The Tax Court Considers Fundamental SR&ED Principles
Written by Robert D. McCue
Bennett Jones LLP represented Feedlot Health Management Services Ltd. (FHMS) in the recent Tax Court of Canada proceeding, Feedlot Health Management Services Ltd v The Queen (2015 TCC 32). The case concerned certain fundamental principles with respect to the interpretation of the definition of scientific research and experimental development (SR&ED), as set out in the Income Tax Act (Canada), as well as the interpretation of one of the most important SR&ED expenditure rules.
Justice Judith Woods issued judgment in FHMS's favour on February 9, 2015.
FHMS Litigation Team
This litigation was led by Bob McCue, who leads Bennett Jones' Tax Litigation & Dispute Resolution Group. Bob was supported by a Bennett Jones team that included Todd Marr, Erica Hennessy and Wes Novotny. Darlene Gehrke, CA, provided accounting support. Dr. Kee Jim was FHMS's sole witness at trial. His careful preparation and articulate presentation to the court were essential to FHMS's success. Dr. Calvin Booker was also in court and prepared to testify. However, given the course of events at trial, his testimony was not required. Drs. Jim and Booker are FHMS's largest shareholders, and senior officers.
FHMS is one of the world's leading feedlot research and consulting organizations. During its 2010 year, it conducted approximately 40 large-scale, feedlot based scientific research projects. Four of those studies (the Research Studies) became the subject matter of this case. The Crown accepted that the Research Studies constituted SR&ED.
This case concerned the eligibility for SR&ED deductions and investment tax credits (ITCs) of approximately $1,650,000 respecting fees (the Access Fees) paid by FHMS in order to obtain access to the cattle (the Study Cattle) required for the Research Studies.
FHMS usually obtained study cattle from feedlots or other parties interested in the results of particular research projects. However, in a small percentage of cases, where study cattle were not available from these sources because of the financial and biological risk the studies involved, FHMS contracted with GK Jim Farms to provide the study cattle. This was the case with respect to each of the Research Studies.
Jim Farms is a sole proprietorship, owned by Dr. Jim. Dr. Jim is also a minority shareholder of FHMS. The terms of the agreement between FHMS and Jim Farms with respect to the Study Cattle were set out in four virtually identical agreements, referred to as the Study Agreements. These agreements provided, among other things, that Jim Farms would:
- deliver the Study Cattle to the required feedlots,
- pay all feed and health costs with regard to the Study Cattle while they were at the feedlots,
- permit the Study Cattle to be dealt with in accordance with the Research Studies, and
- allow FHMS to make all health, feeding and marketing decisions with respect to the Study Cattle.
In exchange, FHMS agreed to pay Jim Farms a percentage of the feed costs Jim Farms incurred with respect to the Study Cattle. These amounts are referred to above as the Access Fees, which the Crown assessed as not qualifying for SR&ED deduction and ITC purposes.
Regrettably, FHMS elected to use the so-called "proxy method" for its SR&ED filing with respect to its 2010 taxation year. The proxy method provides taxpayers who use it with a deemed overhead entitlement for SR&ED purposes, and in exchange, dramatically limits the expenditures that are eligible for SR&ED deduction and ITCs. The proxy method is intended to make SR&ED filing easier for the taxpayers who wish to take advantage of it, while ensuring that they do not claim overhead, or overhead-like expenditures, in addition to having been provided with the deemed overhead entitlement that accompanies the use of the proxy method.
If FHMS had used the so-called traditional method of claiming SR&ED, instead of the proxy method, the Access Fees would have been eligible for SR&ED deduction and ITCs. Having used the proxy method, FHMS was required to claim eligibility with respect to the Access Fees pursuant to clause 37(8))(a)(ii)(B). FHMS relied on clause 37(8)(a)(ii)(B)(I), with respect to expenditures for leased equipment (the Leasing Provision), and clause 37(8)(a)(ii)(B)(II), with respect to expenditures for SR&ED undertaken by third parties on its behalf (the Contract SR&ED Provision).
FHMS argued that the Study Agreements are equipment leases, pursuant to which FHMS leased the Study Cattle from Jim Farms for use in the Research Studies, and therefore that the Access Fees qualified for SR&ED deduction and ITCs pursuant to the Leasing Provision. Alternatively, FHMS argued that the Access Fees were "in respect of" SR&ED work performed by Jim Farms or otherwise, and therefore that the Access Fees satisfied the requirements of the Contract SR&ED Provision.
The Tax Court Judgement
Justice Woods prefaced her reasons by noting that the "scheme of the Act in relation to scientific research expenditures is tortuously complex". We agree. She is to be commended for the way in which she solicited additional submissions from the parties, and digested a mass of highly technical, complex data in the course of preparing her judgement.
The Leasing Provision
As noted above, the Crown acknowledged that all of FHMS's work with respect to the Research Studies was SR&ED. Accordingly, if the Study Agreements were found to be equipment leases for purposes of the Leasing Provision, then the Access Fees would be wholly attributable to FHMS's SR&ED, and therefore eligible SR&ED expenditures.
The Contract SR&ED Provision
Justice Woods then moved on to consider the application of the Contract SR&ED Provision and ultimately, decided the case in FHMS's favour on the application of this provision.
The Contract SR&ED Provision required Justice Woods to determine whether the Access Fees were expenditures
in respect of the prosecution of scientific research and experimental development in Canada directly undertaken on behalf of the taxpayer (emphasis added)
Justice Woods summarized the parties' positions as follows:
 The Crown submits that the [Contract SR&ED Provision] does not apply because the work performed by Jim Farms under the [Study Agreements] is not SRED, as that term is defined in s. 248(1) of the Act.
 FHMS submits the Jim Farms did perform SR&ED, and that in any event it is not necessary that Jim Farms perform SR&ED because expenditures qualify if they are "in respect of" SR&ED.
Justice Woods held that the Crown's position failed to put sufficient weight on the phrase "in respect of" in the Contract SR&ED Provision. She went on to rule in favour of FHMS on the basis that even though Jim Farms' work pursuant to the Study Agreements was not SR&ED, the Access Fees were "in respect of" the data collection SR&ED work performed by the feedlots at which the Study Cattle were located pursuant to the Study Agreements. The reasoning that led Justice Woods to this conclusion follows.
Justice Woods emphasized the importance of the connecting phrase "in respect of", and referred to the Supreme Court of Canada's reasons in The Queen v Savage,1 where the Court held that:
The words "in respect of" are, in my opinion, words of the widest possible scope. They import such meanings as "in relation to", "with reference to" or "in connection with". The phrase "in respect of" is probably the widest of any expression intended to convey some connection between two related subject matters.
She therefore found that the phrase "in respect of" in the Contract SR&ED Provision means that Jim Farms' work, in consideration of which the Access Fees were paid, need not itself be SR&ED in order for the Access Fees to be qualifying SR&ED expenditures pursuant to the Contract SR&ED Provision. Rather, as long as the Access Fees were "in respect of" SR&ED undertaken on behalf of FHMS by Jim Farms or any other third party, the Access Fees would qualify under the Contract SR&ED Provision.
Justice Woods noted that FHMS had incurred expenditures to the feedlots at which the Study Cattle were located for purposes of the Research Studies, and that these expenditures qualified pursuant to the Contract SR&ED Provision because they were for SR&ED work – namely, data collection – undertaken by the feedlots on behalf of FHMS, and that the Crown had accepted them as such. She then found that the sole purpose of the Access Fees was to facilitate the Research Studies by providing the Study Cattle as subjects for scientific research. Therefore, Justice Woods held that the Access Fees are "in respect of" SR&ED undertaken by FHMS, and they are also "in respect of" the data collection SR&ED work undertaken by the feedlots on behalf of FHMS.
The Access Fees qualified pursuant to the Contract SR&ED Provision because of their relationship to the SR&ED performed by the feedlots for FHMS. Justice Woods held that the fact that the Access Fees are "in respect of" FHMS's own SR&ED work was insufficient to bring them within the Contract SR&ED Provision.
The SR&ED Definition
Justice Woods noted that having ruled as she did with respect to the interpretation of the Contract SR&ED Provision, it did not matter whether the work Jim Farms performed under the Study Agreements was SR&ED. However, in light of the extensive submissions she received relative to that point, she decided to provide comments. These are obiter dicta in light of the basis on which Justice Woods decided the case.
Justice Woods accordingly considered the application of the SR&ED definition to the work performed by Jim Farms. She found that this work fell within paragraphs (a) – (d) of the SR&ED definition. The relevant aspects of that definition read as follows:
"scientific research and experimental development" 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 …
(b) applied research…
(c) experimental development …
and, in applying this definition in respect of the taxpayer, includes
(d) work undertaken by or on behalf of the taxpayer with respect to engineering, design, operations research, mathematical analysis, computer programming, data collection, testing or psychological research, where the work is commensurate with the needs, and directly in support, of work described in paragraph (a), (b) or (c) that is undertaken in Canada by or on behalf of the taxpayer (emphasis added)
Justice Woods noted that Jim Farms work was "with respect to" testing and data collection, which qualifies under paragraph (d). She also noted that the Crown's position – that Jim Farms' work was not data collection or testing – did not appropriately take into account the words "with respect to" in paragraph (d). The reference to the Supreme Court of Canada's interpretation of the phrase "in respect of", described above, is relevant to this point.
Justice Woods did not comment with respect to FHMS's submission that reliance on paragraph (d) was not required, because the work Jim Farms performed should qualify pursuant to either paragraph (b) or (c) of the SR&ED definition.
Then, Justice Woods went on to consider whether the so-called commercial production exclusion found in paragraph (i) of the SR&ED definition excluded Jim Farms' work from SR&ED. That provision states that SR&ED 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
Justice Woods ruled that the work Jim Farms performed pursuant to the Study Agreements was within the commercial production exclusion, and hence not SR&ED. Her reasoning included the following steps:
- Justice Woods noted that the commercial production exclusion required the production or use of either "new" or "improved" products, processes, etc. She held that in the case before her, no improved products, processes, etc. were in commercial use because research with respect to them continued. That is, the purpose of the Research Studies was to determine whether certain products, processes, etc. could be improved, and therefore during the course of the Research Studies, they could not have attained the status of "improved" products, processes, etc. While Justice Woods did not use the term "experimental", that was the concept she employed in contradistinction to "improved". As long as a product, process, etc. was "experimental", in that it was the subject of the Research Studies, it could not be "improved".
- Justice Woods then, surprisingly, held that the word "new" did not have a meaning analogous to that of "improved". Hence, although the products, processes, etc. in question were experimental, she held that they were at the same time "new", and that Jim Farms made commercial use of these "new" products, processes, etc. while performing work pursuant to the Study Agreements, and that this work fell within the commercial production exclusion because it was "with respect to" Jim Farms' commercial activities. This leads to the difficult to understand conclusion that experimental products, processes etc. are in commercial use or production.
- Justice Woods concluded that the commercial production exclusion applies not only to commercial production or use by the taxpayer (FHMS in this case), but also to commercial production or use by a third party (Jim Farms, in this case). Accordingly, from FHMS's perspective, the work performed by Jim Farms pursuant to the Study Agreements was not SR&ED.
FHMS argued for a much narrower interpretation of the commercial production exclusion. Justice Woods acknowledged this, and noted that each case depends on its particular facts, and that in this case, the commercial production exclusion applied because of the degree of integration between the work performed by Jim Farms pursuant to the Study Agreements, and Jim Farms' own commercial activities.
This case is one of the few to consider the interpretation of fundamentally important aspects of the SR&ED system such as:
- the extent of judicial discretion to broadly construe incentive provisions in the Act;
- the meaning of paragraphs (d) and (i) of the SR&ED definition;
- the role that the term "in respect of" and analogous language plays in many parts of the SR&ED rules; and
- the construction of the Contract SR&ED Provision.
As a result, Justice Woods' reasons will be carefully examined by taxpayers and the Crown alike.
Some taxpayers may be particularly troubled (and the Crown may be pleased) by Justice Woods' distinction between the words "new" and "improved" in the commercial production exclusion, as this may broaden that exclusion. The import of her reasons on this point is difficult to determine for a number of reasons, including their obiter nature, and the context within which she made them – a proxy method case dealing with the Contract SR&ED Provisions.
The Crown may also be pleased (and taxpayers troubled) by Justice Woods narrow reading of the term "lease" in the Leasing Provision, and her indication that the interpretation for which FHMS argued was beyond that permitted by prior authority which indicated that such terms within the SR&ED rules should be broadly construed to ensure that the SR&ED systems has its intended effect; to encourage taxpayers to undertake SR&ED. Justice Woods' reasons do not support this well established position.
On the other hand, taxpayers will likely be pleased (and the Crown troubled) by Justice Woods' emphasis of the breadth of connecting phrases such as "in respect of", and how that should expand what has generally been considered to be the ambit of paragraph (d) of the SR&ED definition, and the SR&ED Contract Provision. This principle may also influence the interpretation of many other SR&ED provisions.
- The Queen v Savage,  2 SCR 428, para. 23, referencing Nowegijick v The Queen, 83 DTC 5041 (SCC).