SR&ED and Due Diligence: Are you informed?

By: BeneFACTMarketing in SR&ED

December 10th, 2014

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The term due diligence is often used by the Canadian Revenue Agency’s (CRA) Research and Technology Advisors (RTA) when auditing a Scientific Research and Experimental Development (SR&ED) claim. Yet, a clear definition as it relates to SR&ED, especially in the areas of technical and analytical work does not exist in the Income Tax Act (ITA). Equally important, the CRA does not consider due diligence to be a part of SR&ED work, which creates a catch 22 situation because there can be no SR&ED without due diligence.

According to the CRA, due diligence as it pertains to SR&ED is based on a scientific or technological uncertainty that includes all of the preliminary work conducted up until a scientific limitation or technological uncertainty/obstacle within the technology base or level used, is identified. A technological or scientific uncertainty prevents an organization from reaching its objective using standard practices. This is where a major shift takes place; the investigation and experimental work that takes place is now aimed at overcoming the existing scientific or technological limitation. This situation propels the project into SR&ED work where uncertainties are worked through and scientific or technological advancements unfold to contribute new information to the current knowledge base and/or advance technology. To this end, it is imperative to describe and document all work leading up to the identification of the scientific or technological uncertainty because during an audit, it helps to prove that due diligence was carried out and ensure completed scientific and experimental work is not incorrectly characterized by an RTA as non-SR&ED during an audit. The RTA is looking for proof that a claimant a) tried to achieve a scientific or technological objective using the available technology or science before encountering an uncertainty and b) could not overcome the uncertainty using standard scientific or technological practices and knowledge. Finally, the RTA looks at the technology base or level of the company.

The claimants must understand that during the due-diligence phase of the work, they might conceive a novel and innovative way to conduct their due-diligence to arrive at a technological uncertainty.  Although this novel and innovative way to conduct the due-diligence can be considered as SR&ED work, the RTA may attempt to disregard it as such, claiming that there can be no SR&ED work during the due-diligence phase, thus, carving out a huge portion of the work that could qualify as SR&ED work. In this manner, the RTA may reject experimental or analytical work that goes beyond a routine approach in the due diligence phase by not qualifying it as SR&ED work.

The next section defines some key ITA terms that can help claimants increase their understanding of due diligence.

Technology base or level refers to the existing level of technology and takes into account the knowledge of the technological resources within the company and sources available publicly.

The technological resources within a company include:

Publicly available sources generally include scientific papers, publications, journals, textbooks, and internet-based sources. It also includes expertise accessible to the company such as the recruitment of employees or contractors. The company is expected to have information that is common knowledge at the time the work is performed. Common knowledge refers to the knowledge professionals possess in the specific areas of science or technology that are in question.

Note, the technology base or level will vary from company to company because the internal resources vary from company to company, even though the knowledge available publicly remains the same.

Scientific or technological uncertainty and technological obstacle represents a situation when no one knows or can determine on the basis of generally available scientific or technological knowledge or experience whether a given result or objective can be achieved or how to achieve it. Note that scientific uncertainty relates to science whereas a technological uncertainty and technological obstacle relate to technology.

For more information, refer to section 2.1.1 of the Eligibility of Work for SR&ED Investment Tax Credits Policy.

Scientific Advancement or Knowledge or Technological Advancement is the generation of information or the discovery of knowledge that advances the understanding of scientific relations or technology. Note that scientific advancement and advancement of scientific knowledge relate to science whereas technological advancement relates to technology.

For more information, refer to section 2.1.4 of the Eligibility of Work for SR&ED Investment Tax Credits Policy.

In practice, as it applies to a claimant, due diligence encompasses all work conducted to reach a scientific or technological objective, using available technology, either in-house or external up to the point where a scientific or technological uncertainty has been identified. Technological uncertainties may arise from shortcomings or limitations of the current state of technology or budget limitations that prevent a new or improved capability from being developed. In other words, the current state of technology or finances may be insufficient to resolve a problem. Alternatively, if the scientific or technological objective or solution can be resolved with the available knowledge base, then there is no SR&ED work as SR&ED work can only start when an uncertainty is identified. Recognition of a technological uncertainty is a major step in systematic investigation and it implies the identification of the need for advancement and proof that due diligence was carried out. As such, claimants must remember to track and document all their work.