce bottle. Mr. Schmalz
testified that it was uncertain whether it would be possible to properly
disperse this concentration of sterols in two ounces of water, that is, 800
milligrams of sterols in two ounces of water mixed with nutraceutical
ingredients.
[37]
In my view, the appellant has not succeeded in
demonstrating that it faced a technological uncertainty for the purposes of the
definition of SR&ED in subsection 248(1) of the Act.
[38]
There is no doubt that the appellant was trying
to develop a new product. There is always uncertainty in developing a new
product. That said, not all new product development is faced with technological
uncertainty. In developing its two-ounce beverage, the main issue that the
appellant had was suspending the plant sterols, which are a fat-based substance,
in a liquid. To resolve that issue, the appellant used a methodology and a technology
that are well established in the food industry, namely high-shear mixing,
mechanical pumping, by trying to heat the product at different temperatures and
by utilizing emulsifiers that existed in the market.
[39]
The facts of the present appeal are virtually indistinguishable
from those in R&D Pro-Innovation Inc., a recent decision of this Court, which has been affirmed by the
Federal Court of Appeal. In
that case, the project involved developing a cold-tempered chocolate spread containing
cream and maple syrup, without artificial ingredients or added preservatives. The appellant stated that even though the cold-tempering process
was known, the stabilization of cold tempering with new inputs (such as cream
and maple syrup) added to the chocolate did not exist. Justice Masse concluded
that there was no technological uncertainty because the appellant used
ingredients, food products and methods that are well known. He stated:
[38] But the question is whether there was technological
uncertainty. According to the case law, when uncertainties can be removed by
standard procedures or routine engineering, the project does not qualify for
SR&ED. Novelty or innovation in a product is not sufficient to illustrate
technological advancement.
[39] In the case at bar, the appellant
wanted to develop a spread superior to commercial spreads and specialty
spreads. It used as ingredients food products that are well known, such as
cocoa butter, maple syrup, cream and other dairy products, carbohydrates and
proteins. It modified the ingredients or their proportions in developing the
spread. It then used the cold-tempering process, which is a known process, by
changing the velocity, time and temperature of the tempering. It observed the
results and collected data. The appellant’s work was centered on the use of
existing manufacturing processes and existing materials in an attempt to
improve its spread. The work involved routine engineering and standard
procedures. Having considered all the evidence and the case law, I am not persuaded
that the work in issue involved technological risk or uncertainty that could
not be removed by standard procedures or routine engineering.
[40]
This conclusion applies with equal force in the
present appeal.
[41]
Furthermore, I am also not convinced by Mr. Schmalz’s
testimony regarding the state of knowledge regarding, and the technology available
for, the dispersion of sterols at the time the project was undertaken. Mr. Schmalz
referred throughout his testimony to a 2002 U.S. patent obtained by Cargill
Inc. for a product in which 400 milligrams of sterols were mixed with orange
juice in an eight-ounce format, which patent was entered into evidence as
Exhibit A-4. According to Mr. Schmalz, this product reflected standard
industry practice at that time. This patent was the sole evidence of any search conducted by the
appellant, at the outset of the project, with regards to existing methods for
dispersing plant sterols.
[42]
In cross-examination, Mr. Schmalz was unable to
recall the details of any searches undertaken. As I have said, the Cargill
patent was the only specific evidence supplied by the appellant of any searches
it undertook at the outset of the project. In cross-examination by counsel for
the respondent, the following comments were made in reference to the Cargill
patent:
Q. You call this a standard practice. Are
there other patents that deal with plant sterols and the way to disperse them
or dissolve them in water or liquid, or is that the only one?
A. I don’t know. Easy answer.
Q. Did you conduct a search to see if there
were other patents dealing with
A. I am sure we did at the time and I
couldn’t tell you the results of that because I don’t remember.
Q. So what makes you think-- what makes
you say that this is the standard practice if you don’t know what the other
ones
A. Because it led to commercialization in
the marketplace of plant sterol infused orange juice brands. It led to Cargill
setting up, in their ingredient division, sales of things like frozen blocks of
pulp infused with plant sterols
. . .
Q. Okay. So you may have conducted a search
on other patents but today you’re not able to tell us
A. That’s right.
Q. whether there are other patents?
A. That is correct.
[43]
In her testimony, Ms. Hassanein stated that, at
the time of her review of the appellant’s project 705, there were multiple
patents related to dispersing plant sterols in different products under
different conditions.
[44]
For these reasons, I conclude that the appellant
has not succeeded in discharging its burden of establishing technological
uncertainty since it was using methods and techniques that were available in
the industry.
[45]
While this finding alone is sufficient to
dispose of the appeal with respect to the Plant Sterols Beverage Project, I will nevertheless proceed to apply as well the other criteria in Northwest
Hydraulic Consultants Ltd. to the work undertaken by the appellant.
[46]
Since I have concluded that there was no
technological uncertainty, I cannot conclude that there were any hypotheses aimed
at addressing a technological uncertainty. That said, I have decided to
continue my analysis because, in my view, in this appeal, apart from the fact
that documents were produced to prove that some tests were performed, the
appellant did not meet the other requirements set out in Justice Bowman’s
decision in Northwest Hydraulic Consultants Ltd.
[47]
Justice Sommerfeldt in Joel Theatrical
Rigging Contractors Ltd. explains what constitutes a hypothesis at paragraph 26 of his
reasons for judgment:
[26] In Maritime-Ontario
Freight Lines, Sarchuk J provided a judicial definition of “hypothesis” as
follows:
A hypothesis is a tentative
assumption or explanation to an unknown problem and, as a rule, this
requirement is met by the existence of a logical plan devised to observe and
resolve the hypothetical problem.
Another judicial definition of “hypothesis”
was given by Bonner J in C.W. Agencies, after having set out a
description of the appellant’s hypothesis:
I note here that it is not clear to
me that this “hypothesis” is one which is capable of being proved or disproved
by means of scientific research. It seems to me that it is simply too vague.
The word hypothesis in this context is normally considered to mean a provisional
concept which is not inconsistent with known facts and serves as a starting
point for further investigation by which it may be proved or disproved
objectively.
In other words, a hypothesis is a statement
to be tested by an experiment or a trial.
[48]
On review of the SR&ED filings submitted to
the CRA, the records of experiments supplied by the appellant, and the
testimony of Mr. Schmalz, it is clear that the appellant had difficulty in
articulating a hypothesis in a manner consistent with the way that term is
understood in the SR&ED context. For example, in cross-examination, Mr.
Schmalz formulated the hypothesis in the following terms: “. . . can we be
successful at incorporating those levels of sterols into a solution, disperse
them in a solution?” Later,
Mr. Schmalz referred to the hypothesis as follows:
. . . There is an
uncertainty, obviously, involved in how much of the plant sterols we can
successfully suspend. And the hypothesis is attempting to resolve those
technical uncertainties by testing the non standard practices of trying to
incorporate that much sterols into a liquid. . .
[49]
Mr. Schmalz was clear in identifying the purpose
of the appellant’s project, but he could not explain the hypothesis that was formulated
in order to arrive at the overall objective, namely, proving or disproving an
assumption through further investigation. Since the hypothesis is an integral
part of the scientific method, I also find that the appellant has failed to
discharge its burden with respect to the second requirement.
[50]
Justice Sommerfeldt in Joel Theatrical
Rigging Contractors Ltd.
stated that there is overlap between the second and third requirements
described in Northwest Hydraulic Consultants Ltd. At paragraph 33 of his
Reasons for Judgment, Justice Sommerfeldt states the following with respect to
the third requirement, namely, testing in accordance with the principles of the
scientific method:
[33] There
is some overlap between the second and third requirements described in Northwest
Hydraulic. The second requirement has five stages, the fourth and fifth of
which are:
•
the formulation of a hypothesis or hypotheses
designed to reduce or eliminate the technical uncertainty; and
•
methodical and systematic testing of the
hypotheses.
The third requirement indicates that the
procedures used should accord with established and objective principles of the
scientific method, which is characterized by:
•
trained and systematic observation,
•
measurement and experiment, and
•
the formulation, testing and modification of
hypotheses (it is this third characteristic of the third requirement that
overlaps with the fourth and fifth stages of the second requirement).
As the third characteristic of the
scientific method deals with hypotheses, and as I have already discussed
above the hypotheses formulated by JTR, I will not say anything further about
that characteristic here.
[51]
In light of the testimony and the documentary
evidence, I am satisfied that the appellant undertook trained and systematic
observation. The appellant provided examples of its records of experiments. The
logs contain entries for the various nutraceutical emulsifiers that were mixed
with the sterols and record the effects of variables such as temperature and
mixing method on the dispersion of the sterols. This is sufficient to establish
that the appellant undertook trained and systematic observation.
[52]
I am also satisfied that the appellant undertook
proper measurement of the testing and results with respect to the Plant Sterols
Beverage Project. The sample logs clearly record the measurement of factors
such as the amounts of sterols and nutraceuticals, the temperature in the
heating process, and the degree of resulting dispersion.
[53]
With respect to the adequacy of the
experimentation undertaken by the appellant, this was not as obvious. Parts of
the testimony and documentary evidence suggested that the testing was by and
large done using the trial and error method. For example, I found that the
testimony of Mr. Schmalz and the documentary evidence did not provide any clear
rationale for the selection of certain nutraceuticals, other than the fact that
they were widely known to have various health benefits. This is particularly
striking given that Mr. Schmalz testified that nutraceuticals were incorporated
partly to test whether they aided in the dispersion of the sterols in water. In
Joel Theatrical Rigging Contractors Ltd., Justice Sommerfeldt suggested that experimentation by trial and
error alone does not meet the requirements of testing in accordance with the
principles of the scientific method.
[54]
Finally, I was not satisfied that the
appellant’s formulation, testing, and modification of its hypotheses were in
line with the principles of the scientific method. On review of the testimony
and the documentary evidence, it was not clear that the appellant used the
results of its experimentation to modify its hypotheses with respect to the
feasibility of its dispersion targets.
[55]
Therefore, I am of the view that the third requirement
was not met by the appellant.
[56]
The appellant was trying to concentrate the
prescribed daily dosage of sterols into a two-ounce format. However, in my
view, the appellant pursued this objective using existing methods common
throughout the beverage industry and thus failed to attain the required level
of technological advancement.
[57]
In this case, the appellant attempted to achieve
the required dispersion of the plant sterols and other nutraceuticals in water
using methods that were well known in the beverage industry. Mr. Schmalz
testified that he and Mr. Melling experimented with a variety of
variables, such as temperature and mixing method, in attempting to achieve the
required dispersion. They
used commercially available mixing devices such as ribbon blenders and
high-shear mixers and they used known emulsifiers and known nutraceutical
ingredients. In my view, using known methods and products to attempt to
disperse sterols in a smaller format does not constitute a technological
advancement.
[58]
For example, in Exhibit A-11, the appellant
described its technological advancement as follows:
Testing showed future solutions to the
challenges lie in acquiring higher quality lab mixers, continued testing of
solubility and continued refinement of the partial hot fill process parameters
of time. Mix speed and filling temperatures.
Experimentation led to a blend of
emulsifiers (SSL, Mono and Di Glycerides) that appears to function in a
satisfactory manner and can be optimized further with better equipment. Partial
hot fill process was shown to be a valid, affordable method of preservation
versus the energy and bottle costs associated with continuous hot fill. Product
mixing via pump motor proved satisfactory as it eliminated the need for counter
rotating blades in the mix vessel. It was shown the viscosity of the product
was condusive [sic] to the use of auto fill heads.
[59]
In my view, the appellant did not establish that
there were technological advancements. What the appellant did is well reflected
in the testimony of the CRA’s technical advisor, Ms. Hassanein. She
stated:
. . . the technologies that
they were utilizing to develop that product were based on existing technology
and there was no advancement in those technologies, meaning trying to see how
much sterol I can incorporate in a certain volume by increasing the shear
mixing by heating the product to a different temperature or by utilizing emulsifiers
that existed in the market. . . .
(5) Detailed Record of the Hypotheses, Tests and Results
[60]
Although, it has been held that meeting this criterion
is not compulsory, doing so will assist a taxpayer in establishing that its
activities qualify as SR&ED. Therefore, it is to the taxpayer’s benefit to
keep detailed records of the hypotheses, tests and results as the work
progresses. This criterion is closely related to parts of the third
requirement, which is that the taxpayer conduct its testing in accordance with
established and objectives principles of the scientific method, including systematic
observation, measurement and experimentation.
[61]
The respondent does not contest that the
appellant kept contemporaneous records of its
experiments and I agree that the appellant filed in evidence numerous records
of its experiments.
[62]
In light of the requirements set out by Justice
Bowman in Northwest Hydraulic Consultants Ltd., I conclude that
project 705, the Plant Sterols Beverage Project, does not constitute SR&ED
within the meaning of the definition of SR&ED in subsection 248(1) of the Act.
C. Project
806
[63]
As I have already stated, much of the testimony
by Mr. Schmalz with respect to the development and operation of the Partial Hot
Fill System during the period at issue was inconsistent with the information
contained in the filings with the CRA. More specifically, his description of
the overall project and the work undertaken during the taxation years at issue
bore little resemblance to the project descriptions contained in the filings.
Much of the discussion of the project in the written submissions to the CRA,
particularly Exhibits R-2 and R-5, which are the T661s, related to the
appellant’s effort to design a filling system that could simultaneously fill
two separate streams of liquid into a dual‑chambered bottle.
[64]
In cross-examination, the respondent referred
Mr. Schmalz to the documents in which project 806 was described as having to do
with the dual‑chambered bottle. Mr. Schmalz’s answer was:
. . . to be honest with you,
I wasn’t aware that we had a related focus to the . . . to
augment the filling machine and the capping machine.
[65]
The filling machine and the capping machine are
part of the dual‑chambered bottle project.
[66]
In addition, in some documents, the hot fill
process was described as novel and in other documents it was described as
something that the appellant was already using. In some documents, namely
Exhibit A-1 and Exhibit A-8, project 806 is described as having to do with the Partial
Hot Fill System. [Other documents use the heading Partial Hot Fill but the
description refers to the dual‑chambered bottle.] Exhibit A-9 describes
project 806 as relating to the dual‑chambered bottle:
UNCERTAINTY # 1: Plant development
We were uncertain about the optimal design
to build the process and equipment layout that would enable 2 liquids to be
simultaneously mixed, pasteurized, diluted to 25 C and filled into separate
sides of the same bottle. The company could not determine from all available
sources of readily available information how they could achieve the required
line capabilities of twin mix, heat treat, dilute and cool then fill into a 2
neck bottle. The advancement sought is in the field of beverage design,
manufacturing and custom filling.
Fill rates of a minimum of 50 bottles per
minute will be required to meet cost efficiency target. Normal hot fill lines
hold product hot at 100 C for the length of batch fill time which is 30
minutes. Our system must pasteurize the batch in 1 minute. Regular hot
fill lines heat and hold ready to drink beverage. Our system must heat and hold
a concentrated version of the finished beverage amounting to 30 gallons versus
250 gallons finished volume.
. . .
Results:
•
Maximize fill rate: 50 bottles/minutes [sic]
(100% of goal)
•
Fill bottles simultaneously: 2 Maximize liquids
filled (liquid types)/bottle (100% of goal)
•
Heat treat temperature: 1 minutes[sic]/batch
(100% of goal)
•
[L]iquid concentration: 30 galon [sic] (100%
of goal)
Line multiple liquid capability,
pasteurization time of liquid concentrate, fill rates were all achieved.
[67]
The question of whether the Partial Hot Fill
System was in fact developed prior to the taxation years at issue was also put
to Mr. Schmalz in cross‑examination by counsel for the respondent,
but a clear answer was not provided by him.
[68]
In light of this confusion, the appeal with
respect to project 806 should be dismissed. The burden is on the appellant to
prove that its project falls within the ambit of the definition in subsection
248(1) of the Act.
[69]
In any event, if I were to take for granted that
the Partial Hot Fill System was developed during the years under appeal and
that it was project 806, I would not allow the appeal with respect to this
project since I was not convinced by the testimony of Mr. Schmalz that the
development of the Partial Hot Fill System constituted SR&ED within the
meaning of the definition of SR&ED in subsection 248(1) of the Act.
[70]
The appellant did not introduce any evidence regarding
what was available in the market. In other words, what was the gap that existed
in the filling methodologies? Although, Ms. Hassanein did not review the
Partial Hot Fill System, since what was presented to her by the appellant at
the time of her review was the dual-chambered bottle project, after hearing the
testimony of Mr. Schmalz, she stated that plastic bottles are used for
many products.
[71]
Mr. Schmalz testified that the Partial Hot Fill System
was closely related to the existing hot fill technology, stating:
. . . I guess we created an alternate to the
existing hot fill standard that worked for our application.
[72]
In my opinion, the Partial Hot Fill System
developed by the appellant was not materially different from the hot fill
process widely used in the beverage industry at that time. The essence of the
partial hot fill system was to heat the essential (i.e., non-water) ingredients
separately to accomplish pasteurization and then add sterile water to cool the
mixture and attempt to achieve the correct level of dispersion for bottling in
individual two-ounce units. However, it was the basic principles of the hot
fill process that were being used to heat the mixture in the side kettle. The
system was designed using standard practices and routine engineering.
[73]
Thus, I conclude that the appellant has failed
to discharge its onus of proving that there existed with respect to the design
of the Partial Hot Fill System a technological uncertainty which could not be
removed by routine engineering or standard procedures.
[74]
With respect to the formulation of a hypothesis,
as with the Plant Sterols Beverage Project, the appellant did not formulate one,
that is, it did not formulate an assumption to be tested in order to remove the
technological uncertainty. In addition, there was no technological advancement
since the appellant used means known to the industry to develop its system.
[75]
The burden is on the appellant to establish that
a project constitutes SR&ED within the meaning of subsection 248(1) of the Act.
Project 806 was presented in a manner that was so confusing that it was
impossible for me to determine if that project had to do with the dual-chambered
bottle or the Partial Hot Fill System during the years under appeal. In any
event, I am of the view that the Partial Hot Fill System did not meet the requirements
for qualifying as SR&ED within the meaning of subsection 248(1) of the Act.
VI. CONCLUSION
[76]
The respondent asked for costs under subsection
10(2) of the Tax Court of Canada Rules (Informal Procedure). I am of the
view that the circumstances do not warrant costs.
[77]
The appeal is dismissed with respect to project
705—the Plant Sterols Beverage Project—and Project 806 for the taxation years
ending June 30, 2010 and October 31, 2010, since these projects undertaken by
the appellant did not constitute SR&ED within the meaning of subsection
248(1) of the Act. There will be no award of costs.
Signed at
Ottawa, Canada, this 12th day of September 2017.
“Johanne D’Auray”
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