31 July 2023 Internal T.I. 2021-0876331I7 - SR&ED ITC Recapture Rules

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: What components of the cost of materials for which a SR&ED ITC has been claimed are included in the “cost of the particular property” to a taxpayer described under subsection 127(32) of the Act which applies for purposes of the ITC recapture rules contained in subsections 127(27), 127(28), and 127(29).

Position: Mixed question of fact and law, however, in the situation presented, it is our view that not all SR&ED material costs that are qualified expenditures and eligible for an ITC are required to be recaptured pursuant to the ITC recapture rules contained in subsections 127(27), 127(28) and 127(29) of the Act. More specifically, by virtue of the additional clarifying language in subsection 127(32), the costs will only be included in the "cost of the particular property” if they are an amount paid by the taxpayer to acquire the particular property from a transferor of the particular property and for greater certainty are not an amount paid by the taxpayer to maintain, modify, or transform the particular property.

Reasons: See reasoning below.

Ms. Brigitte Gener						Income Tax Rulings Directorate
Operational and Technical Support Section			Christina Foggia, CPA, CA
SR&ED Directorate
Canada Revenue Agency						2021-087633

January 31, 2024

SR&ED ITC Recapture – Meaning of the expression “cost of the particular property” in subsection 127(32) of the Income Tax Act

Dear Ms. Gener:

This is in reply to your memorandum of July 9, 2021, wherein you requested our views on the meaning of the expression “cost of the particular property” described in subsection 127(32) of the Income Tax Act ( “Act”). The meaning of this expression is relevant for purposes of the investment tax credit recapture rules contained in subsections 127(27), 127(28) and 127(29) of the Act (herein referred to as the “ITC recapture rules”), which generally provide for the recapture of all or a portion of the scientific research and experimental development (“SR&ED”) investment tax credits (“ITCs”) previously claimed, when property that was a “qualified expenditure” (footnote 1) to the taxpayer, is subsequently disposed of or is converted to commercial use.

In particular, you have asked for our views on what components of the cost of materials for which a SR&ED ITC has been claimed are included in the “cost of the particular property” to a taxpayer described under subsection 127(32) of the Act, which applies for purposes of the ITC recapture rules. More specifically, for purchased materials, you have asked whether the cost of the particular property might include costs for services rendered by third-parties (“third-party contract costs”) to bring a particular property to a condition and location to be used in the prosecution of SR&ED, and for materials manufactured in-house, whether the cost of the particular property might include the cost of component parts and raw material inputs. You provided the following hypothetical example, which reflects the activities of a number of taxpayers in the lumber industry:

• The SR&ED claimant (“taxpayer”) has obtained timber rights from the province for which it has agreed to pay provincial stumpage fees. Stumpage fees are generally a fee paid to the province for each tree that is harvested on public land While not specifically indicated, it has been presumed that a timber sales contract, which typically provides for this type of arrangement, has been entered into between the parties.
• The trees are harvested and transformed into logs at the harvesting site and then transported to the taxpayer’s log yard at the sawmill. The taxpayer is developing a new machine that is located at the beginning of the production line in its sawmill and is claiming the work performed as SR&ED. (footnote 2) To perform the SR&ED testing of the new machine, the taxpayer uses logs from its log yard (its inventory) and feeds them into the mill via a conveyor.
• The cost of material for SR&ED purposes on which an ITC is calculated consists of all costs accumulated in the logs prior to the prosecution of SR&ED by the taxpayer. The accumulated costs are incurred to bring the standing trees to the condition and location where they can be used in the prosecution of SR&ED. The inclusion of costs in the cost of material for SR&ED ceases once the material enters the SR&ED testing stage.
• The taxpayer uses the services of third-party contractors to harvest, de-limb, and transport the logs (“third-party services”). The costs for these third-party services are included in the cost of materials for SR&ED.
• In summary, the cost of materials for SR&ED is comprised of the following amounts:

(1) stumpage fees - $10,000;
(2) harvesting fees - $3,000;
(3) delimbing fees - $2,000;
(4) transportation fees - $1,000; and
(5) in-house manufacturing salary and overhead expenses - $1,300 (footnote 3)

• The logs used in the SR&ED testing continue through the manufacturing process and are transformed into finished lumber. They are subsequently sold at market price and to an arms-length party.

You have indicated that, based on the facts of the hypothetical example presented, there is uncertainty in terms of which components of the cost of materials for SR&ED are subject to the ITC recapture rules. You indicated that such a determination depends, among other things, on whether the particular property referred to in these provisions, and specifically in subsection 127(32) of the Act, is the trees or the logs. You explained that, in the circumstances presented, it is your view that an interpretation that regards the trees as the particular property referred to in the ITC recapture rules and subsection 127(32) would result in $10,000 of SR&ED materials (i.e., the stumpage fees) being subject to the ITC recapture rules. On the other hand, in your view, an interpretation that regards the logs as the particular property referred to in the ITC recapture rules and subsection 127(32) could result in $16,000 of SR&ED materials (i.e., the stumpage fees, harvesting fees, delimbing fees and transportation fees) being subject to the ITC recapture rules.

Our Comments

In general terms, the ITC recapture rules require the recapture of all or a portion of a taxpayer’s SR&ED ITCs where, among other conditions, a property that has been the subject of a SR&ED ITC claim has been converted to commercial use or disposed of after February 23, 1998.

Subsection 127(27) of the Act provides for the recapture of all or a portion of a taxpayer’s SR&ED ITCs where all of the conditions outlined in paragraphs (a) to (d) of this subsection are met. (footnote 4) This provision will generally apply to property acquired from a person or partnership in the taxpayer’s taxation year or in any of their 20 preceding taxation years. (footnote 5) For recapture to occur, the provision requires that the cost or a portion of the cost of the particular property was a “qualified expenditure” to the taxpayer, a percentage of which can reasonably be considered to be included in computing the taxpayer’s ITC at the end of the taxation year or any of the 20 preceding taxation years. Furthermore, as previously mentioned, for recapture to occur, the taxpayer must convert the particular property to commercial use or dispose of, without having previously converted to commercial use, the particular property or another property that incorporates the particular property.

For purposes of the application of the ITC recapture rules, subsection 127(32) of the Act limits the scope of the meaning of the term “cost” and, more specifically, clarifies the meaning of the expression “cost of the particular property”. In particular, it provides that the cost of the particular property to a taxpayer shall not exceed the amount paid by the taxpayer to acquire the particular property from a transferor of the particular property and, for greater certainty, does not include amounts paid by the taxpayer to maintain, modify, or transform the particular property.

The interpretation of a statutory provision must be performed according to a textual, contextual and purposive approach as established in Canada Trustco Mortgage Co. v. Canada (2005 SCC 54). The term “cost” is not defined in the Act. Where the legislation does not define a term, one generally relies on the ordinary meaning and the meaning established by case law. In the current context, we generally consider cost to be the price that a taxpayer has paid to acquire a property. In particular, it is the laid-down cost which means all costs expended to acquire the particular property and can include, transportation costs, legal and accounting costs, or other fees. Therefore, in our view, the term “cost” includes the full cost of acquiring the property and incorporates all costs that are necessary to put the property into a position to be used.

Subsection 248(1) of the Act defines the term “property” for purposes of the Act as property of any kind whatever whether real or personal, immovable or movable, tangible or intangible, or corporeal or incorporeal and, in paragraphs (a) to (e), includes various other specific property not relevant in the present context. Accordingly, in the situation described, both the trees and the logs may qualify as the particular property referred to in the ITC recapture rules and subsection 127(32) of the Act, since each are considered a tangible property. Despite this, based on the words of the relevant legislation, the “particular property” referred to in these provisions must be one that is acquired from a person or partnership (as indicated in paragraph 127(27)(a) of the Act) or acquired from a transferor of the particular property (as indicated in subsection 127(32) of the Act), in order to be the “particular property” referred to in these provisions. Therefore, for the present purpose, it is necessary to establish whether it is the trees or the logs that are property acquired from a person or partnership or a transferor.

As the term “acquire” is not defined in the Act, the ordinary meaning of the word, the meaning established by case law, as well as the applicable sales of good legislation, is relevant. In general, for a property to be considered to be acquired, an element of beneficial ownership must exist (possession, use, risk, and control). Thus, the determination of whether an acquisition has occurred is a mixed question of law based on the relevant legal agreements entered into between the parties and the facts applicable in each case. (footnote 6)

Accordingly, in the situation presented, while a question of fact and law, it appears that the trees would be considered the particular property that has been acquired from a person or a partnership (paragraph 127(27)(a) of the Act) or acquired from a transferor (subsection 127(32) of the Act) since the taxpayer will receive property from the province in exchange for the payment of consideration (i.e., the stumpage fees) in accordance with the terms of the timber sales contract entered into between the parties. Conversely, while the logs qualify as property, as defined in subsection 248(1) of the Act, in this particular scenario, they do not appear to be the particular property for purposes of the ITC recapture rules since they are property that has been obtained as a result of third-party services rendered in respect of the trees which, in our view, does not result in the acquisition of a separate property from a person or partnership or a transferor for purposes of the ITC recapture rules. Note that it may be the case that the facts of the particular situation suggests otherwise. For example, if the facts are such that the timber sales contract entered into between the parties specifies that an acquisition of the property from the transferor (i.e., the province) is only considered to occur once the trees are harvested, delimbed and delivered to the taxpayer’s sawmill, a determination that the logs are the particular property for purposes of the ITC recapture rules and subsection 127(32) may be justified.

This being said and as stated above, for purposes of the ITC recapture rules, the scope of the meaning of cost is modified pursuant to subsection 127(32) of the Act. In fact, the additional clarifying language that is included in subsection 127(32) of the Act that begins with “shall not exceed…” needs to be considered since it appears to limit the “cost of the particular property” and, by extension, the costs that are subject to recapture, to certain specified amounts. In particular, the additional statutory wording clarifies that amounts that exceed “the amount paid by the taxpayer to acquire the particular property from a transferor of the particular property…” will be carved out of the “cost of the particular property” for purposes of the ITC recapture rules.

As mentioned earlier, in the present circumstances, the only transferor of the relevant property (i.e., the trees) is the province. Therefore, in our view, any amounts that are considered to be paid to acquire the trees from the province (i.e., to obtain passing of legal title, and incidents of ownership from the province upon the occurrence of this activity) will be included in the “cost of the particular property” by virtue of this additional language.

We note, however, that the legislation does not require that the amounts be paid to the transferor of the particular property; rather, the amounts must be paid for the acquisition of the particular property from a transferor of a particular property. Therefore, it may be possible that some of the third-party contract costs, although not an amount paid to the province, are paid for the acquisition of the particular property from the province. Whether any portion of the third-party contract costs would be included in the cost of the particular property in subsection 127(32) of the Act by virtue of being an amount paid by the taxpayer to acquire the particular property from a transferor of the particular property will depend upon the timing of when the trees are acquired and, more specifically, on whether each of the third-party contract costs are an amount paid to obtain title or incidents of title to the trees from the province. This being said, the question as to the particular acquisition time of the trees will generally depend upon the intent of the parties to the contract, which is expressed based on the terms and conditions of the contract entered into between the taxpayer and the province (i.e., the particular time when legal title and incidents of ownership has transferred to the taxpayer), the conduct of the parties, as well as other circumstances. Any such determination is a mixed question of fact and law which requires a review of all the facts and circumstances applicable to the situation, including the relevant legal agreements entered into between the parties.

Further to the above, additional clarifying language is provided in subsection 127(32) of the Act, which states “…and for greater certainty, does not include amounts paid by the taxpayer to maintain, modify or transform the particular property.” Accordingly, in situations where uncertainty remains as to whether a particular amount should be included in the cost of the particular property that is subject to the ITC recapture rules, this clarification may assist in confirming the appropriate treatment for that amount. The ordinary meaning of the words “maintain,” “modify,” or “transform”, when considered in light of their context, appear to suggest that any costs incurred in connection with these types of activities would be costs that are incurred subsequent to the acquisition of a particular property. Thus, in our view, if the costs are considered an amount paid to acquire the particular property from a transferor of the particular property, then they would not be considered to be amounts paid to “maintain,” “modify” or “transform” the particular property.

As for the treatment of manufacturing salary and overhead costs, it is our view that, since no acquisition of property occurs as a result of the provision of these activities, these amounts cannot be considered an amount paid by the taxpayer to acquire the particular property from a transferor of the particular property. Accordingly, manufacturing salary and overhead costs are not subject to ITC recapture as they would be excluded from the meaning of cost of the particular property as provided in subsection 127(32) of the Act.

While also a question of fact and law, it is also our view that, for property manufactured in-house, the cost of each component part and raw material input might qualify as a separate property that is subject to the ITC recapture rules. To make this determination, the same assessment as that described above must be undertaken.

In summary, based on a textual, contextual, and purposive approach to interpreting the language of the provisions at issue, not all SR&ED material costs that are qualified expenditures eligible for an ITC are required to be recaptured pursuant to the ITC recapture rules. It is our view that, by virtue of the additional clarifying language in subsection 127(32) of the Act, the third-party contract costs may not, in all cases, be expenditures that are subject to the application of the ITC recapture rules. In the situation presented, the determination of whether all or a portion of the third-party contract costs are included in the cost of the particular property for ITC recapture purposes depends upon the timing of when the trees are acquired, and more specifically, on whether each of the third-party contract costs are an amount paid to obtain title or incidents of title to the trees from the province. Any such determination is a mixed question of fact and law.Unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency’s electronic library. After a 90-day waiting period, a severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. You may request an extension of this 90-day period. The severing process removes all content that is not subject to disclosure, including information that could reveal the identity of the taxpayer. The taxpayer may ask for a version that has been severed using the Privacy Act criteria, which does not remove taxpayer identity. You can request this by e-mailing us at: ITRACCESSG@cra-arc.gc.ca. A copy will be sent to you for delivery to the taxpayer.

We trust our comments will be of assistance.

Yours truly

Amanda Couvrette, CPA, CA
Manager
Business and Capital Transactions Section
Business and Employment Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

FOOTNOTES

Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:

1 The term “qualified expenditure” is defined in subsection 127(9) of the Act.

2 All worked claimed meets the definition of SR&ED in subsection 248(1) of the Act.

3 It is our understanding that the manufacturing overhead and labour expenditures are incurred prior to the SR&ED testing stage.

4 Note that a similar rule to subsection 127(27) of the Act, which applies in the context of a partnership, or where the original SR&ED ITC was transferred by an agreement under subsection 127(13), can be found in subsections 127(28) and 127(29), respectively.

5 Subsection 127(36) of the Act, among others, provides for a substitution of the number of taxation years in paragraph 127(27)(a) from 10 to 20.

6 The province of Quebec is civil law jurisdiction rather than a common law jurisdiction, so the distinction between legal and beneficial ownership does not exist. The provisions in the Civil Code of Quebec concerning movable and immovable property, and the contract entered into between the parties, which evidences the parties intentions is relevant and will generally dictate when an acquisition of property has occurred in the province of Quebec.