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Canada Revenue Agency
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Income Tax Information Circular

SUBJECT:  Scientific Research and Experimental Development

NO:  94-2
        Machinery and Equipment Industry Application Paper

DATE:  June 24, 1994


The purpose of this application paper is to assist applicants within the machinery and equipment industry, Revenue Canada in interpreting how the current version of Information Circular 86-4, Scientific Research and Experimental Development, (IC86-4), applies to this industry sector.

Machinery and Equipment Industry Application Paper

Table of Contents

1 Introduction

2 Industry Background

3 Project Eligibility - General

4 Project Eligibility - Special Issues

5 Documentation

6 Examples of Self-Assessment of a Claim

7 Glossary


1 Introduction

Subsection 2900(1) of the Income Tax Regulations (the Regulations) defines what constitutes Scientific Research and Experimental Development (SR&ED). We issued Information Circular 86-4, Scientific Research and Experimental Development, (the circular) to clarify the work that lies within the boundaries of SR&ED, and developed application papers, as supplements to the circular, to address issues specific to particular industries. These papers are adjuncts to the circular and do not override it.

We have prepared this application paper to improve the understanding of SR&ED as it specifically relates to the machinery and equipment manufacturing industry in Canada. The paper is intended to clarify what constitutes SR&ED, and to help claimants self-assess their claims. We will update the application paper as required to reflect changing technology and other issues that arise. The information contained in the application paper concerns only technical issues involved in characterizing eligible SR&ED projects. Questions relating to allowable expenditures, whether capital or current, are not dealt with in this paper except where science advisor input is required. Expenditure issues are covered in Interpretation Bulletin IT-151, Scientific Research and Experimental Development Expenditures. It is important to note that, even if a project is eligible, it does not mean that all the project costs are eligible; this is discussed further in Parts 4.5, 4.9, and 4.10 of this paper, as well as in Interpretation Bulletin IT-151.

For purposes of subsection 2900(1) of the Regulations, developing or improving machinery and equipment and processes for its manufacture is considered to fall within a field of technology. Technology is referred to in paragraph 2.3 of the circular as "the systematic study of the application of scientific knowledge to industrial processes or product development."

The objective of the incentives related to SR&ED is to encourage the advancement of technology in Canadian-developed products and processes. This will foster the competitiveness of Canadian products in the international marketplace. Advancement of technology must be seen to occur within the business environment and context of the claimant.

In Part 6, we provide an example to illustrate the self-assessment of the claim.

2 Industry background

The machinery and equipment manufacturing sector of Canadian industry is represented by many types of businesses including equipment invention, the building and manufacturing of equipment, machinery retrofits and installation, precision machining, materials processing and process development or improvement. Businesses range in size from the very small, to the large and multi-national.

Projects range from short-duration, highly focused component improvements, to multi-year new equipment development. Some examples of machinery and equipment include production equipment, machining tools and equipment, labelling equipment, packaging systems, metal forming equipment, plastics moulding or injection equipment, agricultural machinery and equipment used in the extractive industries.

Technical capabilities and the technological sophistication of companies in this industry sector span a wide range. Typically, projects are "practically oriented" to machinery building and development and product or process improvement through technological innovation. This orientation leads towards applied research or experimental development rather than basic research conducted by the claimant. In many cases, basic research does not directly precede applied research or experimental development. Applied research may include work on improving existing technology.

The resulting scale of improvement may range from incremental (a small improvement), to evolutionary (the next logical generation of machine), to revolutionary (a dramatically different type of machine). Such work may be eligible SR&ED.

Within this industry sector, many organizations do not have technical specialists who have recognized (licensed) designations. However, this does not limit the ability of the claimant's personnel with the knowledge and experience to develop machinery and equipment through applied research or experimental development.

The nature of the equipment being developed within this industry requires organizations to "stretch the capability envelope" of existing technology. For example, market driven technical requirements for higher speed or greater accuracy are often beyond the capabilities of existing machinery. It is often through processes of experimental development that the capabilities of existing machinery are enhanced.

Technological innovation may also be required for in-house production processes. Often the requirements for in-house processing cannot be attained using commercially available products, therefore, the experimental development effort is aimed at developing improved processes.

Within this industry, there are many instances when projects dealing in customized or "one-off" products are undertaken. Frequently, a custom development involves enhancements to existing product lines or processes. These improved products or processes may result in a saleable commodity. In most cases, this type of development is an attempt to take advantage of the "window of business opportunity" for product enhancement.

The development process of this industry can include the following steps, but the steps themselves do not establish the eligibility of the project:

  • outlining specifications or requirements defined by the customer;
  • thinking intuitively (making a hypothesis) about how the customer's requirements can be met;
  • defining the technical objectives to be met;
  • defining the development project to meet technical objectives;
  • formalizing a concept or model;
  • conducting experimental and analytical activities to test the concept and model, including computerized modelling;
  • making iterative refinements in the concept or model; and
  • determining the economic feasibility and technical success of the project.

To qualify as eligible SR&ED, projects do not have to be undertaken based on a formal hypothesis or premise. The hypothesis may be intuitive. Intuitive thought can replace a formal hypothesis if there is a concept that can be formalized to form technical objectives. However, it is important that these technical objectives be established at the start of the experimental development project, but this in itself does not qualify the project as eligible SR&ED.

In this industry sector, the terms engineering and design are used interchangeably. This is in contrast to the general or aesthetic meaning often given to the term design in some other industries.

Concepts of experimental design and advanced problem solving techniques are employed when determining alternate approaches to developing a technical solution. Often the objectives of these techniques are expressed as a desire to correct a specific deficiency, or achieve a specific operational capability. Thus, the intuitive approach to solving problems, followed by a systematic process of testing, is often part of the experimental development project.

During the development cycle, there are often two or more "versions" or "generations" of the same machine, with each generation possessing greater capability or enhancements over the generation that preceded it. Often succeeding generations enhance the capability of the predecessor generation, and/or improve the price performance of the machine.

In this type of development cycle, the first generation machine that is based on the initial concept could be unsophisticated, but technologically advanced. This model can be used to prove the technical feasibility of the project. In some instances, this first generation machine will be sold to satisfy a specific customer demand or is used in-house. Subsequent machines that are targeted at more specific applications are developed both to enhance the technical capability of the first machine, and also to investigate specific alternatives.

In this industry, completing a project to arrive at a conclusion may require field testing, field modification, and field investigation to demonstrate that the technological objective has been met. Often this requirement arises because the equipment is full scale or cannot be tested in isolation without the full process environment. The results of this investigation are necessary to arrive at a conclusion.

Typically, product and process innovations have characteristics that include:

  • a new or improved capability of a machine, equipment, or process which demonstrates technological advancement;
  • technologically based advancement which could have applications for other product lines (i.e., the development applies to a range of products or processes);
  • the initial market-driven specification could not be attained by claimants in their business context, and a technological barrier was identified before the development.

2.1 Activities, projects, and programs

There is a hierarchy of terms used in describing the SR&ED effort. The top level is a program, which may consist of a number of projects that typically have a number of linked activities. Although there is no need to have an umbrella program, it is necessary to consider the eligibility of projects for the purpose of meeting the requirements of subsection 2900(1) of the Regulations. This is necessarily so because in the context of research and development in science and technology individual activities may be routine or standard practice, such as engineering and design, but are linked to high level common technological objectives. These individual activities may only be eligible if they are undertaken directly in support of eligible projects. However, this does not rule out individual activities being eligible on their own merits if they meet the requirements of subsection 2900(1) of the Regulations. Activity is defined in the "Glossary" to this paper. Determination of eligibility is normally made at the project level.

Within this paper, we refer to eligible projects and qualified activities to denote those projects and activities that we consider eligible for SR&ED purposes.

2.2 Major types of technology

The major types of technology that are further developed by members of this industrial sector draw upon, but are not limited to, the following disciplines:

  • mechanical engineering or mechanical design;
  • materials capability (using unconventional materials to meet increased mechanical demands or reduce cost, weight, etc.);
  • electrical and electronics engineering, and electrical and electronics design; and
  • software engineering and design.

3 Project eligibility - General

The definition of SR&ED is set out in subsection 2900(1) of the Regulations, and is further clarified in Parts 2.2 to 2.5 of the circular. A key portion of the definition of SR&ED, as contained in subsection 2900(1) of the Regulations, is:

" ... scientific research and experimental development means systematic investigation or search carried out in a field of science or technology by means of experiment or analysis ..."

In principle, when these elements can be demonstrated, eligibility exists.

A lot of the product development in this industrial sector results from work undertaken to meet contract requirements to deliver equipment with specified performance characteristics or capabilities (custom development). The specific problem in these situations is how to distinguish between experimental and routine development.

As discussed in section 4 of the circular, Characteristics of Experimental Development, the incorporation of capabilities "not previously existing or available in standard practice into a new or existing product or process" may constitute a technological advance if performance is enhanced. Generally, the experimental development project is the technological advance incorporated into the custom development. It is crucial that claimants involved in custom product development claim only the work related to the enhancements (the SR&ED project) to their existing standard practice.

The subsequent commercial sale or use of the resulting product, device, or process, is not a factor when determining project eligibility, since it is not relevant to the intrinsic eligibility of this work. However, it is generally an indication that the experimental development has been completed, and eligibility ceases. The relevant issue in proving eligibility as SR&ED is whether the work has the characteristics of SR&ED regardless of the overall goals in a commercial sense.

The treatment of the proceeds of sale is an expenditure issue that is covered in Interpretation Bulletin IT-151. Project eligibility must be determined with regard to the technical activities and the time frame in which the project was carried out.

The three essential criteria that must be met before any work can be considered eligible SR&ED, as detailed in Part 2.10 of the circular, are:

  • scientific or technological advancement;
  • scientific or technological uncertainty; and
  • scientific and technical content.

The following sections provide a brief explanation of each criterion.

3.1 Business environment

The three criteria of the circular must be applied within the context of the claimant's business environment (business context, as defined in Appendix A of the circular).

Business environment characteristics include business size, competition, area of industry, and access to technical resources.

3.2 Criteria and indicators - Eligible projects

In relatively simple terms, a project is eligible for SR&ED if its objective is to advance technology, within the claimant's business context, by resolving a technological uncertainty in a systematic manner using individuals who are skilled in the technologies involved.

Due to the diversity of activities in the machinery and equipment manufacturing sector, comprehensive tests have not been devised to determine the potential eligibility of projects. However, an attempt has been made to devise "conditions" and "technical indicators" to determine whether the considerations outlined in Part 2 of the circular are satisfied. Specifically:

  • Conditions are tests that must be satisfied if the requirement being tested is to be met. The meeting of any condition or conditions, however, may not be enough to show that a requirement is satisfied.
  • Technical indicators are tests that prove that a particular requirement may have been met.

Conditions provide stronger evidence than technical indicators.

3.3 Scientific or technological advancement

The criterion of scientific or technological advancement is defined in Part 4.1 of the circular as:

"... the incorporation, by means of experimental development, of a characteristic (capability), not previously existing or available in standard practice, into a new or existing process or product that enhances its performance"

The paragraph in question continues on to suggest that novelty, uniqueness, or innovation alone does not indicate the existence of a technological advancement.

Technical information is often of a proprietary nature that limits the ability of claimants to gain access to information known to other claimants, specialists, or in academic circles. Members of this industry may not be closely associated with specialists in academic circles.

As previously mentioned in Part 2, members of this industry are often required to "stretch the capability envelope" of existing technology: to provide greater tolerance, greater speeds, and general performance improvements. This can and does result in advancing technologies within the business context of the members and, more often than not, advancing technologies within the public domain. The technology base in the public domain can be considered that level of knowledge readily available to the claimants. The claimants' level of technological knowledge within their business context is a combination of the body of knowledge in the public domain as well as the claimants' own proprietary knowledge best typified by current products and proprietary knowledge available only to them. In those situations where the solutions of the uncertainties or problems are readily available in the public domain, the development would not qualify as an eligible project. As well, to meet the advancement criterion, claimants must demonstrate that the experimental development work goes beyond the standard practice of their organization, such that a project will be considered to fall outside of routine engineering (which is defined in the "Glossary" in the circular).

Technological advancement can occur even if a project is not successfully completed. By showing why a particular approach will not succeed or may not meet the desired technical objectives, a claimant's knowledge of equipments' potential technical capabilities can increase. In some instances, the claimant may not have been able to achieve the project's objectives after having exhausted all the planned technological approaches, and in the process learned the reasons for the failure.

Conditions and technical indicators which would provide evidence of scientific or technological advancement include:

Conditions

  • a demonstrated increase in the claimant's technological knowledge base such as the introduction of an improved or new product or process based on the results of the experimental work undertaken; or in the case of an unsuccessful project, the ability to explain the technological basis of the failure;
  • the fact that the technological knowledge required to develop a new or improved product or process is not readily accessible (as defined under "commonly available sources of knowledge or experience" in the glossary of terms in the circular) to the claimant; and
  • the new or improved product or process represents an advance in the claimant's technology.

Technical indicators

  • an enhancement of capability (e.g., automation or range of application);
  • an improvement in performance indicators (e.g., speed, weight, tolerance, etc.);
  • a new development specific to a particular product, process, or requirement (e.g., experimental development of automated design software);
  • customer enquiries for enhanced capabilities beyond current equipment operating capabilities; and
  • customer complaints regarding technological capabilities in existing machinery or equipment

3.4 Scientific or technological uncertainty

The definition of scientific or technological uncertainty is contained in Part 2.10.2 of the circular. Scientific or technological uncertainty can occur in either of two ways:

(a) it may be uncertain whether the goals can be achieved at all; or

(b) the claimant may be fairly confident that the goals can be achieved, but may be uncertain which of several alternatives (i.e., paths, routes, approaches, equipment configurations, system architectures, circuit techniques, etc.) will either work at all, or be feasible in order to meet the desired specifications and/or cost targets.

In (a), the uncertainty is due to insufficient technological knowledge. SR&ED is the process undertaken to advance the technological knowledge to eliminate the uncertainty.

In (b), the definition suggests that the technical objective can be met in a number of ways, even when the claimant is fairly certain of success in meeting the technical goals of the project. For example, there may be uncertainty about which of the several alternative approaches to the problem will work, or which will achieve the product cost targets. Therefore, all approaches may have to be tried. There may also be uncertainty about which of the several alternative approaches will achieve the desired specifications and the product cost targets. The definition recognizes that, while most experimental development can succeed in a technical sense given an infinite amount of time and money, attempting to achieve a particular cost target can at times create a technological challenge which needs to be resolved.

Business risk relating to the project's success or failure in the marketplace is not relevant to project eligibility. The ultimate assessment for eligibility will be based upon the technological characteristics and the ability of the project to meet the three essential criteria of scientific or technological advancement, scientific or technological uncertainty, and scientific and technical content.

It is crucial for project eligibility that technological uncertainties are identified before a specific project is undertaken, and that these uncertainties are addressed during the design and development of the first and subsequent generations of equipment. If there are no identifiable technological uncertainties at the start, then there can be no eligible project. However, when new technological uncertainties arise during the course of routine work, the activities directed at resolving the technological uncertainties may be eligible.

Technological uncertainties often arise within the industry from the need to meet reasonable product cost targets so that a product can be sold at a price the market will bear. Typically, cost targets for the delivery of the product require that uncertain paths be considered, although more costly and relatively certain alternatives exist either within the claimant's business context, or in the public domain. In this case, the existence of a technologically certain alternative would not automatically negate the eligibility of a project dedicated to searching or experimenting in order to assess the technical feasibility of these alternative routes, paths, or system configurations. The claimant has to identify the paths and the technological advancement associated with the various paths to meet the criterion of technological uncertainty.

Failure to meet reasonable cost targets may be caused by many variables. The inability to meet restrictive or ambitious cost targets does not in itself prove technological uncertainty. Each project must be assessed on a case-by-case basis.

Conditions and technical indicators that would provide evidence of scientific or technological uncertainty include:

Conditions

  • the result was not achieved before using the claimant's standard practice;
  • an unresolved problem or technological challenge exists;
  • there is a system uncertainty (see definition in Part 4.8 of the circular); and
  • several iterations of experiment and/or analysis have been identified and documented.

Technical indicators

  • there is difficulty or failure in meeting the objectives, specifications, and benchmarks;
  • components or pieces have been modelled (including computer-generated or developed models);
  • there is a change in materials to meet specifications and/or cost targets;
  • cost constraints that cannot be met by using current technology;
  • new technical personnel or outside consultants with expertise were required to assist with the project;
  • there were multiple designs or design models for planning; and
  • various approaches were used to meet cost targets.

3.5 Scientific and technical content

The definition of scientific and technical content is in Part 2.10.3 of the circular as follows:

"The scientific research and experimental development activity must incorporate a systematic investigation from hypothesis formulation, through testing by experimentation or analysis, to the statement of a logical conclusions. Such experimentation can include work on the evolution of prototypes or models."

Demonstration of scientific and technical content can be achieved by following a project outline such as:

  • Defining technological objectives
  • Formulating a project plan
  • Analyzing/experimenting
  • Testing and verifying technological objectives
  • Explaining results/summary

Examples of the documents that could substantiate scientific and technical content are discussed in Part 5 of this paper.

As well, the work must be performed or directed by qualified personnel who have relevant experience in science, technology, or engineering. Qualification is not limited to formal training but includes skills and knowledge gained through experience.

Conditions and technical indicators that would provide evidence of scientific and technical content include:

Conditions

  • following a planned methodology;
  • documenting technological objectives, project steps, and technical results; and
  • using qualified key personnel experienced and/or trained in experimental development and/or research to undertake or direct the project.

Technical indicators

  • previous experience and successful claims in the area of SR&ED;
  • some elements of work contracted out to qualified research bodies and/or sub-contractors;
  • the identification of specific objectives; and
  • a documented project plan identifying departures from the technical knowledge base of the applicant.

4 Project eligibility - Special issues

To qualify as eligible SR&ED, a project must meet the criteria of the preceding section; that is, scientific or technological advancement, scientific or technological uncertainty, and scientific and technical content. In this industry, there are certain general "types" of projects that will be described in more detail. Typical characteristics that relate to these projects will also be identified. Although these types of projects do not cover all types of projects conducted within the industry, they do provide a general guideline of the more common types experienced. Many other types of projects are, and will be, conducted. Project eligibility still needs to be examined on a case-by-case basis.

4.1 Complete new machinery development

A member of this industry will respond to a new market opportunity by developing a completely new machine or piece of equipment. This project, which may be eligible, could involve significant scaling up or scaling down where technological uncertainty is present. Often the technological challenges that confront new machine development include mechanical considerations that can only be resolved through "breakthrough engineering," such as is applied to the miniaturization of components.

Typical characteristics

  • relatively significant design time due to complexity;
  • new components;
  • the approach used to resolve technological challenge is different than that previously used;
  • patents may result from the development; and
  • scaling up or down requires the significant re-engineering or redesign of associated components.

4.2 Technological enhancement of current machinery

Work on technological enhancement of current machinery may be eligible SR&ED. Typical projects could be identified as meeting or requiring:

  • higher performance standards; and
  • improvements in efficiency and quality of existing processes.

In this type of project, an existing product or process will require an enhancement in capability to meet new or emerging requirements. Frequently, developing technological capability within the industry results in identifying new applications for the new technology. This situation arises most frequently when new capabilities are developed for one type or family of products, and that same capability is desired in another family of products. Adapting this new technology to existing applications in a different operating environment may prove to be technologically uncertain.

In determining whether the adaptation work is eligible experimental development, distinction must be made between work based on standard practice alone, and work that goes beyond standard practice to resolve technological uncertainties.

If the project involves the direct adaptation of a known technology to a new situation, where it is reasonably certain that the approach will work, the project is ineligible. On the other hand, if there are identifiable technological uncertainties present, then experimental development will occur. The experimental development work that goes beyond standard practice to resolve the uncertainties is eligible.

Frequently, adapting a new technology to a different operating environment or for a different application involves a combination of standard (existing) technologies. The criterion for distinguishing between eligible experimental development and ineligible routine development is the element of technological uncertainty. If the combination of standard technologies resulted in a new product or process, the development of which was the almost certain outcome of applying a progression of well-known techniques, then the work is ineligible routine development. The work may represent a complex engineering task, but is not characterized by technological uncertainty. If it can be shown that integrating several standard technologies to achieve a new product is technologically uncertain, called system uncertainty, then the work is eligible. System uncertainty is addressed in Section 4.9.

Typical characteristics

  • patents may result from the development;
  • there are more or new materials or mechanical testing than would be required in the usual quality-control procedures;
  • the testing and failure of existing products to meet new performance standards; and
  • testing under more stringent operating environments.

4.3 Stand-alone software development

Due to the nature of machining and automation undertaken in this industry, major software developments are being made. Many of the industry members are actively developing automation and software capabilities, especially in the area of machine and tool control systems, design processes, and process control systems. The evaluation of projects in this area must be conducted by individuals who have experience and/or knowledge, and who appreciate the intricacies of the area of software in this industry. It is also important to emphasize that routine software development, which is not eligible on its own, would be eligible if it directly supports an eligible project.

In some cases, this development is initiated with commercially available software products. Claimants may start with a base package (e.g., computer-aided design software) which requires significant upgrading to enhance and/or achieve specific capability of the system.

Typical examples

The following examples are typical of the type of software development undertaken in this industry. These examples alone do not establish project eligibility.

  • adapting commercial software to meet new or enhanced requirements for process control;
  • adapting control systems for machinery control and/or process control (e.g., programmable logic controllers); and
  • automating existing processes that are currently manually controlled.

4.4 Technical feasibility studies

Technical feasibility studies and technical studies are not, in and of themselves, eligible projects. If a technical study leads to an eligible project, then the technical analysis of it would, by virtue of such a linkage, be a qualified activity within the project. Even without this linkage, eligibility can occur if the analysis advances the knowledge of the claimant's technology base, provided it meets the essential criteria discussed in Part 3 of this paper.

4.5 Process improvements

Typical projects within this industry include:

  • the construction of equipment to meet unique capability or performance criteria;
  • significant enhancements to current production processes to gain increases in productivity and/or meet specific production cost targets;
  • the design of tooling and testing of new tooling methods and techniques; and
  • increased automation (i.e., robotics).

In this industry, experimental development activities in the process improvement field are typically directed at ways of achieving continuous improvement, and verifying the results by performing experimental production runs. The activities that may be eligible are often carried out with the ineligible activities. The following sections explain the activities that fall within the boundary of SR&ED.

4.5.1 Continuous improvement

For many members, due to the nature of the industry, a major part of their development work is to develop machinery capabilities that are not readily available commercially for their own purposes, or that make improvements to their process.

Typically, constructing machinery and equipment for internal use does not follow a conventional development path. Often this equipment is in a continuous stage of development to enhance the technical capability of the equipment as new demands and requirements are identified by the applicant. For the purpose of such SR&ED claims, submissions should be based on a separate project basis for each successive improvement. Documentation must clearly show how each successive improvement represents an incremental advance over the previous improvement and, specifically, the technological uncertainty that was resolved.

The resulting machinery and equipment are often used primarily for production purposes, but specific situations arise when production equipment is used directly in the prosecution of SR&ED.

The use of this internally developed machinery and equipment in commercial production does not negate the existence of eligible activities. In these situations, documentation must clearly distinguish between activities that are routine in nature and involved only the standard practice of the claimant, which are ineligible, from those activities that resolve technological uncertainties and result in technological advance, which are eligible.

4.5.2 Testing to demonstrate technological advancement

For certain experimental development projects, such as process and equipment improvements, the only way to verify that the technological objectives can be achieved is to carry out trial production runs. This phase of the development is the period of testing that corresponds with the proving out of specifications for the product or process. It does not coincide with the usual learning curve for the start-up of established systems. These testing activities are eligible to the extent that they correspond with the needs, and are directly in support, of an eligible experimental development project. The product or output from such activities (sometimes known as experimental production) may not qualify for SR&ED tax treatment, depending on what uses are made of the output.

The tax treatment of the expenses involved with output from these testing activities will be different if commercial activities are involved (e.g., some or all of the output is sold). In these situations, only the costs of materials used in carrying out SR&ED, as well as related current expenditures, may be claimed.

The trial production phase will generally be considered complete once the resulting product or process meets the intended technological objectives. However, sometimes high scrap rates are encountered in early production runs, and this may be used by a claimant as an indicator that the development is still in an experimental stage. The claimant's activities at this point may or 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.

However, if new technological problems are encountered subsequent to this time, the attempts to resolve these problems may be eligible SR&ED. These activities should be claimed as a separate project, and the project's eligibility depends on whether it meets the three criteria.

4.6 Machine user interface

Projects are often initiated to specifically address the man-machine user interface. Work in this area can often involve control systems and other areas that involve developing specific-use software programs. Software development is addressed in Part 4.3 of this paper.

Man-machine user interface can also require the development of mechanical devices, electronic hardware, and certain sensor applications to facilitate the interface. Again, the ability of the projects to meet the three essential criteria discussed in Part 3 of this paper will determine a project's eligibility.

Typical projects within this industry could include:

  • providing audio and visual characteristics to machine control; and
  • making relatively significant design efforts towards the ergonomics of a machine application.

4.7 Beta site testing

Frequently, the machinery and equipment produced by members of this industry are destined to be installed in the customer's production or process facilities. The development work is not complete until the machinery or equipment achieves its technological objectives. This is demonstrated through testing in the real production environment, also known as beta site testing. Most often, the claimant cannot simulate a typical production environment. Beta site testing is therefore essential.

Beta site testing may take place after legal ownership of the machinery or equipment has been transferred to the customer. The change of ownership issue, and the location of beta testing should not affect whether the activities qualify as SR&ED. However, in such a situation, the right to claim may be questionable. The determination has to be made on a case-by-case basis.

Although the location of beta testing should not affect whether the activities qualify as SR&ED, the tax treatment of their costs may be different if the activities take place outside Canada. Please see Interpretation Bulletin IT-151 for information on how such costs are treated.

Generally, it is during the beta site testing that certain technological uncertainties are resolved. In some cases, new technological uncertainties arise during beta site testing and are then resolved. Activities to demonstrate the achievement of technological objectives, but not including demonstrations to prospective buyers, and those aimed at resolving technological uncertainties during beta site testing, are considered qualifying activities. This phase will often denote the completion of the project. Therefore, claimants must demonstrate in their documentation how the beta site testing activities relate to resolving technological uncertainties and achieving the technological objectives.

In some instances, when documentation is lacking, it may be questionable whether activities carried out at a customer's site are beta site testing or routine trouble-shooting, debugging or fine-tuning of the machinery after its installation. This is discussed in the following section.

4.8 Trouble-shooting, debugging, and fine-tuning

Difficulty often arises in determining when an experimental development project is complete. The basic criterion for ascertaining when experimental development has been completed is the point at which the project's initial technological objectives have been achieved. This occurs when all identified technological uncertainties have been resolved, and the application of standard operating practices permits the achievement of the technological performance objectives which were established when the project was defined.

The work generally associated with trouble-shooting, debugging, and fine-tuning 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 when the equipment, process, or technology is installed to ensure that it meets all the established technological specifications agreed upon. Such work is ineligible.

However, if it can be shown that in the process of trouble-shooting and debugging a new technological uncertainty occurs, then the work which is directed at resolving this specific uncertainty, but not including the trouble-shooting and debugging activities, is eligible. This work should be claimed as a new project identifying the new technological uncertainty involved.

4.9 System uncertainty

System uncertainty is addressed in Part 4.8 of the circular, as follows:

"Work on the combination of standard technologies, devices, and/or processes is eligible if non-trivial combinations of established (well-known) technologies and principles for their integration carry a major element of technological uncertainty; this may be called a "system uncertainty"...".

This concept recognizes that even though behaviours of individual components may be well understood or documented, the combination of components may fail to perform as expected. This type of uncertainty is frequently encountered in the context of this industry, where known components are selected, but the combination of these components may produce unexpected or undesirable results (such as vibration, overloading of components, controls instability, etc.). Often these system uncertainties can be the cause of a development project to determine the reasons for undesirable behaviour, and eliminate it.

Identifying and assessing system uncertainty can be a very complex exercise. A high degree of technical experience and training is required. Essentially, the exercise becomes one of identifying the major components within the system then assessing the interdependence and interaction of the various components.

If it is necessary to redesign closely related components to meet the specifications for the system, as well as make significant modifications to provide interface of various components, and efforts in the integration of components go beyond that which could be usually determined as routine engineering, then a system uncertainty would exist. The degree of system uncertainty can range from minor (only one component or aspect of the system requires redesign) to major (many components of the system require redesign) depending on the system specifications. In a system configuration, the components or subsystems that require redesign to resolve the system uncertainty are known as associated established components. Only those activities related to redesigning the associated established components are eligible. As a result, only portions of an overall project may be eligible SR&ED. The group of eligible activities, including all directly supporting activities, becomes part of the "envelope of SR&ED." The "envelope of SR&ED" is defined in the "Glossary" to this paper.

Documenting the combination of standard technologies, devices, and/or processes, and assessing the degree of triviality associated with the combination and integration becomes paramount. Identifying the "envelope of SR&ED" can pose significant problems due to system complexity. The documents must clearly show what activities are related to the redesign of the associated established components. Only the current costs of the "envelope of SR&ED" may qualify.

As stated previously, in a complex system, identifying the "envelope of SR&ED" may not be a simple task. This task should be handled by individuals who possess the appropriate technological knowledge and training. Therefore, it is the responsibility of the science advisor or technical expert, when reviewing the eligibility of the project, to determine the "envelope of SR&ED."

The claimant's accounting system must be detailed enough in these situations to segregate costs associated with every major technical component, as well as identifying costs and expenditures associated with the integration and redesign activities.

Typical characteristics

The following characteristics will be present in an eligible project, but they do not in themselves establish project eligibility:

  • designing new applications for existing equipment that require the redesign of components to achieve technological specifications;
  • substituting components with new parts or components to improve performance or increase capability;
  • discovering some uncertainty concerning the interface and integration of components; and
  • requiring complex analysis to select components.

4.10 Prototypes, custom products/processes, and commercial assets

It is common in this industry for members to construct equipment or machinery to meet market-dictated technical requirements. The equipment or machinery ultimately ends up being sold or put into commercial use. Frequently, such equipment and machinery are labelled as prototypes. For the purposes of section 37 of the Act, and 2900 of the Regulations, it is important to distinguish between prototypes, and equipment or machinery developed for sale or put into commercial operation. To apply the provisions of the Act and Regulations, it is necessary to determine the intent for which a particular asset is constructed. The definition of scientific research and experimental development (SR&ED) in subsection 2900(1) of the Regulations, and the definition of SR&ED expenditures in section 37 of the Act, essentially govern the tax treatment in these situations. The following paragraphs differentiate between the tax treatment for a prototype, and for a custom product/process and commercial asset.

4.10.1 Prototypes

The Act does not define prototypes or specifically provide for their treatment. However, prototype is defined in the glossary of terms (Appendix A) of the circular.

A prototype is an original model on which something new is patterned, and of which all things of the same type are representations or copies. It is an experimental model possessing the essential characteristics of the intended product to test the feasibility of the concept or hypothesis. It is not being constructed for commercial use or sale, and it has no lasting value. The design, construction, and testing of prototypes generally fall within the scope of experimental development and, when this is the case, the costs would usually be an eligible current SR&ED expenditure.

4.10.2 Custom products/processes and commercial assets - custom development

As stated in Part 4.10, it is quite common in this industry for members to construct equipment or machinery to meet a customer's technical requirements with the intention of an ultimate sale. Such an undertaking is referred to as a custom product/process. Another common practice for claimants is to construct equipment and machinery to meet their own technical requirements and which are intended for their own commercial operations. Such equipment and machinery are referred to as commercial assets. Generally, developing custom products/processes and commercial assets may involve both eligible SR&ED and ineligible activities. Subsection 2900(1) of the Regulations excludes any activities considered to be the commercial production or commercial use of a product or process. Therefore, only a portion of the development of a custom product/process or commercial asset (custom development) may be eligible SR&ED since not all the activities fall within the "envelope of SR&ED." Within this custom development is the claimant's SR&ED project which consists of those activities that fall within the "envelope of SR&ED." For the purpose of section 37 of the Act, and 2900 of the Regulations, the issue is how much of the custom development is the eligible SR&ED project? It is the claimant's responsibility to separate the eligible SR&ED project from the custom development and claim only the eligible SR&ED project. In addition, the claimant should isolate the costs associated with the eligible SR&ED project from the total cost of the custom development. It is important to note that some costs, particularly material costs, of custom development relate partly to SR&ED activities and partly to non-SR&ED activities. The costs that relate to SR&ED activities will generally only be considered to be eligible to the extent that they can be directly attributable to carrying out SR&ED (see Regulation 2900(2)-(4)). Also, the documentation must clearly show how the SR&ED activities are related to resolving technological uncertainties.

5 Documentation

The need for adequate documentation is dictated in Part 3 of the circular - "Requirement for scientific and technical content and documentation." It is essential to emphasize that the documentation to support an eligible claim should be of a technical nature. A business plan, set out to promote the initiation and approval of a particular project, does not meet the documentation requirements. The lack of adequate technical documentation will lead to the disallowance of the claim.

The following discussion is merely a guide on how traditional documentation could be used to substantiate a claim, and is not intended to dictate to SR&ED performers what documentation they should keep.

Documentation to support the technical uncertainty incorporated in the project should address either the uncertainty of achieving the technological goals at all, or identifying the possible alternative approaches that have been considered as a potential solution. It should also include an analysis of their feasibility (based on technical and cost target considerations) showing why a particular path was selected. It would also be necessary to identify the resulting technological advancement that the claimant would make within the business context of the firm.

The project plan, and documentation of the plan, should initially describe the investigative methods to be used, the personnel and services to be allocated to the project, and the indications or measurements to be used in determining the success or failure of the various experiments and/or analysis.

As the plan is being carried out, the progress must be documented on a periodic basis, including the various successes and/or failures experienced along the way. These include test results, test reports, notes on experimentation, etc. Evidence of changes in methodology or the selection of alternative strategies, routes, etc., must be identified and documented to record a complete tracking of the plan through to its conclusion.

Once the plan has been completed, or perhaps aborted due to a failure, the conclusions must then be documented. The conclusions should use the results of the experimentation or analysis to measure the degree of success in achieving the technological objectives.

Costs incurred on the project should be identified and appropriately allocated when necessary. If there are payments to other parties, access to any contracts is essential, as are the technological studies or plans on which the work was based and the maintenance of all records in the transaction. When there is a proliferation of activities in the "envelope of SR&ED," it becomes necessary to be able to quantify the costs allocated to each activity.

5.1 Technical information requirement for claims: Form T661

Form T661, Claim for Scientific Research and Experimental Development Expenditures Carried on in Canada, is a prescribed form that we require for filing SR&ED claims. Guide T4088, Claiming Scientific Research and Experimental Development Expenditures - Guide to Form T661, is available to help claimants complete Form T661. It is the claimant's responsibility to maintain records that are adequate and can support a claim. A general outline of a typical narrative that would generally be sufficient is provided as follows:

A) General information about your business

  • name of the business or company;
  • name, telephone number, and title of the person or persons responsible for scientific research and experimental development;
  • a brief description of the nature of your business;
  • key words describing the fields of technology of your project or projects (e.g., robotics, metal and alloys, electrical engineering, etc.);
  • names of other businesses, if any, that your business is associated with through inter-linking management, joint ventures, ownership, partnerships, etc., which could have a significant bearing on the conduct of your SR&ED; and
  • the taxation year of previous claims, if any.

B) Technical narrative for each project

Each project's technical narrative should include the following:

  • project title:

- name of project or project number;

- start date and actual or estimated completion date;

  • brief description of project in technical terms;
  • the technological advancement sought;
  • the technological uncertainties associated with the project:

- identifying the possibility of achieving technological goals;

- identifying the different paths, approaches, configurations, etc., to be tested, if any, to meet desired specifications and/or cost targets;

  • brief description of technical work done:

- progress made to date;

- key findings and conclusions, if any;

  • identifying activities (e.g., engineering, design, computer programming, data collection, etc.) directly in support of the experimental development project;
  • names, qualifications, and experience of key personnel involved in the project;
  • technical reports:

- significant internal technical documentation;

- published reports or other records that relate to the technical aspects of the project;

  • summary of approximate resources allocated during the year:

-number of hours allocated to project;

- estimate of amount of current expenditures;

- estimate of capital expenditures.

6 Examples of self-assessment of a claim

In this section we present a typical custom product development that contains both SR&ED and non-SR&ED activities as an example of the self-assessment of a claim. The intent is to help claimants identify and claim the SR&ED work (project) that is present in the custom development. This example will also illustrate how the criteria of scientific or technological advancement, scientific or technological uncertainty, and scientific and technical content are applied.

Note

In this example all activities are carried on in Canada.

Objective of the project

To build a machine that uses electric motors and servos rather than hydraulic power to reduce the mechanical complexity and the size of the machine, as well as to enhance the throughput of the machine.

Company background

ABC, a Canadian company, is a manufacturer of speciality machines using hydraulic power to form steel. These machines are sold to, and used by, customers in a production facility. The company identified an opportunity with one of its customers to develop a product with enhanced capabilities (e.g., productivity and output in pieces per hour). The customer agreed to purchase a machine that met its specifications at a fixed price (regardless of ABC's development costs).

The company was quite certain that these new specifications could not be met using the company's current hydraulic technology. However, the company believed that the new specifications might be met if they replaced the hydraulic drive with an electric one. The electric drive technology represented a new technology to the company. It potentially could be applied to the company's other products.

Based on the following, the company believes that there is eligible SR&ED work (project) within the custom development:

  • Scientific or technological advancement

Electric drive technology represented a new technology to the company, which could have application to other products in its existing product line. The company had not used, and was not aware of electric technology being used, in a similar application. In the business context of the company, the success or failure of such an undertaking would represent an advancement for the company. Success would mean an advance in technology (e.g., enhanced capability using electric drive) while failure would mean an advance in technological knowledge (e.g., limitations of electric drive technology as a replacement for hydraulic drive technology in this particular application).

  • Scientific or technological uncertainty

The company had examined the technical requirements, and by simple testing of existing products, concluded that the specifications could not be met using a hydraulic system. As an alternative, the company conducted a feasibility study that identified that an electric drive and an electronic control system might have the capability of meeting the performance requirements. However, it was uncertain that an electric drive and an electronic control system would meet the following goals:

  • physical space: the new drive system must have dimensions of not more than 2m long by 1m wide by 0.5m high;
  • speed: must achieve more than 300 presses per hour; the current hydraulic system was capable of 240 presses per hour;
  • power (electric systems might not be capable of providing sufficient power/force): must be sufficient to form steel parts; and
  • control: drive system must have sufficient control to achieve the mechanical tolerance desired in the pressing.
  • Scientific and technical content

The company identified a project team to perform this assignment. The team was led by a senior electrical technologist who had several years of experience with electric power machinery and the development of hydraulic machinery. He was responsible for developing a project plan, and monitoring progress throughout the project.

Plan

The project leader developed a project chart showing key project steps and milestone dates. During the development of the plan, the project leader identified the need for outside expertise in the area of electric motors and electronic controls. An independent qualified electrical engineer was contracted to provide the expertise required for the project.

The plan also identified modelling opportunities for a new control system, and stationary testing of key components. The result of the testing would be to assess the suitability of key components in the final machine design.

Analysis/experimentation

The designer assigned to the project developed the alternative equipment configurations to meet the customer's requirement. By using the company's computer-aided design (CAD) system, design time was minimized, and down loading to computer-aided manufacturing (CAM) and the building of certain components was simplified. Several design iterations had to made to achieve the physical size constraint. The design iterations were based on the results of the mock-up experiments and the recommendations of the electrical engineer.

The electrical engineering consultant, in a report, recommended three possible motors based on the force requirement for pressing the work piece, the speed of the drive system, and the physical size constraint. Each motor had a different speed-torque characteristic. The final selection would be made after experiments were conducted using a scaled-down model of the drive unit, and the prototype logic system as the programmable logic controller (PLC). The engineer also developed the functional specifications for the PLC.

The project team assembled a prototype logic system to model the PLC behaviour; the ultimate implementation of this system would be a micro chip. Experiments were performed to simulate the fine control required to achieve the mechanical tolerance on the work piece. Several modifications had to be made to the PLC design before the required results were achieved.

The project team also built a scaled-down model of the drive system and coupled it to the prototype logic system to investigate whether sufficient force could be developed to form steel parts; and the speed of the drive system. The results from these prototyping tests would also dictate which electric motor would be selected for the final system. Many tests were performed, and several modifications to the PLC design had to be made before fine control of the drive was achieved. The results of these tests seemed to indicate that the motor that had a mid-range speed-torque characteristic should be the one selected for the final system. However, this could only be confirmed by building and testing the actual system.

System construction and testing

The results from the prototype tests were fed back to the designer for the design of the actual system. Various modifications had to be made to the original design configuration to achieve the dimensional specification of the system now that the choice of the motor was made. The new electric drive system using the selected motor and the new control system was constructed, assembled and retrofitted to an existing hydraulic model. This custom model was then installed at the customer's site and tested to meet the technological specifications.

As a result of those tests, the need for a number of modifications became obvious:

  • The control system was too complex; fewer features would make the system simpler for operators to use. The control system was modified to make it simpler to use.
  • The control system needed to be modified to eliminate hysteresis due to the inertia of the motor. This problem was not evident in the prototyping tests using a scaled-down drive model.
  • The drive system appeared to work, but was noisy under high-load conditions. Extensive acoustic damping was required to correct this problem.
  • The motion of the drive system was not smooth under load, which resulted in unacceptable variance in the mechanical tolerance specification for the pressing. It took several modifications to the drive system by trial and error before the problem was corrected.
  • Several relays had to be replaced with ones with higher ratings, and line filters were added to the control system to eliminate line spikes.
  • Initially, the system was operating intermittently. Further investigation showed that dust from the environment was interfering with the operation of some position sensors and interlock switches. The problem was eliminated when dust covers were installed over the sensors and switches.

Results and summary

As a result of the modifications done on-site, the system was finally able to achieve all its technological objectives. Typically, a standard machine (i.e., hydraulic version) is installed and commissioned in a one-week period. Installing and commissioning the electric drive model took six weeks, during which required modifications were made in the field.

Identification of the SR&ED project

The task in self-assessing this claim is not just to determine that the SR&ED project meets the eligibility criteria (uncertainty, advancement, and content), but also to identify those activities that fall within the "envelope of SR&ED" since the custom development contains both SR&ED and non-SR&ED activities. The SR&ED project then consists of the activities that fall within the "envelope of SR&ED." Based on the development described, an eligible SR&ED project exists since the three criteria are met. The issue is how much of the development is the SR&ED project?

a) The SR&ED project

The following activities constitute the SR&ED project (i.e., "envelope of SR&ED"):

  • the activities relating to the new drive and the new control system, time, and materials consumed (resolving technological uncertainties);
  • project management of the SR&ED project, time only (support activity);
  • planning, time only (support activity);
  • design of alternative equipment configurations and iterations to meet physical constraint requirement, time only (support activity and resolving technological uncertainty);
  • outside consultant study (support activity);
  • prototype logic system to model the PLC behaviour, including experiments to simulate the fine control of the drive and modification to the PLC design, both time and materials consumed (resolving technological uncertainty);
  • construction of scaled-down model of drive system and investigations of sufficiency of force to form steel parts and speed of system, both time and materials consumed (resolving technological uncertainty);
  • testing at customer's site to meet technological specifications (validating and demonstrating technological advancement), including modification work to the control system to eliminate hysteresis, and modification work to the drive system to correct uneven motion under load, both time and materials consumed (resolving technological uncertainties required to achieve technological objectives).

b) Activities that are not considered to be part of the SR&ED project

The following activities do not fall within the "envelope of SR&ED" and cannot be claimed:

  • The activities relating to the interface between the new drive and the existing components (did not involve any technological uncertainty, and, therefore, fall outside the "envelope of SR&ED.")
  • final design (the last redesign using the results of the last prototype test) of the actual system (a one-time routine engineering activity related to commercial activity);
  • construction and assembly of new drive, both time and materials, including new electric motor (related to commercial activity);
  • construction and assembly of new electronic control system, both time and materials (related to commercial activity);
  • the acoustic damping work during testing at customer's site, both time and materials (standard practice not related to resolving technological uncertainty);
  • control system modification to make it simpler to use, both time and material (standard practice not related to resolving technological uncertainty; not required to achieve technological objectives, but required to satisfy customer's need;
  • all work related to replacing relays and installing line filters during testing at customer's site, both time and materials (trouble-shooting and debugging not related to resolving technological uncertainty);
  • all work related to investigating intermittent operation due to dust, and installing dust covers during test at customer's site, both time and material (trouble-shooting and debugging not related to resolving technological uncertainty).

This example illustrates a development involving technological enhancement of current machinery. The claimant in this case would claim only the SR&ED project identified.

In general, each custom development within this industry sector has to be considered on a case-by-case basis regarding the identification of how much of the development constitutes the SR&ED project.

Second example

As a second example, assume the same facts as those described in the first example. However, in this case, there was uncertainty about whether integrating the new electrical drive system into the current machine structure could be achieved without major modifications to the machine structure. In carrying out the integration, it was learned that major modifications had to be made to the current machine structure before the integration would meet technological specifications. These modifications required both new construction materials and significant changes to the basic design and interface of standard components.

In this example, system uncertainty exists about whether integrating standard components to the new electric drive can be achieved without major modifications while still meeting the required technological specifications. Although the operation of individual components may have been known, the result of the interactions among them as a whole was unknown, and could only be resolved through a project that incorporated a systematic investigation to determine the result of the interactions. Therefore, the SR&ED project would include those activities identified in the first example, as well as all those activities related to modifying all related components.

In the examples, to ensure a smooth review of their claims, claimants must properly allocate the expenditures to the SR&ED project.

7 Glossary

Activity

An activity is a small increment of work within a project. The activity is usually the lowest level of accountability, and can refer to a technical specialty (e.g., logic design) or process (e.g., infrared spectrum analysis). It clearly defines the specific work performed, and can be attached to a specific individual or piece of equipment.

Analysis

Analysis is a method used to determine or describe the nature of a thing by separating it into its component parts.

Envelope of SR&ED

The "envelope of SR&ED" contains basic research work, applied research work, experimental development work, and activities that are necessary to resolving technological uncertainties, as defined in subsection 2900(1) of the Regulations.

Experimentation

Experimentation is an act or operation designed to discover, test, or illustrate a truth, principle, or effect - to make a test or trial.

Increment

An increment is the level of small improvement or "continuous improvement" by which a machine or piece of equipment can be improved (as opposed to radical improvement).

Process development

Process development is the design of a new method of converting one material into another, either by transforming it or adding material to it, as used in the context of manufacturing.