Application Policy

NUMBER	SR&ED 96-10
DATE	October 15, 1996
SUBJECT	Third Party Payments - Approval Process

Issues

This Application Policy paper discusses payments for scientific research and experimental development (SR&ED) to certain entities under subparagraph 37(1)(a)(ii) of the Income Tax Act (the Act), i.e. "third party payments".

This paper provides guidance on the "approval" process for certain entities who wish to obtain approved status under the Act.

Application Policy 96-04 entitled "Payments to Third Parties for SR&ED" clarifies the tests for third party payments, e.g. "entitled to exploit", "related to a business".

This paper also distinguishes between "contract payments" and payments to third parties for SR&ED. Application Policy 94-04 provides additional criteria to assist in the determination of whether or not an amount is a contract payment.

Background

Under the Act, a taxpayer is permitted to make payments to be used for SR&ED to certain entities. The key difference between third party payments and contract SR&ED is the degree of control the payer has over the SR&ED being performed.

In a contract situation, the SR&ED services are performed directly for the payer who obtains the rights to the SR&ED. The entitlement to the SR&ED tax incentive occurs at the time the SR&ED is performed.

In comparison, a third party payment allows the payer to obtain entitlement only to the results of the SR&ED. Control over the SR&ED activities is relinquished to the performer. Furthermore, unlike contract SR&ED, these payments generally become eligible for the SR&ED tax incentive at the time the payment is made rather than at the time the SR&ED is performed.

Policy

"Third party payments", in the context of this policy, refers to payments for SR&ED not directly undertaken by or on behalf of the taxpayer, i.e. payments described in new subparagraph 37(1)(a)(i.1), and subparagraphs 37(1)(a)(ii) and (iii) of the Act.

Payments to a corporation

Under subparagraph 37(1)(a)(i.1), a payment will be recognized as eligible SR&ED where it is paid to a corporation resident in Canada to be used for SR&ED. The SR&ED must be related to a business of a taxpayer and the taxpayer must be entitled to exploit the results of the SR&ED. For payments made after 1995, the eligibility of the tax incentive may be otherwise available only in the year in which the SR&ED is performed rather than at the time of payment. Prior approval is not required from the Income Tax Rulings and Interpretations Directorate for this type of entity; a corporation must simply be resident in Canada. However, the Canadian resident corporation must be able to carry on SR&ED on an ongoing basis.

Payments to subparagraph 37(1)(a)(ii) Entities

Under subparagraph 37(i)(a)(ii) a taxpayer can qualify for the SR&ED tax incentive by making a payment to any one of the following entities which carry on SR&ED activities in Canada:

1. an approved association that undertakes SR&ED;
2. an approved university, college, research institute or other similar institution;
3. a corporation resident in Canada and exempt from tax under paragraph 149(1)(j) (non-profit corporation for SR&ED);
4. an approved organization that makes payments to an association, institution or corporation described in any of A) to C) above.

All entities listed in (A) and (B) above, other than Canadian universities and affiliated colleges, must receive written approval from the Minister through the Policy and Legislation Branch. To be considered "approved" for the purposes of subsection 37(7) of the Act, entities should write to:

Policy and Legislation Branch

Income Tax Rulings
and Interpretations Directorate
Revenue Canada
Ottawa, Ontario
K1A 0L5

It is possible that the Department has in the past accepted some third party payments based on a cursory review of the information on the schedule taxpayers file with their T661 form, and/or knowledge of the performer's SR&ED work, without further verification of the entity's adherence to the approval requirements in the legislation. Enhanced review procedures will be effective from the date of the release of this Application Policy paper; as a result, all third party payments claimed must meet the criteria in the legislation. For example, if a payment is made to an organization that needs to be "approved", then third party payments will not be deductible unless the organization is, in fact, "approved". In the event that a payment does not meet the criteria of subparagraph 37(1)(a)(ii), the claimant will be notified of the deficiency.

The claimant will also be notified that a claim for the subsequent period for the same third party payment recipient will be disallowed unless the third party comes forward for formal approval as outlined in this policy or meets other criteria which would otherwise allow payments to be legislatively acceptable.

The requirements to be satisfied by each of the above entities are outlined below.

1. Approved Associations or Research Institutes

For the purpose of clauses 37(1)(a)(ii)(A) and (B), an association, research institute or other similar institution must be "approved". In order for any entity to become an "approved association", it must meet the criteria of a non-profit organization. In addition, to be considered for "approved" status by the Income Tax Rulings and Interpretations Directorate, an association, research institute or other similar institution, must be able to show that it meets all of the following requirements:

1. the entity must have the facilities, equipment and personnel capable of carrying out SR&ED as defined in the Act;
2. the entity must carry on only activities that are unquestionably SR&ED;
3. in order to satisfy the requirements for non-profit status, there must be no personal benefits to members, no control of other associations, satisfactory provisions for the distribution of assets upon dissolution, etc.;
4. the general public must be a beneficiary of the results of any successful research; and
5. the funding of the association or research institute must be sufficient to ensure ongoing SR&ED.

The written request to Rulings would also have to include, in addition to the information submitted to show that the above requirements are met, copies of the following documentation relating to the association or research institute and its activities:

1. copies of the entity's charter, code of ethics, letters patent or bylaws indicating that the association or research institute satisfies all requirements in clauses 37(1)(a)(ii)(A) and (B) of the Act and the post-amble thereto, as well as how its property will be distributed in the event of a wind-up;
2. detailed description of the entity's arrangements for obtaining funds;
3. detailed description of the entity's arrangements for disbursing funds;
4. financial statements for prior years (if any); and
5. details of the research activities to be carried out by the association or research institute in the future and evidence that it has the staff, equipment and facilities to carry out such activities.

2. Approved Universities and Colleges

For the purpose of clause 37(1)(a)(ii)(B), and according to Revenue Canada's policy outlined in paragraph 11 of IT 151-R4, all Canadian universities and affiliated colleges are considered to be "approved".

3. Paragraph 149(1)(j) Corporation

For the purpose of paragraph 149(1)(j) of the Act, the following criteria must be met by a corporation so that it may be considered a non-profit corporation for SR&ED in a particular fiscal period:

1. The corporation's activities must be carried on without the purpose of gain for its members and any profits or other accretions shall be used in promoting its objects. No part of the income may be payable to or otherwise available for the personal benefit of any member thereof.
2. The directors and members including any director or member who also serves as an officer, shall serve in that capacity without remuneration. No director, member or officer shall directly or indirectly receive any profit from his/her position as director, member or officer, however, it is permitted that a director or officer may be reimbursed for reasonable expenses incurred by him/her in the performance of his/her duties.
3. The corporation must not acquire control of any other corporation nor will it carry on any business as that term is used in the Act.
4. The objects of the corporation must be to exclusively carry on and/or promote SR&ED. The SR&ED activity may be directly undertaken by or on behalf of the corporation or by an entity described in clauses 37(1)(a)(ii)(A) or (B) of the Act.
5. The amounts to be expended in Canada on SR&ED must not be less than 90% of the corporation's income for the period.

The determination of whether a corporation will qualify under paragraph 149(1)(j) of the Act is a question of fact.

The determination can only be made by the Taxation Services Office once the corporation's income tax return for a particular fiscal period is filed and the activities of the corporation are reviewed.

4. Approved Organization That Makes Payments to 1., 2., and 3, above

Providing that the work undertaken falls within the definition of SR&ED as described in regulation 2900, for the purpose of clause 37(1)(a)(ii)(E) and according to Revenue Canada's policy as outlined in paragraph 11 of IT 151-R4, an "approved organization" will include the three granting councils, i.e. National Sciences and Engineering Research Council, Medical Research Council, and Social Sciences and Humanities Research Council.

Payments for basic or applied research to 149(1)(J) corporations

Subparagraph 37(1)(a)(iii) third party payments are limited to payments for basic or applied research which may have applications to other types of businesses unrelated to the business of the taxpayer.

Payments for this type of research must be made by a corporation to a corporation exempt from tax under paragraph 149(1)(j) of the Act. The intent of this legislation is to allow the formation of consortia to carry out broadly based pre-competitive research that would have applications in more than one type of business.

Director
Specialized Compliance Enhancement Division

Issued by: Tax Incentive Audit Section and Scientific Research Section.