Application Policy

NUMBER - SR&ED 2000-01
DATE - March 1, 2000
SUBJECT - Cost of materials for SR&ED

Issue

The purpose of this application policy is to outline the CCRA's position with respect to the "cost of materials consumed or transformed" when administering the Scientific Research and Experimental Development (SR&ED) legislation under the Income Tax Act (Act) and the Income Tax Regulations (Regulations).

General comments

For taxpayers using the traditional method, subclauses 37(8)(a)(ii)(A)(I) and (II) of the Act provide that an expenditure of a current nature which is all or substantially all attributable to the prosecution of SR&ED or which is directly attributable to such prosecution constitutes an expenditure on or in respect of SR&ED. For the purpose of the directly attributable rules, paragraph 2900(2)(a) of the Regulations is being amended to provide that an expenditure directly attributable to the prosecution of SR&ED includes the "cost of materials consumed or transformed" in such prosecution. This amendment to paragraph 2900(2)(a) of the Regulations applies to costs incurred after February 23, 1998.

For taxpayers using the proxy method, subclause 37(8)(a)(ii)(B)(V) of the Act provides that the "cost of materials consumed" in the prosecution of SR&ED in Canada constitutes an expenditure on or in respect of SR&ED. Since only items that meet the definition of "materials" and "consumed" could be claimed, it is very important to have a definition for these words.

The Act does not define the expression "cost of materials consumed" or the words "cost", "materials", "consumed" and "transformed". We, therefore, believe that these words must be given their ordinary meaning, taking into account the overall context of the text in which they are used so that the interpretation adopted is consistent with the spirit of the Act and the legislator's intent.

The word "cost"

What meaning should be attributed to the word "cost" for the purposes of subclause 37(8)(a)(ii)(B)(V) of the Act and paragraph 2900(2)(a) of the Regulations?

In the case of merchandise purchased for resale or specifically for SR&ED, or raw materials acquired for a manufacturing process or specifically for SR&ED, cost means laid-down cost. This includes invoice cost, custom and excise duties, transportation and other acquisition costs, and when they are significant, storage costs.

In the case of inventories of goods manufactured by the taxpayer for its commercial operations or specifically for SR&ED purposes, we are of the opinion that the word "cost" can be construed as the production cost or the industrial cost price of a product. It would include the laid-down cost of materials plus the costs of direct labour applied to the product and the applicable share of overhead expense properly chargeable to production. For more details refer to Interpretation Bulletin IT-473 under the section "meaning of cost". Note that the cost of materials for SR&ED purposes will be the same whether the taxpayer uses the traditional or the proxy method; production overhead expenses should not be excluded from the cost of producing the material if the taxpayer uses the proxy method. See example 1 below.

The word "materials"

We are of the opinion that the word "materials" used in subclause 37(8)(a)(ii)(B)(V) of the Act and paragraph 2900(2)(a) of the Regulations 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 applying this definition, the CCRA will consider whether an item composes the body of a thing in the overall SR&ED process rather than restricting the definition to only the new or improved materials, devices, products or processes being developed. See examples below.

We are of the view that energy sources directly related to the prosecution of SR&ED (fuel, electricity, oil, etc.) are generally not materials, as they are not items composing the body of a thing at some point in time in the SR&ED process. Costs related to these energy sources are overhead expenditures.

We consider that certain items which may be used in the SR&ED process are not materials, including, for example, cleaning products, floppy diskettes and CD's used in computers, and test tubes, petri dishes and pipettes used in biotechnology. These items do not compose the body of a thing at a given moment in the SR&ED process.

In the case of animals and growing things (e.g., plants) used in a SR&ED project, we consider that they are "materials" if they compose the body of a thing at a given moment in the SR&ED process. For example, this would be the case for animals required for testing purposes. This is a question of fact that relates to the scientific aspect of the project. See examples 3 and 5 below.

Where animals or growing things used in a SR&ED project are considered to be materials, the animal feed, plant fertilizer, pesticides, herbicides, and fungicides should also be considered to be materials. The costs incurred for such items would be deductible as "cost of materials consumed" in the prosecution of SR&ED.

The word "consumed"

The ordinary meaning of the word "consumed" is "absorbed, used up or broken down into small pieces". Consumed in the prosecution of SR&ED basically means that the material was destroyed or rendered virtually valueless as a result of the SR&ED.

Materials in inventory or that form part of a custom product or a commercial asset are not consumed in SR&ED. In the case of experimental production sold, the materials used in that production would not have been consumed in the prosecution of SR&ED.

Certain laboratory items, such as liquid chemicals, enzymes and growth media, that are used in the prosecution of SR&ED, could be "materials consumed" if they are what a thing is made of at some point in the SR&ED process.

The cost of materials consumed in the prosecution of SR&ED is an allowable SR&ED expenditure under both the proxy and the traditional methods. If the materials are consumed 90% or more in SR&ED, the entire cost of materials is an allowable SR&ED expenditure.

The word "transformed"

The meaning of transformed was explained in the Supplementary information to the February 24, 1998 Budget:

The cost of materials used in SR&ED does not generally qualify for the SR&ED tax incentives unless it is consumed in the course of performing the SR&ED. At the outset of an SR&ED project, a taxpayer may not know whether materials used in a project will be consumed or will instead be incorporated into a product that has some value either to the taxpayer or to another party.

Once amended, paragraph 2900(2)(a) of the Regulations will include the cost of materials transformed in the prosecution of SR&ED. The paragraph will refer to "the cost of materials consumed or transformed in the prosecution of SR&ED". We are of the view that this amendment makes it clear that, generally speaking, materials that are transformed into a product are not materials that are consumed in SR&ED.

The tax treatment of costs incurred after February 23, 1998 in respect of materials transformed into a product in the course of performing SR&ED is as follows:

• The cost of materials transformed is an allowable SR&ED expenditure, but only if the taxpayer uses the traditional method and if the expenditure is all or substantially all attributable, or directly attributable, to the SR&ED.
• where, however, the product of the SR&ED project is sold or converted to commercial use after February 23, 1998, there will be a recapture of ITC (as an addition to the taxpayer's Part I tax payable for the year). The ITC recapture rules are covered in subsections 127(27) to 35 of the Act and will be the subject of a separate application policy.

Example 1

Two companies ("Company A" and "Company B") each operate a business in Canada and pursue SR&ED activities in Canada. Each of these companies is conducting an SR&ED project to develop a process for printing cardboard boxes, and both companies, therefore, need cardboard boxes to run printing tests. Once these tests are completed, the cardboard boxes are destroyed because they have no resale value.

Company A manufactures the cardboard boxes itself. The unit cost price for an unprinted cardboard box is $1.00, comprising $0.50 for raw materials, $0.30 for labour, and $0.20 for overhead. Company B purchases the cardboard boxes from another company, at a unit price of $1.20. Both companies use the proxy method.

Do the cardboard boxes used to run the printing tests constitute materials? More generally, can a taxpayer have expenditures for "materials" when the purpose of the taxpayer's research project is to develop a new process or improve an existing one?

Since the cardboard boxes are destroyed after the tests are completed, we believe that they are consumed. Thus all that remains to be determined is whether these boxes constitute "materials" for the purposes of subclause. subclause 37(8)(a)(ii)(B)(V) of the Act.

To constitute materials within the meaning of subclause 37(8)(a)(ii)(B)(V) of the Act, the cardboard boxes must be either raw materials, substances, or other items that compose the body of a thing at a given moment in the SR&ED process. We believe that the boxes used for the printing tests do in fact constitute the body of a thing in the overall SR&ED process, because they constitute the body of the printed boxes. In other words, the cardboard boxes that serve as inputs to the printing process constitute the body of the cardboard boxes that have gone through the printing process.

Note: under a strict interpretation of the word "materials" it could also be argued that the cardboard boxes used to perform the tests do not constitute materials within the meaning of subclause 37(8)a)(ii)(B)(V) of the Act, because they do not compose the body of a thing within the printing process and they are not raw materials or substances used to do printing. However, considering that section 37 of the Act is designed as a tax-relief measure, our policy is as described above.

The cost under subclause 37(8)(a)(ii)(B)(V) of the Act would be $1.00 for Company A and $1.20 for Company B. Note that the production overhead expenses of $0.20/box for Company A is not excluded from the cost of producing the material even if the taxpayer uses the proxy method.

Example 2

A taxpayer develops a new chemical for treating wood. Does the wood used to test this chemical constitute materials?

As in Example 1, we believe that the wood used for the tests does in fact constitute the body of a thing in the overall SR&ED process because once the wood has been treated with the chemical, the wood composes part of the thing.

Similarly it could be argued, under a strict interpretation, that the wood used to perform the tests does not constitute materials in the sense of subclause 37(8)(a)(ii)(B)(V) of the Act because the wood does not constitute the body of a thing within the chemical being developed, which is the subject of the SR&ED project. However, in considering the overall SR&ED process, the wood will be allowed as "materials" because it is required for testing purposes.

The wood will be considered consumed in the prosecution of SR&ED if it was destroyed or rendered virtually valueless as a result of the SR&ED. Otherwise it will be considered transformed in the prosecution of SR&ED and therefore, eligible only under the traditional method.

Example 3

A taxpayer has developed an improved hormone to increase growth in cattle. The taxpayer used cattle for testing purposes. The animals were sold at the end of the SR&ED project for the usual sale proceeds for such animals. Are the costs incurred to acquire the cattle for testing purposes and the costs of the regular feed allowable SR&ED expenditures?

We are of the opinion that the cattle used for the testing could be considered as materials in the overall SR&ED process. Similarly, the regular feed is considered also to be materials. Given that the feed would certainly be "consumed" when used, it would qualify as materials consumed in SR&ED.

Since the animals were sold at the end of the SR&ED project, they were not consumed in the prosecution of SR&ED. Consequently the cost of the cattle is not an allowable SR&ED expenditure under the proxy method.

Under the traditional method the cost of the cattle are allowable as "cost of materials transformed". However, there will be a recapture of ITC when the cattle are sold.

Example 4

A textile manufacturer is modifying an advanced weaving machine to increase the rate of production by 50%. A series of test production runs are required to assist in the resolution of the technological problems involved with these modifications. The test production runs produce fabric of poor quality which is sold to a customer for 50% of the usual sale price.

To be "materials" the yarn used for the tests must constitute the body of a thing at a given moment in the SR&ED process. In the example, there are two "things". The first one is the new advanced machine. The second one is the fabric resulting from the testing, which is a support activity to the SR&ED project. We are of the opinion that the yarn constitutes the body of a thing (the fabric, an experimental product) during the experimental process.

The cost of the yarn cannot be claimed under the proxy method, as the materials are not consumed. It can be claimed under the traditional method as cost of materials transformed, if there is no excess quantity.

The new ITC recapture rules will apply when the fabric is sold, if the taxpayer uses the traditional method.

Example 5

A corporation is involved in an SR&ED project, the purpose of which is the creation of a genetically altered canola seed, the plant from which it is hoped will be resistant to certain varieties of parasites. The SR&ED process involves the lab activities necessary to evolve a series of these genetically altered seeds. Once these seeds are evolved, they are then tested through outdoor field planting trials to determine their resistance to these parasites.

The following items were used in the SR&ED project:

1. Used in the lab:

A) Petrie dishes, beakers, microscopes, incubators, flasks, bunsen burners, pipettes, measuring appliances, etc.
B) Utilities: gas, propane, electricity, etc.
C) Seed and plant chemicals.

2. Used in the field:

A) Growth hormones, and other chemicals
B) Fertilizers, pesticides and herbicides

To constitute "materials" the items must compose the body of a thing at a given moment in the SR&ED process. Of the above noted items, items 1C), 2A) and 2B) would qualify as materials under our definition.

Addendum - Water and Energy Sources as Materials

Norine Heselton
Director General
SR&ED Directorate

Issued by: Financial Legislative Application Section