14 June 1990 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.

14 June 1990

TO Appeals Branch Appeals & Referrals Division

FROM Scientific Research Audit Applications Audit Programs Directorate R.P.Laramy 952-0605

Attention: J.E.Nordin

SUBJECT: Current Expenditures of Sole-Purpose Scientific Research and Experimental Development (SR&ED) Corporations

We are writing in reply to your memorandum which dealt with expenditures incurred by sole-purpose SR&ED companies. As you are aware, we referred the issue on two occasions to Legislative Affairs (Rulings), who in turn referred the issues to Current Amendments and the Department of Finance.

ISSUE

Essentially, the issue is whether or not current expenditures of sole-purpose SR&ED companies qualify as SR&ED expenditures, even though some expenditures are attributable to the overall business purposes of the company rather than a specific SR&ED activity.

It has been argued that, where the prosecution of SR&ED is a business, in and by itself, then current expenses which are attributable to the business must, by default, be attributable to SR&ED. Essentially, there is nothing else that they can be attributable to.

It has also been argued that each current expenditure must qualify as an SR&ED expenditure on its own merits. That is, each expenditure must be linked to the actual prosecution of SR&ED in order to qualify. Consequently, expenditures that are attributable to the business of prosecuting SR&ED may not qualify unless it can also be demonstrated that the expenditures are directly linked to a specific SR&ED activity.

CLARIFICATION OF VARIOUS INTERPRETIVE ISSUES

1) Expenditures MUST meet the tests in section 37 to be eligible for SR&ED tax incentives. Regulation 2902 does not override section 37. An expenditure must qualify as an SR&ED expenditure for the purposes of section 37 before one considers whether or not it is eligible for investment tax credits ("ITC").

2) Subparagraphs 37(7)(c)(i) and (ii) should be interpreted as lists of expenditures which qualify for SR&ED purposes. Expenditures for SR&ED carried on in Canada are listed in subparagraph 37(7) (c)(ii), and expenditures for SR&ED carried on outside Canada are listed in subparagraph 37(7) (c) (i).

3) Given the interpretation noted in point 2, a current expenditure in respect of SR&ED carried on in Canada would qualify provided it met the requirements of EITHER clause (A) OR clause (B). Consequently, if a current expenditure is considered to have been "incurred for and all or substantially all attributable" to SR&ED (i.e., it meets the test in clause (A)), then there is no need to consider the "directly attributable" rules in clause (B).

4) Sole-purpose SR&ED companies qualify as such by virtue of the fact that they derive all or substantially all their revenue from the prosecution of SR&ED or the sale of rights in or arising out of SR&ED. Regulation 2902(a) expenditures will not be "prescribed" expenditures for such companies. Provided the expenditures listed in Regulation 2902(a) qualify as SR&ED expenditures, then the expenditures will earn ITC for sole purpose SR&ED companies.

5) Notwithstanding the fact that a company is considered to be a sole-purpose SR&ED company for the purposes of Regulation 2902(a), it may still be carrying on non-SR&ED activities. For example, a sole-purpose company could carry on a non-SR&ED business which earned revenue that is less than 10% of the total. Also, it could undertake activities that are specifically excluded from the definition of SR&ED (i.e., Regulation 2900(1)(d) to (j) activities). The costs associated with these activities would not qualify for SR&ED purposes, even though the company qualifies as a sole-purpose SR&ED company.

6) Some current expenditures will never qualify as SR&ED expenditures, even though they are incurred by a sole-purpose SR&ED company. Most rental expenses for buildings fall into this category (see paragraph 37(7)(f)). Also, expenditures in respect of the acquisition of rights to SR&ED are specifically excluded by subsection 37(4).

(7) Some current expenditures will never earn ITC, even though they may otherwise qualify as SR&ED expenditures, and even though they are incurred by sole-purpose companies. Such expenditures are listed in Regulations 2902(b) through (e), and include, inter alia, donations and most expenses that are reimbursed.

POSITION OF LEGISLATIVE AFFAIRS (RULINGS)

1) Whether or not a current expenditure can be considered to have been "incurred for and all or substantially all" attributable to the prosecution of SR&ED or the provision of facilities for the prosecution of SR&ED is a question of fact.

2) There is no support in law for the position that all current expenditures attributable to the business of prosecuting SR&ED in a sole-purpose company are also attributable to the actual prosecution thereof. Each expenditure must be considered on its own merits.

3) The criteria used to differentiate an expenditure that qualifies for SR&ED purposes from one that does not is the same for sole-purpose SR&ED companies as it is for any other taxpayer. It is the linkage of an expenditure to a specific SR&ED activity that governs its eligibility for SR&ED purposes, not whether the company is or is not in the business of prosecuting SR&ED.

POSITION OF THE DEPARTMENT OF FINANCE

1) From a tax policy perspective, it is clear that each expenditure under consideration as an SR&ED expenditure must meet the required criteria (i.e., it must meet the tests in subparagraph 37 (7) (c) (ii)) . However, in the context of a sole purpose SR&ED company, one may find that general evidence relating to the activities of the corporation is sufficient to conclude that the tests have been met.

(2) The "directly attributable" provisions were intended as relieving rules "....permitting the portion of an expenditure of a current nature that is directly attributable to SR&ED to qualify as an SR&ED expenditure, even if that portion is less than 90% of the expenditure,....".

OUR OPINION

General

The fact that the prosecution of SR&ED is a business, in and by itself, does not mean that all business expenses are SR&ED expenditures. This has been confirmed by both the Legislative Affairs Branch and the Department of Finance. Rather, each expense must qualify on its own merits by meeting the definition of an SR&ED expenditure. In any event, we believe that in actual practice, most expenses incurred by sole purpose SR&ED companies will qualify as SR&ED expenditures by virtue of the fact that they can generally be considered to meet the "incurred for and all or substantially all" requirement in clause 37(7) (c) (ii) (A) of the definition of SR&ED expenditures. Under this provision, it is not necessary for the entire expense to be attributable to SR&ED, suffice that 90% or more of that expenditure is such. For instance, if 90% or more of a particular wage expense is attributable to SR&ED, then the entire expense would qualify as an SR&ED expenditure, notwithstanding the fact that up to 10% thereof may be in respect of non qualifying activities.

Application Problems

It seems to us that problems in applying the SR&ED expenditure rules to sole-purpose SR&ED companies can be traced to the implementation of the "directly attributable" rules in the 1985 budget. Under those rules, only the portion of an expense that is attributable to SR&ED can be considered to be an eligible expenditure for SR&ED purposes. It appears that the definition of an SR&ED expenditure has often been interpreted by departmental officials in the past to mean that each expenditure must meet BOTH the "directly attributable" test and the "all or substantially all" test. As noted earlier, the Department's interpretation on this point has been clarified. Specifically, a CURRENT expenditure can be EITHER "all or substantially all" OR "directly attributable to SR&ED in order to qualify as an eligible SR&ED expenditure. Consequently, where 90% or more of an expense is attributable to SR&ED, the "directly attributable" rules should NOT be considered. It was never the intent, when introducing the "directly attributable" rules in 1985, to disqualify expenditures that otherwise qualified before the change in law. This point is clearly made in an October 21, 1987 memorandum from the Current Amendments and Regulations Division to the Specialty Rulings Directorate, where the following comments are found:

"The purpose of the amendments to the Act and the Regulations which introduced the "directly attributable" concept was intended to be relieving. Finance officials have confirmed that a sole-purpose SR&ED company should not be treated any differently as a consequence of those amendments.

Accordingly,... where they ( audit) would, have accepted expenditures of a sole-purpose SR&ED company as qualifying expenditures before the "directly attributable" provisions were added to the Act and Regulations, they (audit) should continue to accept such expenditures."

In a more recent response to Legislative Affairs, the Department of Finance noted that "general evidence relating to the activities of the corporation (sole-purpose) may be sufficient to conclude that these criteria ("all or substantially all") have been met. From a practical point of view, we believe this makes good sense. That is, where a company's business is the prosecution of SR&ED, it is unlikely that the company is incurring expenditures that are not at least 90% or more attributable to the actual prosecution of the SR&ED. We should emphasize that in our view, the costs associated with personnel services (including training), management, accounting, financing, etc., (i.e., the costs of running the SR&ED business) will be costs that are "incurred for and all or substantially all attributable" to the SR&ED in the context of sole-purpose SR&ED companies. We believe these so called "general management and administrative" expenses should be considered as such because, quite simply, there is USUALLY nothing else that they can be considered to have been incurred for and attributable to.

Administrative Position

Generally, most sole-purpose SR&ED companies try to keep their activities as "pure" as possible (i.e., only qualifying SR&ED activities and the general management and administration of these SR&ED activities). Most-expenses incurred by these companies can be linked to specific SR&ED activities. However, these companies do incur costs which relate more to the overall business aspects of prosecuting SR&ED within a corporate entity, rather than to any specific SR&ED activity. Items such as contract bidding, general advertising and promotion, business strategy formulation, preparation of financial statements, etc., would usually fall into this "questionable expense" category.

When viewed in isolation, we do acknowledge that it may be difficult for some of the "questionable expenses" to qualify on their own merits as SR&ED expenditures. Moreover, to determine exactly which of these expenditures do not qualify for SR&ED purposes requires, in most cases, a very detailed review of each expenditure in each factual situation. We believe it is inappropriate and administratively cumbersome to treat these expenditures in this manner. In our view, the "linkage" requirement should be applied in a manner which acknowledges that such expenditures are general management and administration expenses incurred as a necessary consequence of prosecuting SR&ED within business context of a sole-purpose SR&ED company.

We believe the Department should be prepared to accept for SR&ED purposes, all current expenditures (including "questionable expenses") which specifically relate to the business of prosecuting SR&ED within the context of a sole-purpose SR&ED company. All such expenditures should be considered to be "incurred for and all or substantially all attributable" to the prosecution or provision of facilities for SR&ED in general. Although we acknowledge in law that each expenditure must meet the test on its own merits, our position will provide a close approximation of the expenditures that are truly eligible, and will also save the department considerable time in applying the SR&ED rules to such companies. In our view, this position is also consistent with the manner in which the Department treated sole-purpose SR&ED companies prior to the introduction of the "directly attributable" rules in the 1985 budget.

Certain exceptions to our position are discussed in the following two sections.

Exceptions

Expenditures specifically disallowed for SR&ED purposes

Admittedly, some current expenditures of sole-purpose companies will not qualify for SR&ED purposes, even after applying the linkage criteria discussed above. For example, rents in respect of buildings, and expenditures in respect of the acquisition of SR&ED rights, do not qualify as SR&ED expenditures and could not be permitted even though they are incurred by a sole-purpose SR&ED company.

"Tainted" sole-purpose companies

Not all sole-purpose companies keep their activities "pure". For instance, sole-purpose companies could be performing activities which are specifically excluded from the definition of SR&ED by virtue of Regulation 2900(1)(d) to (h) (e.g., market research and sales promotion, commercial production, etc.). even though these activities might be considered to relate to its business of prosecuting SR&ED. On the other hand, a sole-purpose SR&ED company may incur expenditures that do not relate to its business of prosecuting SR&ED. For example, a sole-purpose SR&ED company may be carrying on a NON-SR&ED business (where the revenues from that business are less than 10% of the total revenues for the company), or it may be incurring start-up costs associated with the future manufacturing (to be done by a related company) of products that result from the SR&ED. Also, where the sole purpose SR&ED company is a member of a corporate group, it may be charged with expenses that pertain to the business of the group as a whole, rather than the specific business of the sole-purpose company (e.g., carrying charges in respect of common investments, corporate image advertising, etc.).

Sole-purpose companies that are involved in the above would "taint" their status for SR&ED tax purposes. The costs associated with excluded activities ( i.e., regulation 2900(1)(d) to (h) activities) would not qualify as SR&ED expenditures. Moreover, all costs which do not specifically relate to the business of prosecuting SR&ED will not qualify for SR&ED purposes either. In addition, "tainted" sole-purpose companies will find that their general management and administration expenses are not "incurred for and all or substantially all attributable to SR&ED", where 10% or more are attributable to the excluded activities and\or the non-SR&ED business activities. Consequently, some of the general management and administration expenses would also be ineligible expenditures for SR&ED purposes.

APPLICATION OF POSITION Bidding Costs

In your referral, you cited an example of an actual case that involved, inter alia, expenditures relating to bidding on contracts by a taxpayer which did not appear to be a "tainted" sole-purpose SR&ED company. By and large, the contract bidding activities were technical in nature, and generally pertained to the identification of technical problems and the proposed route to resolve them. The Department had proposed to disallow the costs associated with the unsuccessful bids as they did not specifically relate to any qualifying SR&ED activities.

It would seem to us that bidding expenditures (on both successful and unsuccessful bids) are essential to the continuing existence of the company. They are clearly attributable to the business of prosecuting SR&ED, and when considered within the taxpayer's particular business context, we believe that they should be accepted as expenditures that are "incurred for and all or substantially all attributable" to the prosecution of SR&ED.

Advertising

In the same example, you noted that the sole-purpose SR&ED company incurred costs associated with promoting its technical capabilities. The Department had proposed to disallow these expenditures for SR&ED purposes on the basis that they related to ineligible activities (i.e., Regulation 2900(1)(d) sales promotion) or, alternatively, that the expenditures were not SR&ED expenditures as they could not be specifically linked to qualifying SR&ED activities.

Generally, when dealing with sole-purpose SR&ED companies, the Department should not disqualify advertising or selling expenditures which constitute general management and administration costs. We believe such costs can usually be considered to have been "incurred for and all or substantially all" attributable to the prosecution of SR&ED, where they specifically promote the SR&ED business activities of such taxpayers. Clearly, the need to "prescribe" these expenditures for ITC purposes (i.e. to disallow ITC on these expenses to NON sole-purpose SR&ED companies), implies that such expenses must qualify in some situations as an SR&ED expenditure.

The Department should, however, disqualify advertising or selling expenditures which are attributable to NON-SR&ED activities. For instance, where advertising or selling costs can be attributed to activities which constitute "market research or sales promotion" (excluded activities by virtue of Regulation 2900 (1) (d), the costs should be disallowed. Also, where the advertising and selling expenditures do not relate to the business of prosecuting SR&ED, they should not be permitted for SR&ED purposes. For example, where advertising and selling expenses are allocated to a sole-purpose SR&ED company, and the expenditures relate to the promotion of the general business activities of a group of taxpayers which include NON-SR&ED performers as well, the costs will usually not qualify for SR&ED purposes to the sole-purpose company. Generally, such costs are attributable to promoting the business activities of the group as a whole, rather than the specific activities of the sole-purpose company.

It is sometimes difficult to differentiate advertising and selling expenditures which constitute general management and administration expenditures from those that constitute "market research and sales promotion. The following sections expand on our view of the differences.

Market Research and sales promotion - Regulation 2900(1) (d) expenditures

In law, all market research and sales promotion activities are excluded activities by virtue of Regulation 2900(1)(d). Accordingly, the costs which specifically relate to such activities do not qualify as SR&ED expenditures. In our view, the activities specified in Regulation 2900(1)(h) refer to market research and sales promotion that is undertaken as part of the marketing efforts for the new product or process referred to in Regulations 2900(1) (a) through (c).

It would be useful to note at this point that market research and sales promotion activities are far more common in SR&ED performers who develop, produce and market their own products, rather than in sole-purpose SR&ED companies. However, such activities are sometimes found in sole-purpose SR&ED companies that sell or licence the rights to their SR&ED (especially where the SR&ED performer and the purchaser or licensee are related parties). For example, the SR&ED performer may undertake market research studies on behalf of the related company, or may commence sales promotion activities designed to "pull" the new product which was developed from the SR&ED into the marketplace. The advertising and selling costs associated with these activities will not qualify for SR&ED purposes.

It has been our experience that Regulation 2900(1) (h) activities are relatively rare in sole-purpose companies that perform SR&ED under contract for arms-length parties. Generally, the contracts are strictly for SR&ED services.

Advertising and selling expenses which constitute general administration and management expenses - Regulation 2902 (a) (i) (D) & (E) expenditures

In our view, advertising and selling expenses that fall into this category would relate specifically to promoting the business of performing SR&ED, rather than promoting the product or process that is developed as a result of the SR&ED. Such amounts would usually include the promotion of the technical capabilities by a sole-purpose SR&ED company which performs SR&ED under contract for arm's length parties.

Provided that we are not dealing with a "tainted sole-purpose SR&ED company, the Department should be prepared to accept such advertising and selling expenses as SR&ED expenditures.

We have attached, for your perusal, copies of all relevant correspondence between Rulings, Current Amendments, Finance and our Section.

We trust that our comments are of assistance to you.

A\Chief Scientific Research Audit

c.c. R. Roberts, Senior Science Advisor

B. Dath, Director, Small Business and General Speciality Rulings Directorate

C. Toussaint, Director, Bilingual Services, and Resource Industries Division, Rulings Directorate