Principal Issues: (1) Does paragraph 127(11.8)(a) apply to reduce to nil the cost of acquiring used equipment to the non-arm's length supplier so that the SR&ED claimant is deemed not to have any qualified expenditure in respect of the leased of said equipment? (2) If so, is that the intent of the legislation?
Position: (1) Yes. (2) Yes.
Reasons: (1) Plain reading of the Act and its Regulations. (2) It is our understanding that any expenditure related to used equipment is intended to be a prescribed expenditure.
February 15, 2007
SR&ED Directorate Income Tax Rulings Directorate Attention: Roxane Brazeau-Leblond S. Lewis Director (613) 941-7239 Policy Development Division 2006-020676
Lease of used equipment from a non-arm's length party
This is in response to your memorandum of September 20, 2006, regarding whether a lessee of equipment can claim an expenditure in respect of the lease of used equipment from a non-arm's length supplier.
Facts
You provided the following facts:
- There are two non-arm's length corporations, (they are related and associated to each other).
- One corporation (the "Lessor") buys a piece of used equipment that is not general purpose office equipment or furniture and leases it to the related corporation ("Claimant") to be used all or substantially all ("ASA") in its scientific research and experimental development (SR&ED) activities.
- The lessee claims the expenditures as lease costs of equipment on its T661.
Your concern is whether paragraph 127(11.8)(a) of the Income Tax Act (the "Act") applies to reduce to nil the cost of acquiring used equipment to the Lessor so that the SR&ED Claimant is deemed not to have any qualified expenditure in respect of the leased of said equipment. If so, you are concerned whether this result was intended by the Department of Finance.
Your Analysis
1. The definition of "qualified expenditure" is found in subsection 127(9) of the Act and includes (a) an amount described in paragraph 37(1)(a) of the Act, but does not include (c) a prescribed expenditure.
2. Prescribed expenditures are listed in section 2902 of the Income Tax Regulations (the "Regulations").
3. Subsection 37(1) of the Act allows a deduction in computing income and paragraph (a) identifies certain current expenditures on SR&ED that are to be included in determining that deductible amount.
4. Subsection 37(8) of the Act defines what expenditures are included as expenditures on or in respect of SR&ED. When computing expenditures under the traditional method subclause 37(8)(a)(ii)(A)(I) of the Act provides for the expenditure for the lease of equipment used ASA in SR&ED. (Subclause 37(8)(a)(ii)(B)(I) is relevant under the proxy method. For the purpose of this analysis it is irrelevant which method is used to calculate the expenditures).
5. Subsection 127(11.5) of the Act refers to adjustments to qualified expenditures and states that the amount of a qualified expenditure is deemed to be the amount of the expenditure determined after the application of subsection (11.6).
6. Subsection 127(11.6) of the Act refers to non-arms' length costs. Paragraph 127(11.6)(c) limits the amount of qualified expenditure incurred by the Claimant for the service to the adjusted service cost to the supplier.
7. Subsection 127(11.7) of the Act defines "adjusted service cost" to the Lessor as being in short, the cost to the supplier of rendering the service.
8. Paragraph 127(11.8)(c) of the Act deems the leasing of a property to be the rendering of a service for the purposes of subsections 127(11.6) and 127(11.7).
9. Subparagraph 127(11.8)(a)(ii) excludes from the cost to the Lessor, as the supplier of service, "any expenditure of the supplier to the extent that it would, if it were incurred by the recipient, not be a qualified expenditure of the recipient."
10. An expenditure for the acquisition of used equipment is a prescribed expenditure pursuant to subparagraph 2902(b)(iii) of the Regulations.
11. It is your view that paragraph 127(11.8)(a) of the Act applies to reduce to nil the cost of acquiring used equipment to the Lessor so that the Claimant is deemed not to have any qualified expenditure in respect of the lease of said equipment.
In your analysis you also referred to the Department of Finance's December 1995 Technical Notes to subsections 127(11.4) to 127(11.8) which provide an example as to the application of subsections 127(11.6), (11.7) and paragraph 127(11.8)(c). This example refers to leased property generally and indicates how a SR&ED performer leasing property from a non-arm's length person (owner) should calculate the amount of the expenditure in respect of the lease. The example indicates that, pursuant to subsections 127(11.6) and (11.7), the amount of the expenditure incurred by the SR&ED performer is computed with reference to the owner's cost of acquiring the equipment and the life-expectancy of the equipment. (The Technical Notes state that it is intended that the cost of leasing of a property be based on the normal accounting depreciation available with respect to the property by the owner of the property.) You note that this example does not indicate whether or not the equipment is new or used and would like confirmation as to whether, based on the provisions of subsection 127(11.8), the example should only be in respect of new equipment.
Our Comments
We agree with your analysis and your conclusion that paragraph 127(11.8)(a) of the Act would apply, in the situation you described, so as to exclude the cost of the used equipment from the Lessor's cost of rendering a service to the Claimant. This would result in the Claimant not having incurred a qualified expenditure in respect of the lease of said used equipment acquired by the Lessor. With respect to the example in the Technical Notes to which you made reference, we informally discussed with officials of the Department of Finance whether the example covered leasing of both new and used equipment. It is our understanding that the example in the Technical Notes is intended to only apply to new equipment; accordingly, in the situation you described, the cost of leasing used equipment would not represent a qualified expenditure to the Claimant since the leased equipment would be considered a prescribed expenditure to the Claimant if it were acquired by the Claimant. XXXXXXXXXX.
We trust that these comments will be of assistance.
S. Parnanzone
For Director
Business and Partnerships Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch