Tax Court of Canada Rulings, SR&ED Rulings

The 5 Questions For SR&ED – Intent and Evolution

The Scientific Research and Experimental Development (SR&ED) program uses 5 questions to determine the eligibility of the work performed.  While it is important to know the Canada Revenue Agency (CRA) policies, it is also helpful to review the Tax Court of Canada’s original intent with the five questions.

The first ruling to introduce the 5-part test was Judge Bowman in Northwest Hydraulic Consultants v. The Queen (1998).  In Northwest Hydraulic Consultants v. The Queen (1998) the judge developed a 5-part test to determine SR&ED eligibility. Based on this five-part test, it was the opinion of the court that four of the five projects in 1994 qualified for SR&ED investment tax credits. This assessment was then expanded to all 17 projects submitted from 1983-1994.

The five questions Judge Bowman outlined have been referenced often by other judges: as of the time of writing, this ruling has been cited over 44 times in other court cases, the most recent of which was VLN Advanced Technologies Inc. v. The Queen. In 2012, this five-part test was formally added the Eligibility of Work for SR&ED Investment Tax Credits Policy. It was later refined in the 2015 revision to the same policy.

This article outlines the five questions as they first appeared in 1998, followed by the two revisions that appear in CRA policies (2012 / 2015). We then compare and contrast the differences between the text and the implications this may have for taxpayers seeking to access the SR&ED program.

Tax Court of Canada - Questions from Northwest Hydraulics Ruling (1998)
Original Policy Questions (2012)
Updated Policy Questions (2015)
1. Is there a technical risk or uncertainty?1. Was there a scientific or a technological uncertainty—an uncertainty that could not be removed by standard practice?1. Was there a scientific or a technological uncertainty?
2. Did the person claiming to be doing SR&ED formulate hypotheses specifically aimed at reducing or eliminating that technological uncertainty?2. Did the effort involve formulating hypotheses specifically aimed at reducing or eliminating that uncertainty?2. Did the effort involve formulating hypotheses specifically aimed at reducing or eliminating that uncertainty?
3. Did the procedures adopted accord with established and objective principles of scientific method, characterized by trained and systematic observation, measurement and experiment, and the formulation, testing, and modification of hypotheses?3. Was the adopted procedure consistent with the total discipline of the scientific method, including formulating, testing, and modifying the hypotheses?3. Was the overall approach adopted consistent with a systematic investigation or search, including formulating and testing the hypotheses by means of experiment or analysis?
4. Did the process result in a technological advance, that is to say, an advancement in the general understanding?4. Did the process result in a scientific or a technological advancement?4. Was the overall approach undertaken for the purpose of achieving a scientific or a technological advancement?
5. Was a detailed record of the hypotheses, test, and results kept as the work progressed?5. Was a record of the hypotheses tested and the results kept as the work progressed?5. Was a record of the hypotheses tested and the results kept as the work progressed?

The five questions currently used by the CRA to determine SR&ED eligibility have evolved since Northwest Hydraulic Consultants v. The Queen (1998).

To view the original sources, please visit:

What can we discern from reviewing the evolution of the terms? Quite a lot. We will review each of the questions individually and provide our commentary.

Question #1

Original: Is there a technical risk or uncertainty?

2012: Was there a scientific or a technological uncertainty—an uncertainty that could not be removed by standard practice?

In 2012, this was modified and broadened to “scientific or technological uncertainty” when it was added to the policies.

In particular, the switch from the term technical to technological is significant. The CRA uses the term technical in the context of technical problems which are defined as:

Technical problem:

“the existing scientific or technological knowledge base is sufficient to resolve the problem. Overcoming a technical problem will not lead to a technological advancement, although it may lead to the creation of a new or improved product or process.”1

Technological uncertainty:

“technological uncertainty means whether a given result or objective can be achieved or how to achieve it, is not known or determined on the basis of generally available scientific or technological knowledge or experience.”2

More information on technical versus technological can be found in our post Technical vs. Technological in SR&ED.

Further, in 2012 the CRA added “that could not be removed by standard practice” to the question. This stems from Northwest Hydraulic Consultants v. The Queen (1998), where the judge ruled that “routine engineering” did not qualify as SR&ED.  Judge Bowman stated:

“What is “routine engineering”? It is this question, (as well as that relating to technological advancement) that appears to have divided the experts more than any other. Briefly it describes techniques, procedures and data that are generally accessible to competent professionals in the field.”3

The term “standard practice” was used as a synonym of routine engineering.  This became a source of contention in many SR&ED applications, as the concept of “standard practice” was sufficiently broad such that it nullified the “uncertainty” of many projects. The CRA would argue that all work was “standard practice” if a known method was used, even if the subsequent analysis generated new results/information.  The original intent of the judge was to ensure that the purpose was to generate new information / knowledge that could not be generated without experimentation or analysis.

Judge Bowman states:

“The respondent’s position, ably articulated by Mr. Yaskowich, was essentially that the appellant, admittedly a world leader in the field of hydraulic model testing, by its own excellence sets the standard for what represents routine engineering or standard practice.

With respect I think that this sets an unrealistically high standard – indeed a standard of perfection that would discourage scientific research in Canada.

 It is quite true, as Mr. Yaskowich observes, that the work done by NHC does raise the client’s confidence in a solution that is proposed or devised, but I do not think that this fact in itself detracts from the nature of the activity, or makes it any the less SRED.”4

2015: Was there a scientific or a technological uncertainty?

Due to widespread complaints from taxpayers stating their projects were denied as they were “standard practice,” the text “– an uncertainty that could not be removed by standard practice” was removed from the policies in 2015.

For more information on uncertainties please refer to section 2.1.1 of the Eligibility of Work for SR&ED Investment Tax Credits Policy.

 

Question #2

Original: Did the person claiming to be doing SR&ED formulate hypotheses specifically aimed at reducing or eliminating that technological uncertainty?

Formulating a hypothesis is a vital part of an SR&ED project; failure to document what is being verified through experimentation (and the subsequent knowledge or information generated) can result in having the application disqualified.

The SR&ED Glossary defines a hypothesis as “an idea, consistent with known facts, that serves as a starting point for a further investigation to prove or disprove that idea.”5 Further, a well-developed hypothesis can help to answer Questions #3-5.

Judge Bowman outlined a five-step plan where Questions #3-5 are solved organically:

(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 an hypothesis or hypotheses designed to reduce                  or eliminate the uncertainty;

(e) the methodical and systematic testing of the hypotheses.6

For more information on how to formulate a hypothesis for SR&ED please see our article on What Is a Good Hypothesis for SR&ED Purposes?.

2012: Did the effort involve formulating hypotheses specifically aimed at reducing or eliminating that uncertainty?

In 2012, the question was shortened and given more clarity. The phrase “the person claiming to do SR&ED” was changed to “did the effort”, presumably many SR&ED projects are conducted by more than one person.  It was not altered in 2015.

Question #3

Original: Did the procedures adopted accord with established and objective principles of scientific method, characterized by trained and systematic observation, measurement and experiment, and the formulation, testing, and modification of hypotheses?

The judge stated his intent with question #3:

 It is important to recognize that although the above methodology describes the essential aspects of SRED, intuitive creativity and even genius may play a crucial role in the process for the purposes of the definition of SRED. These elements must however operate within the total discipline of the scientific method.”7

“What may appear routine and obvious after the event may not have been before the work was undertaken. What distinguishes routine activity from the methods required by the definition of SRED in section 2900 of the Regulations is not solely the adherence to systematic routines, but the adoption of the entire scientific method described above, with a view to removing a technological uncertainty through the formulation and testing of innovative and untested hypotheses.”8

2012: Was the adopted procedure consistent with the total discipline of the scientific method, including formulating, testing, and modifying the hypotheses?

In 2012, this question was dramatically simplified. Terms such as “accord with established and objective principles of scientific method” and “observation, measurement, and experiment” were all removed. The three words are crucial aspects of the scientific method and while it may have seemed redundant for the CRA to keep them in the question they provided guidance for the taxpayer in terms of the process the CRA expects them to follow. Instead, the focus was on the formulation, testing, and modification of hypotheses, not necessarily the overall process (“trained and systematic observation, measurement, and experiment”).

2015:

In 2015, the language was changed and softened, including the modification of “adopted procedure” to “overall approach adopted” and removal of the term “scientific method” in favour of “systematic investigation or search”.  The reference to modifying the hypothesis has also been removed.

The original version of Question #3 was clearer, although more limited in scope. It may be preferable to have kept the original definition, to avoid the confusion faced today.  By removing “scientific method” and “observation, measurement, and experiment” over the years, confusion sometimes arises over what method is most acceptable for experimentation and how to measure results. That said, the inclusion of the term “systematic investigation or search” better aligns with the definition for income tax purposes provided in subsection 248(1) of the Income Tax Act: “ʽscientific research and experimental developmentʼ means systematic investigation or search that is carried out in a field of science or technology by means of experiment or analysis […]”9

Question #4

Original: Did the process result in a technological advance, that is to say, an advancement in the general understanding?

Judge Bowman understood that the scientific community is large and diverse.  In Question #4 the judge implies that a “technological advance” is synonymous with “an advancement in the general understanding.”10  The judge also stated, “A technological advance in Canada does not cease to be one merely because there is a theoretical possibility that a researcher in, say, China, may have made the same advance but his or her work is not generally known.”11

Another vital part of the judge’s reasoning was identified as follows:

 “The rejection after testing of a hypothesis is nonetheless an advance in that it eliminates one hitherto untested hypothesis. Much scientific research involves doing just that. The fact that the initial objective is not achieved invalidates neither the hypothesis formed nor the methods used. On the contrary it is possible that the very failure reinforces the measure of the technological uncertainty.”12

2012: Did the process result in a scientific or a technological advancement?

In 2012, the phrase “advancement in the general understanding” was removed and the question was reworded to imply that a “scientific or technological advancement” was required.  The CRA went on to define advancement as follows:

“Scientific or technological advancement is the generation of information or the discovery of knowledge that advances the understanding of scientific relations or technology.”13

This implies that the claimant must be able to articulate the new information generated or knowledge discovered.  Put another way, it limited the scope of multi-year projects where 8-12 months may be required to set up an experiment but running the experiment or analyzing the results does not occur in the same period. In these multi-year scenarios, the work would not qualify as the claimant would not be able to demonstrate new information being generated or knowledge discovered. This posed an issue for taxpayers with multi-year or large/complex SR&ED projects.

2015: Was the overall approach undertaken for the purpose of achieving a scientific or a technological advancement?

In 2015 the question was modified to explicitly allow for advancement not yet achieved. It was altered to ensure that the intent of the project (“for the purpose of”) was for a scientific or technological advance, regardless if that advance has already occurred.

The 2015 version of the question better aligns with the current Income Tax Act definition of SR&ED:

“ʽscientific research and experimental developmentʼ means systematic investigation or search that is carried out in a field of science or technology by means of experiment or analysis and that is

(a) basic research, namely, work undertaken for the advancement of scientific knowledge without a specific practical application in view,

(b) applied research, namely, work undertaken for the advancement of scientific knowledge with a specific practical application in view, or

(c) experimental development, namely, 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,”14

Question #5

Original: Was a detailed record of the hypotheses, test, and results kept as the work progressed?

Judge Bowman stated, “Although the Income Tax Act and the Regulations do not say so explicitly, it seems self-evident that a detailed record of the hypotheses, tests, and results be kept, and that it be kept as the work progresses.”15 It is very hard to prove that SR&ED work was conducted if there is no record.

2012/2015: Was a record of the hypotheses tested and the results kept as the work progressed?

In 2012, the word “detailed” was removed in 2012 and not added back in 2015, likely due to the vague definition of “detailed”. Further, the question was rephrased to imply that you do not have to keep the test information, only the hypotheses, and results.

In the Eligibility of Work for SR&ED Investment Tax Credits Policy it is explained:

“It is expected that the work be recorded, clearly showing why each major element is required and how each fits into the project as a whole. It is also expected that the indicators or measures that will be used to determine if the goals of the work are met will be identified and recorded at an early stage of the work.”16

Despite these changes, the question of “How much documentation is enough documentation?” remains contentious, particularly in software claims.

The guide to Form T661, the T4088 elaborates on the importance of documentation:

“Most often, supporting evidence is in the form of contemporaneous documents (for example, documents generated as the SR&ED was being carried out). In fact, contemporaneous documentation that is dated, signed, and specific to the work performed are the best supporting evidence that you can provide.”17

Lines 270-282 on Form T661 list evidence one may have to support their claim:18

  • Project planning documents
  • Records of resources allocated to the project, time sheets
  • Design of experiments
  • Project records, laboratory notebooks
  • Design, system architecture and source code
  • Records of trial runs
  • Progress reports, minutes of project meetings
  • Test protocols, test date, analysis of test results, conclusions
  • Photographs and videos
  • Samples, prototypes, scrap or other artefacts
  • Contracts

This list is not an exhaustive list and lines 281 and 282 allow for additional types of documentation to be submitted with your claim.

Conclusion

As you can see, the questions have changed over time. As the questions have been altered throughout the years the original intent was sometimes hidden.   Occasionally the questions become clearer, other times less so. In the most recent iteration (2015) there appears to be more of an effort to align with the text in the Income Tax Act.

It is important to show alignment with the Income Tax Act first and the policies second.  Understanding the nuances of the five questions and how they relate to the definition of the Income Tax Act can be helpful when preparing your claim and in the case of a dispute. As Northwest Hydraulic Consultants v. The Queen (1998) is still being cited as legal precedence by judges today, ensuring that projects align with the original legal text is important for a claim to be accepted.

Show 18 footnotes

  1. Government of Canada. (March 30, 2017.) “Scientific or Technological Uncertainty.” SR&ED Glossary. Retrieved November 18, 2018, from https://www.canada.ca/en/revenue-agency/services/scientific-research-experimental-development-tax-incentive-program/glossary.html.
  2. Government of Canada. (March 30, 2017.) “Scientific or Technological Uncertainty.” SR&ED Glossary. Retrieved November 18, 2018, from https://www.canada.ca/en/revenue-agency/services/scientific-research-experimental-development-tax-incentive-program/glossary.html.
  3. Tax Court of Canada. (May 1, 1998.) Northwest Hydraulic Consultants Ltd. v. The Queen. Retrieved November 18, 2018, from: http://decision.tcc-cci.gc.ca/tcc-cci/decisions/en/item/24675/index.do.
  4. Tax Court of Canada. (May 1, 1998.) Northwest Hydraulic Consultants Ltd. v. The Queen. Retrieved November 18, 2018, from: http://decision.tcc-cci.gc.ca/tcc-cci/decisions/en/item/24675/index.do.
  5. Government of Canada. (March 30, 2017.) “Hypothesis.” SR&ED Glossary. Retrieved November 25, 2018, from https://www.canada.ca/en/revenue-agency/services/scientific-research-experimental-development-tax-incentive-program/glossary.html#hypthss.
  6. Tax Court of Canada. (May 1, 1998.) Northwest Hydraulic Consultants Ltd. v. The Queen. Retrieved November 18, 2018, from: http://decision.tcc-cci.gc.ca/tcc-cci/decisions/en/item/24675/index.do.
  7. Tax Court of Canada. (May 1, 1998.) Northwest Hydraulic Consultants Ltd. v. The Queen. Retrieved November 18, 2018, from: http://decision.tcc-cci.gc.ca/tcc-cci/decisions/en/item/24675/index.do.
  8. Tax Court of Canada. (May 1, 1998.) Northwest Hydraulic Consultants Ltd. v. The Queen. Retrieved November 18, 2018, from: http://decision.tcc-cci.gc.ca/tcc-cci/decisions/en/item/24675/index.do.
  9. Government of Canada. (April 24, 2015.) Eligibility of Work for SR&ED Investment Tax Credits Policy. Retrieved November 18, 2018, from https://www.canada.ca/en/revenue-agency/services/scientific-research-experimental-development-tax-incentive-program/eligibility-work-investment-tax-credits.html#s2_1_2.
  10. Tax Court of Canada. (May 1, 1998.) Northwest Hydraulic Consultants Ltd. v. The Queen. Retrieved November 18, 2018, from: http://decision.tcc-cci.gc.ca/tcc-cci/decisions/en/item/24675/index.do.
  11. Tax Court of Canada. (May 1, 1998.) Northwest Hydraulic Consultants Ltd. v. The Queen. Retrieved November 18, 2018, from: http://decision.tcc-cci.gc.ca/tcc-cci/decisions/en/item/24675/index.do.
  12. Tax Court of Canada. (May 1, 1998.) Northwest Hydraulic Consultants Ltd. v. The Queen. Retrieved November 18, 2018, from: http://decision.tcc-cci.gc.ca/tcc-cci/decisions/en/item/24675/index.do.
  13. Government of Canada. (July 15, 2015.) Scientific or technological advancement / scientific advancement / advancement of scientific knowledge / technological advancement. In SR&ED Glossary. (Accessed: November 18, 2018.) Retrieved from: https://www.canada.ca/en/revenue-agency/services/scientific-research-experimental-development-tax-incentive-program/glossary.html#dvncmnt.
  14. Government of Canada. (April 24, 2015.) Eligibility of Work for SR&ED Investment Tax Credits Policy. Retrieved November 18, 2018, from https://www.canada.ca/en/revenue-agency/services/scientific-research-experimental-development-tax-incentive-program/eligibility-work-investment-tax-credits.html#s2_1_2.
  15. Tax Court of Canada. (May 1, 1998.) Northwest Hydraulic Consultants Ltd. v. The Queen. Retrieved November 18, 2018, from: http://decision.tcc-cci.gc.ca/tcc-cci/decisions/en/item/24675/index.do.
  16. Government of Canada. (April 24, 2015.) Eligibility of Work for SR&ED Investment Tax Credits Policy. Retrieved November 18, 2018, from https://www.canada.ca/en/revenue-agency/services/scientific-research-experimental-development-tax-incentive-program/eligibility-work-investment-tax-credits.html#s2_1_2.
  17. Government of Canada. (November 10, 2015.) T4088 Scientific Research and Experimental Development (SR&ED) Expenditures Claim- Guide to Form T661. Appendix 2 – Documentation and other evidence to support your SR&ED claim. Supporting the SR&ED work claimed. Retrieved November 19, 2018, from: https://www.canada.ca/en/revenue-agency/services/forms-publications/publications/t4088/guide-form-t661-scientific-research-experimental-development-expenditures-claim-guide-form-t661.html#ppdx2.
  18. Government of Canada. (November 10, 2015.) T661 Scientific Research and Experimental Development (SR&ED) Expenditures Claim. Retrieved November 19, 2018, from: https://www.canada.ca/content/dam/cra-arc/migration/cra-arc/E/pbg/tf/t661/t661-15e.pdf.

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