Application Policy

Number: SR&ED 96-05
Date: July 19, 1996
Subject: Penalties under Subsection 163(2)


Issue

The purpose of this application paper is to clarify when the Department will apply penalties under subsection 163(2) of the Income Tax Act (the Act) to overstated scientific research and experimental development (SR&ED) claims. This paper should be read in conjunction with TOM 13(163)0. This paper does not address the application of section 239 of the Act. However, some of the circumstances described with respect to the application of subsection 163(2) penalities may refer to actions which could be construed as tax evasion.

In order to consider the application of a penalty under subsection 163(2) in respect of a SR&ED claim, the claimant must have knowingly, or under circumstances amounting to gross negligence, been involved in filing an overstated SR&ED claim. The Act clearly places the burden of proof on the Department for any subsection 163(2) penalty assessed by the Minister.

Since SR&ED claims involve a complex area of the income tax law and require determinations (usually by an expert) of both fact and opinion, it may be a challenge for the Department to prove that a claimant knowingly, or under circumstances amounting to gross negligence, made a false statement or omission in filing a SR&ED claim. Nonetheless, penalties should be considered in the following circumstances:

  • Where the claimant has participated in the overstatement of amounts on which the SR&ED tax incentives are being claimed.
  • Where the claimant has included amounts in respect of a project and there is clear evidence that the claimant knew the project did not involve any eligible SR&ED activities.
  • Where the claimant described the performance of eligible SR&ED activities which did not take place and claimed normal business expenses as SR&ED expenditures in respect of the performance of these alleged activities.
  • Where the claimant has continued to claim amounts that do not qualify for the SR&ED tax incentives after being advised in writing that these type of amounts do not qualify and the amounts in question are not under objection or appeal.
  • Where the claimant has continued to miscalculate the SR&ED tax incentives after being notified in writing of the proper calculation and the basis of the calculation is not under objection or appeal.
  • Where the claimant has continued to claim unsubstantiated amounts for the SR&ED tax incentives after being advised in writing what is required to support these types of amounts.

The Department cannot apply penalties with respect to taxpayer requested adjustments involving claims for SR&ED tax incentives because requesting a change does not constitute the carrying out of a duty or obligation imposed by or under the Act.

The Department may consider the application of penalties under subsection 163(2) of the Act under the following circumstances:

1. Understatement of income caused by the overstatement of amounts included in a deductionfrom income under section 37.

The amount of this penalty will be calculated in accordance with paragraphs 163(2)(a) and 163(2.1)(b) of the Act. Penalties in respect of the understatement of income can be applied to both refundable and non-refundable SR&ED claims.

SR&ED expenditures included in the subsection 37(1) pool can be deducted in the year or carried forward indefinitely. Where the overstated expenditures have been included in the subsection 37(1) pool and it is not clear as to whether or not such expenditures have been deducted, the overstated amounts would be considered to have been deducted first.

2. Overstatement of SR&ED investment tax credits deducted from taxes otherwise payable under subsection 127(5).

This overstatement could be caused by the overstatement of amounts or the miscalculation of SR&ED incentives. The amount of this penalty will be calculated in accordance with paragraph 163(2)(a) of the Act. Penalties in respect of the overstatement of deductions from taxes otherwise payable can be applied to refundable and non-refundable SR&ED claims.

SR&ED investment tax credits can be deducted from federal taxes otherwise payable under subsection 127(5) in the year earned or included in the investment tax credit pool which can be carried back or forward to offset federal taxes otherwise payable under subsection 127(5) of the Act in other years. Where there is an overstatement of SR&ED tax credits that is subject to a penalty and it is not clear whether or not overstatement has been deducted, penalties should be applied on the basis that the overstated investment tax credits have been deducted first.

3. Overstatement of amount deemed paid for a year under subsection 127.1(1)

Subsection 127.1(1) of the Act addresses SR&ED investment tax credit refunds. Overstatements of such refunds could be caused by the overstatement of amounts or the miscalculation of SR&ED incentives. The amount of this penalty will be calculated in accordance with paragraph 163(2)(d) of the Act.

Example

A claimant records $225,000, which was inflated by $100,000, in a 1995 SR&ED claim as the cost of materials consumed in a SR&ED project. The facts clearly show that the claimant knowingly inflated the cost.

Penalty Implications:

1. The claimant would be subject to a penalty on the tax relating to the first $100,000 deducted under subsection 37(1) for 1995 or any subsequent year. One exception to this course of action would occur if the investment tax credit (ITC) relating to inflated cost is deducted from taxes otherwise payable before the inflated amount was deducted under subsection 37(1). In the event that the overstated ITC was reported as a reduction to the SR&ED pool under paragraph 37(1)(e), the penalty would be applied on the net amount (i.e. $80,000 or 65,000).

2. If the claimant included the inflated material cost in calculating SR&ED investment tax credits which can be utilized to offset federal taxes otherwise payable, the claimant would be subject to a penalty on the overstated investment tax credits, i.e. 20% of $100,000. For purposes of applying this penalty, the overstated investment tax credits are considered to have been deducted first in either offsetting taxes or offsetting taxes in prior or subsequent years through the investment tax credit pool mechanism.

3. If the claimant included the inflated material cost in calculating a SR&ED investment tax credit refund, i.e. 35% of $100,000, the claimant would be subject to a penalty on the resulting overstatement of the refund.

for Director
Specialized Compliance Enhancement Division

Issued by: Tax Incentive Audit Section and Scientific Research Section

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