General Eligibility Issues

Distinguishing Between Routine and Qualifying Testing and Data Collection Activities

As indicated elsewhere in this newsletter, Revenue Canada has circulated a draft copy of their revised information circular (IC86-4R4) which elaborates on, and clarifies, a number of thorny issues respecting SR&ED claims. One of the thorniest has been the correct identification of testing and data gathering activities.

The testing issue was touched on briefly in our Fall 1997 issue of Strategies as it pertained to testing existing products to determine if they meet new regulatory requirements. Here we will attempt to contrast the issue of routine testing and routine data gathering, which are non-eligible activities, with those of testing or data gathering as support activities within an SR&ED project.

Distinguishing qualifying from routine testing
The draft revised IC states “Testing is a qualifying activity for an SR&ED project when commensurate with the needs, and directly in support of SR&ED. However, quality control, or routine testing of materials, devices, products or processes is an excluded activity.” It goes on to state “In the scientific method, a hypothesis is tested to attempt to (either) corroborate or reject it. Testing in this sense qualifies. Thus, testing of the scientific results or technological output, such as a new material, of an SR&ED project is eligible up to the point of the SR&ED project completion.” All other testing is not eligible.

Unfortunately, this description does little to help clarify the confusion. For example, if, in the process of routine development of a new product (Non-SR&ED work) the company performs routine testing of its component parts, such as motors or printed circuit boards, to ensure they meet their published specifications prior to using them, this activity is clearly not eligible. If however, the company has a qualifying SR&ED project and performs the same testing, this testing would be an eligible activity. It’s still routine work, but performed directly in support of the SR&ED project.

Not quite so clear is the following example. If the company performs testing of new materials as part of developing a new ink or paint formulation, does this qualify as eligible testing? The foregoing description would seem to indicate that it would, provided the company had formulated a hypothesis as to the correct ingredients, the component quantities, and their chemical and physical interactions in relation to desired product performance objectives such as drying time or viscosity. The same testing would (presumably) not qualify if performed in the course of simply attempting to test performance of a single ingredient prior to replacing a similar ingredient in an existing formulation. This approach implies the absence of a hypothesis and hence would be denied on that basis.

Another murky example can be found in agribusiness research. If a company decides to investigate various plant varieties by cloning particular ones with different characteristics, and testing them against desired objectives such as frost resistance, would this qualify as eligible or is this routine testing? It would appear this is routine, based on the above definition, because presumably the testing does not involve a hypothesis - or does it? Could it be argued the company put forth a hypothesis that certain characteristics in the plant variety were needed to achieve a specific frost resistance objective and that the testing was performed in support of this theory? To make the issue even murkier, could it be argued that the activities are simply routine data collection, or are they observation of a trial or experiment?

Distinguishing qualifying from routine data collection
Again the information circular states “data collection is a qualifying activity when commensurate with the needs, and directly in support of, SR&ED. However, routine data collection is excluded….”

The circular goes on to state “The analysis of large quantities of survey data can serve to search for scientific or technological advancement and to resolve scientific or technological uncertainty, even if the data were not specifically collected for the needs of the SR&ED project. In these cases, only activities associated with analysing the data would qualify, not the actual data collection”. It then carries on with four examples of routine data collection activities, including collecting baseline data to support routine development such as may be encountered in collecting physical property data; generally descriptive data and data collected from routine or standard repetitive procedures or processes, all of which are all ineligible.

The Strategy
Data collection and testing form a large part of many R&D projects. Indeed, observation and analysis of results of trials or experiments is considered to be a core SR&ED activity. In order to maximize your claim, make particular note in your documentation that the data being collected or the testing being performed is in direct support of your scientific or technological hypothesis. Be prepared to show why all the data collected or all the testing performed was necessary for your analysis to draw your scientific or technological conclusion.

Links

IC-86-4R3 - Scientific Research & Experimental Development - Identifying Eligible Activities Associated With Collecting Data - Section 5 [6]

How is an SR&ED project defined?

When filing an SR&ED tax credit claim with the Canada Revenue Agency (CRA) the work claimed is structured as a “projects”. The claimant defines the projects undertaken, and the activities within a project. An intuitive definition of a project is used, and boundary areas are subject to interpretation.

Project start and end dates are often difficult to determine. Eligibility of routine support activities for a project is frequently questioned. As well, large projects involving teams or multiple teams of researchers can be considered “over aggregated”. CRA has requested work be broken into more easily digestible units, each unit being an SR&ED project. Each of these issues presents considerable difficulties both for tax preparers and CRA auditors as each attempts to fairly assess the overall eligibility of work for tax credits. A fundamental problem is that industrial research projects can encompass a broader set of activities than CRA is able to support.

A steering committee composed of industry sector representatives and CRA have now released a consensus document describing the principles that will assist in the application of IC 86-4 as it relates to the definition of an SR&ED project. The primary reason for issuing this paper is to develop a common level of understanding so work is reviewed at a proper level of aggregation to avoid projects being broken down in such a way that ineligibility is inadvertently lost.

There are three criteria necessary for any project: scientific and/or technological advancement, uncertainty, and content. A project is considered to be a set of “interrelated activities that collectively are necessary for the attempt to achieve the specific advances(s) defined for the project, are required to overcome uncertainty, and are pursued through a systematic investigation by means of experiment or analysis performed by qualified individuals.”

While the above definition provides a clear starting point, the CRA document goes on to provide guiding principles in many difficult areas. Of particular importance to many claimants are the following:

Projects should be assessed in their entirety, rather than broken up into their constituent parts.
CRA will review the claimants process for preparing their SR&ED claims. How is SR&ED differentiated from non-eligible work? Who makes these decision and what is their experience and credentials for making the decision? What is their level of understanding and experience with the SR&ED claims preparation process?
Projects tend to come in two flavours. Those that are distinct and well defined units of work, and those that are long-term multi-year projects that evolve in their goals as time progresses. In these later type of projects CRA recognizes that many activities may be routine, that these activities do not form SR&ED projects by themselves, and that they are eligible due to their contribution to the overall project.
A project start point is defined as the point at which the scientific and/or technological objectives could be defined. Where unanticipated difficulties are encountered in otherwise routine work the project would commence when the difficulties are recognized. However, prior work that is integral to the SR&ED process can still qualify.
A project end is defined as when activities associated with the resolution of uncertainty is complete, and it has been demonstrated that project objectives have been met.

The Strategy
Work on developing a process for identifying and tracking projects. Be prepared to discuss with CRA how you identify eligible SR&ED work and differentiate it from standard practice. In preparing your claim define projects at the highest level.

Links

Application paper - Cost of materials for SR&ED [7]

SR&ED Policy on Regulatory Testing

An area of significant controversy as to whether an activity qualifies as SR&ED, is one where the activity involves meeting a regulatory requirement. Generally, testing to meet regulations only qualify when they are linked in as part of an SR&ED project. With limited exceptions, they do not of themselves meet the definition of SR&ED. Particularly they do not meet the technological advancement and uncertainty criteria that must be met before an activity would qualify as SR&ED. The Canada Revenue Agency (CRA) considered this issue in relation to testing activities undertaken to meet the requirements of the March 1993 New Substances Notification Regulations of CEPA. Their policy is that testing to meet these Regulations is eligible only where the testing is done to generate new knowledge by resolving scientific uncertainty in direct support of an SR&ED project. Further references to CRA policy on Regulatory Testing appear in parts 7.4 and 7.5 of Information Circular IC 86-4R3 (linked below) and in application policy number SR&ED 1996 - 02, dated January 16, 1996, Tests and studies required to meet in regulated industries (linked below).

The Strategy
Testing work, performed up to the point that there are still technological uncertainties to be resolved and where that testing is designed to resolve some or all of those uncertainties, is generally eligible. It is important therefore, during the course of an audit, to establish that testing to resolve technological uncertainties in relation to the new regulations, was performed.. If the taxpayer cannot establish this, the claim will be denied.

Links