17 November 1988 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.

NOV 17 1988

TO        Audit Programs Directorate
          S.C. Lemelin, Chief
          Scientific Research Audit
          Applications Section

ATTENTION I.J.D. Rathwell

FROM      Specialty Rulings Directorate
          Merchandising, Manufacturing
            and Construction Section
          R. Albert
          Tel. (613) 957-2098

RE        All or Substantially All Revenue Test
          Regulation 2902

We are responding to your August 15, 1988 request for guidance as to the determination of revenues which satisfy the "all or substantially all revenue test in section 2902 of the Income Tax Regulations (the "Regulations").

Section 2902 of the Regulations sets out expenditures which are prescribed expenditures for purposes of the definition of "qualified expenditure" in subsection 127(9) of the Act. Paragraph (a) thereof prescribes certain current expenditures "except any such expenditure incurred by a taxpayer who derives all or substantially all of his revenue from the prosecution of scientific research and experimental development or the sale of rights in or arising out of scientific research and experimental development carried on by him". The Department has taken the view that "all or substantially all" refers to 90% or more of revenues. In this regard, consideration should not only be given to a particular taxation year but to the pattern established over a number of years.

For a start-up company, the Department has administratively adopted the position of looking to the manner in which the taxpayer is proposing to derive his revenue. In the absence of this administrative position, a start-up company would not meet the revenue test exception in section 2902 of the Regulations, i.e. a company that does not have any revenues cannot be said to derive all or substantially all of its revenues from qualifying sources. For these reasons we do not believe it to be unreasonable to look to the manner in which the company intends to derive its revenues. In addition, the fact that a start-up company states that it intends to derive all or substantially all of its revenue from the prosecution of scientific research and experimental development ("SR & ED") should not, by itself, be conclusive. The auditor should be satisfied that this assertion is reasonable and attainable.

It is our view that revenue arising from the prosecution of SR & ED generally envisages the provision of scientific services for a fee. If a taxpayer does not intend to sell the know-how developed (i.e. rights) but will commercially exploit the products or processes developed by using the know-how either in the present or future periods, it is our view that the taxpayer would not meet the revenue test. This is so because the taxpayer would be deriving his revenues from the sale of a product or process and not from the sale of its services or the sale of the know-how.

As the commercial production of a new or improved material, device or product or the commercial use of a new or improved process is not, by virtue of Regulation 2900(1)(h), SR & ED, a company which intends to commercially exploit the results of its SR & ED efforts cannot be said to derive 90% or more of its revenues from SR & ED.

The ultimate determination will, however, depend on the substance of the eventual contracts. As previously noted, in our view, revenue from the prosecution of SR & ED is essentially revenue from the provision of a service. And there is jurisprudence, see Dixie X-Ray Associates Ltd. 88 DTC 6076, which indicates that a court will look to the substance of a contract in order to determine whether a contract is for the sale of goods or for the supply of services to which the transfer of title to goods is merely incidental.

With regard to the situation where a corporation earns incidental interest income, it remains our opinion that the receipt of interest derived from the temporary investment of surplus funds which are to be used in SR & ED will not necessarily result in a taxpayer failing to satisfy the all or substantially all of revenue test under subsection 2902(a) of the Regulations.

We are currently seeking clarification as to whether it was intended that royalties earned by a taxpayer (eg. an independent research laboratory) whose business consists of carrying out SR & ED on its own behalf which it then licenses on an exclusive or non-exclusive basis to one or more third parties (eg. a manufacturer) to commercially exploit would satisfy the revenue test in subsection 37(7)(e) of the Act as amended by Bill C-139 and in subsection 2902(a) of the Regulations. In our view, these royalties do not arise from the prosecution of SR & ED because in these situations the royalties are not revenues from contracts to carry out SR & ED on behalf of others. Furthermore, a license does not constitute a sale of rights. In our view a sale of rights would generally involve the disposition or transfer of all proprietary rights in and to the SR & ED. This interpretation has been verbally confirmed with an official of the Department of Justice. However, we understand from discussions with an official of the Department of Finance that from a tax policy perspective there is no reason to treat a licensing arrangement any different from an outright sale of the SR & ED results. It is also our understanding that in practice most SR & ED which is carried out by such sole purpose SR & ED companies would be commercially exploited through a licensing of the technology rather than an outright sale.

XXX

Although we have not been provided with a copy of the relevant agreements it would seem that under our current interpretation of "the sale of rights" that XXXX would not qualify as a sole purpose SR & ED corporation. However, as previously noted you may wish to adopt an administrative position on this matter.

You have requested that we set out, the various types of revenue which would satisfy the revenue test. In general, the prosecution of SR & ED envisages the provision of SR & ED services for a fee. The revenue test also envisages the outright sale of the know-how developed.

ORIGINAL SIGNED BY ORIGINAL SIGNÉ PAR

T. Harris

Chief Merchandising, Manufacturing and Construction Section Small Business and General Division Specialty Rulings Directorate