Over the past five years, CRA has narrowed its views of SR&ED eligibility. Is this justified and what can be done about it?
By David R. Hearn, A. Christina Tari and Peter M. Weissman
*This is an expanded version of a summary that first appeared in the June/July 2011 issue of CAmagazine.
The Canadian tax system’s provisions for research and development aren’t quite as old as CAmagazine, but they do date back more than 60 years, to 1948. While the provisions always targeted scientific research, they were specifically broadened in 1985 to include “experimental development” — thus giving us the acronym SR&ED. In 1994, the government further strengthened the definition of experimental development, thereby reaffirming its support for industrial R&D undertaken in pursuit of new products or processes.
Given the government’s apparent commitment to fostering R&D in Canada, it is discouraging to see the extent to which the CRA has varied its views on SR&ED eligibility over the years, with no material changes in the legislation to back them up. Peter Weissman, one of the co-authors of this article, already wrote about this problem in the 1990s (see “Credit where It’s due,” September 1997, p. 30) and it’s happening again today.
What is driving this trend? Has the CRA changed its policies with respect to SR&ED eligibility? If so, are these changes justified and supported under the existing legislation? If not, what is best way for taxpayers to get redress?
The political environment
The federal government has to balance competing (even conflicting) goals when it comes to economic development policy for science and technology. One is to offer a rich research and development tax credit incentive that is internationally competitive. This requires both high benefit rates and legislation that is flexible enough to make the credit available to fulfill a wide range of political objectives. Another goal is to control the amount of SR&ED tax credit disbursements that are actually paid out so that costs are adequately contained in a fiscally responsible way. Finally, CRA must guard against what appears to be an explosion of abusive claims.
Over the past four years, the goals of cost containment and abuse control seem to have won out. This might be due to provisions in the 2008 and 2009 federal budgets that increased the cash refund available to qualifying CCPCs. Alternatively, it could be because government needs to balance off losses in tax revenue resulting from the recession and other factors. We think many of the present malfunctions in the SR&ED program stem from the government’s attempts to reduce (or at least contain) benefit payouts using only administrative policy measures, and thus avoid any actual tightening of the governing legislation that might diminish Canada’s appeal as an R&D destination in the international business community.
Is the SR&ED program malfunctioning?
There are growing indications that both taxpayers and the government believe the SR&ED program is malfunctioning. In September 2009, the federal government commissioned its taxpayers’ ombudsman, Paul Dubé, to investigate whether CRA was correctly administering the program. Although his report has been delayed at least three times and has yet to be released, the Globe and Mail quoted him last fall as saying the following about his work on the SR&ED program: “We’ve heard a lot of industry complaints. Now we have to put the allegations to the CRA and see what they say.”
In October 2010, the federal government set up a six-member SR&ED expert review panel headed by Open text chair Tom Jenkins to review the economic benefits of all government funding for R&D, including SR&ED.
In the past few months, several industry associations have voiced their dissatisfaction with the program. In its February 2011 submission to the expert review panel, Canadian Manufacturers and Exporters – an industry association representing more than 3,000 manufacturers across Canada – reported: “Problems in the administration of the [SR&ED] system include uncertainty with respect to eligibility, tighter definitions that exclude many previously eligible development activities, lack of technical expertise, long processing times, and lack of client[taxpayer] support.”
A similar submission to that panel was made by the Canadian Advanced Technology Alliance. CATA, Canada’s largest technology industry association with more than 28,000 members, was even more pointed in its criticism: “There is also concern about what they [our members] see as a tightly narrowing interpretation of [SR&ED] eligibility and ineffective (negative) eligibility assessment methods that are resulting in significantly reduced allowed credits where they have been available in the past.”
In April 2011, the Canadian Chamber of Commerce published a report called Election 2011: The Canadian Business Game Plan, which said the following about SR&ED: “Unfortunately, the program’s administration — which results in tax credits not being delivered in a predictable, timely and cost-effective manner — is frustrating to businesses. The current narrow focus of the Canada Revenue Agency regarding what is supported and how SR&ED claims should be documented is simply not delivering the broad-based incentive that was intended.”
How is SR&ED eligibility defined?
CRA has published a variety of guidelines, administrative policies and interpretation bulletins aimed at helping taxpayers better understand SR&ED rules. While these contain information intended to help taxpayers understand the law, they are not law themselves, but merely statements of administrative policy.
The definition of SR&ED is in the Income Tax Act (Canada). While the definition in the act has been moved, the wording has not changed in any material way since the mid-1990s, when the 18-month deadline and other modifications were introduced. The challenge right now is to keep up with CRA’s moving administrative definition of what is eligible.
Ultimately, Canada’s tax courts decide on the correct interpretation of the words in the act. There have been three important court decisions pertaining to the definition of SR&ED: Northwest Hydraulic Consultants Ltd. and C.W. Agencies Inc., which were decided by the Tax Court of Canada in 1997 and 2000 respectively. Plus Rainbow Pipe Line Company, Ltd., decided by the Tax Court of Canada in 1999 and by the Federal Court of Appeal in 2002. Just as the language in the legislation has not materially changed, none of the court decisions can justify the extent to which CRA has narrowed its definition of SR&ED eligibility in recent years.
Trends in SR&ED audits
Our experience mirrors what industry associations such as CATA, CME and the Canadian Chamber of Commerce have been reporting; namely, CRA has been adopting claim review positions that are substantially more restrictive than in the past. To be fair, some of CRA’s recent “policy tightening” positions that are unpalatable to industry are in fact supported by the wording of the act. However, in an increasing number of assessments issued over the past four years, we see auditors’ findings that all too frequently are not supported by the legislation. Unfortunately, most taxpayers (and many accountants) are simply not sufficiently familiar with the nuanced differences between law and administrative policy to appreciate which CRA audit positions are correct. Here are some of the more frequently applied claim reduction strategies that, in our view, are not supported by the legislation.
Project deconstruction: The taxpayer makes a claim for a project involving a set of interrelated activities that are collectively necessary for the technological advancement. The CRA auditor arbitrarily breaks the project into smaller subprojects, then assesses some of these as “standard engineering” and, therefore, not eligible. The SR&ED claim is either reduced or disallowed altogether. With this strategy, almost any SR&ED claim can be broken down into pieces of “standard engineering,” none of which has “sufficient scientific” content on its own to be eligible.
Misinterpretation of “experimental development”: The vast majority of SR&ED claims are made for work that is “experimental development” as defined in paragraph 248(1)(c) of the act. The term experimental development was first enacted in 1985 specifically to broaden the scope of the legislation to encompass industrial R&D activity aimed at product development. However, CRA auditors are now too frequently importing the more restrictive “basic research and applied science” wording from paragraphs 248(1)(a) or (b) and disallowing the claim on the basis that the taxpayer has failed to demonstrate “an advancement in a field of science or technology,” thus effectively subjecting taxpayers to pre-1985 rules.
“Technological obstacle” vs. “technological uncertainty”: An SR&ED claim is disallowed on grounds that there was no “technological uncertainty” or “technological obstacle” that would justify making a systematic investigation.
The act doesn’t actually contain the words “technological uncertainty” or “technological obstacle.” Rather, the term “technological uncertainty” evolved from a 1997 court case, Northwest Hydraulic Consultants Ltd. There, Justice Bowman described uncertainty as something not known to a qualified specialist in a given field. The term “technological obstacle” appeared in 2008 with the CRA form T661-08, but has yet to be sanctioned by any jurisprudence. In various publications since then, CRA has taken to defining “obstacle” as shortcomings in the existing state of the art. It would seem that CRA is now using the entire world as a benchmark and as such is setting the eligibility bar much higher than Justice Bowman did in 1997.
Failure to appreciate the difference between the traditional and proxy overhead methods:
There are two methods of claiming overhead costs as an SR&ED expenditure. The simplest and most commonly used is the “proxy method,” whereby the overhead is deemed to be 65% of the claimed T4 wages. Alternatively, the taxpayer can elect to use the “traditional method,” which involves a more complex and detailed accounting of actual overheads, but also allows for a broader scope of eligible activity than the proxy method. Under the traditional method, for example, expenditures incurred for long-term planning for future SR&ED projects, human resource activities, preparation of the T661, certain clerical tasks, repairs, maintenance and supplies all attract SR&ED. In most cases the proxy method provides the best result, but in certain situations, the traditional method is required to fully capture all the overheads.
Now we are seeing more and more cases where the CRA auditor denies the expenditures for the “broader scope” activities, allows an overhead amount equivalent to about 65% of the T4 wages, and effectively negates the taxpayer’s election of the traditional method.
Any taxpayer who has had SR&ED claims reviewed by the CRA over the past four years has probably suffered a substantial cutback in benefit eligibility. In some assessments, CRA might well have deliberately or inadvertently relied on administrative positions that are not supported by the legislation. Given all of the changes that have been occurring within CRA’s SR&ED section, first as a result of the implementation of unilateral policy changes, then because of pressures exerted by the ombudsman and others to correct these changes, the probability for flawed assessment is very high.
To determine whether a CRA assessment has any merit, it is important to examine the facts, then examine whether CRA properly applied the governing legislation to those facts. When it comes to SR&ED, the facts typically involve complex technological issues requiring highly specialized (and current) knowledge that most CRA auditors simply don’t have.
There are a number of redress measures available for taxpayers that have experienced a flawed assessment. Each involves a different estimated time frame for relief and a different cost. Given the administrative policies that CRA has recently adopted, we believe the Tax Court of Canada (TCC) is currently the best venue for the resolution of SR&ED matters where the main issue is “scientific eligibility.”
Why not resolve your SR&ED dispute through notice of objection? Negotiating with the CRA in relation to a notice of objection remains a useful route for expenditures issues in an otherwise eligible claim. However, based on our experience, it is now taking 24 to 36 months for an appeals officer even to be assigned to an SR&ED objection, and that is only the first step in the review process. Perhaps more significantly, appeals officers, who consider and decide the objection, are CRA employees, and in a choice between the agency’s administrative policy and the legislation, they will not typically overturn an assessment decision that is consistent with administrative policy.
The TCC process
Before the TCC process can begin, a notice of objection must have been served on CRA within 90 days of the date shown on the notice of assessment. In rare circumstances it might be possible to extend this deadline by up to a year, but the outcome of the request for an extension is not guaranteed.
An appeal can be launched in the TCC on the 91st day after the notice of objection has been served, so long as CRA has not notified the taxpayer that it has made a decision in respect of the notice of objection within the 90 days following service of the objection. In our view, the present backlog of SR&ED-related objections in the inventory of CRA’s Appeals Division is so large, the objection will probably not even be acknowledged within 90 days.
Once the notice of appeal is filed in the TCC, if necessary, a trial can be secured within 24 months, if not sooner. However, the TCC route does not always mean a trial. There are a variety of TCC pre-trial procedures that taxpayers can use to get the government to consider an earlier resolution. For example, a settlement meeting can be arranged informally by simply asking the Department of Justice counsel assigned to the file to agree to hold one. Alternatively, the taxpayer can make a formal request that TCC schedule a settlement conference. The CRA is obliged to attend at such a conference with its counsel, and the conference is presided over by a judge of the court. The TCC has affirmed that it is committed to facilitating the settlement of appeals without resorting to a trial wherever possible and, indeed, most SR&ED-related actions are settled in exactly this way.
While the TCC route looks promising for redress of flawed SR&ED assessments, there are two caveats. First, even a settlement conference is a highly structured process that requires expert knowledge of the rules of procedure and the legislation. Second, like any court action, the taxpayer must be prepared to present evidence to support its position. In SR&ED cases this means documenting exactly why the claimed activity meets the legislated definition. This is critical in the TCC process because the onus of proof – the obligation to establish the facts – is on the taxpayer. The facts that CRA relied on in making the assessment are presumed correct. That said, the burden of proof in TCC is the civil standard of a “balance of probabilities” and not the criminal standard requiring proof “beyond a reasonable doubt.”
Despite these caveats, we still think the TCC is the best option for resolving SR&ED disputes, especially when it concerns scientific eligibility. Of course, it would be preferable not to have any disputes at all. We look forward to seeing the CRA re-align its operating doctrines with the original objective of the SR&ED program – encouraging research and innovation in the private sector.
David R. Hearn is managing director of Scitax Advisory Partners LP and has been working in the SR&ED advisory field since 1993.
A. Christina Tari, LLB, LLM, is a founder of Richler and Tari, Tax Lawyers, and has a practice restricted to tax dispute resolution.
Peter M Weissman CA, TEP, is a partner in Cadesky and Associates LLP, a Toronto firm focusing on income tax planning, and was formerly the leader of the SR&ED practice in a full-service national accounting firm.