Recent Developments in SR&ED Tax Litigation

Transcription

1 in SR&ED Tax Litigation Olivier Fournier, Deloitte Tax Law LLP, Montreal Daniel McKindsey, Deloitte LLP, Montreal 67 th Annual Tax Conference 67e Conférence fiscale annuelle 2015 Topics 1. Brief overview of the rules 2. How experimental development has evolved 3. Issues addressed so far in jurisprudence 4. General takeaways from the case law 5. Next threshold issues 2

2 A Brief Overview of the SR&ED Rules Purpose: incentive to invest in innovation in Canada Many concepts derived from the Frascati Manual Operative statutory provisions Definition in 248(1) Section 37 ITC provisions Sections 127, Peripheral concepts The five questions 3 Important Aspects of 248(1) Four (3+1) categories of eligible work a) basic research b) applied research c) experimental development d) work with respect to engineering, design, operations research, mathematical analysis, computer programming, data collection, testing or psychological research commensurate with the needs directly in support of (a), (b), or (c) undertaken in Canada by or on behalf of the taxpayer 4

3 Important Aspects of 248(1) Exclusions e) market research or sales promotion, f) quality control or routine testing of materials, devices, products or processes, g) research in the social sciences or the humanities, h) prospecting, exploring or drilling for, or producing, minerals, petroleum or natural gas, i) the commercial production of a new or improved material, device or product or the commercial use of a new or improved process, j) style changes k) routine data collection 5 The Five Questions 1. Was there a scientific or a technological uncertainty? 2. Did the effort involve formulating hypotheses specifically aimed at reducing or eliminating that uncertainty? 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. Was the overall approach undertaken for the purpose of achieving a scientific or a technological advancement? 5. Was a record of the hypotheses tested and the results kept as the work progressed? 6

4 A Changing R&D Environment The way R&D is conducted has radically changed Streamlining, Cost Reduction Increasing Costs of Dedicated Research Shortened Development Cycles Globalization Convergence of Development and Operations Multi-National / Multi- Institutional Collaboration New Development Methodologies (iterative, solution focused) Risk & Innovation Sharing 2015 Frascati Manual decouples R&D from linear innovation model 7 Issues addressed so far in SR&ED jurisprudence a. Technological uncertainty b. Existing Technology applied or adapted to a new situation c. Testimonial evidence of the systematic observation, measurement and experimentation performed e. Testing eligibility on a whole project basis, as opposed to a trial-by-trial or period-by-period basis f. in respect of SR&ED g. Commercial use or production d. Expert evidence 8

5 a. Technological uncertainty Northwest Hydraulic Consultants Ltd. v. R., 98 DTC 1839, para. 16: (a)implicit in the term technological risk or uncertainty in this context is the requirement that it be a type of uncertainty that cannot be removed by routine engineering or standard procedures. [ ] If the resolution of the problem is reasonably predictable using standard procedure or routine engineering there is no technological uncertainty as used in this context. (b)what is routine engineering? [ ] it describes techniques, procedures and data that are generally accessible to competent professionals in the field. 9 a. Technological uncertainty Northwest Hydraulic, para. 16(3)(b): 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. para. 82: The technological uncertainty is something that exists in the mind of the specialist such as the appellant, who identifies and articulates it and applies its methods to remove that uncertainty. 10

6 a. Technological uncertainty Les Abeilles Service de Conditionnement Inc., 2014 TCC 313, para. 142: It must be borne in mind that these criteria are used to help determine whether or not a technological advancement has occurred. The first criteria, technological uncertainty, is one way of dealing with the technological advancement criteria; there can hardly be a technological advancement if one already knows how to achieve the end result para. 177: Again, it is clear that there was technological uncertainty; the appellant did not know at the outset how it was going to achieve its goals and, indeed, it was only partially successful in achieving them [ ]. The appellant tried to obtain the necessary knowledge elsewhere, but was unable to do so and therefore had to develop its own solutions. 11 a. Technological uncertainty Highweb & Page Group Inc., 2015 TCC 137 [Informal Procedure], para. 18: For technological uncertainty to exist there must be a gap in knowledge. It was described by the Appellant s agent as a missing piece of a jigsaw puzzle. It cannot be that the knowledge exists, but is merely unknown to an ITC claimant, or that the gap is soluble by the application of another product through usual techniques applied by, in this case, skilled and experienced software developers. Simply applying such skills with generally available knowledge and/or other products is not scientific or experimental development. It is product research and development. 12

7 a. Technological uncertainty Hypercube Inc., 2015 TCC 65 [Informal Procedure], para. 47: Although the appellant s program could constitute an entirely new product, it was created using well-known techniques. Novelty or innovation in a product is not sufficient to illustrate technological advancement 13 b. Existing technology applied or adapted to a new situation Acsis EHR (Electronic Health Record) Inc., 2015 TCC 263: Existing software that required sophisticated telecommunications infrastructure Technology had to be adapted to deficient network environment (Belize) Appellant had to change the software (not just debugging) to develop a means to compensate for yet unresolved connectivity and data integrity issues 14

8 b. Existing technology applied or adapted to a new situation Acsis EHR (Electronic Health Record) Inc., 2015 TCC 263 [31] Although the Respondent argued that some of the uncertainties were not technological and that possible available solutions were restricted by budgetary constraints and licensing considerations, the evidence of the Appellant s witnesses, which was not challenged on cross-examination, demonstrated that it was impossible to resolve the uncertainties, encountered by the Appellant, through routine engineering or standard procedures. The Appellant had no reasonable expectation of success with the Belize project unless new knowledge could be obtained. According to the evidence, the Appellant developed a new approach by creating a multi-write database replication system. 15 b. Existing technology applied or adapted to a new situation Northwest Hydraulic, 98 DTC 1839, Paras 39-40: [ ] Q. The sedimentation basin, you indicated that design was provided to you by the Japanese firm? A. Yeah, they had a standard sedimentation basin design, so we adopted that. Q. Did you know before it was put in the model whether or not it would work? A. No, I didn't. [ ] The myriad of technological uncertainties are obvious. It is clear that these uncertainties could not be removed by routine engineering. Indeed even with the appellant's highly developed skills in this area a number of the problems could not be resolved. 16

9 c. Testimonial evidence as a complement Historically, documentary evidence was considered the only reliable method of demonstrating that scientific research was undertaken in a systematic fashion ( ) (Zeuter Development Corp v. R., 2006 TCC 597 [Informal Procedure], para. 28) 17 c. Testimonial evidence as a complement However, providing documentary evidence is not a requirement of the ITA, and Testimonial evidence is considered, in some cases, sufficient to demonstrate a systematic investigation was carried Canada Inc., 2015 TCC 77, para. 92: 92 The respondent stated that the appellant had not filed in evidence any documents demonstrating that it had followed a systematic approach in performing its SR&ED s work. As I have stated earlier, the filing of the documents proving a systematic investigation is not a requirement in the ITA. The ITA requires that the appellant prove that he has followed a systematic investigation in order to resolve a technological uncertainty with the purposes of achieving a technological advancement. 18

10 c. Testimonial evidence as a complement Acsis EHR (Electronic Health Record) Inc., 2015 TCC 263: No expert testified At para. 38: Mr. Kilburn testified that the scientific method, when applied to computer programming, does not have the same structure that would be employed in a science such as chemistry, where measurement is used in a different context. When asked on cross-examination if he tracked the number of tests that he ran, he stated that the tests conducted take many forms, average in the hundreds and there s tests [sic] that s written once and is executed a thousand times. 19 c. Testimonial evidence as a complement Acsis EHR, paras : While it will always be preferable that an appellant maintain contemporaneous documents to support its systematic investigative procedures and methods, [ ] the Act contains no legislative requirement to file those documents in order to qualify for the deduction of expenditures. [ ] [ ] This is not to say that taxpayers should ignore detailed record keeping. Such documentary evidence is always to be preferred and each case will vary in respect to how the evidence will be viewed. Taxpayers who come to court without proper documentation will always remain in the unenviable position of persuading a court that systematic investigation did occur. 20

11 c. Testimonial evidence as a complement A question of credibility Canada Inc., 98 D.T.C (TCC [Informal Procedure]), para. 41: [ ] the Act and the Regulations do not require that such written reports be produced in order for a taxpayer to qualify for the deduction of such expenditures: it is possible to adduce evidence by way of oral testimony. Whether the Minister or a judge could conclude that the activities purported to have been carried out by the taxpayer were actually carried out then becomes a question of credibility. 21 d. Expert evidence White Burgess Langille Inman v. Abbott and Haliburton, 2015 SCC 23: An expert s independence and impartiality goes to admissibility, rather than only weight Once the threshold for admissibility is met, remaining concerns should be considered as part of cost-benefit analysis left to the judge in his / her gatekeeping role 22

12 d. Expert evidence At para. 46: I agree with Prof. (now Justice of the Ontario Court of Justice) Paciocco that the common law has come to accept that expert witnesses have a duty to assist the court that overrides their obligation to the party calling them. If a witness is unable or unwilling to fulfill that duty, they do not qualify to perform the role of an expert an should be excluded [ ] The expert witnesses must, therefore, be aware of this primary duty to the court and able and willing to carry it out. See also s. 145 of the Tax Court of Canada Rules (General Procedure) 23 d. Expert evidence At para : [ ] I emphasize that exclusion at the threshold stage of the analysis should occur only in very clear cases in which the proposed expert is unable or unwilling to provide the court with fair, objective and nonpartisan evidence. Anything less than clear unwillingness or inability to do so should not lead to exclusion, but be taken into account in the overall weighing of costs and benefits of receiving the evidence. [ ] When looking at an expert s interest or relationship with a party, the question is not whether a reasonable observer would think that the expert is not independent. The question is whether the relationship or interest results in the expert being unable or unwilling to carry out his or her primary duty to the court to provide fair, non-partisan and objective assistance. 24

13 d. Expert evidence HLP Solution Inc., 2015 TCC 41: Appellant undertook two projects: (1) mobile synchronization software and (2) parallel mail collector Minister disallowed SR&ED credits claimed Appellant challenged qualification of respondent's expert witness for lack of independence and impartiality Appellant s motion was granted 25 d. Expert evidence In HLP Solution Inc., the proposed expert was disqualified because this person: was involved at every stage of the file delivered opinion which served as basis for assessment acknowledged appellant s representations and wrote addendum to her technical review report participated in every meeting with appellant as CRA representative 26

14 d. Expert evidence HLP Solution Inc., at para. 31: I determined on the voir dire that Ms. Rosu did not have the necessary impartiality to testify. In weighing the probative value of her testimony against the cost of that testimony in terms of its impact on the trial process, I decided that it was preferable to disqualify Ms. Rosu at the qualification stage. 27 d. Expert evidence Experts should not overstep their role and provide opinion evidence in any areas that are the exclusive purview of the court Advanced Agricultural Testing Inc., 2009 TCC 190 [ ] If they had been asked to give their opinion as scientists as to what constitutes systematic investigation or search then their evidence could have been helpful [ ] Instead they were all asked the most general of questions, and thereupon launched into lengthy and rambling speeches in which they purported to answer the ultimate question that is before me in respect of each trial, rather than confining themselves to scientific opinion. Contributing to the imprecise nature of their evidence was the failure of the pleadings to define adequately the issues as to which opinion evidence might be addressed. All these factors leave me reluctant to give significant weight to any of the opinion evidence. 28

15 e. Testing eligibility on a project basis Les Abeilles Service de Conditionnement Inc., paras 150, 152 and 153: It is true that when reviewing individual tests they often do not appear to be, in and of themselves, a significant advancement. [ ] I fully agree that experimental development was required in the year in question. However, this does not mean that one cannot examine the history of a project that began in a previous year by considering whether, in the particular year at issue, experimental development was carried out within the meaning of the Act. Furthermore, it is important to consider each project globally in the year and not each test individually. 29 f. In respect of SR&ED Feedlot Health Management Services Ltd., 2015 TCC 32: Research projects undertaken to test innovative diets, supplements and vaccine on cattle Cattle owned by third party, kept in commercial feedlots and raised for commercial production Arrangement concluded between appellant and third party: Appellant could make certain decisions regarding the cattle (such as health, feeding, marketing decisions and general access to data) Third party acquired, raised and processed the cattle, in a manner identical to its regular business Expenditure in dispute = amounts paid by appellant the supply of cattle 30

16 f. In respect of SR&ED Question: Were the expenditures in respect of SR&ED undertaken on behalf of the appellant pursuant to clause (II) of s. 37(8)(a)(ii)(B) ITA? (II) an expenditure in respect of the prosecution of scientific research and experimental development in Canada directly undertaken on behalf of the taxpayer Work performed by the third party is not SR&ED because of the commercial exclusion but the expenditures qualify as being undertaken in respect of SR&ED 31 f. In respect of SR&ED At paras : 61 [ ] Clause (II) does not simply apply to expenditures for SRED but also expenditures in respect of SRED. This phrase, in my view, extends the qualifying expenditures under clause (II) to include expenditures that relate to SRED. 62 It is well understood that the phrase in respect of generally has a very wide scope in the Act. [ ] 63 Accordingly, qualifying expenditures for purposes of clause (II) do not have to be incurred for SRED per se. 32

17 g. Commercial use or production In Feedlot, because the work performed by the third party under the agreement was in respect of the commercial use of new processes Excluded pursuant to para. (i) of SR&ED in 248(1) but does not include work with respect to [...] (i) the commercial production of a new or improved material, device or product or the commercial use of a new or improved process 33 g. Commercial use or production At para. 42: Coincident with the RSAs, the cattle were also acquired, raised and processed for Jim Farms benefit in a manner identical to its regular business, except to the extent necessary to accommodate the Projects. At paras : [ ] These activities are for the benefit of FHMS, but they are also exploited by Jim Farms in its ordinary business of raising cattle. [ ] In my view, a sufficient number of activities under the [agreements] are connected with Jim Farms regular business that the work under the [agreements] is generally with respect to Jim Farms commercial use of new processes. I would comment that each case depends on its own particular facts. [ ] 34

18 Analysis (Eligibility Issue) Primarily in respect of ED (vs. SR) Two questions of intention, namely: Was work in interest of technological advancement? Was work with a view to creating new, or improving existing processes, even slightly? May also be a business objective, but intention to seek advancement gives eligibility (subject to exclusions) fair, large and liberal construction and interpretation Defining the SR&ED Project A practical matter (not theoretical), applied in context Examine project as a whole, in context of project and objectives, not as isolated activities Combination or interaction of technologies (multidisciplinary) vs. specified fields of technology Work inside/outside period contributing to overall work May overlap with commercial work (e.g. may continue after commercial release of product) Multi-disciplinary vs. «underlying technology» Ultimately based on specific facts

19 TU/TA vs. Standard Practice Recognition that technological development aims to solve a technological problem (and that this is sufficient), vs. improving scientific understanding Not standard practice if TU/TA (not independent concepts) Must however prove existence of TU (outcome not reasonably predictable using standard procedure or routine engineering) Due diligence important to establish existence of uncertainty, that solution was not available TU, TA linked 37 Further Clarification of TU/TA Evaluated in context of entire project/technology; not deconstructing project Tools used vs. techniques used vs. problem to solve The practical meaning of "system level" uncertainty as a criteria for SR&ED eligibility Use of existing technology does not necessarily disqualify Linking the observed problem to the underlying relationships, processes, materials, etc. TA can be new knowledge of technologies gained through work 38

20 Dissecting the 5 Questions Validity of the 5 Questions but: Not absolute May not appear the same in all industries or situations Practical application in specific context of taxpayer Hypotheses may be implicit, but must be explainable Examine holistically; not necessary to evaluate each hypothesis in detail but must be satisfied that the overall process was followed 39 Systematic Investigation: Lab Coat not Required! Systematic approach has a common framework (scientific method), but can look very different depending on the industry and setting and may even be implicit Systematic process of development iterative in nature: each time gaining knowledge but not necessarily resolving the technological challenges presented. Ability to link what is done and the progress towards resolving the problem is key 40

21 Evidence? The filing of the documents proving a systematic investigation is not a requirement in the ITA. The ITA requires that the appellant prove that he has followed a systematic investigation in order to resolve a technological uncertainty with the purposes of achieving a technological advancement. Oral testimony of a credible witness can make up for a lack of supporting documents However, given the burden of proof on taxpayer it would seem foolish to not document the work adequately to provide proof of the nature of the work 41 Elements of Success The ability to articulate what is technologically limiting is determinative. Due diligence to demonstrate existence of TU, limitations of existing technology Describe work in technological, not functional, terms (understanding of underlying phenomena) Convey evolution of thinking throughout the work, demonstrate knowledge gained through work Documentation not essential but 42

22 Next Threshold Issues Feedlot opened the door to the question of the exclusions but did not answer it fully or provide a framework for the analysis of the exclusions Relationship between the exclusions and the (3+1) types of eligible work Multinational SR&ED projects 43