Not all Research and Development is Treated Equally When it Comes to Tax Deductions

written on behalf of Feigenbaum Law

It’s completely natural for a business to look for ways to lower its tax burden while staying within the boundaries of the law. That’s why a well-thought-out approach to corporate tax planning and compliance is necessary for businesses looking to reduce the amount of taxes they have to pay. Making sure that such planning is in compliance with the law is one of the best ways to avoid unwanted tax litigation. A recent decision from the Tax Court of Canada shows that while it might seem that certain tax deductions are available to a business, the nuance of what is necessary to be able to claim a deduction might lead to a different conclusion.

Company claims research and development costs

The appellant in the decision (“the appellant”) operates a business that manufactures concrete, including concrete countertops. During the course of their business, they decided they wanted to manufacture concrete slabs that were transportable, which required a reduction in thickness. In doing so, they also needed to ensure there would be no warping of fractures in the concrete, and that their strength would be equal to or greater than traditional concrete while maintaining an equal quality of finish.

In trying to produce these new panels, the appellant encountered what was described as “technical uncertainties” related to the proportions of ingredients to be used as well as chemical additives and fibres related to the finish. They experimented with different formulations and when filing their taxes in 2015, claimed $63,134 in costs for scientific research and experimental development (“SRED”). They also claimed $23,8222 as an investment tax credit. These claims were denied by the Canada Revenue Agency (the “CRA”)

What is the legal definition of scientific research and development?

The Income Tax Act contains a definition of SRED, stating that basic and applied research undertaken for the advancement of scientific knowledge with a practical application qualifies, as does experimental development taken for the purpose of achieving technological advancement such as the improvement of materials.

In terms of whether specific work can qualify, the court issued a decision in 1998, which outlines five criteria needed to determine if work constituted SRDE. The factors ask:

1. Was there scientific or technical uncertainty?
2. Was there a hypothesis being tested?
3. Was the scientific method followed?
4. Did the work result in technological or scientific advancement?
5. Were there detailed records of the SRED?

The court began its analysis by applying the appellant’s work to these factors. After first hearing about how the appellant went about its research (largely through trial and error of different mixtures), the court looked at the first factor and determined that making a thinner, yet equally strong concrete slab was not a matter of scientific or technical uncertainty. Instead, their research only applied to difficulties encountered along the way. In short, the appellant knew what they were aiming for could be made, it was just a matter of how. The court wrote that doubt concerning the way in which an objective will be achieved does not meet the standard required if the procedures and data are generally accessible.

The court turned to the second factor, which asked whether the approach tested a hypothesis, which comes with its own steps, which are:

(a) the observation of the subject matter of the problem;

(b) the formulation of a clear objective;

(c) the identification and articulation of the technological uncertainty;

(d) the formulation of a hypothesis or hypotheses designed to reduce or eliminate the uncertainty; and

(e) the methodical and systematic testing of the hypotheses.

The evidence presented to the court found that the appellant did not conduct any systematic testing of the technical problems it encountered. Instead, the appellant tried various approaches but did not undertake systematic testing.

The court then asked whether the appellant followed the scientific method, which requires there to be trained and systematic observation, measurement, testing, and more. The appellant’s trial and error approach to testing fell outside of what is necessary to qualify as following the scientific method.

The fourth stage of the test asked whether there was any technological or scientific advancement made through the appellant’s work. The court found that while the appellant succeeded in developing the product they set out to make, including the desired strength and characteristics of the product, they did so by using known technologies to solve problems they ran into. Therefore, no technological or scientific advancement was found to have occurred.

Finally, the court pointed out that the documentation filed by the appellants was “clearly insufficient.” While the appellant said this was due to budgetary constraints, the court was not satisfied that this requirement had been met.

After failing to meet any of the required criteria, the court found that the activities carried out by the appellant did not constitute SRED in the context of tax law.

Contact Feigenbaum Consulting in Toronto for guidance on your business’s tax obligations

The decision serves as a good example that while certain expenses might seem to qualify for tax breaks, it is important to consider whether the legal requirements to qualify have been met. This often means looking past the ordinary meaning of a term such as “research and development” and into how terms are defined by both lawmakers as well as courts. That’s why our team, led by Mark Feigenbaum, helps individuals and businesses with tax planning and compliance. We help our clients do all they can to qualify for a reduction in taxes while avoiding the costly and time-consuming experience of having to dispute these claims with the CRA.

Feigenbaum Consulting’s extensive experience in both US and Canadian tax law puts us in a unique position to assist clients who are looking to expand into the United States or Canada, as well as those who already have done so and want to ensure they are using the best practices for their tax compliance. Contact us online or toll-free by phone at 877-275-4792 to discuss how we can assist you.