JULY 28 1988
TO J. Daman
Chief
Scientific Research Audit
Applications SectionAttention I.J.D. Rathwell
FROM Small Business and
General Division
Specialty Rulings Directorate
B. Fields
957-2096This is in reply to your memorandum of June 9, 1988, concerning XXXX eligibility for the manufacturing and processing profits deduction the MPP deduction), whether or not XXXX derives all or substantially all of its revenue from the prosecution of or the sale of rights in or arising out of scientific research and experimental development (SR & ED) for the purposes of Regulation 2902(a) and whether XXXX accrued management bonuses as at September 30, 1985 are "directly attributable" to SR & ED within the meaning of Regulation 2900(2)(b).
We have reviewed the information that was provided with the memorandum of April 20, 1988, from the Toronto District Office, including the representations that were prepared by XXXon behalf of XXX
Briefly, the significant facts of this case are as follows:
XXX
As the discussion that follows should illustrate, a proper determination of the taxpayer's entitlement to the MPP deduction would, in our view, require an analysis of the nature and substance of the contracts the taxpayer has entered and may in fact ultimately require legal advice on the status of the particular contracts under the relevant sale of goods legislation. However, in view of the urgency associated with your request we have not requested the submission of copies of the taxpayer's contracts and have attempted to restrict our comments to the general issue of qualification for the MPP deduction and whether or not a taxpayer could satisfy both revenue tests simultaneously.
MPP Deduction
In order to qualify for the MPP deduction 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. In determining whether or not a taxpayer manufactured goods for sale 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".
Although the Toronto District Office has indicated that they can see no reason to disallow XXX MPP deduction there are two factors which suggest to us that XXXX customers may have contracted for XXXX)research skills and experience to which the creation and transfer of a good (the XXXX) were merely incidental. If this is in fact the case, it would seem that one could rely on the above jurisprudence to disallow (XXXX claims for the MPP deduction. The first factor, which in our view would lend support to such a finding, is the representative's admission that the design of the XXX involves significant SR & ED. The second factor is the opinion the department's science advisor that all of the taxpayer's projects qualify as SR & ED. Presumably the expenditures and activities related to the creation of the good (i.e. the component parts and assembly labour) in a particular contract or project must be insignificant elements otherwise the science advisor would have relied on Regulation 2900(l)(h) to recommend that the SR & ED elements of the taxpayer's activities be "carved- out" as discussed in paragraph 7.9 of Information Circular 86-4R dated September 25, 1987.
If, however, the facts of this case reveal that the component parts and assembly labour were significant aspects of the contracts while the SR & ED elements were insignificant it may be that the taxpayer's contracts are, in fact, contracts for the sale of goods in which case you may wish to request that the science advisor reconsider his opinion with a view to the application of Regulation 2900(l)(h) and the "carve-out" concept. However, such a finding may also taint the taxpayer's apparent status as a sole purpose SR & ED company.
We should caution however that the ultimate determination will depend on the substance of the contracts.
Regarding whether or not the revenue from a particular contract could satisfy both revenue tests simultaneously we are inclined to rely on the same jurisprudence cited above. Since, in our view, revenue from the prosecution of SR & ED is essentially revenue from the provision of a service and since we believe that the courts would attempt to distinguish the particular contracts as being for the sale of a good or for the provision of a service, we believe the tests are mutually exclusive in the context of the revenue from a particular contract in that the revenue that is from the provision of a service could not, in our view, also constitute revenue from the sale of a good. However, this does not mean that a taxpayer could not in a particular taxation year satisfy both tests only that the revenue from a particular contract could not satisfy both. Thus, where a taxpayer derived 10% of its revenue from the sale of goods it manufactured in Canada and 90% of its revenue from the prosecution of SR & ED in Canada it would be difficult to argue that both of the tests have not been met.
Also, although the contract could provide that the "intellectual property" that is produced as a consequence of the taxpayer's activities is sold to the taxpayer's customers, the creation and sale of this intellectual property would not, in our view, constitute the manufacture of a good for sale. It could, however, constitute the sale of rights in or arising out of SR & ED for the purposes of Regulations 2902(a). Again, the nature of the contract would have to be reviewed to determine whether it was, in essence, a sale of technology or a sale of goods. However, it would still be our view that the contract could not satisfy both revenue tests.
All or Substantially All
In interpreting the words "all or substantially all" in the context of Regulation 2902, the Department has indicated that it means 90% or more. Thus, it would appear that a taxpayer that is entitled to make a claim for an MPP deduction, since for example 14% of its revenue in a particular year was from the sale of goods it manufactured, would be unable to satisfy the requirement that 90% or more of its revenue be derived from the prosecution of SR & ED. The Department, however, has also indicated that in determining whether or not a taxpayer derived all or substantially all of its revenue in this fashion it will consider not only the taxpayer's revenue in a particular taxation year but also the pattern established over a number of taxation-years. Thus, notwithstanding that the courts could interpret Regulation 2902 as an annual test it may be misleading in light of the Department's public statements on its interpretation of Regulation 2902 (see 1984 Revenue Canada Round Table page 814) to rely on the revenue of one particular year in making the determination.
Regarding the Department's interpretation that all or substantially all means 90% or more we should advise that the courts have recently considered the meaning of the term "all or substantially all" in the context of paragraph 115(1)(f) of the Act (see Douglas Wood case 87 DTC 312). In considering the "90% rule" Taylor, TCJ, indicated (page 313) that he "... would think the Minister might be hard-pressed to refuse a claim where the percentage was 89%, maybe even 85% or 80% or lower". He did conclude, however, that 70% clearly was not "all or substantially all" for the purposes of section 115 of the Act.
Accrued Management Bonuses
As a secondary issue, you have requested our comments on the proposed disallowance of an accrued management bonus as an SR & ED expenditure. The Toronto District Office has submitted that since the bonuses in question were not paid in the year they cannot be considered to be directly attributable to the prosecution of SR & ED as required by clause 37(7)(c)(ii)(B) and Regulation 2900(2)(b) and accordingly, cannot qualify for deduction pursuant to section 37. The taxpayer, however, has submitted that the denial of a deduction for accrued management bonuses is inconsistent with tax policy since the stated intention upon the introduction of the "directly attributable" concept was the relaxation of the former requirement that the expenditure be wholly attributable to scientific research. The taxpayer is also of the view that since the requirement in Regulation 2900(2)(b) that the amounts be paid was not contained in the the May 23, 1985 announcement that the Department's interpretation results in a retroactive change.
In our view, the disallowance of the accrued bonuses is correct in law. While the stated intention upon the introduction of the directly attributable concept was the relaxation of the "wholly-attributable" rule, the Regulation which was enacted clearly requires that salaries and wages be paid, not payable. Accordingly, accrued salaries and wages (other than those which meet the Department's administrative position as described in paragraph 11 of IT- 151R3) relating to taxation years ending after May 23, 1985 are no longer deductible. With respect to the taxpayer's contention that this requirement was not reflected in the May 23, 1985 Budget Papers, it is nonetheless reflected in the law. We also note that the provisions contained in subsection 2900(4) of the Regulations were not described in the Budget Papers; however, that does not make them invalid. It is also our understanding that the use of the term "paid" in Regulation 2900(2)(b) was deliberate and intended to deny deductions for, and investment tax credits on, such accruals.
In view of these comments we would conclude that the disallowance of the bonuses is consistent with tax policy and, notwithstanding the use of the term paid in Regulation 2900(2)(b), that the amendments achieved the stated intention of relaxing the "wholly attributable" rule.
Conclusion
In conclusion, based on the limited information available and the presumption that the taxpayer's contracts are in substance contracts for services and not contracts for the sale of goods, we would support the disallowance of the taxpayer's claims for the MPP deduction. If it is determined that the taxpayer's contracts are in fact contracts for the sale of goods we would be inclined to support a reassessment of the taxpayer's claims for the investment tax credit on the basis that the taxpayer does not satisfy the revenue test contained in Regulations 2902(a). We would support the disallowance of the accrued bonus in 1985 in either case.
Should you have any questions concerning the above comments please contact Brian Fields at 957-2096.
Original Signed by Original signÉ par
T. HARRIS
Chief Merchandising, Manufacturing and Construction Section Small Business and General Division Specialty Rulings Directorate Legislative and Intergovernmental Affairs Branch