... tax back for your research

Ensuring SR&ED eligibility- 'subcontractor' vs. 'royalty' agreements

MEUK Newsletter 2002-1 outlines the following situation:

A taxpayer hires a subcontractor to perform eligible SR&ED on his behalf and negotiates to pay by way of future royalties. The subcontractor estimates that his normal charges for this work would have been $100,000. Can $100,000 be claimed as an SR&ED expenditure by the taxpayer?

Unfortunately for the taxpayer, under the current scenario they will likely not earn SR&ED credits on these payments due to specific legislation that reads: "no deduction may be made under this section (i.e. SR&ED) in respect of expenditure made to acquire rights in or arising out of SR&ED" (per ITA subsection 37(4)).

Since in the above example the legal agreement itself had not split the invoice into separate contractor vs. royalty payments, the entire amount of the payment would be ineligible under a strict reading of the legislation. If instead the taxpayer had agreed to pay the subcontractor fees of $100,000 (perhaps at an accelerated rate e.g. 10% of sales), and then once these fees are paid, pay any remaining fees as 'royalties' (perhaps at a lower rate say 5%), the subcontractor payments would arguable be eligible since it is not caught by the strict wording of the 37(4) legislation above.

This issue is discussed in further detail, including other potential effects, in MEUK Newsletter 2002-1. An example of a tax court case which involved a similar issue is discussed in MEUK Newsletter 2001-2.