Documentation and Evidence Proving SR&ED

This article was previously published by the Canadian Tax Foundation and is reproduced with permission.

Subsection 248(1) defines scientific research and experimental development (SR & ED) for qualifying Canadian corporations that can benefit from SR & ED tax credits, which are some of the most lucrative tax credits available. In the oft-cited Northwest Hydraulic decision (1998 CanLII 553 (TCC)), the TCC set out five criteria to establish a claim for SR & ED tax credits, including the taxpayer's ability to demonstrate proper documentation and evidence or proof of eligibility for its SR & ED expenses (defined in subsection 37(1)). An important but less well-addressed and understood issue is what constitutes sufficient evidence or proof of eligibility to support an SR & ED tax credit claim.

No specific guidance is provided in the Act regarding proof of eligibility, and the CRA offers little guidance; however, that does not mean that none is required. According to the general procedure case of 6379249 Canada Inc. v. The Queen (2015 TCC 77), the TCC states that, under the Act, "the appellant [must] prove that he has followed a systematic investigation in order to resolve a technological uncertainty with the purposes of achieving a technological advancement."

The courts have held that evidence can be provided either through testimony from expert witnesses (people with scientific or technical training) or in documentation prepared by the taxpayer, its employees, or its agents. The latter documentation is preferably contemporaneous—recorded when the actual work is being performed—because that provides the maximum credibility.

Recent decisions in Concept Danat Inc. v. The Queen (2019 TCC 32) and Dock Edge + Inc. v. The Queen (2019 TCC 11) are useful reminders of the proof required to establish expenses as SR & ED as set out in Northwest Hydraulic. Both decisions denied the taxpayers' SR & ED claims and commented on a lack of suitable evidence.

Danat upheld the minister's initial assessment disallowing the taxpayer's claim for SR & ED tax credits of approximately $14,000 for its 2015 taxation year. The TCC cited a lack of proper documentation to support the appellant's hours claimed as qualifying expenses; estimated hours were not considered acceptable. This is important, especially if a resource-starved claimant tends to estimate qualifying expenses for the purposes of calculating the SR & ED tax credits.

In Dock Edge, the TCC dismissed the taxpayer's claim for SR & ED tax credits of approximately $72,000 for its 2011 taxation year. The court observed a lack of informed testimony as to what was, and was not, routine engineering or standard procedure in respect of technologies underlying the projects claimed:

A technological advancement is the gaining of new knowledge that advances general understanding. We had no informed testimony or evidence indicating that DEI had advanced general understanding, as distinguished from advancement of its own specific knowledge. DEI counsel's questions on this point tended to be, as noted above, whether DEI's own knowledge had been advanced re these several projects. No doubt it was, in each case. DEI is to be commended on its innovative approach and success in developing new or improved commercial products.

Case law on the subject of relevant evidence is slim. Testimony from expert witnesses was instrumental in proving the taxpayer's eligibility for SR & ED incentives in ACSIS EHR (Electronic Health Record) Inc. v. The Queen (2015 TCC 263).

The TCC decisions in both Danat and Dock Edge emphasized the importance of documentation. The key is to prove use of the scientific method as the work proceeds, to illustrate that an attempt was made based on a particular idea (and a certain scientific/technical rationale for why the idea should work). When the approach failed in a particular way, a different approach was tried, based on another scientific/technical rationale. The lack of such a decision based on a scientific or technical rationale caused the taxpayer to lose in Mac & Mac Hydrodemolition v. The Queen (2017 TCC 256). The taxpayer kept a set of handwritten notes that described various parameters being tested, but only in vague terms; the notes contained scant details about changes being made and very little information about test results. Interestingly, the court in Dock Edge took a tone similar to the one in Mac & Mac:

Only a few photographs of prototypes and three pages of someone's handwritten notes for one of the projects were entered in evidence. The evidence was uncontroverted in this regard that no detailed records were made or in any event kept.

In observing a lack of proper evidence in the cases discussed above, the judge in CRL Engineering Ltd. v. The Queen (2019 TCC 65) ruled in the taxpayer's favour, stating:

The Appellant's witness explained that "system snapshots were captured on a weekly basis and maintained in a document repository" that were accessible and regularly reviewed. It also maintained a "wiki" that was used to "log data, methods, issues and results." The documentary evidence, notably Exhibits A-1 and A-3, supported Dr. Paranjape's oral testimony on this issue. [Dr. Paranjape was allowed as an expert witness.]

A ray of hope for taxpayers is provided by RIS-Christie Ltd. v. Canada (1998 CanLII 8876 (FCA)), which held that a taxpayer may not be obliged to adduce documentary evidence if the taxpayer had already demonstrated the existence of technological uncertainty and a corresponding advancement. The court relieved the taxpayer from the burden of producing evidence for testing when the technological advancement was established. However, given the recent court emphasis and renewed clarification on documentation and evidence, it is unclear whether a successful outcome similar to RIS-Christie is likely. In any event, it may not be worth the risk of losing generous SR & ED tax credits.

For more information, contact Balaji Katlai, Manager, Canadian Corporate Tax, at 514.228.7858 or [email protected].

Read the article and comments in the July 2019 CTF Newsletter.