IC86-4R2SUP1 Scientific Research and Experimental Development Automotive Industry Application Paper
IC
SCIENTIFIC RESEARCH AND EXPERIMENTAL DEVELOPMENT
86-4R2 June 28,1991
Supplement 1
Automotive Industry Application Paper
The purpose of the supplement to Information Circular 86-4R2 is to
help taxpayers and Canada Customs and Revenue Agency (CCRA),
staff interpret how the Circular applies to this industry sector.
AUTOMOTIVE INDUSTRY
APPLICATION PAPER
TABLE OF CONTENTS
SPECIAL ISSUES
1 INTRODUCTION
Generally, the automotive industry is representative of
manufacturing industries in Canada, with products ranging from
simple auto parts to complete vehicles and engines with
sophisticated computer controls, as well as production facilities
using simple machine tools to fully automated transfer lines with
multiple operations. It is an industry that has to create new
methods with new technologies to supply a quality product in a very
competitive market.
Information Circular 86-4 was issued to clarify work which lies
within the boundaries of scientific research and experimental
development (SR&ED;). This supplement has been prepared to improve
the understanding of SR&ED; as it specifically relates to the
automotive industry, and, in particular, to amplify the concept of
what constitutes eligible experimental development activities that
may not be clear in the Circular. There is no intent to deal with
questions relating to allowable expenditures, although in
addressing certain issues these questions will be touched upon to
clarify the position. Expenditure issues are discussed in detail in
the current version of Interpretation Bulletin IT-151.
2 PROJECT ELIGIBILITY
The definition of scientific research and experimental development
is set out in Section 2900 of the Income Tax Regulations and is
detailed in Parts 2.2 to 2.5 of the Circular. This section of the
Regulations calls for technological development through a
systematic process of experimental development and/or analysis. In
principle, when these elements are demonstrable, eligibility
normally exists. The three criteria for characterizing eligibility
-- scientific or technological advancement, uncertainty, and
content -- are developed in Part 2.10 of the Circular, and it is
essential that these criteria be understood completely for any
evaluation of project eligibility.
In relatively simple terms, a project is eligible if its objective
is an advancement in technology, with a technological uncertainty
resolved in a systematic manner by individuals who are skilled in
the technologies involved.
2.1 SR&ED; envelope
All of the experimental and analytical activities associated with
the search to resolve the technological problems relating to SR&ED;
in the automotive sector are part of the envelope of SR&ED;, when
undertaken in support of basic research, applied research, and
experimental development (Part 2.4 of the Circular).
The envelope also includes direct support activities concerning
engineering or design, operations research, mathematical analysis
or computer programming, and psychological research (Part 2.5 of
the Circular). Data collection and testing commensurate with the
needs of the experimental development and resolution of the problem
are also within the envelope (Part 5.1 of the Circular).
All other activities regarding "market research, sales promotion,
quality control, routine testing, research in the social sciences
or humanities, prospecting, exploring or drilling for or producing
minerals, petroleum or natural gas, commercial production or the
commercial use of a new or improved process, style changes and
routine data collection are excluded." These activities are outside
the envelope, by virtue of Income Tax Regulation 2900(1), and are
excluded as an element of SR&ED.; Other activities not in the
envelope of SR&ED; include communication, training, and
consultations. The tax treatment of activities associated directly
with SR&ED; projects can be different, depending on whether or not
they are within or outside the envelope. Of particular
consideration is whether or not the activities take place within or
outside Canada (for more details, see the current version of
Interpretation Bulletin IT-151).
2.2 Technological advancement
Development work is eligible if it is expected that a technological
advance could be obtained through the experimental development
of a capability not previously existing or available in standard
practice. The development can result in the technical enhancement
of both new and existing processes or products.
2.3 Knowledge
In any assessment of the issues of uncertainty or advancement,
judgement must be exercised on the merits of each individual case,
and must be dependent on the resource base of the company and
availability of the knowledge. For more details, see Part 3.1
of the Circular.
The technical knowledge and facilities available to companies will
vary. What is technologically uncertain to one company may be
routine or standard practice to another. The objective of this
incentive is not to duplicate knowledge that is openly available to
the taxpayer. If, however, it is not generally available,
eligibility may exist. This could be the case when a company is
starting out in a new field, although the knowledge has been
developed as a proprietary item elsewhere. Reverse engineering
would not be eligible, but experimental development in association
with the application of the technology could be. Opportunities may
also exist where a technology that is common in another field of
manufacturing could be utilized in a field where it has not
previously been used. The experimental development carried out in
this adjustment could be eligible.
The resolution of any technological uncertainty by a company in its
particular field must result in an advancement of its knowledge of
the technology in the field involved in the experimentation. This
knowledge would not normally have been available to the company.
The establishment of comparative cost studies and work done to
establish competitive specifications would not normally be
eligible, except for an experimental development component.
There are frequent occasions when the apparent simplicity of the
project or problem might be expected to be resolved by routine
procedures or standard practice. However, some projects which at
first sight appear to be routine or mundane may require
considerable experimentation and analysis to provide a solution. It
is the process used in finding the solution rather than the project
itself that often provides strong evidence of its eligibility. When
projects of this nature are initiated, the taxpayer should maintain
a record of the analytical and/or experimental work done, the
problems encountered, and whether or not a resolution was found,
whichever the case may be.
Example
A new product had been developed and a problem arose that
affected its appearance. Because the finish of the
product was critical to its success in the marketplace,
the removal of the blemishes was essential. At first
sight, it appeared to be a simple matter to correct.
However, when the source of the problem was located, a
review of the manufacturing process was undertaken and
further analytical and experimental development work was
required to change the procedures used, and to come up
with a satisfactory answer.
Similarly, an existing product or process may need to be
modified or enhanced to meet constraints that were not
originally a requirement in the product or process. If
the solutions were not readily available and were
identified through a systematic process of experimental
development, the experimental component would be
eligible. The documentation of the experimental process
outlining the problems and solutions is strong evidence
of eligibility.
2.4 Purchase of established technology
The cost of obtaining established technology is not eligible (see
the current version of IT-151, i.e., technology refers to the
results from systematic studies of the application of scientific
knowledge to industrial processes, which is discussed on page 4 of
the Circular). If, however, in the process of adapting an
established technology for a new use, an experimental development
process resulted (i.e., the work is carried out in a systematic
manner and advances the knowledge of the taxpayer), then the
associated activities themselves may generate eligible expenditures.
2.5 Debugging
The work normally associated with "debugging" and trouble-
shooting after the start up of any new equipment, process, or
technology refers to those activities where the outcome is
reasonably predictable, and is often carried out at the time of the
installation of the equipment, process, or technology to ensure
that it meets all the established technological specifications
agreed upon. However, it is possible that, in the process of
debugging a piece of equipment, the knowledge of a company could be
advanced. It is the ability of the taxpayer to demonstrate an
experimental process of reducing or removing problems for the
future that establishes eligibility.
Example
A documented experimental process to determine which
sensors, switches, or actuators are appropriate for fault
detection, prevention, or correction could be eligible.
Simply replacing one style of switch with another style
to improve function or reliability would not. This is
routine engineering that does not advance the taxpayer's
fundamental knowledge of the technology. It is a matter
of expediency, and a business decision.
2.6 Scientific or technological uncertainty
In experimental development, either the outcome or the method of
achieving the outcome is uncertain, because the present level of
technology (state-of-the-art) is insufficient, the compatibility of
new combinations of technologies is uncertain, or the probability
or methodology of obtaining a given result or objective cannot be
known or determined in advance on the basis of normally available
scientific or technological knowledge or experience. As noted, the
resolution of uncertainty which does not result in advancement of
the technology, such as is normally associated with "debugging," is
ineligible. For example, if each time a process is started problems
recur that simply require fine tuning, this does not advance the
fundamental knowledge of the process. Experimental and analytical
work to resolve the technological uncertainty in any project will
result in a technological advancement, and it is the work on the
resolution of these uncertainties that characterizes an eligible
experimental development activity. The problem must be
technologically based, and it is neither the failure nor the
success of a project that is proof of the existence of
technological uncertainty. It is the reason why the project failed
or succeeded that is important.
2.7 System uncertainty
Work on a combination of standard technologies, devices, and/or
processes is eligible, if such combinations of established (well-
known) technologies and principles, for their integration, carry a
major element of uncertainty. This can be called "system
uncertainty." The compatibility of various technologies is also
raised in this context, and this subject is further developed in
Part 4.8 of the Circular. System uncertainty can arise when the
integration of standard technologies that are known and can stand
on their own create uncertainty in the final outcome. Such
uncertainty can be very difficult to demonstrate and has been a
difficult concept to apply in the automotive industry.
The following examples may help illustrate this point:
- A vehicle or sub-assembly is made up of the
integration of a number of different components,
the technologies of which are well-known. This
integration of all the parts, components, and
sub-assemblies in the development of a new model of
a vehicle is normally taken for granted. However,
if it can be shown in this integration process that
there was uncertainty in the compatibility of the
elements to achieve the desired result and produce
an acceptable product, system uncertainty would
exist.
Of all the related labour costs, only the labour
costs incurred directly for experimental or
analytical development in the project and directly
related to problem resolution are eligible. An
indicator that was useful as evidence of system
uncertainty in the computer industry is outlined on
page 44 of the Circular.
- In the manufacturing process of the automotive
industry, the assembly line is made up of a number
of distinct and separate processes. These processes
are systems in their own right, and the assembly of
the vehicle is achieved by subjecting it to a
series of sequential processes or operations. Each
of these separate processes could be eligible as
experimental development, as long as they meet the
criteria set out in Part 2.10 of the Circular.
However, any claim for eligibility for an assembly
line on the basis of system uncertainty could only
be related to any experimental development carried
out in resolving the transfer mechanism for
the vehicles from operation to operation, or in
integrating of the individual systems.
- The design and development of a tool, die, or mold
for the production of a new part would be
ineligible, unless technological uncertainty can be
demonstrated by the use of a systematic process to
resolve the uncertainty. Such uncertainty could
arise from a new material formulation, new or
increased performance requirements for the part, a
significantly different shape for the part, or a
new type of processing in which the tool, die, or
mold is used. The end result must be an advancement
in the knowledge of the taxpayer.
Once a product or system is complete and the system uncertainty is
resolved, activities associated with modifying the system
may be eligible, to the extent necessary for the modification
itself. Also, any changes to the original product or system made
necessary by the modification may be eligible. The original system
is not made eligible by the changes; only the necessary changes may
be eligible.
2.8 Cost restraints
Quite frequently there is a need to meet specific cost restraints
imposed by the market for the product or process. The imposition of
cost restraints would, on its own, not justify technological
uncertainty, but in any attempt to meet such a goal,
technologically based problems may arise that create an element of
uncertainty. Resolving these problems can create a component of
eligibility.
SPECIAL ISSUES
3 PROTOTYPES AND PILOT PLANTS
Prototypes of "concepts" are constructed or prepared for a variety
of reasons, which include the practicability of the design for
manufacturing, the ability of the design to meet a variety of
technical criteria required in its end use and by regulation, the
potential of the product in the market place, and many others. They
can be classified basically as engineering prototypes and
experimental prototypes. The engineering prototype is normally the
type found in the automotive sector where a part or vehicle is
made, tested, and evaluated both by the vendor and the purchaser.
Today, however, the vehicle manufacturers are moving more and more
of the design and development of parts and sub-assemblies to their
suppliers, and are maintaining input in the process by setting up
consultative groups to ensure all their needs are met. The
prototypes produced by this system are becoming more commonplace in
the parts industry, and are essential to meet the needs of a very
competitive market. This consultative process (or "simultaneous
engineering," where the vehicle manufacturers and the parts
suppliers work together in the development of parts or
sub-assemblies for new vehicles) can create problems in the
assessment of a project. Normally, all the experimental development
and testing activities carried out in Canada could be eligible,
along with essential consultation and training to meet the needs of
the project, wherever it occurs. While the activities may clearly
be eligible, it is important to note that the amount of qualified
expenditures claimed by either of the parties will depend on
the arrangement between them (see the current version of
IT-151).
3.1 Definition
The Income Tax Act does not define prototypes, or pilot plants, nor
does it specifically provide for their treatment. However, they are
defined in the glossary of terms (Appendix A) of the Circular.
The tax treatment of prototypes and pilot plants is essentially
governed by the definition of scientific research and experimental
development in subsection 2900(1) of the Income Tax Regulations and
the definition of SR&ED; expenditures in Section 37 of the Act.
3.2 Application - Experimental prototype
To apply the provisions of the Income Tax Regulations to a concept
or prototype, it is necessary to determine the purpose for which a
particular concept or prototype is constructed. When a prototype is
being constructed for its experimental or technical content only
(i.e., it has no lasting value other than the knowledge acquired
from its development) and is not being constructed for commercial
use or sale, its cost would not normally be subject to the
separation of costs for tax purposes or "carve out" of the SR&ED;
expenditures.
This exception to the separation of costs or "carve out"
requirement is generally applied to situations where the concept or
prototype is constructed for specific experimental or technical
purposes, and then shortly thereafter is dismantled, destroyed,
scrapped, or shown to have nominal residual value.
3.3 Prototype as an asset
When a constructed prototype will itself be an asset of enduring
benefit, normally only part of the costs associated with it will be
treated as SR&ED; for tax purposes. The remaining portion of the
costs could be given various forms of tax treatment, depending on
whether or not the concept or prototype is to be retained by the
taxpayer or sold to a third party. The costs that would not
normally qualify as SR&ED; expenditures in these situations are
generally those costs that would have been incurred
to construct the prototype if the technology and outcome were
predictable. Accordingly, these non-qualifying costs would often
include expenditures related to routine design, component parts,
materials, and assembly. If, however, a prototype is assembled and
disassembled several times in the course of construction, the
exclusion from SR&ED; for such assembly costs would normally be
limited to the cost of only one assembly of the prototype.
The "carve out" of SR&ED; expenditures does not apply in a situation
where the prototype will only be used by the taxpayer in an SR&ED;
capacity. As a result, the cost of constructing the prototype would
simply be included with the other qualifying SR&ED; expenditures.
3.4 Pilot plants
The ability to expand or extend to a larger scale the initial
scientific research and experimental development in any product or
process could require the use of a pilot-scale operation. Pilot
plant studies and facilities are normally designed and used to
resolve the technological uncertainties entailed in scaling up a
manufacturing process to commercially viable proportions. The
actual size or capacity of such facilities is not a factor. Indeed,
the pilot plant facilities for an established major corporation may
be larger than the actual production facility for a small
developing company. What is important is the actual use made of the
pilot plant facilities. They must be used to resolve technological
uncertainties so that the associated activities can be eligible for
SR&ED.; The tax treatment will differ when the facilities are
maintained only for SR&ED; purposes and where the setting is used,
or will be used, for commercial purposes. This treatment is very
similar to that accorded to the prototype as an asset.
Frequently in the automotive industry, pilot-scale experiments are
carried out in production facilities to evaluate the process in a
commercial environment, and to resolve the technological
uncertainties that arise in such a process. In these circumstances,
the eligible expenditures must be segregated from those which would
normally be associated with the operation, and reflect only the
incremental costs to run the experiments for the SR&ED; activities.
Often, much of the testing relating to the establishment of
standards, such as quality control, are carried out in laboratories
used routinely in the daily operations of the taxpayer. These
expenditures also must be documented as part of a preplanned,
systematic development program and, in cases like this, it is
necessary to establish the specific periods of use.
3.5 Commercial versus experimental production
The determination of what would be a suitable experimental run to
allow for the complete evaluation and testing of the product or
process presents a problem for the industry. It is normally the
experimental production that is required to verify that the
technological objectives and customer acceptance levels have been
achieved. It is also the period of testing that is commensurate
with the proving out of specifications for the product or process,
and does not coincide with the normal learning curve for the start-
up of established systems. Documentation must show what use was
made of this experimental production: whether it was used solely
for evaluation purposes, or in conjunction with normal commercial
activities. The tax treatment in the commercial setting is
different and requires a "carve out" similar to the prototype as an
asset. This will vary with each product or process.
Sometimes high scrap rates are encountered in early production
runs, and this may be used by a company as an indicator that the
project is still in an experimental stage. The company's activities
at this point may not be eligible. It is the reason for the scrap
rate problem and the process (experimental) followed to resolve it
that will indicate whether or not the activities are eligible. To
make a judgement in this industry, any assessment would have to be
made on a case-by-case basis by qualified technical and accounting
personnel.
3.6 Feasibility study
For eligible projects, the technical feasibility study qualifies
but needs to be distinguished from all other types of studies
(marketing, commercial, or financial). In some cases, only
feasibility studies are carried out. The costs of feasibility
studies may, in these cases, be eligible when the three criteria
(scientific or technological advancement, scientific or
technological uncertainty, and scientific and technical content)
set out in Part 2.10 of the Circular are met.
Example
In investigating the feasibility of a product or
process development, it may be necessary to evaluate
materials or products to be used. This could initiate
an exhaustive testing program of potential materials,
processes, or products before any decision is made to
advance beyond the feasibility stage. In carrying
out these activities, information is generated that
advances the understanding and knowledge of the taxpayer
and allows for a logical decision (whether or not to
proceed to the next stage) to be made.
Feasibility studies or components carried out solely for marketing,
sales promotion, or product evaluation would not be eligible.
3.7 Documentation
The following consideration of documentation needed to identify the
technological objectives is the result of a consensus of opinions
expressed by members of the Industry, Science and Technology Canada
(ISTC) Committee on Automotive R&D.;
When considering any project for eligibility as SR&ED;, the project
should be identified and the technological objectives clearly
defined. The method of achieving these objectives should be
outlined and the success or failure of any of the experiments
carried out in resolving the project must be well-documented.
The project plan and its documentation should incorporate the
design, services supplied, problems encountered and their
solutions, and the personnel involved in the project, as well
as evidence of progress in the tracking of the plan to its
successful or unsuccessful conclusion. Costs should be separated
and appropriately allocated. Failure to do so makes verification
difficult, even when eligible SR&ED; was done. If there are any
payments to other parties, access to the contract is essential, as
are the technological studies or plans on which the work was based,
and the maintenance of all records in the transaction.
At this juncture, it should be pointed out that a business plan,
set out to promote the initiation and approval process, will not
normally meet this requirement. The objective of such a plan is to
sell the project to management. It usually does not outline in any
detail the problems expected or the methodology required to
overcome these problems, which is essential in any claim for SR&ED;
expenditures.
3.8 Records
It is the taxpayer's responsibility to maintain records that are
adequate and can support the claim. Documentation that would
normally be sufficient should include the following:
- project title
- purpose of the project undertaken (hypothesis)
- technologically feasible plan and/or methodology adopted
- status reports or progress reports
- problems met in the course of the project that identified
areas of technological uncertainty and experimental
development
- personnel involved in the project
- notebooks, lab reports, patents, and patent applications
It should be noted that documentation prepared at the time of the
event is more helpful than material prepared in retrospect. In many
cases, it is difficult to reconstruct details of project activities
after time has passed. This is particularly the case in identifying
technological uncertainty. Any advancement must be explicit.
3.9 Personnel
Personnel responsible for directing or performing projects
should have demonstrable basic professional skills or experience
relevant to the requirements of the project (Part 2.10.3(2) of the
Circular). For example, many of the projects, particularly in the
smaller companies in the automotive parts sector of the industry,
are carried out on the shop floor by skilled tradespeople or
toolmakers with limited supervision. The objective of the work
being done on the project is known, but there is little or no
record kept of the work performed or the personnel involved. The
project may be eligible but, without adequate documentation or
records, it cannot be assessed.
3.10 Industry committee membership
The Automotive Directorate of ISTC chose the industry
representatives whose participation and assistance was
indispensable. The Senior Science Advisor, two of his staff,
and Mr. D.W.C. McEwan, a consultant, represented the CCRA.
The contributions of the membership towards developing
the application paper are greatly appreciated.
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