B. Field: (613) 957-2096
Re: Request for Technical Interpretation Scientific Research and Experimental Development
We are writing in response to your letter of August 15, 1988, wherein you requested our views with respect to the application of certain provisions of the Income Tax Act (the "Act") relating to the incentives available for expenditures or scientific research and experimental development (SR & ED).
Your first concern relates to whether or not subsection 127(11.1) of the Act would apply to reduce the amount of the capital cost of a property or of a qualified expenditure for the purpose of calculating a corporation's investment tax credit under subsection 127(9) of the Act if the corporation claims a Research and Development Superallowance (as proposed in the Ontario Budget of April 20, 1988) of a Nova Scotia Research and Development Tax Credit as provided by section 3A of the Nova Scotia Income Tax Act.
In view of the Department's practice to provide opinions on proposed changes in law only in circumstances where draft legislation is available and since the Province of Ontario has not yet released draft legislation in respect of the proposed Research and Development Superallowance we will restrict our comments to the Nova Scotia Research and Development Tax Credit.
Paragraph 127(11.1)(c) of the Act provides, for the purposes of the definition of the term investment tax credit in subsection 127(9), that "... the amount of a qualified expenditure made by a taxpayer shall be deemed to be the amount of the qualified expenditure made by the taxpayer ... less the amount of any government assistance, non-government assistance or contract payment in respect of the expenditure that at the time of filing of the return of income for the taxation year in which the expenditure was made, the taxpayer has received, is entitled to receive or can reasonably be expected to receive". The term "government assistance" is defined in subsection 127(9) of the Act and means "... assistance from a government, municipality or other public authority whether as a grant, subsidy, forgivable loan, deduction from tax, investment allowance or as any other form of assistance other than as a deduction under subsection 127(5) or 127(6)..." of the Act. Since the Nova Scotia Research and Development Tax Credit constitutes a deduction from tax that is not described in subsection 127(5) or (6) of the Act it constitutes "government assistance". Accordingly, paragraph 127(11.1)(c) of the Act will normally operate to require the taxpayer to reduce its qualified expenditures by the amount of the Nova Scotia Research and Development Tax Credit earned in the year since, in our view, a taxpayer can, at the time of filing his tax return for that year, reasonably be expected to receive the Nova Scotia Research and Development Tax Credit relating to expenditures made in that year.
We should also advise that with the enactment of Bill C-139 on September 13, 1988, paragraph 37(1)(d) now requires that a taxpayer's pool of unclaimed SR & ED expenditures must be reduced by the amount of government assistance and non-government assistance (which would include the Nova Scotia Research and Development Tax Credit) that the taxpayer has received, is entitled to receive or can reasonably be expected to receive.
Your second concern involves whether or not subparagraph 125.1(3)(b)(x) would disqualify a company, whose sole business is the performance of SR & ED for profit, from claiming the deduction from tax under section 125.1 of the Act when Regulation 5202 expressly includes scientific research as a "qualified activity".
In order to qualify for the deduction provided by section 125.1 it must be established, inter alia, that the taxpayer manufactured goods for sale or lease in Canada and that the revenue from this activity was not less than 10% of its gross revenue from all active businesses carried on in Canada. Although scientific research constitutes a "qualified activity" for the purpose of computing a taxpayer's adjusted business income under Regulation 5202 it does not, in our view, necessarily follow that a taxpayer that performs SR & ED is manufacturing or processing goods for sale or lease.
In determining whether or not a taxpayer manufactured goods for sale or lease there is jurisprudence (see Crown Tire Services Ltd. case 83 DTC 5426 at page 5429) to support the view that in interpreting the words "goods for sale or lease" contained in section 125.1, reference should be made to the general law of sale or lease in order to give greater precision to the phrase. There is also jurisprudence (see Dixie X-Ray Associates Ltd. case 88 DTC 6076) to support the view that the courts would look to the substance of the contract in order to determine whether the contract is for the sale of goods or for the supply of services to which the transfer of title to goods was merely incidental. As indicated by McNair, J. in Dixie X-Ray (page 6079) "... if the substance of the contract is the production of something to be sold and the transference of property therein to a buyer then the contract is a sale of goods. But, if the real substance of the contract is the skill and labour of the supplier in the performance of work for another then that is a contract for work and labour, notwithstanding that property in some materials may pass under the contract as accessory thereto".
Since, in our view, the performance of SR & ED on a contract for fee basis constitutes the provision of services as opposed to the manufacture and sale of a good it is our view that subparagraph 125.1(3)(b)(x) would normally apply to disqualify a company whose sole business is the performance of SR & ED for profit from claiming the deduction from tax provided by section 125.1 of the Act.
Your last concern involves the revenue test contained in Regulation 2902 and whether or not a corporation that develops prototypes and derives a substantial percentage of its revenues from the sale of these prototypes could be considered to derive all or substantially all of its revenue from the prosecution of scientific research or the sale of rights in or arising out of scientific research carried on by it for the purpose of Regulation 2902.
Although the design, construction and testing of prototypes normally fall within the scope of experimental development it does not necessarily follow that all the expenditures associated with the development of a prototype constitute expenditures that are all or substantially all attributable to the prosecution of SR & ED or that the activities associated with the development of the prototype do not involve the commercial production of a new or improved material, device or product or the commercial use of a new or improved process for the purpose of Regulation 2900(1)(h). As indicated in paragraph 23 of Interpretation Bulletin 151-R3 dated June 24, 1988, expenditures for projects that can reasonably be expected to result in the acquisition of property (such as a prototype) that will be used in the taxpayer's business or that will be sold are not fully deductible under section 37 since in the Department's view such expenditures are not all or substantially all attributable to SR & ED. The Department is, as indicated in section 7.9 of the Information Circular 86-4R2, prepared to allow deductions under section 37 for a portion of the expenditures on such projects provided the SR & ED expenditures are carved-out (segregated) from those which would normally be associated with the construction of the prototype if the technology had already existed.
Thus, in circumstances where a substantial portion of a taxpayer's revenue is derived from the sale of prototypes and it was intended or reasonably expected at the outset of the projects that the prototypes would be sold, it is our view that the taxpayer does not derive all or substantially all of its revenue from the prosecution of SR & ED or the sale of rights in or arising out of SR & ED. Relating these comments to our response to your second concern it is possible that the non-SR & ED portion of the taxpayer's activities could constitute the manufacture of goods for sale or lease and that although the taxpayer would not be entitled to the various SR & ED incentives for all of its expenditures it is possible that the taxpayer may qualify for the deduction from taxes payable provided by section 125.1 of the Act.
We trust our comments will be of assistance.
for Director Small Business and General Division Specialty Rulings Directorate Legislative and Intergovernmental Affairs Branch