R&D Tax Update, December 2005

Earlier this year, in Alcatel Canada Inc. v. The Queen, (2005 DTC 387), the Tax Court of Canada (TCC)  allowed the taxpayer’s appeal of an assessment by the federal tax authorities. The Canada Revenue Agency (CRA) had disallowed the eligibility of stock option benefits as salaries and wages incurred for the taxpayer’s scientific research and experimental development (SR&ED) activities, for investment tax credit (ITC) purposes.

The tax authorities denied the taxpayer’s ITC on the ground that the stock option benefits were not expenditures incurred within the meaning of the Income Tax Act (ITA).

The TCC’s decision in favour of the taxpayer was based on the economic reality of stock options, as a cost to the corporation and a benefit for the employees.

CRA’s position
While the CRA did not appeal the TCC’s ruling, it responded by releasing, in June 2005, a document establishing the conditions under which taxable benefits arising from the exercise of stock options will be allowed as salaries or wages for ITC purposes:

• the options have been issued in a fiscal year during which the employee was involved in the SR&ED activities of the claimant;
• the claimant filed the prescribed forms within the 18-month deadline;
• the options were received by reason of employment (if the employee is also a shareholder, it will be a question of fact whether that person received the shares as a shareholder or as an employee);
• all or part of the employee's salary was an eligible SR&ED expenditure for the claimant in the year the options were issued; and
• the employee has either exercised the option or disposed of it.

Department of Finance’s position
Although the CRA recognized the possibility of claiming an ITC on the value of the employees’ taxable benefits, the Department of Finance has issued a press release and tabled a Notice of Ways and Means Motion (NWMM)  that put an end to this possibility of claiming ITCs.

The press release and the NWMM issued last November 17 are designed to ensure that, for income tax purposes, no expenditure other than an actual outlay or expense incurred will be considered to have been made by a taxpayer.

The proposed modifications related to employee stock options apply to options granted and shares issued on or after November 17, 2005.  As a result, options granted and shares issued before that date could still be part of an SR&ED tax credit claim, as long as the 18-month deadline for filing the claim has not expired.

It should be noted that, even though there seems to be a window of opportunity for claiming ITCs on stock option benefits, the tax authorities may still litigate situations similar to the Alcatel case since, in the explanatory notes accompanying the NWMM, the Department of Finance mentioned that “it may very well transpire that future jurisprudence may constrain or eliminate any such expenditure that may be considered to arise in these circumstances.”

Deadline to file an SR&ED claim
In addition to the proposed modifications discussed above, the press release and the NWMM tabled on November 17 end the CRA’s ability to grant an extension to the 18-month period taxpayers have for claiming SR&ED tax incentives.

Under the proposed modifications, there will be no exception to the 18-month filing deadline for applications for ITCs and SR&ED treatment.

These proposed modifications are applicable as of November 17, 2005.

Dissolution of Parliament on November 29, 2005
The proposed modifications above were introduced but not adopted prior to the dissolution of Parliament on November 29, 2005. To become law, these proposals will have to be tabled once again and adopted by the next government.

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Opportunities, issues and developments affecting the federal and provincial scientific research and experimental development tax incentive programs.

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