SR&ED change penalizes shopfloor innovation

By Derek Wong

The impact of a policy change made last year by the Canada Revenue Agency (CRA) is beginning to be felt on industrial shop floors across the country. The change dramatically revises CRA’s interpretation of the Income Tax Act on Scientific Research and Experimental Development (SR&ED). As a result, industries such as agriculture, automotive, consumer packaged goods, food, oil and gas, pulp and paper, and other industries that typically conduct SR&ED in their production line, are seeing their SR&ED tax credits reduced by as much as 90% or more.

The policy change is described in the revised version of CRA Application Policy 2002-02R “Experimental Production and Commercial Production with Experimental Development Work – Allowable SR&ED Expenditures”. The issue concerns mainly production line SR&ED activities, or so called “shop-floor” SR&ED, when these activities also generate revenue. A company spending $1 million on test runs to develop a production process could receive a tax credit of $200,000 before the policy change (assuming the other eligibility criteria are met). Under the new policy, the tax credit could be reduced to $20,000 or less.

The reason behind the sharp reduction is that CRA now considers many shop-floor SR&ED to be predominantly commercial activities. As such, according to the new interpretation, only “incremental” expenditures incurred, if any, can be attributed to SR&ED and earn tax credits. The “baseline” expenditures are fully attributed to commercial activity, even though the SR&ED could not have been performed without also incurring the baseline expenditures.

This new approach could lead to some strange results. Take the scenario where an experimental production process costs less to run compared to the existing process — reducing production costs is, of course, a common drive for industrial innovation. The new policy could attribute the full costs to commercial production and no cost to SR&ED in some cases. The taxpayer apparently gained the new know-how with no cost. Eligible work was conducted. But eligible expenditure is zero.

Could this method of expenditure attribution have legal basis in the Income Tax Act? Long-time tax credit claimants may feel déjà vu as the concepts of the new application policy closely resemble those of an old one published in 1996, called “Prototypes, Custom Products/Commercial Assets, Pilot Plants and Experimental Production”. Those concepts were ruled baseless by the Tax Court in the Consoltex case in 1997. CRA stopped using that approach from around 2000. It is questionable whether the new policy is supported by the Income Tax Act. The new policy introduced conflicts with other CRA policy papers, such as the examples given in “Cost of Materials for SR&ED” and “Recapture of Investment Tax Credit”. The answer to the policy’s legal basis may only come from a court ruling on a test case. As yet, there is no court judgement on its validity.

The intent of Canada’s SR&ED research and development tax credit program is to promote innovation by providing SR&ED performers with tax credits. The amount of tax credit is calculated based on the SR&ED expenditures incurred. The separation of SR&ED expenditures from commercial expenditures in shop-floor environments has always been difficult. In the past, many conflicts occurred between CRA auditors and taxpayers when subjective judgement was required on whether an activity was predominantly SR&ED, which earned tax credit, or predominantly commercial, which didn’t.

This changed with the introduction of “tax credit recapture” legislation by the Department of Finance in 1998. Under the new law, tax credit is earned in full when an SR&ED/shop-floor activity is performed and expenditures are incurred. The tax credit earned on materials and other properties acquired for SR&ED is progressively recaptured from the taxpayer when these same expenditures generate revenue. The net tax credit should then reflect the net SR&ED expenditure. No subjective judgement is required from either the CRA auditor or the taxpayer. This law — together with the requirement that only work commensurate with the needs and directly in support of SR&ED is eligible — has worked well in assessing fair and reasonable amounts of tax credit for most SR&ED performers.

With the new application policy, an additional step is introduced which requires subjective judgement. According to CRA’s guidelines used by their auditors, they have to make a judgement, for instance, on whether the taxpayer had an expectation of sellable output from the experimental production run. If such an expectation is judged to have existed in the taxpayer’s mind, then that’s an indication that the work was predominantly commercial production, not SR&ED. (Why any taxpayer would test a production run he does not expect to have successful output, the paper does not say.) In any case, the judgement based on this and other factors by the CRA auditor could result in a tax credit to the taxpayer of either hundreds of thousands of dollars or close to nil. The auditor has to make an either/or judgement, there’s no in-between. These are unnerving situations for taxpayers, likewise for CRA auditors.

Stepping outside the hypothetical example scenarios used by CRA for illustration, judgement in most real-life situations on whether an activity is “experimental production”, “commercial production” or “experimental development”, proves to be very complicated and highly subjective. This is also true for what is considered “baseline” activity and what is “incremental” activity, especially in multi-year development of complex production systems. Not surprisingly, there are signs across Canada that different CRA auditors do not apply this policy with much consistency. Taxpayers conducting similar experiments have found widely different amounts of tax credits issued to them.

The long-term impact of this policy change may take many years to be known. The short-term impact can be felt right now. Industries where technological advancement commonly takes place in continuous shop-floor process improvement are seeing their tax credits sharply reduced. Innovation that aims to reduce production costs, particularly, will receive little tax incentive. Will the policy change slow down these types of innovation? Likely. Is this the intent of the policy change? Hopefully not. Is the new policy supported by the law? Questionable. Does the policy change serve Canada’s innovation strategy? No.

Derek Wong (derek.c.wong@ca.pwc.com) is a senior manager in the SR&ED Group of PricewaterhouseCoopers LLP.