20 May 1981 Income Tax Severed Letter

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.

Robert Macdonald (613) 995-1723

MAY 20 1981

Dear Sirs:

Re: Qualified Expenditures on Scientific Research Paragraphs 37.1 (5)(c) and 127(10.1)(c)

This is in reply to your request, dated February 12, 1981, for our opinion concerning qualified expenditures and proscribed expenditures for purposes of paragraphs 37.1(5)(c) and 127(10.1)(c) of the Income Tax Act. The details of the situation prompting your enquiry pertain to a specific corporate taxpayer whose 1978 tax return has been reassessed in connection with the above-mentioned paragraphs. Our reply therefore addresses only principles of interpretation that you have raised.

The assumed facts which we consider to be relevant to an assessment of these principles are as follows:

1. A corporation places a heavy emphasis on its research and development activities in terms of staff utilization, and financial resources.

2. Certain expenditures, which are incurred for the benefit of various divisions of the corporation's operations (including the research and development division), are charged to "expense pools" because direct allocations to the divisions benefiting would be cumbersome due to the nature of the expenditures.

3. The two primary "expense pools" used by the corporation are the purchasing and warehousing pool (P&W) and the general and administrative pool (G&A). Costs are accumulated in these pools and are subsequently distributed among the corporation's divisions.

4. P&W includes expenses which pertain to: provisioning and storing of material; safeguarding of inventories; controlling receipts and issues; scrap control; replenishment control; and stock taking.

5. Cost accumulations in P&W are distributed to the various company cost centres based on the cost of material purchased for the various divisions.

6. G&A includes expenses which pertain to: cost accounting and control; divisional planning; payroll; processing and systems; finance related subjects; personnel; legal; taxation; and the executive office.

7. Cost accumulations in G&A are distributed pro-rata to the various divisions on the basis of total divisional costs before such allocation.

You have asked us to support your opinion that:

(a) The intention of the legislators in defining qualified expenditures for purposes of the incentives provided in subsections 37.1(1) and 127(5) cannot be viewed as a wish to restrict or disallow those expenses that are clearly related to the research and development activity. (i.e., Expenses that are wholly attributable to the prosecution of scientific research and which are incurred only if such activities are carried on.) On this assumption, where there is any doubt as to interpretation of the rules, that interpretation should be made in light of the government's determination to provide incentives for the expansion of R&D activities in Canada.

(b) For the purposes of the prescribed expenditures in Regulations 2901 and 2902, the "general administration or management of a business" encompasses those activities associated with the general or executive level management of the business and should not restrict the allocation to the research and development activity of cost that can reasonably be determined to have been incurred for that activity.

(c) The fact that such costs are allocated on a formula basis, as long as it is reasonable, should not prejudice the inclusion of those expenses as qualified expenditures.

(d) The methods of allocating expenditures that have been approved and in fact insisted upon by other government departments should be accepted for the purpose of the new incentive rules.

Based on the assumptions outlined in 1. to 7. above, it is our opinion that:

(a) expenses charged to G&A and P&W that relate to scientific research which vary in amount in proportion to the quantum of scientific research and development activity carried on are qualified expenditures for the purposes of paragraphs 37.1(5)(c) and 127(10.1)(c). Although from a pure technical interpretation of paragraph 37(7)(c) one could conclude that any particular expenditure that relates partly to scientific research and partly to something else is excluded, the Department is satisfied that the aforementioned incremental cost concept is also technically acceptable. It is therefore unlikely that an allocation of G&A and P&W expenses to scientific research on the given formula basis would be acceptable. It would seem to be necessary to review all of the elements of G&A and P&W to establish the extent by which their cost would be reduced if no scientific research were carried on. The amount of the reduction so determined would be considered to be "wholly attributable" to scientific research.

(b) the phrase "general administration or management of a business" encompasses those activities associated with the general or executive level management of the business. However, within any particular service oriented division, supervisory or managerial positions while not constituting an administrative or management expenditure may not be a qualified expenditure because the cost related thereto may not vary in proportion to the quantum of scientific research activity carried on and for that reason will not be wholly attributable to the prosecution of scientific research. (see paragraph a, above)

(c) costs allocated on a formula basis, consistent with the principles outlined in (a) above, would be acceptable subject to periodic confirmation that underlying assumptions remain valid.

(d) the methods of allocating expenditures that have been approved and in fact insisted upon by other departments of the Federal Government should be given no official recognition for income tax purposes. If upon review of a particular method of allocation, which has been recommended by another department, it appears that our department's policy has been adhered to, we would agree to its use provided the pertinent criteria be reviewed periodically to ensure that its use continues to be appropriate.

Yours truly,

for Director Corporate Rulings Division Legislation Branch

RJM/mj