Regulation 2900 - Interpretation

The taxpayer (Kute Knit), which was acknowledged by the ARQ to be engaged in SR&ED, had claimed percentages (ranging from 15% to 75%) of the salaries incurred during its 2011 and 2012 taxation years for 13 management and supervisory employees as being the times that they were directly supervising the prosecution of SR&ED within the meaning of Reg. 230R1(b) pursuant to the Taxation Act (similar to Reg. 2900(2)(b) under the ITA). These same percentages had been used for the managers and supervisors since 2006.

Before dismissing the taxpayer’s appeal, the Court of Appeal stated (at para. 20):

The only evidence the appellant submitted was a table in which it listed the names of the employees in the two groups and attributed to each of them a percentage of the total time it stated had been spent on the SR&ED projects. Other than this table, the appellant did not file supporting documents regarding the percentages set out therein, be they time sheets, SR&ED progress reports, correspondence, minutes of meetings, internal notes or emails related to these tasks, nor did it … call any of the employees from these two groups as witnesses to support these percentages … .

The Court went on to confirm the finding in the Court of Quebec find that the taxpayer had not “demolished” the basis for the assessments by demonstrating, “on a prima facie basis, that the respondent’s premise — i.e., that the appellant had not shown that the reported portions of each employee’s salary could reasonably be attributed to the prosecution of SR&ED — was false” (para. 25).

The taxpayer (Kute Knit), which was acknowledged by the ARQ to be engaged in SR&ED, had claimed percentages (ranging from 15% to 75%) of the salaries incurred during its 2011 and 2012 taxation years for 13 management and supervisory employees as being the times that they were directly supervising the prosecution of SR&ED within the meaning of Reg. 230R1(b) pursuant to the Taxation Act (similar to Reg. 2900(2)(b) under the ITA). These same percentages had been used for the managers and supervisors since 2006.

In confirming the full denial by the ARQ of such management and supervisor salary claims, Alcindor JCQ stated (at paras. 44 - 46, TaxInterpretations translation):

Although there is no doubt that SR&ED was performed and that a lot of work was done in this regard, the evidence does not show the number of hours spent by the managers and supervisors on SR&ED activities. …

No one has explained the day-to-day activities of each of the employees whose salaries are in question, nor did they testify. No job descriptions were submitted. No documentary evidence was submitted by Kute Knit to support its claim … .

… It did not demonstrate that the managers and supervisors actually worked on SR&ED activities that were eligible for the credit.

The claim of the taxpayer (Focus) for the portion of the salaries of its employees that directly related to the prosecution of SR&ED as described in Reg. 230R1(b) pursuant to the Taxation Act (similar to Reg. 2900(2)(b) under the ITA) was determined on the basis of the president’s estimates made after the year of the percentage of their salaries that represented such involvement based on his perception of the efforts of those employees in the various SR&ED projects. No time sheets were kept.

In affirming the ARQ denial of 2/3 of the salary amounts claimed for the purposes of the SR&ED credit, Chalifour JCQ stated (at paras. 70-72, TaxInterpretations translation):

The testimony of employees assigned solely to SR&ED and their work notes are not sufficient in themselves to justify Focus in counting their salaries as a qualifying expenditure.

The employees' notes and other documents that could demonstrate the SR&ED project work are useful as long as they are part of a larger body of evidence that can provide a sufficient degree of precision.

The arbitrariness of an officer relying on his knowledge of the business is not sufficient to demonstrate the proportion of salaries eligible for a tax credit.

Although the ARQ accepted that the taxpayer was carrying on SR&ED, the taxpayer had failed to establish with any convincing evidence what proportion of the remuneration of its employees qualified under Regulation 230R1 (s. 230)(b) – equivalent to federal Reg. 2900(2)(b)) as being amounts that could reasonably be considered to be in respect of the prosecution of such SR&ED.

After stating (at para. 39, TaxInterpretations translation) that “[i]t is true that neither the Act nor the Regulations require that employee time sheets be prepared and filed,” Dufour J noted that time sheets were the only evidence presented, and these had been fabricated well after the fact and were incoherent and unreliable (paras. 57-59). He concluded (at paras. 109-110):

While the fisc conceded that the taxpayer performed activities that qualified as SR&ED … it denied almost all expenditures for salaries of employees who performed tasks that could reasonably be expected to be related to SR&ED.

This is a disheartening result, but it is not unfair. Hubmar had the burden of persuasion … .

He had also noted (at para. 45) that:

The criteria mentioned in the [CRA] SR&ED Salary or Wages Policy guide the taxpayer in this task since the tax authorities state, in a manner, how they will apply the Regulations when processing a tax credit claim.

The taxpayer was a Canadian corporation, owned equally by two brothers, that carried on a small-scale business of designing and manufacturing agricultural implements, and which used the proxy method in computing its SR&ED claims. Tom and Gary each worked 3,000 hours in 2010, of which Tom and Gary spent 1094.5 and 201.5 hours, respectively, on SR&ED activities. The taxpayer at year end determined that their draws would be treated in aggregate as comprising (i) wages equal to $30 per hour spent on SR&ED (for an aggregate of $38,880, but with $11,940 of this allocated to Gary, so that he effectively received more than $30 per hour), and (ii) (as to the balance of their “compensation," or $31,200 each) as dividends. CRA reassessed on the basis that a pro rata portion of each brother's wages should be treated as having been paid for non-SR&ED activities, based on his non-SR&ED hours as a percentage of his 3,000 hour total, so that the eligible Reg. 2900(2)(b) amounts were reduced pro tanto.

In allowing the taxpayer’s appeal, D’Arcy J stated (at paras 31, 32, and 33):

… [T]he Appellant paid Gary McCrea and Tom McCrea wages of $38,880 solely for the work Gary McCrea and Tom McCrea performed conducting SR&ED. As a result, 100% of those wages can reasonably be considered to relate to SR&ED and they represent an expenditure on or in respect of SR&ED.

Counsel for the Respondent argued that… Gary McCrea and Tom McCrea did not receive any compensation for the significant time they spent “performing director or management activities” for the Appellant.

… As the controlling shareholders and managing directors of the Appellant, they chose to receive dividends in lieu of salary and/or bonuses. This was their choice and did not require a formal agreement.

The taxpayer (“Oldcastle”), which was a leading producer of concrete building products, entered into an employment contract in 2004, with a former shareholder and principal of the business (“Castonguay”) who now was no longer a “specified employee,” for Castonguay to direct a research centre (with a staff of over 25) for the development of new and improved building products. The contract stipulated a base salary, plus a “bonus” (which Archambault J stated he would instead term “variable pay”) calculated as a sliding percentage of the sales (net of shipping and insurance expenses) of new and modified products developed by the research centre. However, the base salary eroded based on the variable pay level, so that no base salary would be payable in any year in which Castonguay’s variable pay exceeded $1 million, which was the case in the taxation years in issue (2010 and 2011). Oldcastle took the variable pay into account under Reg. 2900(4) for purposes of computing its prescribed proxy amount having regard to s. 37(8)(a)(ii)(B)(IV).

Before finding that 55% and 40% of the variable pay of Castonguay for 2010 and 2011, respectively (being the respective percentages of Castonguay’s time conceded by the Crown to relate directly to his R&D activities), should be included in computing Oldcastle’s prescribed proxy amount under Reg. 2900(4), Archambault J turned first to the Reg. 2900(9)(c) exclusion of “bonuses,” and stated (TaxInterpretations translation, paras. 25, 27):

This variable pay is quite similar to the remuneration of employees working for intermediaries, such as sales persons, commercial representatives and brokers… .

Oldcastle had no discretion as to paying the variable pay. It was payable in accordance with the terms of the employment contract. … [T]he sole remuneration which was paid to Mr. Castonguay in 2010 or 2011 was not an “amount paid in addition that which is due.” We are not dealing here with a bonus for purposes of the Act and Regulation.

The taxpayer (“Oldcastle”), which was a leading producer of concrete building products, entered into an employment contract in 2004, with a former shareholder and principal of the business (“Castonguay”) who now was no longer a “specified employee,” for Castonguay to direct a research centre (with a staff of over 25) for the development of new and improved building products. The contract stipulated a base salary, plus a “bonus” (which Archambault J stated he would instead term “variable pay”) calculated as a sliding percentage of the sales (net of shipping and insurance expenses) of new and modified products developed by the research centre. However, the base salary eroded based on the variable pay level, so that no base salary would be payable in any year in which Castonguay’s variable pay exceeded $1 million, which was the case in the taxation years in issue (2010 and 2011). Oldcastle took the variable pay into account under Reg. 2900(4) for purposes of computing its prescribed proxy amount having regard to s. 37(8)(a)(ii)(B)(IV).

Before finding that 55% and 40% of the variable pay of Castonguay for 2010 and 2011, respectively (being the respective percentages of Castonguay’s time conceded by the Crown to relate directly to his R&D activities), should be included in computing Oldcastle’s prescribed proxy amount under Reg. 2900(4), and after finding that the variable pay was not a “bonus” given inter alia that the taxpayer had no discretion as to how much it paid, Archambault J turned to Reg. 2900(9)(d) and stated (TaxInterpretations translation, para. 28):

[T]he formula set out in the employment contract provided for remuneration based on the computed sales revenues for products developed by the Research Centre, reduced by two expenses, namely, shipping and insurance expenses. … Too many of the expenses incurred in making the sales were missing for it to be possible to state that Oldcastle realized a profit on the sale… . At the end of the day, the expression “variable pay” appears to me to be most appropriate for describing the remuneration paid to Mr. Castonguay.