Application Policy

NUMBER: SR&ED 94-04
DATE: September 16, 1994
SUBJECT: Definition of "contract payment" in subsection 127(9)

This application policy addresses the issue of "contract payments".

Where a Canadian taxpayer contracts to have SR&ED activities carried out on its behalf by another party, the amount payable under the contract may be a qualified SR&ED expenditure for ITC purposes. On the other hand, for the Canadian party performing the contract (the contractor), the contract payment reduces the qualified SR&ED expenditures for ITC purposes. In this way duplication of the ITC is avoided.

Issue

It may be difficult based on the terms of the contract to determine whether it is the person who paid the amount (the payer) or the contractor who is entitled to the ITC. Generally, the problem arises where a contract is not specific on whether an amount paid to the contractor who performed SR&ED work is a "contract payment" for the purposes of calculating the ITC. Further, in certain cases, the fact that a contract specifically states that a payment is or is not a "contract payment" for the purposes of subsection 127(9) of the Act may not be conclusive. This would be where the substance of the contract is different from what is stated.

There is no unique test nor jurisprudence that will determine that an amount paid is clearly a contract payment. This application policy is intended to provide criteria to assist in the determination of whether or not an amount is a contract payment.

I. Payments under para. b) of definition in subsection 127(9)

Paragraph b) of the definition of "contract payment" includes amounts payable by a Canadian government or municipality or other Canadian public authority.

The key element for determining an amount as a contract payment is whether the payer requested the contractor to perform SR&ED on behalf of the payer under the terms of the contract. This determination can only be made on the basis of the terms of the contract read as a whole and by reviewing all the facts surrounding the particular situation.

The following is a list of criteria that should be considered in assessing the nature of the payment. An analysis is required of all circumstances relating to the payment to determine if the amount is to be treated as a contract payment. None of the following is, in itself, conclusive.

1. Contractor Performance Requirements

• Does the contract indicate that the contractor was required to perform specific SR&ED work (e.g. "the contractor shall design, integrate, test, verify performance")?

Note: The question is not whether SR&ED work was carried out but whether SR&ED was carried out because it was required under the contract.

• Are there certain specifications that the contractor had to comply with in performing the contractor's tasks?

These two elements may be an indication that the contractor had to perform SR&ED on behalf of the payer, i.e. that the amount is a contract payment.

2. Pricing vs. Risks Assumed

• Is there a ceiling price beyond which the contractor would not have been paid?

If yes, it may be an indication that the contractor was obliged to assume certain risks under the contract because the contractor was responsible for costs exceeding the ceiling price.

A ceiling price clause may raise doubts as to whether the contractor had to perform SR&ED on behalf of the payer. Since the contractor had agreed to absorb the excess costs related to the project, this may be indication that the SR&ED was in fact being carried out by and at the risk of the contractor and not on behalf of another person.

• Would the contractor have been entitled to payments even if the work had not met the requirements of the contract as to the work to be performed?

If the answer is yes, this may be an indication that the risks taken by the contractor were limited, i.e. risks rested with the payer, even if there was a ceiling price clause. This would support the position that the SR&ED work was carried out on behalf of the payer.

Note: A repayment because the work ceased or the other obligations of the contractor were not fulfilled should not be considered in making the determination.

3. Intellectual Property (IP)

• If the rights to the IP of the SR&ED work belong to the contractor, this may be an indication that the contractor was not required to perform SR&ED on behalf of the payer since the results of the SR&ED remain with the contractor.

The payer may have a conditional right to use the results of the SR&ED. However, existence of a conditional right suggests that the SR&ED was not performed on behalf of the payer since the payer is not permitted to use the results of the SR&ED as desired.

However, a distinction can be made in the case of a contract with the Crown. The fact that the IP rests with the contractor rather than the Crown does not necessarily have a notable effect on the qualification of a payment as a contract payment. As with the other criteria, the ownership of the IP is only one factor that will assist in the global analysis of the payments.

4. Contract for Services vs. Contract for Goods

• Where a definite conclusion cannot be made using the other criteria, determining whether a contract is a contract for services or a contract for the sale of a good (based on the substance of the contract) may provide some guidance.

A contract for services may be an indication that the SR&ED work was being performed on behalf of the payer; however, a contract for the sale of a good does not necessarily indicate that the SR&ED work was not being performed on behalf of the payer.

II. Payments under para. a) of definition in subsection 127(9)(e.g. contracts between two corporations)

The definition of "contract payment" under paragraph a) was changed for amounts that became payable after December 20, 1991. As a first step, distinguish between amounts payable before December 21, 1991 and those payable after December 20, 1991.

A. Amounts payable before December 21, 1991

The legislation refers to an amount payable for SR&ED work "related to the business" of the payer. Therefore, it is not necessary to determine if the SR&ED was performed on behalf of the payer to conclude that an amount paid is a contract payment. The test is whether the SR&ED work performed by the contractor is related to the business of the payer.

1. "Related to the Business" of the Payer

The words "related to the business" used in the definition should be interpreted broadly and are meant to capture the amounts payable by a person for SR&ED work that is directly or indirectly related to the business of that person.

For example, Corporation A performs SR&ED work as a subcontractor for Corporation B (the contractor) in the performance of a principal contract between Corporation B and a third party. Corporation B pays Corporation A for the performance of the subcontract. Although the SR&ED work carried out by Corporation A is directly related to the business of the third party, this does not preclude the SR&ED work of Corporation A to be related also to the business of the payer, Corporation B, since Corporation B needs the SR&ED work of Corporation A to meet its obligations under the principal contract with the third party.

2. Intellectual Property (IP)

• If the payer retains the rights to the IP related to the SR&ED work carried out by the contractor, this is an indication that the work is related to the business of the payer and that the amounts are contract payments.

B. Amounts payable after December 20, 1991

The legislation refers to an amount payable for SR&ED reasonably considered to have been performed "for, or on behalf of," the payer.

Apply the same criteria applicable to payments under paragraph b) of definition in subsection 127(9) to establish whether the contractor was carrying out SR&ED on behalf of the payer.

If the conclusion is that the contractor was carrying out SR&ED on behalf of the payer, then the amounts payable are contract payments provided the payer is or was entitled to a deduction under either subparagraph 37(1)(a)(i) or clause 37(1)(a)(ii)(D).

J.-P. Lavigne
Director/Directeur
Audit Programs Division/Division des programmes de vérification
Issued by: Specialized Audit Programs Section and Scientific Research Services Section