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.
Principal Issues: Whether the cost of transporting the prototype for testing outside Canada is an expenditure that may be eligible for deduction in computing income pursuant to subsection 37(1) or (2).
Position: May be deducted pursuant to subsection 37(2), but not subsection 37(1).
Reasons: Whether subsection 37(1) or (2) applies to the transportation cost in the situation described depends on the location where the SR&ED activities are carried out and not on the location where the transportation cost is incurred or paid (e.g., the location where the transportation contract is entered into or the location of the bank account used for payment).
2007-023964
XXXXXXXXXX André Gallant
613-957-8961
May 9, 2008
Dear XXXXXXXXXX :
RE: Transportation Costs
This is in reply to your letter of May 30, 2007, concerning the application of paragraph 2900(2)(c) of the Income Tax Regulations (the "Regulations") for the purposes of subsections 37(1) and (8) of the Income Tax Act (the "Act").
Our understanding of the hypothetical situation is as follows:
1. The work activities of a particular project result in the development of an experimental prototype. The project activities meet the definition of scientific research and experimental development ("SR&ED") in subsection 248(1) of the Act.
2. The SR&ED work is carried out in Canada, with the exception of the testing of the prototype that is carried out in the United States ("US").
3. All expenditures dealing with the SR&ED project work and the shipping of the SR&ED prototype to the US for testing have been incurred and paid to arm's length parties.
4. There are no unpaid amounts with respect to the expenditures in issue.
5. The SR&ED claim is prepared using the traditional method.
Your question is whether the cost incurred in transporting the prototype to the US for testing there qualifies as an expenditure deductible under subsection 37(1) of the Act.
Your Position
In your view, the transportation cost is directly related and incremental to the prosecution of SR&ED in Canada and should qualify both for a deduction in computing income under subsection 37(1) and for an investment tax credit ("ITC") pursuant to subsection 127(9) of the Act for the following reasons:
1. The transportation cost has been incurred and paid in Canada.
2. The transportation cost is directly related and incremental to the prosecution of SR&ED, within the meaning of paragraph 2900(2)(c) of the Regulations.
3. The project work that resulted in the development of the prototype is SR&ED, as defined in subsection 248(1), and is carried out in Canada.
4. Testing, which by itself is not SR&ED as defined in subsection 248(1) of the Act, qualifies as SR&ED work only if it can be linked, as provided for in paragraph (d) of the definition of SR&ED in subsection 248(1) ("linked work" or "support work") to work that is described in paragraph (a), (b) or (c) of the definition of SR&ED that is undertaken in Canada; paragraph 2900(2)(c) of the Regulations refers to expenditures or portions of expenditures that are directly related to the prosecution of SR&ED and that would not have been incurred if such prosecution had not occurred; in the situation described above, the development of the prototype is carried on in Canada, and not outside Canada.
5. The transportation cost is directly related to, and is an incremental cost of the prototype development (i.e., SR&ED carried on in Canada) and not of the testing (i.e., SR&ED carried on outside Canada).
6. Subsection 2900(2) of the Regulations deals strictly with SR&ED expenditures and not with SR&ED work (activities) or location of the work.
7. Based on court cases, the SR&ED legislation should be interpreted keeping in mind the incentive nature of the SR&ED program.
Our Comments
Written confirmation of the tax implications inherent in particular transactions is given by this Directorate only where the transactions are proposed and are the subject matter of an advance income tax ruling request submitted in the manner set out in Information Circular 70-6R5, Advance Income Tax Rulings, dated May 17, 2002. Where the particular transactions are completed, the inquiry should be addressed to the relevant Tax Services Office. We are, however, prepared to offer the following comments.
For the reasons evident below, we are of the view that the cost of transporting the prototype for testing outside Canada is an expenditure that may be eligible for deduction in computing income pursuant to subsection 37(2) and is not an expenditure deductible under subsection 37(1) of the Act.
We agree that in the scenario described, the prototype development activities would be considered SR&ED carried on in Canada and that the testing (i.e., support work) would be considered SR&ED carried on outside Canada. We also agree that the transportation cost would be an expenditure that would meet the requirements of paragraph 2900(2)(c) of the Regulations. However, in our view, under this provision, the transportation cost in the case described is directly related to the prosecution of SR&ED outside Canada (i.e., testing) and would not have been incurred if such prosecution had not occurred. Therefore, the applicable provisions are subsection 37(2) and clause 37(8)(a)(i)(B) (as opposed to subsection 37(1) and subclause 37(8)(a)(ii)(A)(II)).
As indicated by the Federal Court of Appeal ("FCA") in LGL Ltd., in cases where part of a SR&ED project is carried on in Canada and another part outside Canada:
"the only criteria for determining which expenditures come under subsection 37(1) is whether the expenditures were made for SR&ED carried on in Canada." 1
The issue in LGL Ltd. was whether the cost of data collection carried on outside Canada fell into subsection 37(1), as argued by the taxpayer, on the basis that the balance of the SR&ED project was carried on in Canada. The project had to be considered, in the taxpayer's view, as "an indivisible whole." The Minister rejected the taxpayer's position based on the plain meaning of the words in subsection 37(1), and the context of this provision. As a result, according to the Minister, the expression "carried on in Canada" had to be defined as "to "conduct" or "engage in" in Canada" (LGL Ltd., paragraphs 8-9).
In agreeing with the Minister, the FCA dismissed the taxpayer's appeal, while at the same time stating that the following two Tax Court cases were wrongly decided: Tigney Technology Inc. v. The Queen, 97 DTC 414 (TCC) and Data Kinetics Ltd. v. The Queen, 98 DTC 1877 (TCC) (only a small part of the work was done outside Canada). Tigney was overturned by the FCA (2000 DTC 6112), as it was heard in tandem with LGL Ltd.
Whether subsection 37(1) or (2) applies to the transportation cost in the situation described depends on the location where the SR&ED activities are carried out and not on the location where the transportation cost is incurred or paid (e.g., the location where the transportation contract is entered into or the location of the bank account used for payment). As indicated in paragraph 46 of the Interpretation Bulletin IT-151R5,
"Even if a particular expenditure for SR&ED carried on outside Canada is incurred in Canada or is made through a Canadian subcontractor, or if it represents a minor portion of the project, it will not qualify for a deduction under subsection 37(1)."
In summary, in our view, the cost of transporting the prototype for testing outside Canada in a situation where the testing constitutes SR&ED in that it is linked work or support work for SR&ED undertaken in Canada is an expenditure for SR&ED carried on outside Canada.
While we agree that the incentive nature of the SR&ED legislation must be taken into account in interpreting the related legislation, we would like to observe that whether or not ambiguity exists must also be taken into account. As indicated by Bowman J. (as he then was) in LGL Ltd. the incentive and generous nature of the SR&ED legislation "does not... permit a court to strain the plain meaning of the words to achieve a result that appears to be desirable" (supra note 1, paragraph 56).
We trust that the foregoing comments are helpful.
Yours truly,
S. Parnanzone
For Director
Business and Partnerships Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
ENDNOTES
1 LGL Ltd. v. The Queen, 2000 DTC 6108 (FCA), confirming 99 DTC 675 (TCC), per Bowman J. (now C.J.).
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