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Can water and energy sources be claimed as 'consumed materials'?

In some cases, yes. The CRA has added an Addendum to 2000-01: Water and Energy Sources as Materials to address this issue:

"Generally water and energy sources used to carry out SR&ED are not considered to be materials. Their costs are treated as overhead expenses and could be allowable SR&ED expenditures only in the traditional method of calculating the investment tax credit (ITC)."

"In most industries, specifically in the chemical, petrochemical, minerals, pulp and paper and textile industries, water consumed is usually separated into several streams. One is the utility water used throughout the plant, another stream is the boiler feed water, which is used to generate steam on site, and the third is the process water stream which, like any other feed material, enters the process and becomes part of intermediate and/or final product(s), as governed by the chemical equation(s) on which the process is based."

"This process water stream is often pre-treated or conforms to specifications unique to the process. Once water enters the process, for all practical purposes, it is rendered useless - as process water feed - even if it is recovered."

"Such process water streams meet the definition of "materials" and "consumed". The problem, however, is the identification of the costs and the quantity consumed in SR&ED."

With respect to energy use, a similar argument could be made that some of the energy sources used in the plant can be part of the chemical/physical process - i.e. it is part of the conversion/production process and is integral to the chemical reaction on which the process is based.

All endothermic reactions in the chemicals, petrochemicals, pharmaceutical and biotechnology industries, most metallurgical refining processes, production of cement, glass, ceramics and other industrial raw materials, as well as most forming operations in the plastics industry, require significant energy input directly into the process. In physical terms, the intermediate and final products of these processes may retain this energy in their new form, but often the energy must be removed (sometimes dissipated).

The cost of such energy sources used in a process, that is part of SR&ED, could be included in the cost of materials consumed. However, the problem is to clearly identify its cost and quantity, apart from the portion used for lighting, space heating and running the machinery and equipment.

Although it is theoretically possible to calculate the energy and water consumed in a particular physical/chemical process, or to measure such consumption precisely in an operating plant, or in an experiment or trial run, often this data is not readily available to the claimant or the technical reviewers. Where some data may be available, it is often hard to clearly identify the portion of consumed water and energy sources directly related to the project.

Where expenditures on portion of water and energy sources that might qualify as "materials consumed" are expected to be significant, the claimant has the choice of the traditional method of calculating ITCs, where cost of all water and energy sources directly attributable to the SR&ED are allowable overhead expenditures.

A claimant can also choose the proxy method of calculating ITCs and claim water and energy sources as consumed materials. In the case of proxy, claimants will have to identify and document clearly the portion of the water and energy sources "consumed" in the process.