SR&ED while Developing an Asset Policy

Date: December 19, 2012

The current version of the policy is available below.

July 19, 2016 SR&ED while Developing an Asset Policy

Table of contents

• 1.0 Introduction
• 2.0 Pilot plants
  • 2.1 Expenditures applicable to pilot plants
• 3.0 Commercial plants
  • 3.1 Expenditures applicable to commercial plants
• 4.0 Prototypes
  • 4.1 Expenditures applicable to prototypes
  • 4.2 Copies of a prototype
    • 4.2.1 Copies of a prototype used as materials for SR&ED
    • 4.2.2 Example – Copies of a prototype used as materials for SR&ED
    • 4.2.3 Copies of a prototype used for commercial purposes
  • 4.3 Versions of a prototype
  • 4.4 Sale of a prototype – de minimis rule
• 5.0 Custom product / commercial asset
  • 5.1 Expenditures applicable to custom products and commercial assets
  • 5.2 Allocation of project costs
  • 5.3 Sale or conversion to commercial use
  • 5.4 Alternative approach for a custom product or a commercial asset
    • 5.4.1 When can the alternative approach be used?
    • 5.4.2 Example – Alternative approach for a custom product or a commercial asset
• Appendix A – References
  • A.1 Legislative references
  • A.2 CRA publications

1.0 Introduction

An asset can be a material, device, product, or process facility. SR&ED in a commercial environment may involve the development (design, construction, and testing) of an asset. Even if an asset arises from or is being used for scientific research and experimental development (SR&ED), it does not mean that all of the work (and the associated expenditures) on that asset qualifies for the tax incentives. The development and / or use of an asset can involve SR&ED work, a mixture of SR&ED and commercial work, or only commercial work.

In the context of SR&ED, an asset can be a:

• pilot plant;
• commercial plant;
• prototype; or
• custom product / commercial asset.

However, it must be clearly established that there is SR&ED (refer to section 2.1 of the Eligibility of Work for SR&ED Investment Tax Credits Policy) before any consideration is given to the type of asset resulting from or used in SR&ED. If it is determined that there is SR&ED, then the extent of the SR&ED must be identified (refer to section 2.2 of the Eligibility of Work for SR&ED Investment Tax Credits Policy), which includes identification of the type of asset involved. This is important in order to help apportion the costs of developing the asset between SR&ED work and non-SR&ED work.

It is possible that there may be any combination of assets in a given SR&ED project. The type of each asset (pilot plant, commercial plant, prototype, or custom product / commercial asset) must be established by demonstrating how and why the asset was developed and used.

2.0 Pilot plants

The Income Tax Act (ITA) does not define the term pilot plant. This section describes the Canada Revenue Agency (CRA) meaning of this term in the context of SR&ED, even though industry may assign different meanings to it. For work involving the development of a plant that will eventually be a commercial facility, or the modification of an existing commercial plant see section 3.0.

A pilot plant is a production facility that is developed for the primary purpose of carrying out SR&ED during its useful life. It is used solely for its technical or experimental content and not for the purposes of commercial operations. Therefore, a pilot plant is sized taking into consideration the SR&ED to be conducted in / on it. It is typically isolated from normal business operations.

A pilot plant is a non-commercial scale plant in which processing steps are systematically investigated under conditions simulating a full production unit. Usually, it is used to obtain engineering and other data needed to evaluate hypotheses, establish finished product technical specifications, write product or process formulae, or design special equipment and structures that are required by a new or improved fabrication process.

More specifically, when carrying out SR&ED, pilot plants may be used to study the behaviour of certain raw materials, develop an economically viable manufacturing process, modify equipment for new applications, test unproven equipment, test new conditions, produce samples for research, or determine environmental effects.

A pilot plant for one company may be larger than the actual commercial production facility for another company. The actual size or capacity of the facility and / or equipment is not a factor when determining if it is a pilot plant, to the extent that it remains a non-commercial facility. What is important is that the determination of the type of the asset must take into consideration the facts of the actual use made of the facilities and equipment. A pilot plant must be used for SR&ED over its useful life.

Industry sometimes refers to commercial projects (or portions thereof) as “pilot plants,” when the purpose is to subsequently transform the plant into a commercial facility. The use and subsequent transformation of such a facility may involve SR&ED. However, a plant will not meet the CRA definition of a pilot plant if it is developed for temporary or permanent conversion to commercial operations during or after any SR&ED work.

Experimental production results from the operation of a pilot plant. A pilot plant is not used for non-SR&ED work (such as commercial production or for sales promotion or technology demonstration).

2.1 Expenditures applicable to pilot plants

Expenses incurred for the development and operation of the pilot plant qualify for SR&ED tax incentives. However, neither the capital costs for the acquisition / construction of a building nor a leasehold interest in a building qualify for SR&ED tax incentives. Allowable SR&ED expenditures incurred for salary or wages, overhead and other expenditures, SR&ED contracts and materials for SR&ED (expenditures of a current nature) for the development of a pilot plant retain their nature and are considered to be SR&ED expenditures of a current nature.

Examples of current expenses applicable to pilot plants include the following:

• labour used and materials consumed in resolving technological uncertainties;
• labour used and materials consumed or transformed in resolving the technological uncertainties of developing equipment for incorporation in the pilot plant; and
• labour used and materials consumed or transformed in operating a pilot plant.

Expenditures of a capital nature relating to, for example, equipment purchased off-the-shelf, or equipment developed for the pilot plant (where the development of the equipment does not involve resolving the technological uncertainties) may qualify if the equipment meets the criteria for SR&ED capital expenditures.

Equipment that does not meet the all or substantially all test can be considered to be shared‑use-equipment (SUE) provided the SR&ED use requirements for first term shared‑use-equipment and second term shared‑use-equipment are met. This could be the case, for example, of a machine that is used in a pilot plant but that is intended to be used eventually in a commercial plant. In the case of a pilot plant, the SUE will not be considered prescribed depreciable property in accordance with the Income Tax Regulations (Regulations) and therefore it can earn an investment tax credit.

3.0 Commercial plants

A commercial plant refers to production facilities used for commercial (or other non-SR&ED) purposes. Although new plants may sometimes be built or existing commercial plants may be modified, to test and demonstrate new processes, these plants are generally not "pilot plant" as their intended purpose and actual use is commercial.

It is recognized that some work related to the development and operation of a commercial plant may involve SR&ED work. So, even in cases when a facility does not qualify as a pilot plant, certain expenditures may be allowed for  SR&ED purposes when SR&ED takes place in or on a commercial facility. In cases when the development of a commercial plant involves SR&ED, the segregation of SR&ED work from the non-SR&ED work is important. The work and related expenditures that would usually be associated with the development of a commercial plant, if the technology had already existed, will not qualify for the SR&ED tax incentives.

3.1 Expenditures applicable to commercial plants

To determine the allowable SR&ED expenditures for projects involving the development or modification of a commercial plant, the SR&ED work and the non-SR&ED work should be identified as well as the project costs allocated between these activities. It is the claimant’s responsibility to identify the SR&ED work and the non-SR&ED work and allocate the project costs accordingly.

For the purposes of allocating the project costs to SR&ED, appropriate internal controls and accounting methods must be sufficient to explain the allocation of costs to the SR&ED portion of the project. The use of an allocation method for determining the costs will generally be acceptable to the CRA, as long as there is supporting information to establish the reasonableness of the method. Allocations should be supportable through effective controls and information that can be used to test the reasonableness of the amounts claimed. For an example of an allocation of labour expenditures for SR&ED, please refer to section 13.0 of the SR&ED Salary or Wages Policy.

Examples of current expenses that will qualify for SR&ED tax incentives, when a commercial plant is being developed, include the following:

• labour used, materials consumed, and materials transformed to resolve technological uncertainties of developing the commercial plant in an attempt to achieve technological advancement; and
• labour used, materials consumed, and materials transformed to resolve the technological uncertainties of developing equipment to incorporate in the commercial plant in an attempt to achieve technological advancement.

Expenditures of a capital nature involved in the development of a commercial plant will usually not meet the all or substantially all test unless their intended use in SR&ED outside the development of the commercial plant is evident. For more information on capital expenditures, please refer to the SR&ED Capital Expenditures Policy.

Equipment acquired to develop a commercial plant will not normally qualify as shared‑use-equipment (SUE) because the property will normally be considered prescribed depreciable property in accordance with the Regulations and therefore it will not earn an investment tax credit.

Note:

The production that results from the operation of a commercial plant when there is also SR&ED performed will involve expenditures such as salary or wages, overhead and other expenditures, materials consumed, and materials transformed into products. For a discussion on the treatment of these costs, please refer to SR&ED During Production Runs Policy.

4.0 Prototypes

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. It is a basic experimental model that possesses the essential characteristics of the intended product. A prototype is normally understood to be a trial model or preliminary version. It is developed to test the feasibility of a concept or hypothesis within a systematic investigation or search and generally has no lasting value.

A prototype is developed for its technical or experimental content to, for example:

• study the behaviour of materials and / or the practicability of the design for manufacturing;
• develop an economically viable process for manufacturing of a new product, or for the application of a new manufacturing process;
• improve an existing product or process or modify equipment for new applications; and / or
• test the technical feasibility of the project or idea and provide guidance to achieve the final goal.

A prototype is not developed for the purpose of sale or its subsequent use in the business. Normally, the sale of a prototype is only incidental or secondary to the carrying out of the SR&ED work. Usually, the prototype is dismantled, destroyed, scrapped, or otherwise recognized to have nominal residual value (less than 10% of the construction costs of the prototype). It is important to note that even if the asset is sold or converted to use in business operations, it is the purpose for which the asset was constructed that will determine whether it will be treated as a prototype or as a custom product or commercial asset.

The development (design, construction, and testing) of a prototype falls within the scope of basic research, applied research, or experimental development.

4.1 Expenditures applicable to prototypes

Expenditures relating to the labour and the materials used in developing a prototype will qualify for SR&ED tax incentives. Since a prototype usually has no commercial application or limited value once it has been tested, materials used in its development are in most cases consumed in SR&ED. However, in certain cases, the input materials that form part of the prototype could still have value and are treated as materials transformed in the prosecution of SR&ED. For more information see section 4.2.2.

The expenditures for the development (design, construction, and testing) of a prototype are treated as expenditures of a current nature. All or substantially all of these expenditures are attributable to the prosecution of SR&ED.

Sometimes, after verifying the feasibility of a concept or hypothesis by designing, constructing, and testing a prototype, copies or versions of a prototype are constructed either at the same time or one following the other. This may result in different scenarios as described below.

4.2 Copies of a prototype

4.2.1 Copies of a prototype used as materials for SR&ED

The construction of several duplicate copies of a prototype—to meet a need or to establish an inventory after successful testing of the original prototype—is not SR&ED. However, in certain cases, while the work itself is not considered to be SR&ED, the construction of several duplicate copies of a prototype to be used for testing may qualify for SR&ED purposes. When the testing is commensurate with the needs and directly in support of basic research, applied research, or experimental development prior to commercial production or use, the copies of the prototypes may be considered materials for SR&ED purposes. The cost for the construction of a copy of a prototype (including the labour, materials, and overhead) can be claimed as materials for SR&ED when the copy of a prototype is consumed or transformed in the prosecution of SR&ED. This means the expenditure can be claimed when the tests are completed and not when the copies of the prototype (materials) are constructed. For more information on materials for SR&ED, please refer to the Materials for SR&ED Policy.

4.2.2 Example – Copies of a prototype used as materials for SR&ED

Supplier Co. is a part supplier. It is developing a new part (a prototype, see section 4.0) to meet technical specifications required by Manufacturer Co., its main customer. Both companies are dealing at arm’s length. Once the prototype has been developed, Supplier Co. makes 100 copies of the prototype and sends them to Manufacturer Co. to be tested on its production line. For the purpose of this example, the testing is eligible. The copies were damaged in the testing. After the testing is completed, Manufacturer Co. pays $100,000 to Supplier Co. for the copies.

Supplier Co. should treat the copies of the prototype as materials transformed in SR&ED expenditures. The fact that Supplier Co. receives $100,000 for the copies being tested does not change the nature of the expenditure (materials). The copies do not become a custom product, as there is no commercial production yet. Supplier Co. will have to apply the investment tax credit (ITC) recapture rules on the disposition of the materials provided to Manufacturer Co.

4.2.3 Copies of a prototype used for commercial purposes

The construction of several duplicate copies of a prototype—to meet a need or to establish an inventory after successful testing of the original prototype(s)—is not considered SR&ED because the construction and use of these copies are part of commercial production. Consequently, the costs related to the construction of these copies will not qualify for SR&ED tax incentives.

4.3 Versions of a prototype

In certain situations, several different versions of a prototype may be developed, each one involving SR&ED in an attempt to improve on the previous version. In other words, each new version of the prototype utilizes the knowledge gained from the previous version. In such cases, for each version of the prototype, the expenditures associated with the identified SR&ED work will be treated as SR&ED current expenditures.

In the case of any version that is developed for the purpose of its sale or subsequent use in the business, the costs associated with any non-SR&ED work performed in its development cannot be claimed for SR&ED purposes. In this case, it is a custom product or commercial asset and not a prototype (see section 5.0). However, if a version is developed for its technical or experimental content, the costs associated with any non-SR&ED work may be treated as part of the cost of materials for SR&ED to be used for testing (see section 4.2.2).

4.4 Sale of a prototype – de minimis rule

When the proceeds from the sale of a prototype are nominal (less than 10% of the construction costs of the prototype), the sale is considered to be a sale of scrap materials. The proceeds will be included in income for tax purposes. The ITC recapture rules do not apply in the case of scrap sales, but do apply to other sales.

5.0 Custom product / commercial asset

Custom product or commercial asset refers to an asset developed for business purposes. When that purpose is to sell the asset, it is a custom product. A custom product is constructed to meet customer specifications or market-driven technical requirements. When that purpose is to use the asset within the company’s own business, it is a commercial asset. A commercial asset is constructed to meet the company’s own requirements.

In some cases, the development of a custom product or commercial asset may require  SR&ED that is carried out in conjunction or simultaneously with non-SR&ED work. It is important to be able to distinguish between the SR&ED work and other non-SR&ED work so that the project costs can be allocated accordingly.

There may be situations when the specifications for components (in a complex project) that require advances in technology do not significantly affect the design requirements of other components (in the same project). In such situations, only the work on specific components that require advances in technology (in a complex project) will be considered eligible. When advanced technological specifications require redesigning closely related components, then the work associated with redesigning the associated components is eligible. These considerations apply to the assessment of any custom design project (customization), pilot plants having commercial potential, and prototypes which are ultimately sold.

5.1 Expenditures applicable to custom products and commercial assets

To determine the allowable SR&ED expenditures for projects involving the development of a custom product or a commercial asset, the SR&ED work and the non-SR&ED work must be identified and the project costs allocated between these activities.

When determining eligible work and related expenditures, the claimant must identify the components that were constructed, as well as the SR&ED work and the nature of the work in the commercial project. The development work must be viewed at a level that properly recognizes the attempted technological advancements that define the full scope of eligibility.

Allowable SR&ED expenditures incurred for salary or wages, overhead and other expenditures, SR&ED contracts, and materials for SR&ED (expenditures of a current nature) for the development of a custom product or a commercial asset retain their nature and are considered to be SR&ED expenditures of a current nature. The other costs (that are not allowable SR&ED expenditures) are current expenses or capital outlays relating to the commercial portion of the property developed, depending on the situation.

For materials, only the cost of the materials consumed or transformed in the prosecution of SR&ED work will be allowed for SR&ED purposes. No cost of materials will be allowed for SR&ED purposes if the related activity is not SR&ED work, even if the portion of the asset that does not involve SR&ED is an integral part of the asset.

An expenditure must meet the expenditure rules to be allowable. Accordingly, the CRA will not automatically allow for SR&ED purposes all of the cost of material transformed in a custom product or a commercial asset and apply the investment tax credit (ITC) recapture rules in the year of disposition or conversion to commercial use. It should be noted that when the cost of materials transformed is allowed as an SR&ED expenditure, it generally implies that the salary or wages incurred in the year for the transformation are attributable to SR&ED work.

5.2 Allocation of project costs

For the purposes of allocating the project costs to SR&ED, appropriate internal controls and accounting methods must be sufficient to explain the allocation of costs to the SR&ED portion of the project. The use of an allocation method in determining the costs will generally be acceptable to the CRA, as long as there is supporting information to establish the reasonableness of the method. Allocations should be supportable through effective controls and information that can be used to test the reasonableness of the amounts claimed. For an example of an allocation of labour expenditures for SR&ED, please refer to section 13.0 of the SR&ED Salary or Wages Policy.

5.3 Sale or conversion to commercial use

The claimant must identify any subsequent use or sale of the asset that was developed. The ITC recapture rules will apply to recapture the ITC or a portion of the ITC earned relative to the costs of the materials transformed in SR&ED, in the year the product is sold or converted to commercial use. The ITC recapture rules will also apply to contract expenditures for SR&ED performed on behalf of a claimant in the year the product is sold or converted to commercial use. For more information on ITC recapture, including an example where an  SR&ED contract is involved, please refer to the Recapture of SR&ED Investment Tax Credit Policy.

5.4 Alternative approach for a custom product or a commercial asset

In some cases, it is very difficult to apportion expenses between SR&ED work and commercial work. The alternative approach provides an estimate of the overall amount of incremental costs incurred as a result of SR&ED (should be allocated between SR&ED current expenditures on a reasonable basis). This method can be used when either the traditional or proxy method is selected to calculate SR&ED expenditures. It is not necessary to show that a specific expenditure item meets the incremental test on its own. Under this approach, the allowable SR&ED expenditures correspond to:

a) the total actual costs of developing the custom product or commercial asset minus the estimated costs that would usually be associated with the construction of the asset if the technology had already existed;

plus

b) an estimated amount representing the costs of materials transformed in SR&ED.

5.4.1 When can the alternative approach be used?

An alternative approach to estimate the allowable SR&ED expenditures of the claimant can be used if all of the following conditions are met:

• it is impossible to isolate the SR&ED work (that is, neither the claimant nor the CRA can isolate the work);
• the CRA agrees to the use of this approach, meaning it is of the opinion that it is appropriate to use such an approach in the context (for example, only a portion of the work can be isolated); and
• the claimant agrees with the use of this approach and has signed a waiver of the right to object or appeal under the subsection 169(2.2) of the ITA (this is because this approach is not founded in law and is only allowed on an administrative basis).

If there is no joint agreement regarding the use of this approach, only the cost attributable to substantiated SR&ED work can be considered for the SR&ED tax incentives.

However, if the claimant submitted a claim utilizing the alternative approach and the segregation of work could have been made, the CRA will accept the use of this alternative approach, but not for years subsequent to the first CRA review where the claimant utilized this approach. Although the use of the alternative approach may be accepted, the CRA must agree on the basis used for estimating the overall amount of incremental cost.

5.4.2 Example – Alternative approach for a custom product or a commercial asset

A client ordered a machine with an improved engine. The claimant’s SR&ED project is about improving the engine in the machine to enhance its throughput. The engine was developed and incorporated into the machine for testing. The total costs incurred for the project (including SR&ED costs) are $150,000. However, the claimant could not segregate the eligible work from the commercial work. The claimant and the CRA agreed to use the alternative approach to estimate the SR&ED expenditures for the claim under review.

The claimant estimated that it would cost $125,000 to develop that machine now that all of the technological uncertainties have been resolved. The claimant estimated that the cost of materials transformed in the improved engine was $30,000. The CRA found these estimates to be reasonable.

Total project costs incurred to develop the machine: $150,000

Minus: costs of the asset if the technology had already existed: $125,000

Allowable SR&ED costs: $25,000

Plus: cost of materials transformed in SR&ED: $30,000*

Total allowable SR&ED expenditures: $55,000

* Subject to ITC recapture

Appendix A – References

A.1 Legislative references

A.2 CRA publications