Computer Software and the Technological Content Criterion
Revenue Canada will allow SR&ED claims where the taxpayer demonstrates three requisite criterion - technological advancement, uncertainty and content. If a project fails to satisfy one of these three criteria it will disqualify as SR&ED. In this article we identify issues related to technological content. We have discussed the other two criteria, namely uncertainty and advancement, on other pages in this web site.
The Income Tax Act defines SR&ED to embody, among other things, a systematic investigation or search in a field of science or technology by means of experiment or analysis. Revenue Canada takes this to mean that a valid SR&ED project must exhibit technological content. Further, the technological content requirement has three elements; a scientific or experimental methodology, documentation and the experience of personnel. The first two, methodology and documentation have been sanctioned by the courts. The third, experience of personnel, has yet to be tested in the courts.
Experimental or analytical methodology
Revenue Canada regards the methodology requirement to incorporate a systematic search or investigation involving the formulation of a theory or hypothesis, testing this hypothesis by experiment or analysis, and a statement of logical conclusions. The process of experimentation or analysis includes all activities that flow systematically from the definition of technological requirements to testing and documentation. According to Revenue Canada the following activities will qualify as SR&ED when they are necessary and sufficient in attempting to achieve technological advancement to resolve the technological uncertainty.
- technological feasibility studies (support) research into techniques, methods and status of computer software as a technology (support)
- reviews of emerging, existing and competing technologies that are required to define the advancement (core)
- technical specifications preparation to the extent it is required to define the advancement and uncertainty (core)
- technical analysis and design (core)
- tool and process development (core)
- programming (support)
- trials and testing the software which embodies the advancement (core)
- preparation of development documentation (support)
- SR&ED project planning and control including quality assurance that is essential to the SR&ED (support)
Documentation
Revenue Canada requires that documentation must be prepared on a contemporaneous basis to demonstrate that SR&ED activities have actually occurred. For example, the types of documentation they would expect to see on an audit of an information technology project would include:
- the earliest SR&ED project plan including project objective statement and any subsequent modifications, showing the rationale for design choices supported by factual comparison of the alternatives considered
- Design review documents, intermediate designs, and status reports or technical meeting minutes
- Project notebooks
- Backup versions of commented source code or other evidence representing major phases of development and identifying the author(s) of each module and changes made
- “as built” system diagrams and design overviews
- Test plan and test results
- Staff resumes
- Personnel time records and activity reports
Revenue Canada stated policy is that the appropriate detail and sophistication of documentation will depend on the size of the taxpayer’s organization and the magnitude of the claim. Smaller projects may have less documentation than larger projects, and smaller companies are to be given more leeway in these requirements. However, if there is no documentation or record to substantiate the project, the claim will be rejected.
Experience of Personnel
In order to meet the experience requirement Revenue Canada takes the position that the personnel responsible for directing theSR&ED project must have the professional (technical) skills or experience commensurate with the needs of the project.
Specific Software Issues
Software development involves a systematic process progressing from operational or system analysis, through functional specifications to technical specifications, programming, testing and debugging prior to commercial use. It could be argued that software development always meets the methodology element of the technological content criteria. However many claims are rejected because they do not shown or cannot show that the methodology was experimental or analytical in nature.
In order to support a valid claim, records should indicate that the work should show that the work differs from routine development. Evidence of differentiation between routine and experimental work is the existence of technological uncertainty toward which the work is addressed, and evidence that there have been iterative attempts to resolve this uncertainty.
Where a problem is resolved successfully on the first attempt, the activities are generally considered to be routine development. In such cases there is a greater need to substantiate an experimental or analytical methodology. Also, where an inexperienced developer might use an iterative process, their work would not qualify on the basis of inappropriate experience.
In additional, there can be audit issues where projects make use of powerful development environments and tools which can forego the need for formal development methodologies. This often leads to inadequate documentation of the SR&ED activities and hence the rejection of a claim. Even where experimentation is conducted using these development tools there is a risk that the work may be judged to be “blind trial and error”, and not involving a systematic investigation.
Revenue Canada generally takes the position that user interface development, adding new functionality, performance enhancement projects, porting or migrating to new platforms, or work on management information systems and projects that involve issues of scale will generally be considered in the nature of routine development. Where these types of projects involve qualifying work, it is useful to substantiate a claim at the time of an audit, with a formal development methodology, along with contemporaneously prepared documentation.
The Strategy
It would be prudent to ensure that appropriate documentary records are created. Revenue Canada expects to see such records as project plans, design review documents, project notebooks, evidence of major phases of the development showing the iterations, test plans and test results, and personnel time and activity records. Further these records must differentiate between SR&ED activities including the needed support activities and other non-eligible routineactivities. Other supporting evidence as necessary and appropriate may be accepted. Electronic versions are acceptable.
