7 October 1990 Income Tax Severed Letter - SR & ED Capital Expenditures - \"All or Substantially All\" Test

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.

Dear Sears:

Re: Clause 37(7)(c)(ii)(A) of the Income Tax Act (the "Act")

We are writing in reply to your letters of April 10 and September 5, 1990, wherein you requested our comments on the Department's published position on the interpretation of clause 37(7)(c)(ii)(A) of the Act. We apologize for the delay in responding to your letters.

Background

Our Department's interpretation of the phrase "all or substantially all of which was attributable" found in clause 37(7)(c)(ii)(A) of the Act as it applies to capital expenditures used in scientific research and experimental development ("SR&ED") activities is outlined in paragraph 21 of Interpretation Bulletin IT-151R3 and also presented in Question 47 of the Revenue Canada Round Table in the 1985 Conference Report of the Canadian Tax Foundation.

Your Questions

• 1. It is your understanding that our Department's interpretation of that clause is based on a legal opinion obtained from the Department of Justice and you requested a copy or a precis of this opinion.
• 2. While out Department's position implies that subsequent events are merely evidence to or an indication of a taxpayer's intention at the time of incurring capital expenditures to be used in SR&ED activities, it is your experience that our Department's auditors take the position that subsequent events are determinative and that a taxpayer's original intentions should be disregarded if the actual use does not meet one of the two 90% attributable tests outlined in paragraph 21 of IT-151R3. You requested confirmation that even where the taxpayer's original intentions are frustrated by subsequent events, they will still be paramount in determining whether one of the 90% attributable tests has been met.
• 3. It is your opinion that our Department's position in paragraph 21 of IT-151R3 results in disparate treatment of economically equivalent choices. To illustrate your point, you compare the situation where a taxpayer purchases equipment to be used in SR&ED activities that does not meet the "90% attributable" test with a situation in which payment, equivalent to the amount the taxpayer would have spent purchasing his own equipment, is made to the National Research Council ("NRC") in order to have the SR&ED activities performed. In the former case, the amount of the expenditure is not deductible to the taxpayer under paragraph 37(1)(b) of the Act, while in the latter situation the amount is deductible to the taxpayer under subparagraph 37(1)(a)(ii) of the Act. This would be the result even though the main components of the fee charged by NRC would be for use of the same equipment that the taxpayer would have had to purchase had he undertaken the SR&ED activities himself. You point out hat paragraph 37(7)(f) of the Act ensures that economically equivalent expenditures of different types incurred for occupancy costs of a building are treated in a uniform manner regardless of the type of expenditure. It is your opinion that the same rationale should apply to the deductibility of SR&ED expenditures, regardless of whether the SR&ED activities are undertaken directly by the taxpayer, on his behalf or as a result of a payment to an entity described in clauses 37(1)(a)(ii)(A) to (E) of the Act.
• 4. It is your opinion that, per paragraph 7.9 of Information Circular 86-4R2, our Department is prepared to accept that the incremental costs of constructing a pilot plant qualify as SR&ED expenditures, although such expenditures may include capital expenditures. You asked whether a similar deduction for capital expenditures of mixed use would be permitted for other SR&ED activities.

Our Comments

• 1. Legal opinions received from the Department of Justice (or our precis thereof) are not released to the public, even through the Access to Information Act, as they represent solicitor-client privileged information. However, should you wish to submit legal representation supporting your interpretation of clause 37(7)(c)(ii)(A) of the Act, we will consider it and respond to the arguments prevented therein.
• 2. We confirm that paragraph 21 of IT-151R3 and Question 47 in the 1985 Conference Report still represent our Department's position in interpreting clause 37(7)(c)(ii)(A) of the Act. The determination of whether a capital expenditure made by a taxpayer to be used in SR&ED activities will meet either of the two 90% tests can only be made on a case by case basis based upon knowing all of the facts of a particular situation. In determining a taxpayer's original intention at the time of making a capital expenditure, the onus is on the taxpayer to provide evidence to support his claim. In many cases, the subsequent non-SR&ED use made of an asset, after it has been used for SR&ED purposes, will provide strong evidence as to the taxpayer's intention at the time the expenditure was made.
• 3. Where a taxpayer makes a payment to an entity listed in clauses 37(1)(a)(ii)(A) to (E) of the Act, the payment is considered to be of a current nature as the payer does not acquire the ownership of any equipment or assets of a capital nature purchased and used by the entity to carry out the SR&ED activities. We can envisage the possibility that in some circumstances the fee charged by such an organization or corporation may incorporate part or all of the cost of purchasing the equipment necessary to carry out the contract. However, as your comments suggesting that different income tax treatments are provided for economically equivalent choices appear to involve tax policy, it may be a mater in which the Department of Finance would have an interest.
• 4. Paragraph 7.9 of IC 86-4R2 [Information Circular 86-4R2] indicates that in order to determine those costs of constructing a pilot plant which would be qualifying expenditures for SR&ED purposes, a taxpayer may compare the actual costs incurred of constructing the pilot plant, which had scientific or technological uncertainties to resolve, with a hypothetical cost estimate of building a second plant with the now established technologies. The incremental difference between the cost of the two plants will normally be expenditures of a current nature. The costs of the material and labour used to create or construct a tangible property which does not have technological uncertainty will be excluded from the incremental difference so that normally only the labour and material directly attributable to or all or substantially all attributable to resolving the scientific or technological uncertainty would be included in the incremental difference.

In order for a capital expenditure incurred in the construction of a pilot plant to qualify for a deduction under paragraph 37(1)(b) of the Act, the criteria outlined in paragraph 21 of IT-151R3 must still be met. However, where a pilot plant is being constructed for its experimental or technical content only, has no lasting value (other than the knowledge acquired from its development), and is not being constructed for commercial use or sale, it is our opinion that the construction of such a plant does not normally result in the acquisition of tangible assets of enduring benefit. Consequently, those expenditures would be considered current expenditures. Such a pilot plant would be dismissed, destroyed, scrapped, or shown to have a nominal residual value once the SR&ED activities were completed.

These comments represent our opinion of the law as it applies generally. As indicated in paragraph 24 of Information Circular 70-6R dated December 18, 1978, this opinion is not a ruling and accordingly, it is not binding on Revenue Canada, Taxation.

We trust these comments will be of assistance.