13 May 2002 Internal T.I. 2002-0116807 - M & P - COST OF LABOUR

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: Where amounts are subcontracted for SR&ED and these amounts include both labour and overhead, whether paragraph (b) of "cost of labour" in Reg. 5202 includes overhead.

Position: No - only includes labour.

Reasons: Interpretation of the provisions.

		May 13, 2002

	XXXXXXXXXX  Tax Services Office	HEADQUARTERS
	XXXXXXXXXX 	B.G. Dodd
	Large File Case Manager	(613) 957-8954

		2002-011680

Cost of Labour/Cost of Manufacturing and Processing Labour

We are writing in reply to your memorandum dated January 2, 2002 concerning certain amounts included by XXXXXXXXXX in determining its manufacturing and processing ("M&P") profits deduction for its XXXXXXXXXX taxation years which are currently under audit.

FACTS

Our understanding of the situation is that XXXXXXXXXX carries out a significant amount of scientific research and experimental development ("SR&ED") in addition to its manufacturing operations. Some of the SR&ED is carried out directly by XXXXXXXXXX but most is carried out under contract by its wholly-owned subsidiary XXXXXXXXXX also carries out SR&ED for XXXXXXXXXX under contract, which it subcontracts to XXXXXXXXXX. Of the SR&ED performed by XXXXXXXXXX, over XXXXXXXXXX% pertains to XXXXXXXXXX. You advise that any non-arm's length relationships between the three taxpayers are not at issue.

In determining its "cost of labour" and "cost of manufacturing and processing labour", as these terms are defined in section 5202 of the Income Tax Regulations (the "Regulations"), XXXXXXXXXX includes the full amount of the charges from XXXXXXXXXX pertaining to the SR&ED which XXXXXXXXXX performs for both XXXXXXXXXX Those charges include labour and overhead, but no profit element, and were XXXXXXXXXX respectively. The actual labour costs included in these amounts were XXXXXXXXXX respectively. The amounts increase significantly for each subsequent year up to, and including, the year XXXXXXXXXX.

ISSUE

The issue is whether the portion of the SR&ED charges to XXXXXXXXXX from XXXXXXXXXX relating to overhead as described above may be included in XXXXXXXXXX cost of labour and cost of manufacturing and processing labour.

DISCUSSION

The relevant portion of the definition of "cost of labour" of a corporation for a taxation year in section 5202 of the Regulations provides as follows:

" an amount equal to the aggregate of

(a) the salaries and wages paid or payable during the year to all employees of the corporation for services performed during the year, and

(b) all other amounts each of which is an amount paid or payable during the year for the performance during the year, by any person other than an employee of the corporation, of functions relating to

(i) the management or administration of the corporation,

(ii) scientific research and experimental development, or

(iii) a service or function that would normally be performed by an employee of the corporation."

We have reviewed the arguments of the taxpayer to the effect that this definition envisages costs which are not directly or indirectly salaries or wages which are nevertheless necessarily paid for the prosecution of services under third party arrangements for SR&ED and, as such, qualify for inclusion in XXXXXXXXXX cost of labour. In part, the taxpayer's position is that the deduction in section 125.1 of the Income Tax Act (the "Act") in respect of M&P profits is determined under the Regulations through a mechanism which is essentially formulaic and mechanical in nature and which identifies the only two constituents incurred by an enterprise which are possible, being periodic or current costs on one hand and infrastructure or capital costs on the other. The taxpayer's view is that the definition of cost of labour is intended to capture a corporation's periodic or current costs and the definition of "cost of capital" (also defined in section 5202 of the Regulations) captures infrastructure or capital costs.

As our courts have cited on numerous occasions from E.A. Driedger in Construction of Statutes (2nd ed., 1983), at p. 87:

"Today there is only one principle or approach, namely, the words of an Act are to be read in their entire context and in their grammatical and ordinary sense harmoniously with the scheme of the Act, the object of the Act, and the intention of Parliament..."

In the case of the definition of cost of labour insofar as it concerns SR&ED in subparagraph (b)(ii) thereof, in our view the context and scheme of the Act is suggested by the nature of the deduction, the wording used in the related regulations and in particular, the various facets of the definition itself. As to the deduction, it is provided in respect of M&P profits, and as labour costs are typically a significant element of manufacturing and processing operations in general, their use in the tax system as one of the determinants of the deduction is consistent with industry realities. With respect to the definition of cost of labour, under the Act, it is the substantive provisions of a definition which are determinative, not the title or the term itself, which may not necessarily be indicative and may for example be used as a matter of convenience. However, in this case not only does the term itself suggest that it is concerned with labour costs, the first item included therein, being paragraph (a) thereof, describes amounts which would commonly be understood to be labour costs, i.e., salaries and wages of the corporation's employees for services performed. Together these suggest that the defined term is indeed concerned with labour costs.

With respect to the remaining portion of the definition, i.e., paragraph (b) thereof, in our view it is descriptive of amounts which would be in paragraph (a) of the definition but for the fact that the relevant services or functions are performed by other than the corporation's employees and as such, would not be salaries and wages paid by the corporation. In our view, paragraph (b) of the definition provides for situations in which certain functions that might otherwise be performed by the corporation's employees are performed by other persons, i.e., contracted out. Such amounts are essentially indirect labour costs.

We also note, having regard to the language used in the definition, that it does not simply refer to amounts paid to persons (other than employees) for SR&ED. This arguably would be fairly broad. Rather, it in fact refers to amounts paid to persons (other than employees) for the performance of functions relating to SR&ED. We offer two observations.

1. In our view, such language in itself, and in conjunction with the language in paragraph (a) of the definition, is entirely consistent with the notion of labour.

2. We have difficulty with the notion of a corporation paying a person for the performance of a function relating to SR&ED where the item in question is overhead. It would appear to us that unlike engineering or testing for example, overhead is not a function nor is it performed.

Accordingly, it is our view that the definition of cost of labour includes amounts which are in respect of direct and indirect labour costs but does not extend to include an amount in respect of overhead.

Our views are essentially the same with respect to the definition of "cost of manufacturing and processing labour". Moreover, with respect to paragraph (b) of this definition, it includes the "other amounts" included through paragraph (b) of the definition of cost of labour (discussed above) but only to the extent they were paid or payable to persons for the performance of functions that would be directly related to qualified activities (which include SR&ED) of the corporation if those persons were employees of the corporation. We note first of all that the functions must directly relate to qualified activities. In addition, the performance of those functions must be such that they would directly relate to qualified activities if the persons performing those functions were employees of the corporation. We have considerable difficulty in seeing that an amount would be paid to a person for the performance of a function that would be directly related to SR&ED of the corporation if that person were an employee of the corporation where the "function" in question is overhead. Again, it is our view that the definition of cost of manufacturing and processing labour includes amounts which are in respect of direct and indirect labour costs but does not extend to include an amount in respect of overhead.

We hope this will be of assistance.

Steve Tevlin
for Director
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Legislation Branch

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