SR&ED while Developing an Asset Policy

Date: July 19, 2016

Changes to the SR&ED while Developing an Asset Policy

Revision reasons

This revision accommodates the legislative changes that have been announced.

Revision overview

Expenditures of a capital nature no longer qualify for SR&ED tax incentives starting in 2014.

The text of this document has been revised to reflect these changes, see Appendix B.1 Explanation of changes.


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 SR&ED 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.

This document presents the situation when there is SR&ED in the development of a new asset. Allowable SR&ED expenditures incurred for the development of an asset, such as, salary or wages, materials consumed or transformed, SR&ED contracts, overhead and other expenditures retain their nature, and each are claimed on the appropriate line of Form T661, Scientific Research and Experimental Development (SR&ED) Expenditures Claim.

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

However, it must be 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 the 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 the identification of the asset type 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 asset type (pilot plant, commercial plant, prototype, or custom product / commercial asset) must be established by demonstrating how and why the asset was developed.

This document does not deal with the situation when an asset (acquired or developed by the claimant) is used to carry out SR&ED. An asset used to carry out SR&ED work may be claimed if it meets the definition of materials for SR&ED. The expenditures for capital property, including leased assets, no longer qualify for SR&ED tax incentives.

2.0 Pilot plants

The Income Tax Act 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 purpose 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 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, the capital costs for the acquisition / construction of the pilot plant do not 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  for the development of a pilot plant retain their nature and are considered to be SR&ED expenditures of a current nature.

Examples of expenditures of a current nature 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.

However, expenditures of a capital nature , such as equipment, do not qualify for SR&ED tax incentives.

3.0 Commercial plants

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 plants" 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, will not qualify for the SR&ED tax incentives when the technology used already existed.

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

Expenditures of a capital nature , such as equipment, do not qualify for SR&ED tax incentives.

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. 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 expenditures for 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 the copies of a prototype (including the labour, materials, and overhead) can be claimed as materials for SR&ED when the copies are consumed or transformed in the prosecution of SR&ED. This means the expenditure can be claimed as materials consumed or transformed when the tests are completed and not when the copies 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. 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 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 (copies of the prototype) 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 business, it is a commercial asset. A commercial asset is constructed to meet business 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 where the development of the components of an asset that require SR&ED work do not significantly affect the design requirements of other components in the asset. In these situations, the work on the components that are not affected by the SR&ED work would not be eligible. When the SR&ED work on a component requires redesigning closely associated components, then the work of redesigning the associated components may be eligible.

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 ( SR&ED current expenditures ) 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. Other expenditures of a current nature relating to the commercial portion of the property developed are not SR&ED expenditures. Expenditures of a capital nature do not qualify for SR&ED tax incentives.

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 work is not SR&ED, even if the portion of the asset that does not involve SR&ED, is an integral part of the custom product or commercial asset being developed.

An expenditure must meet the expenditure rules to be allowable. Accordingly, the CRA will not allow the practice of claiming all of the cost of materials 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. Rather, only the cost of the materials transformed in the prosecution of SR&ED work can be claimed which may be subject to ITC recapture. 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 the 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 and 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 work (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?

The 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 Act (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 SR&ED 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

List of provisions
Income Tax Act Description
Section 9 Income
Paragraph 37(1)(b) Pool of deductible SR&ED expenditures – capital expenditures [Repealed]
Subparagraph 37(8)(d)(i) SR&ED expenditures specifically excluded – capital property
Subsection 127(9) Definition of "first term shared-use-equipment"
Subsection 127(9) Definition of "second term shared-use-equipment"
Subsection 169(2.2) Waived issues
Subsection 248(1) Definition of “SR&ED
Subsection 248(1)
 
Definition of “SR&ED”, paragraph (i) commercial
production or use
List of regulations
Income Tax Regulations Description
Subsection 2900(11) Prescribed depreciable property

Appendix B – Revisions

B.1 Explanation of changes

The following are the explanation of changes to the SR&ED while Developing an Asset Policy as part of the revision of July 19, 2016.

Section 1.0 was revised to include two paragraphs clarifying that this policy primarily covers the situation when there is SR&ED in the development of an asset. This policy document does not apply when an asset is used to carry out SR&ED.

Section 2.1 has been revised to reflect the legislative changes resulting from the 2012 federal budget measures with respect to expenditures of a capital nature. Expenditures for leased equipment and SR&ED capital expenditures made after December 31, 2013, do not qualify for SR&ED tax incentives. Because of the interaction of the definition first term shared-use equipment and second term shared-use-equipment, ITCs can be claimed in tax years ending before February 1, 2017, in respect of first term shared-use-equipment acquired before 2014.

Section 3.1 has been revised to reflect that expenditures of a capital nature incurred after 2014 no longer qualify for SR&ED tax incentives.

Appendix A.2 ''CRA publications'' has been removed.

Other minor formatting and editing corrections were made throughout the document.

 B.2 Previous versions

Previous versions are provided for reference purposes:

SR&ED while Developing an Asset Policy (December 19, 2012)

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