When do the cost of materials qualify for SR&ED tax credits?
There are two methods of determining the cost of SR&ED activities, the proxy method and the traditional method. Under either methodology a taxpayer can claim the cost of materials consumed in SR&ED activities. A traditional method filer can also claim the cost of materials transformed in SR&ED activities and the cost of material directly related to SR&ED that would not have been incurred if the SR&ED had not occurred.
Taxpayers and auditors have always had difficulty in determining material costs due to variances in interpretation. CRA recently posted an Application Policy (AP) on their web site which was to provide some clarity. Unfortunately, this policy is somewhat confusing in that it takes issue with itself in important areas.
The AP includes CRA’s position as to the meaning of the words “cost”, “materials”, “consumed” and “transformed”. It should be noted that these interpretations are provided by the CRA to give guidance to auditors and taxpayers. They do not have the force of law.
The word “cost” is defined to mean the laid down cost. For purchased items, this would include the invoice cost plus any duties, transportation, storage and other acquisition costs. If materials are manufactured by the claimant, the cost would also include the cost of direct labour and the applicable share of expenses properly chargeable to production overhead.
In CRA’s opinion the word materials refers to all the raw materials, substances or other items that compose the “body of a thing at a given moment in the SR&ED process”. In other words, the materials have to be incorporated into the subject of the SR&ED claim. CRA takes the position that energy costs and items such as cleaning products, CD’s or diskettes, and test tubes would generally be seen to be “supplies” and not materials that compose the body of a thing.
The word consumed in relation to a material is defined by CRA to refer to something that is absorbed, used up, or broken down into small pieces. As a result, materials such as a motor, which is incorporated into a commercial product or asset is not considered to be consumed. On the other hand, in a lab experiment, such things as enzymes or growth media would be considered to be consumed, because they are part of a thing that is made at some point in the SR&ED process.
As mentioned above, materials transformed in SR&ED activities are eligible costs only where a taxpayer calculates costs under the traditional method. CRA has defined transformed to refer to material that will not be consumed but rather be transformed into another material or thing which has some value either to the taxpayer or to another party. Examples given include nylon thread transformed into a carpet, or resins and dyes transformed into paint.
A recapture (reversal) of tax credits applies if a material has been transformed and then is subsequently sold or converted to commercial use. So if thread transformed into carpet as part of an SR&ED project earns tax credits, those tax credits are reversed in a later year if that carpet is sold.
Interpreting what is mean by “items that compose the body of a thing at a given moment in the SR&ED process” is difficult. In examples that appear at the end of the AP, CRA appears to contradict its own position in that it gives examples of certain situations where materials can include items that are not incorporated into the body of a thing. Now, instead of struggling with what is meant by materials, we will be struggling with what is meant by the phrase “incorporated into the body of a thing”.
The Strategy
Where the cost of materials is significant, some number crunching is required to determine whether the proxy or traditional method provides the greatest benefit. Try to fit into CRA’s definitions for consumed and transformed, but where amounts are significant consider what definitions the courts might apply.
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