SR&ED During Production Runs Policy

Date: July 19, 2016

Table of contents

• 1.0 Introduction
• 2.0 A methodology for determining the context of the production run
  
  • 2.1 Identifying production runs that are part of the experimental development work
  • 2.2 Determining the context of a production run that is part of the experimental development work
    
    • 2.2.1 Technical considerations to establish technical risk
    • 2.2.2 Evidence
• 3.0 SR&ED expenditures associated with production runs
  
  • 3.1 Allowable SR&ED expenditures in the context of ED+EP and ED+CP
  • 3.2 Alternative approach – Incremental cost method for ED+CP
  • 3.3 Continuous processes
• 4.0 Examples
  
  • 4.1 Example 1 – Alternative approach for ED+CP
  • 4.2 Example 2 – ED+EP
• Appendix A – References
  
  • A.1 Legislative references
• Appendix B – Revisions
  
  • B.1 Explanation of changes
  • B.2 Previous versions

1.0 Introduction

This document presents the specific situations when experimental development (ED) is carried out during the operation of equipment or processes in a production or manufacturing environment. This occurs when the operation is part of the systematic investigation or search by experiment or analysis—for example, when experiments are carried out during production runs. Specifically, this document looks at how to determine the costs associated with experimental development carried out during the operation of a commercial facility that are allowable expenditures for scientific research and experimental development (SR&ED) tax incentives.

The key principles and methodology described in this document may also apply to other situations when there is SR&ED during production. However, the principles and methodology described in this document do not apply when there is no experimental development during the production even if the production output will be used in SR&ED, for example, the production of material to be used in SR&ED for testing or for experimentation, when the production does not involve SR&ED.

The following concepts are important to the understanding of this document:

Production

Generally, production refers to the output from the process as well as the act of operating the process.

Production output

For clarity, production output is used to refer to the output from the process (in other words, the product).

Production run

In a commercial environment, businesses run processes and equipment for certain periods of time in order to achieve specific objectives. This is generally referred to as a production run. For example, a production run could involve the period of time during which a particular grade of material is produced for sale. A production run could also be a period of time during which changes to the process are validated.

Experimental production (EP)

Experimental production (EP) is defined as the production output of experimental development (ED) that is required to verify whether the objectives of the SR&ED work have been met or if a technological advancement is achievable.

The purpose of the production run, in which the output is experimental production, is to evaluate the technical aspects of the SR&ED project.

Context of the production run

Context of the production run refers to the circumstances under which the production run is carried out. When ED work is performed during a production run, the context of that production run must be established since the allowable SR&ED expenditures vary depending on that context. In other words, the circumstances surrounding that production run will determine how the expenditures are treated. When experimental development work is performed during a production run, the context of the production run can be ED+EP or ED+CP (experimental development in conjunction or simultaneously with commercial production).

ED+EP

When there is experimental development and the production output is experimental production, the context of the production run is ED+EP. For example, the production run (and therefore the experimental production) may be necessary to establish technological advancements that are applicable in practice, to further resolve technological uncertainties, or to evaluate the SR&ED project.

Although this document focuses on production runs conducted in commercial facilities, the production output from the operation of a pilot plant is experimental production and, therefore, the context of the production run in a pilot plant is ED+EP.

When the context of the production run is ED+EP, there is no simultaneous commercial work occurring and the costs associated with the production may be allowable SR&ED expenditures. For more information on allowable SR&ED expenditures, please refer to the Pool of Deductible SR&ED Expenditures Policy.

Excess production

Any production beyond that required for the SR&ED is called “excess production”. When the context of the production run is ED+EP , only the amount of production output required for the SR&ED is the experimental production.

ED+CP

When SR&ED is involved in a production run, but the context of that production run is not ED+EP , the context of the production run is ED+CP (experimental development in conjunction or simultaneously with commercial production).

For example, when SR&ED is conducted in an existing manufacturing or processing facility, it is generally carried out for process or product improvement while commercial operations are taking place. In this situation, while process indicators are being monitored, changes are made to the process in a way that minimizes the adverse effects on the quality of the output or stability of the process in order to continue with regular production. There is no technical risk to the product or process. Applying the concepts explained in this policy will lead to the determination that the context of the production run is not ED+EP. In this scenario, even though there is SR&ED work being performed, because the context is not ED+EP, the context of the production run is ED+CP.

When the context of the production run is ED+CP, the costs must be apportioned between SR&ED and non‑SR&ED work. Costs attributable to commercial production are not allowable SR&ED expenditures.

It is important to note that the subsequent sale of production output, whether it results in a profit or a loss, or any other subsequent use of production output from a production run does not determine whether the context of the production run is ED+EP or ED+CP . This is because there may be any number of reasons why the production output of commercial production, which is usually sold for profit, is not sold. Just because it is not sold does not mean it is experimental production. Likewise, there may be situations where the experimental production may be sold, although the subsequent sale or other use is normally only incidental or secondary to the carrying out of experimental development work.

For information on how to determine if the context of the production run is ED+EP or ED+CP , see section 2.0. For information on how the expenditures are treated depending on that context, see section 3.0.

2.0 A methodology for determining the context of the production run

2.1 Identifying production runs that are part of the experimental development work

It is important to note that the SR&ED must be clearly established before applying this methodology (please refer to section 2.1 of the Eligibility of Work for SR&ED Investment Tax Credits Policy). If it is determined that there is SR&ED, then the extent of the SR&ED must be identified (please refer to section 2.2 of the Eligibility of Work for SR&ED Investment Tax Credits Policy).

Determining the extent of the SR&ED requires identifying the specific production runs that are part of the experimental development work. This includes, for example:

• determining that the production run is required for SR&ED;
• identifying the section of the commercial facility involved in those production runs;
• establishing a clear rationale for what part of the production line or process was involved in the SR&ED;
• identifying the duration of each production run (what period of time was required to evaluate or validate the SR&ED);
• identifying the personnel who performed the SR&ED; and
• identifying what materials were used in the SR&ED.

This is important in order to help isolate SR&ED work from any excess production or other excluded work (for example, putting the product into a saleable state). Determining the context of each necessary production run, whether it is ED+EP or ED+CP , is part of determining the extent of SR&ED. The purpose of determining the context of the production runs is mainly to apportion the costs between SR&ED and non‑SR&ED work.

Having identified that a production run is part of the SR&ED work, the context of that production run can only be ED+EP or ED+CP . It is possible that experimental development includes several production runs and the context of one or more could be experimental development resulting in experimental production (ED+EP) while the remaining would be experimental development with commercial production (ED+CP). Therefore, the context must be determined based on the facts for each production run.

2.2 Determining the context of a production run that is part of the experimental development work

The context is determined by assessing the characteristics of the production run against the requirements (see sections 2.2.1 and 2.2.2) that establish its context to be ED+EP . If the requirements are met, the context of the production run is ED+EP. If they are not met, the context of the production run must be ED+CP .

The context of the production run is ED+EP when there is a technical risk to the process or product, provided that the technical risk be attributable to the technological uncertainties. This technical risk arises mainly because of the need to test process parameters (including combinations thereof) outside normal established process, procedures, ranges and tolerances. Whether the technical risk to the process or product justifies the ED+EP determination is based on technical considerations (see section 2.2.1) and applicable evidence (see section 2.2.2).

2.2.1 Technical considerations to establish technical risk

The following technical considerations help to make a preliminary evaluation that there is technical risk to the process or product:

• The extent of the changes being undertaken is such that it is uncertain how the experiment will impact the process or the manufactured product.
• The SR&ED involves a change to the process resulting in a potential change to the technical specifications of the product and / or there is a risk that the process itself may become unstable leading to output inconsistencies, production interruptions and / or stoppages, or even equipment damage.
• The efficiency of a new process combination is uncertain. The SR&ED could result in yield losses, over and above normal yield losses. There is potential for a negative impact on the modified process.
• The characteristics of the new product and associated processes being studied are different from normal or existing products and their associated processes, i.e. the normal, established operating states, such that it is uncertain how the experiment will impact on the process or the product manufactured.

2.2.2 Evidence

Establishing the context of the production run takes into account the available evidence. Suitable records must support the rationale for the context of each production run as ED+EP . The facts must support the preliminary evaluation based on the technical considerations described in section 2.2.1. In other words, it is a combination of technical considerations, supported by evidence that makes it possible to determine the context of the production run.

The examples of the types of evidence that suggest the presence of technical risk in the context of ED+EP are listed below:

• Specific experimental operating instructions and other consistent records were prepared for the production run as part of the original project plan.
• Special tracking, classification, monitoring or recognition of the project / product occurred.
• Meeting minutes or other relevant sources of supporting information were available to substantiate and corroborate the planning and technical risk associated with the production run.
• Senior management gave the authorization to proceed with the production run that involved a technical risk to the product or process.
• There was significant input and close monitoring of the work by technically qualified individuals (technical personnel or contractors).
• Additional technical personnel or supervision were present.
• Specific monitoring strategies and operating instructions for the experimental development were communicated to the operating staff.
• There was design of specific experiments, and monitoring and analyzing test data from the production runs.
• The experimental process introduced significant changes that affect the core of the regular production process.
• Production quantities commensurate solely with the needs of the experimental development project were used at each stage (in contrast to what was normally produced).
• The experimental development was performed on a dedicated experimental line, separate from the commercial system or on a production line borrowed solely for this purpose.
• A smaller quantity than normal was produced.
• There were large incremental SR&ED costs (based on the facts of the case).
• The SR&ED costs were significant in terms of the overall standard costs of production.

This is not an exhaustive list nor is it intended to be used as checklist. The different forms of available evidence will depend on the technical considerations identified, as well as the particular project itself. Hence:

• the number of factors met is not relevant;
• no one factor carries a greater weight than another; and
• no one factor, in isolation, is determinative.

Since it has already been determined that the production runs are part of the SR&ED, if the technical considerations and the associated evidence do not support the determination that the context of the production run is ED+EP , then the context of the production run is ED+CP .

3.0 SR&ED expenditures associated with production runs

When the context is ED+EP , for the cost incurred on experimental production (EP) to qualify as SR&ED expenditures the production run(s) or portion of production run(s) must be required for evaluating or validating the SR&ED project. When the production is not required it is referred to as excess production. Labour, overhead, and material costs relating to any excess production are not allowable SR&ED expenditures.

Costs attributable to commercial production (CP) are not allowable SR&ED expenditures. For more information on allowable SR&ED expenditures, please refer to the Pool of Deductible SR&ED Expenditures Policy.

3.1 Allowable SR&ED expenditures in the context of ED+EP and ED+CP

Expenditures	ED+EP	ED+CP
Salaries or wages	Salaries of employees who are directly engaged in experimental development work resulting in the required experimental production are an allowable SR&ED expenditure. Non‑specialized employees required to produce the required experimental production may be considered directly engaged provided certain requirements are met. Please refer to section 7.1.1 of the SR&ED Salary or Wages Policy. Salaries related to any excess production or other excluded activities are not allowable.	Salaries of employees who are directly engaged in experimental development work are an allowable SR&ED expenditure. Non‑specialized employees performing SR&ED work may be considered directly engaged provided certain requirements are met. Please refer to section 7.1.1 of the SR&ED Salary or Wages Policy. Expenditures for salaries or wages attributable to commercial production are not allowable SR&ED expenditures. All costs usually incurred for the normal commercial production must be excluded from the claim. Only the excess costs associated with the experimental development work are allowable.
Cost of materials consumed or materials transformed	Cost of materials consumed in the ED+EP is an allowable SR&ED expenditure. Cost of materials transformed into the production output of the ED+EP will be, attributable or in respect to SR&ED and is an allowable SR&ED expenditure. Cost of materials transformed in excess production, is not an allowable SR&ED expenditure. All costs of input materials incurred before the start of the production run or the SR&ED portion of the production run are attributable to the commercial production, since there is no experimental production carried on.	Only the additional (incremental) costs of materials consumed or transformed because of the experimental development occurring during the production run are allowed. Materials that would in any case have been consumed or transformed in commercial production are not attributable to experimental development. Hence, the fact that standard materials (those normally used for commercial production) are required for the prosecution of experimental development does not make their cost an allowable SR&ED expenditure. All costs of input materials incurred before the start of the production run or the SR&ED portion of the production run are attributable to the commercial production, since there is no experimental development carried on during that time. Costs relating to the incremental loss of materials resulting from their processing may be claimed as cost of materials consumed in SR&ED, provided that the loss is reasonably attributable to the experimental development. For example, a reasonable estimate could be the cost related to the actual loss of materials minus the cost related to the standard loss of materials resulting from processing. Any other reasonable method may be used if it is supportable and verifiable.
Overhead and other expenditures(traditional method only)	Overhead expenditures are allowable under the traditional method if the costs are directly related and incremental to the prosecution of SR&ED. Cost of overhead for excess production, is not an allowable SR&ED expenditure, as excess production is not required for evaluating or validating the SR&ED project.	Overhead expenditures are allowable under the traditional method if the costs are directly related and incremental to the prosecution of SR&ED. Overhead expenditures attributable to commercial production are not allowable SR&ED expenditures.
ITC recapture	The investment tax credit (ITC) recapture rules apply to recapture all or a portion of the ITC relating to the cost of materials transformed if the production output is sold or converted to commercial use. Any proceeds from the sale of experimental production should not be taken into account when determining the SR&ED expenditures attributable to experimental production. The ITC recapture rules do not apply in respect of SR&ED labour costs and overhead expenditures incurred by a claimant. Further, the CRA generally does not apply the ITC recapture rules on materials consumed. For an example of ED+EP and ITC recapture, see section 4.2.	The ITC recapture rules apply to recapture all or a portion of the ITC relating to the cost of materials transformed when the commercial production is sold or converted to commercial use. The ITC recapture rules do not apply in respect of SR&ED labour costs and overhead expenditures incurred by a claimant. Further, the Canada Revenue Agency (CRA) generally does not apply the ITC recapture rules on materials consumed.

3.2 Alternative approach – Incremental cost method for ED+CP

In some cases involving production runs, where the context is ED+CP , it may be difficult to apportion expenses between SR&ED and non‑SR&ED work. An alternative approach in determining an estimate of total allowable SR&ED expenditures may be used. This approach identifies an overall amount of incremental costs incurred as a result of SR&ED. This method can be used when either the traditional method or proxy method is selected to calculate SR&ED expenditures. It is not necessary to show that a specific expenditure item meets the incremental test on its own when using this approach.

The overall amount of incremental costs may be calculated as the difference between the actual costs incurred for the ED+CP production run minus the standard production costs attributable to commercial production without experimental development. The standard commercial production costs are normally readily available and should be verifiable by CRA staff (the standard commercial production costs should not be substantially different from the actual costs of normal commercial production). The incremental costs are allowable Canada Revenue Agency SR&ED expenditures to the extent they are reasonably attributable to the experimental development.

Note: In cases where a standard cost is not available, the CRA will accept a comparable cost chosen by the claimant and supported by evidence, provided that the result gives a reasonable estimate of the SR&ED expenditures.

The use of the alternative approach provides a reasonable estimate of SR&ED costs. However, there is usually a small incremental salary or wages incurred for the non‑specialized employees directly engaged in a production run where the context is ED+CP . Administratively, the CRA will accept a reasonable, supportable and verifiable allocation of the salary or wages of the non‑specialized employees to SR&ED. However, no amount should be allocated for work done before the start or after the end of the experimental development portion of a production process.

The alternative approach to estimating a claimant’s allowable SR&ED expenditures may be used if all of the following conditions are met:

• it is impossible to isolate the SR&ED work (that is, neither the claimant nor the CRA can isolate the work);
• the CRA agrees with the use of this approach, meaning it is of the opinion that it is appropriate to use such an approach in the context (for example, only a portion of the work can be isolated); and
• the claimant agrees with the use of this approach and has signed a waiver of the right to object or appeal under subsection 169(2.2) of the Act (this is because this approach is not founded in law and is only available on an administrative basis).

If there is no joint agreement regarding the use of this approach, only the cost attributable to substantiated SR&ED work can be considered for the SR&ED tax incentives.

However, if the claimant submitted a claim using this alternative approach and the segregation of work could have been made, the CRA will accept the use of this alternative approach, but not for years subsequent to the first CRA review where the claimant utilized this approach. Although the use of the alternative approach may be accepted, the CRA must agree on the basis used for estimating the overall amount of incremental cost. See section 4.1 for an example of the alternative approach.

3.3 Continuous processes

A business may perform production runs using multi‑stage continuous processes that transform step‑by‑step the raw material to its final product. The following are examples of possible situations:

Situation 1

Company ABC’s manufacturing process is comprised of five steps.

The company undertakes an experimental development project in step 3. The context of the production run is ED+CP . The experimental development work includes the transition period (ramp‑up) leading to the experimental development work in step 3. The experimental development work ended before the ramp-down period returning to standard production in step 4.

There is no experimental development work in steps 1, 2, 4 and 5.

Comments

There are no allowable SR&ED costs for steps 1, 2, 4 and 5 (costs are attributable to commercial production).

SR&ED costs for step 3 are subject to the rules governing the situation ED+CP. The cost of the input materials for step 3 is the cost of producing the materials in steps 1 and 2. Only the additional (incremental) costs (from step 1 and 2) of the input materials consumed or materials transformed in step 3 are allowed because the experimental development occurs during step 3.

ITC recapture rules apply to the costs of materials transformed claimed as SR&ED expenditures.

Situation 2

Same as Situation 1 (above) in other words, ED+CP but the experimental development work is performed in each of the 5 steps—ramp‑up before step 1, ramp‑down after step 5.

Comments

SR&ED costs for steps 1 to 5 are subject to the rules governing ED+CP.

ITC recapture rules apply to the costs of materials transformed claimed as SR&ED expenditures.

Situation 3

Company ABC’s manufacturing process includes five steps. The company undertakes experimental development work in step 3. The experimental development in that step is so extensive that all the production line from step 3 onwards was dedicated to the experimental development.

The claimant determines that the context of the production run is ED+EP . The experimental production was required to evaluate or validate the experimental development project and the technical considerations and evidence corroborate the determination of ED+EP.

Comments

The rules relating to ED+EP apply to costs incurred from steps 3 to 5. The cost of input materials required for step 3 is allowable as SR&ED expenditures once the materials were consumed or transformed because of the experimental development performed in step 3. The cost of the input materials includes the cost of producing the materials in steps 1 and 2.

ITC recapture rules apply on the costs of materials transformed that were acquired from a third party if the experimental product is sold or converted to commercial use.

4.0 Examples

4.1 Example 1 – Alternative approach for ED+CP

A claimant is conducting experimental development work and the context of the production run is ED+CP . The continuous production process consists of five stages. The claimant has determined that the experimental development starts at stage 3 and ends in stage 5. In this example the traditional method was chosen. Therefore all costs associated with stages 1 and 2 are attributable to commercial production, which is excluded work. The following costs are incurred for stages 3 to 5 (in $000).

Cost	Actual	Standard	Incremental
Salaries or wages of specialized employees (doing experimental development)	10	0	10
Salaries or wages of non‑specialized employees	32	30	2
Materials consumed	20	7	13
Materials transformed	100	91	9
Overhead	38	32	6
Total	200	160	40

The allowable SR&ED expenditure is $40,000. When the product is sold or converted to commercial use the ITC recapture rules apply only on the allowable $9,000 of materials transformed in SR&ED.

If the claimant had elected to use the proxy method, the allowable SR&ED expenditure would be $34,000 because overhead expenditures cannot be specifically claimed under this method of determining SR&ED expenditures. For information on the method for determining expenditures please refer to the Traditional and Proxy Methods Policy.

4.2 Example 2 – ED+EP

A textile manufacturer’s work to modify a weaving machine to increase the rate of production by 50% has been determined to be experimental development. A series of test production runs are required to assist in the resolution of the technological problems involved with these modifications. Analysis of supporting facts and evidence indicates that the context of the production run is ED+EP . The test production runs produce fabric of poor quality, which is sold for $15 per metre. Due to numerous shutdowns to make adjustments and unusually high waste, the test production runs cost $40 per metre to produce ($4 for materials wasted (materials consumed), $5 for materials transformed into the fabric, $20 for directly engaged salaries and $11 for overhead). The materials were purchased from an arm’s length supplier. Total production was 1000 metres and the research and technology advisor found it to be reasonable and necessary for the SR&ED. A summary of the expenditures under both the proxy method and the traditional method, which would be allowed as SR&ED expenditures, is given below.

Expenditures	Proxy		Traditional
Salaries	Deductible 37(1)	$20,000	Deductible 37(1)	$20,000
Materials consumed	Deductible 37(1)	$4,000	Deductible 37(1)	$4,000
Materials transformed into the fabric	ASA for SR&ED Deductible 37(1)	$5,000	ASA for SR&ED Deductible 37(1)	$5,000
Overhead	N/A	N/A	Deductible 2900(2)(c)/(3)	$11,000
Total 37(1) expenditures	N/A	$29,000	N/A	$40,000
Prescribed proxy amount	55% of $20,000	$11,000	N/A	N/A
Qualified SR&ED expenditures	N/A	$40,000	N/A	$40,000
ITC at 35%	N/A	$14,000	N/A	$14,000
Recaptured ITC	35% of $5,000 (materials transformed)	$ 1,750	35% of $5,000 (materials transformed)	$ 1,750
Net effect on ITC	N/A	$12,250	N/A	$12,250

Appendix A – References

A.1 Legislative references

List of provisions

Income Tax Act	Description
Subsection 37(1)	Pool of deductible SR&ED expenditures
Paragraph 37(1)(a)	Pool of deductible SR&ED expenditures – current expenditures
Subparagraph 37(8)(a)(ii)	SR&ED expenditures in Canada
Subsection 248(1)	Definition of “SR&ED”
Subsection 248(1)	Definition of “SR&ED”, paragraph (i) – commercial production or use

List of regulations

Income Tax Regulations	Description
Subsection 2900(2)	Expenditures directly attributable to the prosecution of SR&ED – traditional method
Subsection 2900(3)	Expenditures directly attributable to the provision of premises, facilities or equipment for the prosecution of SR&ED – traditional method

Appendix B – Revisions

B.1 Explanation of changes

The following are the explanation of changes to the SR&ED During Production Runs Policy as part of the revision of July 19, 2016.

Section 1.0 example illustrating the EP+CP scenario was revised to clarify that the context of a run required for SR&ED is by default ED+CP if it is not ED+EP.

Section 4.0 example 2 has been revised to use the rate of 55% to calculate the prescribed proxy amount.

Appendix A.2 "CRA publications" has been removed.

Other minor formatting and editing corrections were made throughout the document.

B.2 Previous versions

Previous versions are provided for reference purposes:

SR&ED During Production Runs Policy (December 19, 2012)

Date modified:

2016-07-19