CRA Policy Review – SR&ED while Developing an Asset Policy
The numerous and detailed Scientific Research and Experimental Development (SR&ED) related policies can be overwhelming. In an effort to make the inner workings of the SR&ED program more understandable, we have examined some of these policies and summarized them for our readers. This summary pertains to the SR&ED while Developing an Asset Policy.
SR&ED in the Development of a New Asset
The SR&ED while Developing an Asset Policy examines the development of a new asset when there may be SR&ED work involved. An asset can be a material, device, product, or process facility. In a commercial environment the development (design, construction, and testing) of an asset may include SR&ED, however, if an asset is developed through, or is being used for SR&ED, it does not mean that all of the work qualifies for SR&ED tax incentives. It may involve SR&ED work, a mixture of SR&ED and commercial work, or only commercial work.
To apportion the costs of developing the asset between SR&ED work and non-SR&ED work it must be established whether or not there is SR&ED. Please refer to the Guidelines on the Eligibility of Work for SR&ED Tax Incentives Policy to determine this.
Only after SR&ED has been confirmed can you proceed by determining the type of asset which has been developed and how the associated costs may or may not be claimed for SR&ED investment tax credits (ITC). In the context of SR&ED, an asset type can be a:
- “pilot plant;
- commercial plant;
- prototype; or
- custom product / commercial asset.”1
Pilot Plants
In the context of SR&ED, the CRA defines a pilot plant as:
a production facility that is developed for the primary purpose of carrying out SR&ED during its useful life. It is used solely for its technical or experimental content and not for the purpose of commercial operations.2
A pilot plant is sized taking into consideration the SR&ED to be conducted in/on it and is typically isolated from normal business operations. It may be used to study the behaviour of certain raw materials, develop an economically viable manufacturing process, modify equipment for new applications, test unproven equipment, test new conditions, produce samples for research, or determine environmental effects.
Expenditures applicable to pilot plants
Any expenses which are incurred for the development and operation of the pilot plant qualify for SR&ED tax incentives. However, the capital costs for the acquisition/construction of the pilot plant do not qualify for federal SR&ED tax incentives (it might be eligible for the provincial portion in Quebec starting March 25, 2025, see our latest article Québec’s New Provincial R&D Tax Credits: Here’s What Businesses Need to Know). Allowable SR&ED expenditures incurred for salary or wages, overhead and other expenditures, SR&ED contracts, and materials for SR&ED for the development of a pilot plant retain their nature and are considered to be SR&ED expenditures of a current nature.3
Commercial Plants
The policy defines commercial plants as:
production facilities used for commercial (or other non-SR&ED) purposes. Although new plants may sometimes be built or existing commercial plants may be modified to test and demonstrate new processes, these plants are generally not “pilot plants” as their intended purpose and actual use is commercial.4
When considering SR&ED expenditures related to work completed in a commercial plant the segregation of SR&ED work from the non-SR&ED work is crucial. The work and related expenditures that would be associated with the development of a commercial plant, will not qualify for the SR&ED tax incentives when the technology used already existed.
Expenditures applicable to commercial plants
The SR&ED while Developing an Asset Policy states that expenditures of a current nature that will qualify for the SR&ED tax incentive, when a commercial plant is being developed, include the following:
- “labour used, materials consumed, and materials transformed to resolve technological uncertainties of developing the commercial plant in an attempt to achieve technological advancement; and
- labour used, materials consumed, and materials transformed to resolve the technological uncertainties of developing equipment to incorporate in the commercial plant in an attempt to achieve technological advancement.”5
Expenditures of a capital nature are those expenditures that result in the acquisition of capital property, which is depreciable property or property that would result in a gain or loss if disposed of.6 Expenditures of a capital nature, such as equipment, do not qualify for federal SR&ED tax incentives (it might be eligible for the provincial portion in Quebec starting March 25, 2025, see our latest article Québec’s New Provincial R&D Tax Credits: Here’s What Businesses Need to Know).
Prototypes
The 3rd kind of asset listed in the SR&ED while Developing an Asset Policy is prototypes.
A prototype is an original model on which something new is patterned and of which all things of the same type are representations or copies. It is a basic experimental model that possesses the essential characteristics of the intended product. A prototype is normally understood to be a trial model or preliminary version. It is developed to test the feasibility of a concept or hypothesis within a systematic investigation or search and generally has no lasting value.7
A prototype is not developed for the purpose of sale or its subsequent use in the business. If the asset is sold or converted to use in business operations, it is the purpose for which the asset was constructed that will determine whether it will be treated as a prototype or as a custom product or commercial asset.
Expenditures applicable to prototypes
Expenditures used in developing a prototype will qualify for SR&ED tax incentives. Including those relating to the labour and the materials used. These expenditures made in the development (design, construction, and testing) of a prototype are considered expenditures of a current nature and are attributable to the prosecution of SR&ED.8
In some situations, several different versions of a prototype may be developed in an attempt to improve on the previous version. In these cases, each new version of the prototype utilizes the knowledge gained from the previous version, and the expenditures associated with the identified SR&ED work will be treated as SR&ED eligible expenditures. In contrast, the construction of several duplicate copies of a prototype in order to meet a need, or to establish an inventory after successful testing of the original prototype, is not SR&ED.9
Sale of a prototype – de minimis rule
If the prototype is sold after construction the sales and costs incurred will be subject to ITC recapture. For the complete rules surrounding ITC recapture read the Recapture of SR&ED Investment Tax Credit Policy. In the case of ‘scrap’ sales these rules do not apply, this is known as the de minimis rule:
When the proceeds from the sale of a prototype are nominal (less than 10% of the construction costs of the prototype), the sale is considered to be a sale of scrap materials. The proceeds will be included in income for tax purposes.10
If the prototype is sold after construction for above the de minimis rule, those costs will be associated with any non-SR&ED work performed in its development and cannot be claimed for SR&ED purposes. In this case, it is not a prototype but a custom product or commercial asset.
Custom product / Commercial asset
A custom product or commercial asset refers to an asset developed for business purposes. In some cases, the development of a custom product or commercial asset may require SR&ED work that is carried out in conjunction or simultaneously with non-SR&ED work. The SR&ED while Developing an Asset Policy defines custom products or commercial assets as:
When that purpose is to sell the asset, it is a custom product. A custom product is constructed to meet customer specifications or market-driven technical requirements. When that purpose is to use the asset within the business, it is a commercial asset. A commercial asset is constructed to meet business requirements.11
Expenditures applicable to custom products and commercial assets
When determining the allowable SR&ED expenditures for projects involving the development of a custom product or a commercial asset, the SR&ED work and the non-SR&ED work must be clearly identified and the project costs allocated between these activities. To be allowable the costs must meet the expenditure rules, and it is encouraged that an allocation method is used and clearly documented. The use of an allocation method in determining the costs will generally be acceptable to the CRA, as long as there is supporting information to establish the reasonableness of the method and the amounts claimed.12. For more information on the best way to implement an allocation method please see our previous article What is the Allocation Method and When is it Appropriate in SR&ED?
As it can be very difficult to apportion expenses between SR&ED and non-SR&ED work, the CRA has an alternative approach in place which can be used to provide an estimate of the overall amount of incremental costs incurred as a result of SR&ED work. There are strict conditions under which the alternative approach may be used to apportion the expenses. These conditions include:
- “it is impossible to isolate the SR&ED work (that is, neither the claimant nor the CRA can isolate the work);
- the CRA agrees to the use of this approach, meaning it is of the opinion that it is appropriate to use such an approach in the context (for example, only a portion of the work can be isolated); and
- the claimant agrees with the use of this approach and has signed a waiver of the right to object or appeal under the subsection 169(2.2) of the Act (this is because this approach is not founded in law and is only allowed on an administrative basis).”13
Conclusion
When an asset is developed and SR&ED work is completed the related expenses may be claimed for SR&ED ITCs, however, it is important to properly allocate the SR&ED and non-SR&ED work and identify any subsequent use or sale of the asset that was developed. The ITC recapture rules will apply to recapture the ITC or a portion of the ITC earned relative to the costs of the materials transformed in SR&ED, in the year the product is sold or converted to commercial use. Please see the policy in its entirety on the Government of Canada website at SR&ED while Developing an Asset Policy, or listen to our recording of the policy: SR&ED While Developing an Asset Policy – Recording to ensure that you are claiming all eligible expenditures. Please consult with your SR&ED consultant or tax advisor should you have any questions specific to your asset development.