Principal Issues: [TaxInterpretations translation] What is the relevance of the Canada Revenue Agency's SR&ED Application Policy 1996-02 in light of the Federal Court of Appeal decisions in Canada v. Tigney Technology Inc. and LGL Ltd. v. Canada?
Position: There is no need to revise the Canada Revenue Agency policy.
Reasons: Interpretation of the Income Tax Act.
XXXXXXXXXX 2005-015260
January 17, 2007
Dear Sir,
Subject: Request for Technical Interpretation: Application Policy for ______ Scientific Research and Experimental Development ("SR & ED") _______
This is in response to your email of September 28, 2005, in which you requested our opinion on the above subject. We apologize for the delay in responding to your question.
Question
You inquired as to whether Case C of the Canada Revenue Agency's ("CRA") Application Policy 1996-02 - Testing and Studies Required to Meet Requirements in Regulated Industries - ("Application Policy") should be reviewed in light of Justice Bowman's decision in LGL Ltd. v. The Queen1 ("LGL").
In your email to us dated December 8, 2006, you indicated that you were seeking confirmation of your interpretation, which you stated as follows, as to the eligibility of SR&ED testing and study expenses:
It appears to me that, in terms of overall scientific eligibility, it is the project as a whole that must be assessed in the first instance, with the presence of a Canadian contribution within the meaning of ITA 248(1)(a), (b) and (c) in a second step. The accounting eligibility then relates only to the Canadian portion of the expenses associated with the same project.
Analysis
We confirm the accuracy of your interpretation as submitted in your email for the purposes of the deduction of SR&ED expenses under subsection 37(1) of the Income Tax Act (the "Act") and the investment tax credit ("ITC") under section 127.
The application policy aims to clarify the eligibility of tests or studies conducted as part of the development of a product that must meet various regulatory requirements.
Case C of the application policy reads as follows:
The testing or engineering is performed in Canada to meet regulatory requirements, but the project is conducted outside Canada.
Where the project is conducted outside Canada, the taxpayer has not performed SR&ED in Canada. Therefore, the testing, even if done inside Canada, is considered ordinary testing or engineering in itself and is not eligible.
In this case, it does not matter whether the activities performed outside Canada are SR&ED.
However, if the studies required to meet the regulatory requirements meet all three eligibility criteria, as in Case B, they would be considered eligible and would constitute an SR&ED project.
The facts surrounding the decision in LGL can be summarized as follows. The Appellant carried out SR&ED work on four projects relating to the environmental impact of certain activities on whales, birds and fish. All four projects were conducted from within Canada and generally it was only the data collection that was done outside of Canada. Bowman J. held that the costs of SR&ED work that was conducted outside the geographic boundaries of Canada could not be deducted from the appellant's income as scientific research and experimental development under subsection 37(1) of the ITA.
In Tigney Technology Inc. v. Canada2 ("Tigney"), the taxpayer was conducting a project from within Canada and wanted certain expenses incurred outside Canada to qualify for ITCs under section 127. In allowing the Crown's appeal, the Federal Court of Appeal wrote as follows:
In cases where part of a SR & ED project is carried on inside Canada and another part is carried on outside Canada only those expenditures made in respect of the SR & ED inside Canada will be eligible for the refundable investment tax credit.
However, you noted the following passage from the LGL decision which, in your view, could lead to a change in our application policy:
[58] Here, I find no absurdity or repugnancy and in any event, even if I did, I think the words "carried on in Canada" are reasonably clear and comprehensible. Where part of an SR & ED project is carried on in Canada and part is carried on elsewhere I foresee very little difficulty in splitting the costs on a reasonable basis between the two (as was in fact done here). I find this a more reasonable result than attempting to decide whether a project that is carried on both inside and outside Canada is essentially "Canadian" or essentially "non-Canadian". That approach would mean that the cost of activities forming part of an SR & ED project that are in fact carried on in Canada could, if the overall project were held to be non-Canadian because a predominant part of the activity was carried on outside of Canada, be denied paragraph 37(1)(a) treatment.
The approach of the Federal Court of Appeal in Tigney and that of the Tax Court of Canada and the Federal Court of Appeal in LGL can be summarized as follows. The first step is to determine whether a project, as a whole, is carried on in Canada or outside Canada. If the project is carried on in Canada under subsection 248(1) of the ITA (formerly section 2900 of the Income Tax Regulations), thereby satisfying one of the criteria for the project to be considered an SR&ED project, the next analysis is to determine what portion of the expenses were incurred in Canada. Only these expenses will qualify for a deduction pursuant to subsection 37(1) and an ITC pursuant to section 127. This analysis is consistent with Justice Bowman's decision in LGL.
Consequently, we are of the view that your interpretation - as set out above - is correct and that there is no need to change Case C of our application policy.
We hope that the above comments are of assistance.
Best regards,
François D. Bordeleau, LL.B.
Business and Partnerships Section
Income Tax Rulings Directorate
ENDNOTES
1 99 DTC 675 (T.C.C.). That decision was upheld by the Federal Court of Appeal at [2000] FCA No. 166
2 97 DTC 414, rev'd by [2000] FCA No. 165