SR&ED During a Production Run

SR&ED During a Production Run

We are often asked by clients, “Can you make a scientific research and experimental development (SR&ED) claim if you end up selling the product?” and “Can you claim any other costs for the time when there is no way to test without making a product?” Both of these questions fall under the policy SR&ED During a Production Run. This post will explain the different ways you can claim SR&ED investment tax credits (ITCs) during a production run.

SR&ED During a Production Run

The answer is, Yes! There are two different scenarios: experimental development (ED) + experimental production (EP) OR experimental development (ED) + commercial production (CP). The context, or why the production run is carried out, is an important factor to determine how the expenditures may be classified.

Experimental production (EP) is defined in the SR&ED During a Production Run Policy as, “the production output of experimental development (ED) that is required to verify whether the objectives of the SR&ED work have been met or if a technological advancement is achievable.”1

Experimental development (ED) is defined in the SR&ED glossary as, “Experimental development is work undertaken for the purpose of achieving technological advancement for the purpose of creating new, or improving existing, materials, devices, products or processes, including incremental improvements thereto.”2

Experimental Development + Experimental Production (ED+EP)

We will look further at experimental development (ED) where the production output is experimental production (EP). The SR&ED During a Production Run Policy explains,

For example, the production run (and therefore the experimental production) may be necessary to establish technological advancements that are applicable in practice, to further resolve technological uncertainties, or to evaluate the SR&ED project.

Although this document focuses on production runs conducted in commercial facilities, the production output from the operation of a pilot plant is experimental production and, therefore, the context of the production run in a pilot plant is ED+EP.

When the context of the production run is ED+EP, there is no simultaneous commercial work occurring and the costs associated with the production may be allowable SR&ED expenditures. For more information on allowable SR&ED expenditures, please refer to the Pool of Deductible SR&ED Expenditures Policy.3

There are times when it is necessary to produce samples or prototypes to establish that the technological advancements are applicable in practice, resolve technological uncertainties, or evaluate your SR&ED project. In these cases, the production output is considered EP and the costs are allowable SR&ED expenditures if there is no simultaneous commercial work. We will look into cases when there is also commercial work later.

In some cases, production beyond what is required for SR&ED occurs and this is considered “excess production”. The SR&ED During Production Run Policy states, “When the context of the production run is ED+EP, only the amount of production output required for the SR&ED is the experimental production.”4

Experimental Development + Commercial Production (ED+CP)

There are times with SR&ED is part of production but the context is not ED+EP, instead, the production run is ED+CP (experimental development in conjunction or simultaneously with commercial production).  The SR&ED During Production Run Policy states:

For example, when SR&ED is conducted in an existing manufacturing or processing facility, it is generally carried out for process or product improvement while commercial operations are taking place. In this situation, while process indicators are being monitored, changes are made to the process in a way that minimizes the adverse effects on the quality of the output or stability of the process in order to continue with regular production. There is no technical risk to the product or process. Applying the concepts explained in this policy will lead to the determination that the context of the production run is not ED+EP.  In this scenario, even though there is SR&ED work being performed, because the context is not ED+EP, the context of the production run is ED+CP.

When the context of the production run is ED+CP, the costs must be apportioned between SR&ED and non‑SR&ED work. Costs attributable to commercial production are not allowable SR&ED expenditures.5

The subsequent sale of the production output does not determine if the context of the production run in ED+EP or ED+CP.  There are a variety of factors why the production output may or may not be sold.  If it is not sold, it does not mean that it is automatically experimental production.

How to determine your type of production run

In order to identify production runs that are part of experimental development work, the SR&ED should be clearly established first. In order to determine the extent of the SR&ED eligible work requires  identifying the specific production runs that are part of the experimental work including:

• determining that the production run is required for SR&ED;
• identifying the section of the commercial facility involved in those production runs;
• establishing a clear rationale for what part of the production line or process was involved in the SR&ED;
• identifying the duration of each production run (what period of time was required to evaluate or validate the SR&ED);
• identifying the personnel who performed the SR&ED; and
• identifying what materials were used in the SR&ED.6

By following this procedure, you are able to isolate SR&ED eligible work from excess production or other ineligible work. Determining ED+EP or ED+CP is an important piece of determining the extent of SR&ED and apportioning the costs between SR&ED eligible work and non-SR&ED eligible work.7

Once the production run has been identified as part of SR&ED eligible work, it is possible that ED includes multiple production runs where some are ED+EP and some are ED+CP. The context of the run must be examined and established for each production run.

How to determine experimental development work

If the requirements listed above are met, the production run is ED+EP, if they are not met it is ED+CP. According to the SR&ED During a Production Run Policy:

The context of the production run is ED+EP when there is a technical risk to the process or product, provided that the technical risk be attributable to the technological uncertainties. This technical risk arises mainly because of the need to test process parameters (including combinations thereof) outside normal established process, procedures, ranges and tolerances. Whether the technical risk to the process or product justifies the ED+EP determination is based on technical considerations (see section 2.2.1) and applicable evidence (see section 2.2.2).7

The policy also provides technical considerations used to establish technical risk to the process or product:

• The extent of the changes being undertaken is such that it is uncertain how
the experiment will impact the process or the manufactured product.
• The SR&ED involves a change to the process resulting in a potential change to the technical specifications of the product and / or there is a risk that the process itself may
become unstable leading to output inconsistencies, production interruptions and / or stoppages, or even equipment damage.
• The efficiency of a new process combination is uncertain. The SR&ED could result in yield losses, over and above normal yield losses. There is potential for a negative impact on the modified process.
• The characteristics of the new product and associated processes being studied are different from normal or existing products and their associated processes, i.e. the normal, established operating states, such that it is uncertain how the experiment will impact on the process or the product manufactured.7

Another aspect to consider when establishing the context of the production run is the available evidence. The evidence must support the reasoning for classifying the production run as ED+EP. The technical considerations used above should have corroborating evidence. Some examples of evidence are:

  • Experimental operation instructions and records prepared for the production run.
  • Meeting minutes or other sources of information to corroborate the planning and technical risk associated with the production run.
  • There was significant input and close monitoring of the work by technically qualified individuals (technical personnel or contractors).
  • There was design of specific experiments, and monitoring and analyzing test data from the production runs.
  • The experimental process introduced significant changes that affect the core of the regular production process.
  • Production quantities commensurate solely with the needs of the experimental development project were used at each stage (in contrast to what was normally produced).
  • The experimental development was performed on a dedicated experimental line, separate from the commercial system or on a production line borrowed solely for this purpose.
  • A smaller quantity than normal was produced.
  • There were large incremental SR&ED costs (based on the facts of the case).
  • The SR&ED costs were significant in terms of the overall standard costs of production.7

This list is not comprehensive or to be used as a checklist, for additional examples please see the SR&ED During Production Runs Policy. Each production run is unique and the evidence available will be as well. If the technical considerations and evidence do not support that the production run is ED+EP, then the production run is ED+CP.7

What SR&ED Expenditures are eligible during a production run?

There can be SR&ED eligible expenditures during a production run. A big consideration is that commercial costs attributable to CP are not eligible.7 The policy states:

When the context is ED+EP, for the cost incurred on experimental production (EP) to qualify as SR&ED expenditures the production run(s) or portion of production run(s) must be required for evaluating or validating the SR&ED project. When the production is not required it is referred to as excess production. Labour, overhead, and material costs relating to any excess production are not allowable SR&ED expenditures.7

The chart below explains which costs are eligible depending on the type of production run:7

ExpendituresED+EPED+CP
Salaries or wagesDirectly engaged in ED. Salaries related to EP or excluded activites are not eligible.
Non-specialized employees required for EP may be considered directly engaged.
Salaries related to excess production are excluded.
Directly engaged in ED. Salaries related to CP are not elgibile. Only excess costs associated with ED are eligible.
Non-specialized employees performing SR&ED may be directly engaged and eligible.
Costs of materials (consumed or transformed) Materials consumed in ED+EP are allowable SR&ED expenditures.
Materials transformed into the production output of ED+EP will be, attributable or in respect of SR&ED and is an eligible expenditure.
Materials transformed in excess production are not eligible.
Costs of input materials incurred before the start of the production run or SR&ED portion of the production run are attributable to CP, since no EP is carried on.
Only incremental costs of materials consumed or transformed because of ED ocurring are eligible.
Materials that would have been consumed or transformed in CP are not attributable to ED and not an allowable expenditure.
All costs of input materials incurred before the start of the production run or the SR&ED portion of the production run are attritbutable to CP.
Costs relating to the incremental loss of materials resulting from their processing may be claimed as cost of materials consumed in SR&ED, provided that the loss is reasonably attributable to the ED.
Overhead and other expenditures (traditional method only)Allowable under traditional method is costs are directly related and incremental to the prosecution of SR&ED.
Costs of overhead for EP is not allowable.
Allowable under traditional method is costs are directly related and incremental to the prosecution of SR&ED.
Costs of overhead for CP is not allowable.
ITC recaptureITC recapture rules apply to recapture all or a portion of the ITC relating to the cost of materials transformed if the production output is sold or converted to commercial use. Any proceeds from the sale of EP should not be taken into account when determining SR&ED expenditures attributable to experimental production.
ITC recapture rules do not apply in respect of SR&ED labour costs and overhead expenditures.
The ITC recapture rules apply to recapture all or a portion of the ITC relating to the cost of materials transformed when the commercial production is sold or converted to commercial use.
ITC recapture rules do not apply in respect of SR&ED labour costs and overhead expenditures.

Incremental cost for Experimental Development + Commercial Production (ED+CP)

There are times during ED+CP when it is difficult to separate SR&ED expenses from non-SR&ED expenses. There is an alternate approach that may be used that identifies an overall amount of incremental costs incurred as a result of SR&ED. This method may be used with either the Traditional or Proxy Method and it is not necessary to show that a specific expenditure meets the incremental test on its own with this approach.7 The policy states:

The overall amount of incremental costs may be calculated as the difference between the actual costs incurred for the ED+CP production run minus the standard production costs attributable to commercial production without experimental development. The standard commercial production costs are normally readily available and should be verifiable by CRA staff (the standard commercial production costs should not be substantially different from the actual costs of normal commercial production). The incremental costs are allowable Canada Revenue Agency SR&ED expenditures to the extent they are reasonably attributable to the experimental development.7

This method is beneficial when the organization has standard production costs for their commercial production. The incremental costs due to SR&ED are eligible expenditures as long as they are reasonably attributable to the experimental development. Records showing the standard production costs and incremental costs should be available should the CRA ask to view the documentation.

Conclusion

SR&ED can occur during production runs. There are different types of production runs and the type of production run must first be established to determine how expenditures may be classified. If you are conducting experimental development and experimental production or experimental development with commercial production, please review the applicable section of the SR&ED During a Production Run policy or our recording of the policy: SR&ED During Production Runs Policy – Recording to ensure that you are claiming all expenditures which are eligible. Please consult with your SR&ED consultant or tax advisor should you have any questions specific to your production run.

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Show 16 footnotes

  1. SR&ED Glossary. (2017, March 30). Canada Revenue Agency. https://www.canada.ca/en/revenue-agency/services/scientific-research-experimental-development-tax-incentive-program/glossary.html
  2. SR&ED Glossary. (2017, March 30). Canada Revenue Agency. https://www.canada.ca/en/revenue-agency/services/scientific-research-experimental-development-tax-incentive-program/glossary.html
  3. SR&ED During Production Runs Policy. (2016, July 19). Canada Revenue Agency. https://www.canada.ca/en/revenue-agency/services/scientific-research-experimental-development-tax-incentive-program/production-runs-policy-1.html

  4. SR&ED During Production Runs Policy. (2016, July 19). Canada Revenue Agency. https://www.canada.ca/en/revenue-agency/services/scientific-research-experimental-development-tax-incentive-program/production-runs-policy-1.html
  5. SR&ED During Production Runs Policy. (2016, July 19). Canada Revenue Agency. https://www.canada.ca/en/revenue-agency/services/scientific-research-experimental-development-tax-incentive-program/production-runs-policy-1.html
  6. Ibid.
  7. Ibid.
  8. Ibid.
  9. Ibid.
  10. Ibid.
  11. Ibid.
  12. Ibid.
  13. Ibid.
  14. Ibid.
  15. Ibid.
  16. Ibid.

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