TO Audit Programs Directorate
Scientific Research
Audit SectionATTENTION C. Lamarche
FROM Small Business and
General Division
B. Fields
Tel.: 957-2096NOV 25 1987
RE: Prototypes
This is in reply to your memorandum of July 23, 1987, wherein you requested our views on the contents of your memorandum dated June 30, 1987, concerning the deductibility of expenditures in respect of the design, construction and testing of prototypes for the purposes of section 37 of the Income Tax Act (the "Act").
Your comments
In your memorandum you have drawn a distinction between "true" prototypes and other "so-called" prototypes and have concluded that the carve-out concept described in article 7.9 of Information Circular 86-4R (the "Circular") should not be used for a "true" prototype even if the prototype will ultimately be used in the taxpayer's operations or sold.
In your view, a prototype should be considered a "true" prototype provided its development involves a "system uncertainty". A system uncertainty, as indicated in article 4.8 of the Circular, involves the non-trivial combination of established technologies where principles for their integration carry a major element of technological uncertainty. You have also indicated that in your view the expenditures associated with a true prototype would be current expenditures for the purposes of section 37 of the Act.
Our comments
As you are aware, the term prototype is not specifically defined in the Act. The Department, however, as indicated in article 8.5 of the Circular, has accepted that a prototype is an original model on which something new is patterned and of which all things of the same type are representations or copies. Although the Circular indicates that the design, construction and testing of a prototype normally fall within the scope of scientific research and experimental development (R&D), that statement is based, in part, on the premise that the expenditures and activities associated with the development of a prototype will satisfy the definition of R&D contained in paragraph 37(7)(b) of the Act and subsection 2900(1) of the Income Tax Regulations (the "Regulations"). It should also be noted that the exclusions in paragraphs (d) to (j) of Regulation addition to the requirement contained in paragraph 37(7)(c) that all or substantially all attributable to R & D.
Paragraph 2900(1)(h) of the Regulations provides that activities associated with the commercial production of a new or improved material, device or product or the commercial use of a new or improved process, are specifically excluded from qualifying as R&D. In order that expenditures in respect of a particular project could be considered to fall outside the scope of paragraph (h) of Regulation 2900 and to satisfy the requirement that the expenditures be all or substantially all attributable to R&D, it is our expectation that, in addition to satisfying the criteria of technological advancement, technological uncertainty and technical content, the prototype would have no lasting value (other than the knowledge acquired from its development) after the design, construction and testing of the prototype is completed. A "true" prototype, therefore, in our view, is one which has satisfied the aforementioned criteria and has no lasting value or expected commercial use.
Where "so-called" prototypes are constructed and it is apparent that there is a reasonable expectation that the prototype will be sold (whether pursuant to a contract with a specific purchaser or not) or that it will be incorporated into the taxpayer's existing or proposed commercial operations, we believe that a sustainable technical argument exists to support a finding that the activities and related expenditures are not in respect of R&D, on the basis that the expenditures are in respect of commercial production or commercial use or that they are not all or substantially all attributable to R&D.
Where a taxpayer does not have a "true" prototype, notwithstanding the aforementioned technical argument, the Department has adopted the administrative practice whereby we are prepared to accept the "carve-out" of certain activities. In this regard the comments in article 4.8 of the Circular regarding "system uncertainties" acknowledges that more often, it will be necessary to separate those activities which are eligible from those which are not. Consequently, it is our view that expenditures in respect of, or related to, engineering, design operations and mathematical analysis for example, that were undertaken in a systematic fashion and which are directly in support of resolving the technological uncertainties in the design and development of a "so-called" prototype could be qualifying expenditures, to the extent that these expenditures did not represent component materials, devices, equipment, or assembly costs that became an integral part of the "so-called" prototype.
In view of your comment that certain taxpayers abuse the concept of prototypes for the purpose of section 37 of the Act, we would have thought you would be seeking a means of restricting access to the incentives in respect of R&D rather than expanding them. In our view, our method of distinguishing between a "true" prototype and a "so-called" prototype, combined with the administrative practice to carve-out qualifying activities, provides a practical means of challenging those projects which are perceived to be offensive while allowing the incentives for those portions of a project which represent bona fide R&D.
Regarding whether expenditures that are related to the development of prototypes are current or capital in nature, it is your view, notwithstanding the comments in paragraph 2 of IT-151R2 that indicate those expenditures that result in the acquisition of tangible assets are capital in nature, that the cost of developing a prototype, including component materials and labour costs, should be considered current expenditures for the purposes of section 37 of the Act. In support of this view, you have referred to the comments in the May, 1985 Budget Papers that indicate the reason for restricting the enhanced refundability of investment tax credits to qualified expenditures in respect of current expenditures was that capital expenditures can be more easily funded by pledging the assets as security for financing. In your view, these comments, coupled with your observation that projects involving prototypes are difficult to finance, support your position that expenditures in respect of prototypes are current expenditures.
The distinction between current and capital expenditures for the purpose of section 37 is somewhat moot, in that both types of expenditures, assuming they otherwise qualify as R&D, are immediately deductible. The distinction, however, is relevant for the purposes of the recapture provisions of subsection 37(6), the refundable investment tax credit, and the determination of whether or not the expenditures, assuming they are incurred outside of Canada, qualify pursuant to subsection 37(2) of the Act.
Although some support for your view could be found in the CICA accounting recommendations for R&D costs. (See subparagraph 3450.05(b) and paragraph 3450.19), it is our view that the courts, in the event the matter was ever litigated, may not rely on the CICA recommendations given that section 37 of the Act is generally perceived to represent a departure from generally accepted accounting principles. In view of the dearth of jurisprudence to clearly establish criteria that could be used to make the distinction between current and capital expenditures in the context of section 37, we suspect the courts would look to related jurisprudence where the distinction between other current or capital expenditures was at issue. In this regard, decisions of the courts have indicated that when an expenditure is made with a view to bringing into existence an asset or advantage for the enduring benefit of trade, then that expenditure is normally viewed as being on account of capital. Therefore, if one were to accept that there is no enduring benefit associated with the development of a prototype it could be argued that the expenditures incurred in the development of a prototype are current expenditures. If, however, one views the knowledge that results from an R&D project as an enduring benefit, then it could be argued that the expenditures are capital in nature.
Notwithstanding the argument that all R&D costs are capital in nature, we have accepted that expenses that result in the acquisition of tangible assets are capital expenditures for the purposes of section 37 of the Act.
Since R&D projects involving prototypes do indeed result in the acquisition of tangible property we prefer to maintain the view that expenditures in respect of prototypes are normally capital expenditures.
Regarding your interpretation of the comments in the May 1985 Budget Papers that suggest, to us, that considering expenditures in respect of prototypes as current expenditures would be consistent with tax policy in this area, we note that the comments, on page 117 of the White Paper on Tax Reform dated June 18, 1987, (that discuss the proposal to eliminate the incentives in respect of certain capital expenditures on R&D) indicate that "the incentives for other capital equipment and structures (such as a wind tunnel or an experimental wind or hydro energy prototype) used for R&D will be retained", suggest, to us, that expenditures in respect of prototypes may be viewed as capital expenditures in terms of tax policy.
To summarize, we are of the view that all R&D projects involving "so-called" prototypes will be subject to "carve-out" and that the expenditures in respect thereof will be capital expenditures for the purpose of section 37 of the Act to the extent that the expenditures represent component materials, devices, equipment or assembly costs.
We hope our comments will be of assistance.
Original Signed by Original signé par
T. HARRIS
Director Small Business and General Division Legislative and Intergovernmental Affairs Branch