Ergorecherche & Conseils Inc. v. R., [1998] 3 CTC 2062, [1998] DTC 1710

Lamarre Proulx T.C.J.:

This appeal, which is for the appellant’s 1993 taxation year, relates to the investment tax credit provided for in subsection 127(5) of the Income Tax Act (“the Act”).

The issue is whether the appellant can allocate its two shareholders full salaries to scientific research and experimental development (hereinafter “SR & ED”) for which it is entitled to an investment tax credit, even though the shareholders spent much of their time on the appellant’s other business activities.

Before setting out the facts, I believe that it would be helpful to put the issue in the context of the Act, and for this purpose I will refer only to the parts of the Act that are relevant to this case. Subsection 127(5) of the Act provides that an investment tax credit may be deducted from the tax payable by a person. In subsection 127(9) of the Act, “investment tax credit” means the amount, if any, by which the total of all amounts each of which is the specified percentage of a qualified expenditure made by the taxpayer during the year exceeds.... The expression “qualified expenditure” is also found in subsection 127(9) of the Act and it means an expenditure incurred in respect of SR & ED that is an expenditure described in paragraph 37(1 )(a) of the Act, provided that it is not a prescribed expenditure. Section 2902 of the Income Tax Regulations (“the Regulations”) provides that an expenditure of a current nature incurred in respect of the general administration or management of a business is a prescribed expenditure. Paragraph 37(1 )(a) of the Act refers to an expenditure of a current nature made on SR & ED. Paragraph 37(8)(«) of the Act provides that expenditures on or in respect of SR & ED are expenditures directly attributable to the prosecution of SR & ED. These words are explained in paragraph 2900(2)(b) of the Regulations, which reads as follows:

(2) For the purposes of clause 37(8)(a)(i)(B) and subclause 37(8)(a)(ii)(A)(II) of the Act, the following expenditures are directly attributable to the prosecution of scientific research and experimental development:

(b) where an employee directly undertakes, supervises or supports such prosecution, the portion of the amount incurred for salary or wages of the employee that can reasonably be considered to be in respect of such prosecution; and

It is also helpful to read subsection 37(9) of the Act, which provides that an expenditure of a taxpayer does not include remuneration based on profits or a bonus where the remuneration or bonus is in respect of a specified shareholder who is also an employee. According to the definitions found in subsection 248(1) of the Act, the shareholders in this case are specified shareholders.

Vincent Belmonte, CA, the appellant’s accountant, and Alain Laferrière, the appellant’s president, both testified. The facts are not in dispute. During the taxation year ending August 31, 1993, the appellant carried on scientific research and experimental development within the meaning of the Act. Daniel Dumont and Alain Laferrière are the appellant’s only shareholders, and they each have the same number of shares. The appellant worked on six research projects that year. Three of them (I, II and III) were carried out by the appellant on its own behalf, and the other three (IV, V and VI) were carried out on behalf of other persons. Since the appellant was paid for its work on the latter three projects, the expenditures on those projects were not claimed by the appellant as scientific research and experimental development expenditures. The appellant’s two shareholders, both of whom are scientists, spent almost 70 percent of their time on those three projects.

At the end of 1993, the appellant paid each shareholder a salary of just over $50,000, for a total of $107,973. It included this amount in the cost of projects I, II and III.

The hours worked by Mr. Dumont and Mr. Laferrière on each project, as established by the appellant, were as follows:

The appellant allocated the salaries it paid Mr. Dumont and Mr. Lafer- rière as follows:

According to the Minister, the salaries must be allocated to the projects in proportion to the hours worked on each project, as follows:

The persons for whom the appellant did the research for projects IV, V and VI were billed for Mr. Dumont’s and Mr. Laferrière’s services at the rate of $150 an hour.

According to the appellant’s witnesses, the appellant did not pay the two shareholders any salary for projects IV, V and VI, but only for the first three projects, which were in-house projects. The witnesses further stated that the salaries paid to the two shareholders were based not on the hours they worked, but solely on the appellant’s liquid assets at the end of the year.

Paragraphs 6, 7, 8 and 13 of the Notice of Appeal, which set out the appellant’s grounds of appeal, read as follows:

[TRANSLATION]

6. The full salaries paid to Daniel Dumont and Alain Laferrière in connection with their employment with the appellant were paid for their involvement in scientific research and experimental development by the appellant;

7. The Minister of National Revenue refused to consider this factual and legal situation and instead felt that the salaries should be allocated arbitrarily and reassigned in a different way than the reality-based one established by the appellant;

8. Through his actions, the Minister of National Revenue challenged the appellant’s management authority and meddled in its business in order to pay its employees in an arbitrary and unreasonable manner that differed from the one based on the commercial reality of the appellant’s activities;

13. The appellant requests this Honourable Court to confirm that the salaries paid to Daniel Dumont and Alain Laferrière by the appellant were paid solely for their involvement in scientific research and experimental development and that those salaries must therefore be fully deductible, in accordance with the Act, as qualified scientific research and experimental development expenditures in- curred in Canada, and the corresponding tax credit must also be calculated accordingly;

In his argument, counsel for the appellant referred to the Supreme Court of Canada’s decision in Stubart Investments Ltd. v. R., [1984] 1 S.C.R. 536 (S.C.C.), and specifically Wilson J.’s comments at page 540:

A transaction may be effectual and not in any sense a sham (as in this case) but may have no business purpose other than the tax purpose. The question then is whether the Minister is entitled to ignore it on that ground alone. If he is, then a massive inroad is made into Lord Tomlin’s dictum that “Every many is entitled if he can to order his affairs so as that the tax attaching under the appropriate Acts is less than it otherwise would be”: Inland Revenue Commissioners v. Duke of Westminster, [1936] A.C. 1, at p. 19. Indeed, it seems to me that the business purpose test is a complete rejection of Lord Tomlin’s principle.

Relying on the principle that a transaction may be effectual even if it has no purpose other than a tax purpose, counsel for the appellant argued that the appellant was entitled to pay salaries to its shareholder-employees only for some projects rather than all of the projects. He further argued that the appellant’s management role entitled it to determine how salaries would be paid to its directors. He also submitted, based on the wording of subsection 2900(2) of the Regulations, cited above, that if the salaries were allocated entirely to projects I, II and III, the hourly rate would be $54, which is reasonable, whereas if they were allocated to all of the projects, the hourly rate would become $8, which is clearly unreasonable.

Paragraph 12 of the Reply to the Notice of Appeal sets out the basis for the Minister’s assessment:

[TRANSLATION]

12. He respectfully submits that the salaries must be allocated among the various research projects when calculating the investment tax credits under subsections 127(5), (9) and (11.1) of the Act.

Counsel for the respondent argued that if counsel for the appellant’s reasoning were accepted, the effect would be to improperly inflate qualified expenditures — improperly because the expenditures would not be consistent with reality and because what the appellant is asking to do for its shareholders’ salaries could be done for any employee or any other expenditure incurred for SR & ED. The only approach that is consistent with the Act and the Regulations is to allocate the salary expenditures based on the hours worked by the employees on all of the appellant’s projects.

Analysis

No one, including of course counsel for the appellant, has suggested that Stubart called into question the applicability of the Act’s provisions. Accordingly, before dealing with the possible application of the principle stated in that Supreme Court of Canada case, the Act’s provisions on qualified expenditures for the purposes of the investment tax credit must be examined and the conditions under which they apply must be determined.

It is common practice for directors to pay themselves salaries based on the liquid assets of the business. Those salaries are deductible in accordance with the Act’s provisions. For example, salary expenditures are deductible under paragraph 18(1)(«) of the Act if they were actually incurred and if their purpose was to gain or produce income from a business or property.

What about the qualified expenditure for the purposes of the investment tax credit? According to the definition of that expression under subsection 127(9) of the Act, it is an expenditure incurred in the year in respect of SR & ED. An expenditure is therefore a qualified expenditure if it was actually incurred and if its purpose was SR & ED.

In the case at bar, it is acknowledged that the salary expenditures were actually incurred. However, how can a salary paid on the basis of a business’ liquid assets be connected with SR & ED? The Minister did not seek to determine how many hours were spent on the general administration of the business. [1] He decided, however, that the salaries should be allocated on the basis of all of the research work done by the shareholders for the business. The business’ own research and that done for clients were each assigned a proportional share.

The appellant has a management role to play and is entitled to pay salaries to its directors based on the liquid assets of the business. However, when it seeks to claim those salaries as deductions or qualified expenditures for the purposes of the investment tax credit, it is subject to the Act’s provisions. The Act provides a definition of what is a qualified expenditure for the purposes of the investment tax credit: it is an expenditure incurred in the year in respect of SR & ED. Since the shareholder-employees’ salaries were determined on the basis of the appellant’s liquid assets, if the appellant wishes to include them in calculating SR & ED expenditures it must suggest a rational method for connecting their salaries with SR & ED. There is no room for discretion here, nor is it a question of applying the principle of freely ordering one’s affairs accepted in Stubart. It is simply a matter of applying the Act.

As for the argument that the hourly rate is more reasonable if the full salaries are applied only to the appellant’s projects, it seems to me that it is rather difficult to speak in terms of a more reasonable hourly rate, since accepting such a proposition would mean that no salaries were paid for the appellant’s other activities, which is obviously not reasonable.

I consider the method proposed by the Minister, which involves distributing the salaries over all of the hours worked on all of the research projects, the most reasonable way to link the directors’ salaries to SR & ED, since it is based on reality. The real cost of each activity cannot be calculated unless the expenditures are allocated in accordance with what each activity actually cost, and the only qualified expenditures are expenditures that were really, and not arbitrarily, connected with the research and development work.

Accordingly, the appeal is dismissed with costs.

Appeal dismissed.