Machinery and Equipment Industry Application Paper

Table of Contents

1 Introduction

2 Industry Background

 2.1 Activities, Projects and Programs

 2.2 Major Types of Technology

3 Project Eligibility - General

 3.1 Business Environment

 3.2 Criteria/Indicators - Eligible Projects
 3.3 Scientific or Technological Advancement
 3.4 Scientific or Technological Uncertainty
 3.5 Scientific and Technical Content

4 Project Eligibility - Special Issues

 4.1 Complete New Machinery Development

 4.2 Technological Enhancement of Current Machinery
 4.3 Stand Alone Software Developments
 4.4 Technical Feasibility Studies
 4.5 Process Improvements
o 4.5.1 Continuous Improvement
o 4.5.2 Testing to Demonstrate Technological Advancement
 4.6 Machine User Interface
 4.7 Beta Site Testing
 4.8 Trouble-Shooting, Debugging and Fine-tuning
 4.9 System Uncertainty
 4.10 Prototypes, Custom Products/Processes and Commercial Assets
o 4.10.1 Prototypes
o 4.10.2 Custom Products/Processes and Commercial Assets - custom
development

5 Documentation

 5.1 Technical Information Requirements for Claims: Form T661

6 Examples of Self-Assessment of a Claim

7 Glossary

1 Introduction

Subsection 2900(1) of the Income Tax Regulations (the Regulations) defines what
constitutes Scientific Research and Experimental Development (SR&ED). We issued
Information Circular 86-4, Scientific Research and Experimental Development, (the
circular) to clarify the work that lies within the boundaries of SR&ED, and developed
application papers, as supplements to the circular, to address issues specific to particular
industries. These papers are adjuncts to the circular and do not override it.

We have prepared this application paper to improve the understanding of SR&ED as it

specifically relates to the machinery and equipment manufacturing industry in Canada.
The paper is intended to clarify what constitutes SR&ED, and to help claimants self-
assess their claims. We will update the application paper as required to reflect changing
technology and other issues that arise. The information contained in the application paper
concerns only technical issues involved in characterizing eligible SR&ED projects.
Questions relating to allowable expenditures, whether capital or current, are not dealt
with in this paper except where science advisor input is required. Expenditure issues are
covered in Interpretation Bulletin IT-151, Scientific Research and Experimental
Development Expenditures. It is important to note that, even if a project is eligible, it
does not mean that all the project costs are eligible; this is discussed further in Parts 4.5,
4.9, and 4.10 of this paper, as well as in Interpretation Bulletin IT-151.

For purposes of subsection 2900(1) of the Regulations, developing or improving

machinery and equipment and processes for its manufacture is considered to fall within a
field of technology. Technology is referred to in paragraph 2.3 of the circular as "the
systematic study of the application of scientific knowledge to industrial processes or
product development."

The objective of the incentives related to SR&ED is to encourage the advancement of

technology in Canadian-developed products and processes. This will foster the
competitiveness of Canadian products in the international marketplace. Advancement of
technology must be seen to occur within the business environment and context of the
claimant.

In Part 6, we provide an example to illustrate the self-assessment of the claim.

2 Industry background

The machinery and equipment manufacturing sector of Canadian industry is represented

by many types of businesses including equipment invention, the building and
manufacturing of equipment, machinery retrofits and installation, precision machining,
materials processing and process development or improvement. Businesses range in size
from the very small, to the large and multi-national.

Projects range from short-duration, highly focused component improvements, to multi-

year new equipment development. Some examples of machinery and equipment include
production equipment, machining tools and equipment, labelling equipment, packaging
systems, metal forming equipment, plastics moulding or injection equipment, agricultural
machinery and equipment used in the extractive industries.

Technical capabilities and the technological sophistication of companies in this industry

sector span a wide range. Typically, projects are "practically oriented" to machinery
building and development and product or process improvement through technological
innovation. This orientation leads towards applied research or experimental development
rather than basic research conducted by the claimant. In many cases, basic research
does not directly precede applied research or experimental development. Applied
research may include work on improving existing technology.
The resulting scale of improvement may range from incremental (a small improvement),
to evolutionary (the next logical generation of machine), to revolutionary (a dramatically
different type of machine). Such work may be eligible SR&ED.

Within this industry sector, many organizations do not have technical specialists who
have recognized (licensed) designations. However, this does not limit the ability of the
claimant's personnel with the knowledge and experience to develop machinery and
equipment through applied research or experimental development.

The nature of the equipment being developed within this industry requires organizations
to "stretch the capability envelope" of existing technology. For example, market driven
technical requirements for higher speed or greater accuracy are often beyond the
capabilities of existing machinery. It is often through processes of experimental
development that the capabilities of existing machinery are enhanced.

Technological innovation may also be required for in-house production processes. Often
the requirements for in-house processing cannot be attained using commercially available
products, therefore, the experimental development effort is aimed at developing
improved processes.

Within this industry, there are many instances when projects dealing in customized or
"one-off" products are undertaken. Frequently, a custom development involves
enhancements to existing product lines or processes. These improved products or
processes may result in a saleable commodity. In most cases, this type of development is
an attempt to take advantage of the "window of business opportunity" for product
enhancement.

The development process of this industry can include the following steps, but the steps
themselves do not establish the eligibility of the project:

 outlining specifications or requirements defined by the customer;

 thinking intuitively (making a hypothesis) about how the customer's requirements

can be met;

 defining the technical objectives to be met;

 defining the development project to meet technical objectives;

 formalizing a concept or model;

 conducting experimental and analytical activities to test the concept and model,
including computerized modelling;

 making iterative refinements in the concept or model; and

 determining the economic feasibility and technical success of the project.

To qualify as eligible SR&ED, projects do not have to be undertaken based on a formal

hypothesis or premise. The hypothesis may be intuitive. Intuitive thought can replace a
formal hypothesis if there is a concept that can be formalized to form technical
objectives. However, it is important that these technical objectives be established at the
start of the experimental development project, but this in itself does not qualify the
project as eligible SR&ED.

In this industry sector, the terms engineering and design are used interchangeably. This
is in contrast to the general or aesthetic meaning often given to the term design in some
other industries.

Concepts of experimental design and advanced problem solving techniques are employed
when determining alternate approaches to developing a technical solution. Often the
objectives of these techniques are expressed as a desire to correct a specific deficiency,
or achieve a specific operational capability. Thus, the intuitive approach to solving
problems, followed by a systematic process of testing, is often part of the experimental
development project.

During the development cycle, there are often two or more "versions" or "generations" of
the same machine, with each generation possessing greater capability or enhancements
over the generation that preceded it. Often succeeding generations enhance the
capability of the predecessor generation, and/or improve the price performance of the
machine.

In this type of development cycle, the first generation machine that is based on the initial
concept could be unsophisticated, but technologically advanced. This model can be used
to prove the technical feasibility of the project. In some instances, this first generation
machine will be sold to satisfy a specific customer demand or is used in-house.
Subsequent machines that are targeted at more specific applications are developed both
to enhance the technical capability of the first machine, and also to investigate specific
alternatives.

In this industry, completing a project to arrive at a conclusion may require field testing,
field modification, and field investigation to demonstrate that the technological objective
has been met. Often this requirement arises because the equipment is full scale or cannot
be tested in isolation without the full process environment. The results of this
investigation are necessary to arrive at a conclusion.

Typically, product and process innovations have characteristics that include:

 a new or improved capability of a machine, equipment, or process which

demonstrates technological advancement;

 technologically based advancement which could have applications for other

product lines (i.e., the development applies to a range of products or processes);

 the initial market-driven specification could not be attained by claimants in their

business context, and a technological barrier was identified before the
development.

2.1 Activities, projects, and programs

There is a hierarchy of terms used in describing the SR&ED effort. The top level is a
program, which may consist of a number of projects that typically have a number of
linked activities. Although there is no need to have an umbrella program, it is necessary
to consider the eligibility of projects for the purpose of meeting the requirements of
subsection 2900(1) of the Regulations. This is necessarily so because in the context of
research and development in science and technology individual activities may be routine
or standard practice, such as engineering and design, but are linked to high level
common technological objectives. These individual activities may only be eligible if they
are undertaken directly in support of eligible projects. However, this does not rule out
individual activities being eligible on their own merits if they meet the requirements of
subsection 2900(1) of the Regulations. Activity is defined in the "Glossary" to this paper.
Determination of eligibility is normally made at the project level.

Within this paper, we refer to eligible projects and qualified activities to denote those
projects and activities that we consider eligible for SR&ED purposes.

2.2 Major types of technology

The major types of technology that are further developed by members of this industrial
sector draw upon, but are not limited to, the following disciplines:

 mechanical engineering or mechanical design;

 materials capability (using unconventional materials to meet increased mechanical

demands or reduce cost, weight, etc.);

 electrical and electronics engineering, and electrical and electronics design; and

 software engineering and design.

3 Project eligibility - General

The definition of SR&ED is set out in subsection 2900(1) of the Regulations, and is further
clarified in Parts 2.2 to 2.5 of the circular. A key portion of the definition of SR&ED, as
contained in subsection 2900(1) of the Regulations, is:

" ... scientific research and experimental development means systematic investigation
or search carried out in a field of science or technology by means of experiment or
analysis ..."

In principle, when these elements can be demonstrated, eligibility exists.

A lot of the product development in this industrial sector results from work undertaken to
meet contract requirements to deliver equipment with specified performance
characteristics or capabilities (custom development). The specific problem in these
situations is how to distinguish between experimental and routine development.

As discussed in section 4 of the circular, Characteristics of Experimental Development,

the incorporation of capabilities "not previously existing or available in standard practice
into a new or existing product or process" may constitute a technological advance if
performance is enhanced. Generally, the experimental development project is the
technological advance incorporated into the custom development. It is crucial that
claimants involved in custom product development claim only the work related to the
enhancements (the SR&ED project) to their existing standard practice.

The subsequent commercial sale or use of the resulting product, device, or process, is not
a factor when determining project eligibility, since it is not relevant to the intrinsic
eligibility of this work. However, it is generally an indication that the experimental
development has been completed, and eligibility ceases. The relevant issue in proving
eligibility as SR&ED is whether the work has the characteristics of SR&ED regardless of
the overall goals in a commercial sense.

The treatment of the proceeds of sale is an expenditure issue that is covered in

Interpretation Bulletin IT-151. Project eligibility must be determined with regard to the
technical activities and the time frame in which the project was carried out.

The three essential criteria that must be met before any work can be considered eligible
SR&ED, as detailed in Part 2.10 of the circular, are:

 scientific or technological advancement;

 scientific or technological uncertainty; and

 scientific and technical content.

The following sections provide a brief explanation of each criterion.

3.1 Business environment

The three criteria of the circular must be applied within the context of the claimant's
business environment (business context, as defined in Appendix A of the circular).

Business environment characteristics include business size, competition, area of industry,

and access to technical resources.

3.2 Criteria and indicators - Eligible projects

In relatively simple terms, a project is eligible for SR&ED if its objective is to advance
technology, within the claimant's business context, by resolving a technological
uncertainty in a systematic manner using individuals who are skilled in the technologies
involved.

Due to the diversity of activities in the machinery and equipment manufacturing sector,
comprehensive tests have not been devised to determine the potential eligibility of
projects. However, an attempt has been made to devise "conditions" and "technical
indicators" to determine whether the considerations outlined in Part 2 of the circular are
satisfied. Specifically:

 Conditions are tests that must be satisfied if the requirement being tested is to
be met. The meeting of any condition or conditions, however, may not be enough
to show that a requirement is satisfied.

 Technical indicators are tests that prove that a particular requirement may
have been met.

Conditions provide stronger evidence than technical indicators.

3.3 Scientific or technological advancement

The criterion of scientific or technological advancement is defined in Part 4.1 of the
circular as:

"... the incorporation, by means of experimental development, of a characteristic

(capability), not previously existing or available in standard practice, into a new or
existing process or product that enhances its performance"

The paragraph in question continues on to suggest that novelty, uniqueness, or

innovation alone does not indicate the existence of a technological advancement.

Technical information is often of a proprietary nature that limits the ability of claimants to
gain access to information known to other claimants, specialists, or in academic circles.
Members of this industry may not be closely associated with specialists in academic
circles.

As previously mentioned in Part 2, members of this industry are often required to "stretch
the capability envelope" of existing technology: to provide greater tolerance, greater
speeds, and general performance improvements. This can and does result in advancing
technologies within the business context of the members and, more often than not,
advancing technologies within the public domain. The technology base in the public
domain can be considered that level of knowledge readily available to the claimants. The
claimants' level of technological knowledge within their business context is a combination
of the body of knowledge in the public domain as well as the claimants' own proprietary
knowledge best typified by current products and proprietary knowledge available only to
them. In those situations where the solutions of the uncertainties or problems are readily
available in the public domain, the development would not qualify as an eligible project.
As well, to meet the advancement criterion, claimants must demonstrate that the
experimental development work goes beyond the standard practice of their organization,
such that a project will be considered to fall outside of routine engineering (which is
defined in the "Glossary" in the circular).

Technological advancement can occur even if a project is not successfully completed. By

showing why a particular approach will not succeed or may not meet the desired
technical objectives, a claimant's knowledge of equipments' potential technical
capabilities can increase. In some instances, the claimant may not have been able to
achieve the project's objectives after having exhausted all the planned technological
approaches, and in the process learned the reasons for the failure.

Conditions and technical indicators which would provide evidence of scientific or

technological advancement include:

Conditions

 a demonstrated increase in the claimant's technological knowledge base such as

the introduction of an improved or new product or process based on the results of
the experimental work undertaken; or in the case of an unsuccessful project, the
ability to explain the technological basis of the failure;

 the fact that the technological knowledge required to develop a new or improved
product or process is not readily accessible (as defined under "commonly available
sources of knowledge or experience" in the glossary of terms in the circular) to
the claimant; and
  the new or improved product or process represents an advance in the claimant's
technology.

Technical indicators

 an enhancement of capability (e.g., automation or range of application);

 an improvement in performance indicators (e.g., speed, weight, tolerance, etc.);

 a new development specific to a particular product, process, or requirement (e.g.,

experimental development of automated design software);

 customer enquiries for enhanced capabilities beyond current equipment operating

capabilities; and

 customer complaints regarding technological capabilities in existing machinery or

equipment

3.4 Scientific or technological uncertainty

The definition of scientific or technological uncertainty is contained in Part 2.10.2 of the

circular. Scientific or technological uncertainty can occur in either of two ways:

(a) it may be uncertain whether the goals can be achieved at all; or

(b) the claimant may be fairly confident that the goals can be achieved, but may be
uncertain which of several alternatives (i.e., paths, routes, approaches, equipment
configurations, system architectures, circuit techniques, etc.) will either work at all, or be
feasible in order to meet the desired specifications and/or cost targets.

In (a), the uncertainty is due to insufficient technological knowledge. SR&ED is the

process undertaken to advance the technological knowledge to eliminate the uncertainty.

In (b), the definition suggests that the technical objective can be met in a number of
ways, even when the claimant is fairly certain of success in meeting the technical goals of
the project. For example, there may be uncertainty about which of the several alternative
approaches to the problem will work, or which will achieve the product cost targets.
Therefore, all approaches may have to be tried. There may also be uncertainty about
which of the several alternative approaches will achieve the desired specifications and the
product cost targets. The definition recognizes that, while most experimental
development can succeed in a technical sense given an infinite amount of time and
money, attempting to achieve a particular cost target can at times create a technological
challenge which needs to be resolved.

Business risk relating to the project's success or failure in the marketplace is not relevant
to project eligibility. The ultimate assessment for eligibility will be based upon the
technological characteristics and the ability of the project to meet the three essential
criteria of scientific or technological advancement, scientific or technological uncertainty,
and scientific and technical content.

It is crucial for project eligibility that technological uncertainties are identified before a
specific project is undertaken, and that these uncertainties are addressed during the
design and development of the first and subsequent generations of equipment. If there
are no identifiable technological uncertainties at the start, then there can be no eligible
project. However, when new technological uncertainties arise during the course of routine
work, the activities directed at resolving the technological uncertainties may be eligible.

Technological uncertainties often arise within the industry from the need to meet
reasonable product cost targets so that a product can be sold at a price the market will
bear. Typically, cost targets for the delivery of the product require that uncertain paths
be considered, although more costly and relatively certain alternatives exist either within
the claimant's business context, or in the public domain. In this case, the existence of a
technologically certain alternative would not automatically negate the eligibility of a
project dedicated to searching or experimenting in order to assess the technical feasibility
of these alternative routes, paths, or system configurations. The claimant has to identify
the paths and the technological advancement associated with the various paths to meet
the criterion of technological uncertainty.

Failure to meet reasonable cost targets may be caused by many variables. The inability
to meet restrictive or ambitious cost targets does not in itself prove technological
uncertainty. Each project must be assessed on a case-by-case basis.

Conditions and technical indicators that would provide evidence of scientific or

technological uncertainty include:

Conditions

 the result was not achieved before using the claimant's standard practice;

 an unresolved problem or technological challenge exists;

 there is a system uncertainty (see definition in Part 4.8 of the circular); and

 several iterations of experiment and/or analysis have been identified and

documented.

Technical indicators

 there is difficulty or failure in meeting the objectives, specifications, and

benchmarks;

 components or pieces have been modelled (including computer-generated or

developed models);

 there is a change in materials to meet specifications and/or cost targets;

 cost constraints that cannot be met by using current technology;

 new technical personnel or outside consultants with expertise were required to

assist with the project;

 there were multiple designs or design models for planning; and

 various approaches were used to meet cost targets.

3.5 Scientific and technical content

The definition of scientific and technical content is in Part 2.10.3 of the circular as follows:

"The scientific research and experimental development activity must incorporate a

systematic investigation from hypothesis formulation, through testing by experimentation
or analysis, to the statement of a logical conclusions. Such experimentation can include
work on the evolution of prototypes or models."

Demonstration of scientific and technical content can be achieved by following a project

outline such as:

 Defining technological objectives

 Formulating a project plan

 Analyzing/experimenting

 Testing and verifying technological objectives

 Explaining results/summary

Examples of the documents that could substantiate scientific and technical content are
discussed in Part 5 of this paper.

As well, the work must be performed or directed by qualified personnel who have
relevant experience in science, technology, or engineering. Qualification is not limited to
formal training but includes skills and knowledge gained through experience.

Conditions and technical indicators that would provide evidence of scientific and technical
content include:

Conditions

 following a planned methodology;

 documenting technological objectives, project steps, and technical results; and

 using qualified key personnel experienced and/or trained in experimental

development and/or research to undertake or direct the project.

Technical indicators

 previous experience and successful claims in the area of SR&ED;

 some elements of work contracted out to qualified research bodies and/or sub-
contractors;

 the identification of specific objectives; and

  a documented project plan identifying departures from the technical knowledge
base of the applicant.

4 Project eligibility - Special issues

To qualify as eligible SR&ED, a project must meet the criteria of the preceding section;
that is, scientific or technological advancement, scientific or technological uncertainty,
and scientific and technical content. In this industry, there are certain general "types" of
projects that will be described in more detail. Typical characteristics that relate to these
projects will also be identified. Although these types of projects do not cover all types of
projects conducted within the industry, they do provide a general guideline of the more
common types experienced. Many other types of projects are, and will be, conducted.
Project eligibility still needs to be examined on a case-by-case basis.

4.1 Complete new machinery development

A member of this industry will respond to a new market opportunity by developing a

completely new machine or piece of equipment. This project, which may be eligible, could
involve significant scaling up or scaling down where technological uncertainty is present.
Often the technological challenges that confront new machine development include
mechanical considerations that can only be resolved through "breakthrough engineering,"
such as is applied to the miniaturization of components.

Typical characteristics

 relatively significant design time due to complexity;

 new components;

 the approach used to resolve technological challenge is different than that

previously used;

 patents may result from the development; and

 scaling up or down requires the significant re-engineering or redesign of

associated components.

4.2 Technological enhancement of current machinery

Work on technological enhancement of current machinery may be eligible SR&ED. Typical

projects could be identified as meeting or requiring:

 higher performance standards; and

 improvements in efficiency and quality of existing processes.

In this type of project, an existing product or process will require an enhancement in

capability to meet new or emerging requirements. Frequently, developing technological
capability within the industry results in identifying new applications for the new
technology. This situation arises most frequently when new capabilities are developed for
one type or family of products, and that same capability is desired in another family of
products. Adapting this new technology to existing applications in a different operating
environment may prove to be technologically uncertain.

In determining whether the adaptation work is eligible experimental development,

distinction must be made between work based on standard practice alone, and work that
goes beyond standard practice to resolve technological uncertainties.

If the project involves the direct adaptation of a known technology to a new situation,
where it is reasonably certain that the approach will work, the project is ineligible. On the
other hand, if there are identifiable technological uncertainties present, then experimental
development will occur. The experimental development work that goes beyond standard
practice to resolve the uncertainties is eligible.

Frequently, adapting a new technology to a different operating environment or for a

different application involves a combination of standard (existing) technologies. The
criterion for distinguishing between eligible experimental development and ineligible
routine development is the element of technological uncertainty. If the combination of
standard technologies resulted in a new product or process, the development of which
was the almost certain outcome of applying a progression of well-known techniques, then
the work is ineligible routine development. The work may represent a complex
engineering task, but is not characterized by technological uncertainty. If it can be shown
that integrating several standard technologies to achieve a new product is technologically
uncertain, called system uncertainty, then the work is eligible. System uncertainty is
addressed in Section 4.9.

Typical characteristics

 patents may result from the development;

 there are more or new materials or mechanical testing than would be required in
the usual quality-control procedures;

 the testing and failure of existing products to meet new performance standards;
and

 testing under more stringent operating environments.

4.3 Stand-alone software development

Due to the nature of machining and automation undertaken in this industry, major
software developments are being made. Many of the industry members are actively
developing automation and software capabilities, especially in the area of machine and
tool control systems, design processes, and process control systems. The evaluation of
projects in this area must be conducted by individuals who have experience and/or
knowledge, and who appreciate the intricacies of the area of software in this industry. It
is also important to emphasize that routine software development, which is not eligible
on its own, would be eligible if it directly supports an eligible project.

In some cases, this development is initiated with commercially available software

products. Claimants may start with a base package (e.g., computer-aided design
software) which requires significant upgrading to enhance and/or achieve specific
capability of the system.
Typical examples

The following examples are typical of the type of software development undertaken in
this industry. These examples alone do not establish project eligibility.

 adapting commercial software to meet new or enhanced requirements for process

control;

 adapting control systems for machinery control and/or process control (e.g.,
programmable logic controllers); and

 automating existing processes that are currently manually controlled.

4.4 Technical feasibility studies

Technical feasibility studies and technical studies are not, in and of themselves, eligible
projects. If a technical study leads to an eligible project, then the technical analysis of it
would, by virtue of such a linkage, be a qualified activity within the project. Even without
this linkage, eligibility can occur if the analysis advances the knowledge of the claimant's
technology base, provided it meets the essential criteria discussed in Part 3 of this paper.

4.5 Process improvements

Typical projects within this industry include:

 the construction of equipment to meet unique capability or performance criteria;

 significant enhancements to current production processes to gain increases in

productivity and/or meet specific production cost targets;

 the design of tooling and testing of new tooling methods and techniques; and

 increased automation (i.e., robotics).

In this industry, experimental development activities in the process improvement field

are typically directed at ways of achieving continuous improvement, and verifying the
results by performing experimental production runs. The activities that may be eligible
are often carried out with the ineligible activities. The following sections explain the
activities that fall within the boundary of SR&ED.

4.5.1 Continuous improvement

For many members, due to the nature of the industry, a major part of their development
work is to develop machinery capabilities that are not readily available commercially for
their own purposes, or that make improvements to their process.

Typically, constructing machinery and equipment for internal use does not follow a
conventional development path. Often this equipment is in a continuous stage of
development to enhance the technical capability of the equipment as new demands and
requirements are identified by the applicant. For the purpose of such SR&ED claims,
submissions should be based on a separate project basis for each successive
improvement. Documentation must clearly show how each successive improvement
represents an incremental advance over the previous improvement and, specifically, the
technological uncertainty that was resolved.

The resulting machinery and equipment are often used primarily for production purposes,
but specific situations arise when production equipment is used directly in the prosecution
of SR&ED.

The use of this internally developed machinery and equipment in commercial production
does not negate the existence of eligible activities. In these situations, documentation
must clearly distinguish between activities that are routine in nature and involved only
the standard practice of the claimant, which are ineligible, from those activities that
resolve technological uncertainties and result in technological advance, which are eligible.

4.5.2 Testing to demonstrate technological advancement

For certain experimental development projects, such as process and equipment

improvements, the only way to verify that the technological objectives can be achieved is
to carry out trial production runs. This phase of the development is the period of testing
that corresponds with the proving out of specifications for the product or process. It does
not coincide with the usual learning curve for the start-up of established systems. These
testing activities are eligible to the extent that they correspond with the needs, and are
directly in support, of an eligible experimental development project. The product or
output from such activities (sometimes known as experimental production) may not
qualify for SR&ED tax treatment, depending on what uses are made of the output.

The tax treatment of the expenses involved with output from these testing activities will
be different if commercial activities are involved (e.g., some or all of the output is sold).
In these situations, only the costs of materials used in carrying out SR&ED, as well as
related current expenditures, may be claimed.

The trial production phase will generally be considered complete once the resulting
product or process meets the intended technological objectives. However, sometimes
high scrap rates are encountered in early production runs, and this may be used by a
claimant as an indicator that the development is still in an experimental stage. The
claimant's activities at this point may or may not be eligible. It is the reason for the scrap
rate problem and the process (experimental) followed to resolve it that will indicate
whether or not the activities are eligible. To make a judgement in this industry, any
assessment would have to be made on a case-by-case basis by qualified technical and
accounting personnel.

However, if new technological problems are encountered subsequent to this time, the
attempts to resolve these problems may be eligible SR&ED. These activities should be
claimed as a separate project, and the project's eligibility depends on whether it meets
the three criteria.

4.6 Machine user interface

Projects are often initiated to specifically address the man-machine user interface. Work
in this area can often involve control systems and other areas that involve developing
specific-use software programs. Software development is addressed in Part 4.3 of this
paper.
Man-machine user interface can also require the development of mechanical devices,
electronic hardware, and certain sensor applications to facilitate the interface. Again, the
ability of the projects to meet the three essential criteria discussed in Part 3 of this paper
will determine a project's eligibility.

Typical projects within this industry could include:

 providing audio and visual characteristics to machine control; and

 making relatively significant design efforts towards the ergonomics of a machine

application.

4.7 Beta site testing

Frequently, the machinery and equipment produced by members of this industry are
destined to be installed in the customer's production or process facilities. The
development work is not complete until the machinery or equipment achieves its
technological objectives. This is demonstrated through testing in the real production
environment, also known as beta site testing. Most often, the claimant cannot simulate a
typical production environment. Beta site testing is therefore essential.

Beta site testing may take place after legal ownership of the machinery or equipment has
been transferred to the customer. The change of ownership issue, and the location of
beta testing should not affect whether the activities qualify as SR&ED. However, in such a
situation, the right to claim may be questionable. The determination has to be made on a
case-by-case basis.

Although the location of beta testing should not affect whether the activities qualify as
SR&ED, the tax treatment of their costs may be different if the activities take place
outside Canada. Please see Interpretation Bulletin IT-151 for information on how such
costs are treated.

Generally, it is during the beta site testing that certain technological uncertainties are
resolved. In some cases, new technological uncertainties arise during beta site testing
and are then resolved. Activities to demonstrate the achievement of technological
objectives, but not including demonstrations to prospective buyers, and those aimed at
resolving technological uncertainties during beta site testing, are considered qualifying
activities. This phase will often denote the completion of the project. Therefore, claimants
must demonstrate in their documentation how the beta site testing activities relate to
resolving technological uncertainties and achieving the technological objectives.

In some instances, when documentation is lacking, it may be questionable whether

activities carried out at a customer's site are beta site testing or routine trouble-shooting,
debugging or fine-tuning of the machinery after its installation. This is discussed in the
following section.

4.8 Trouble-shooting, debugging, and fine-tuning

Difficulty often arises in determining when an experimental development project is

complete. The basic criterion for ascertaining when experimental development has been
completed is the point at which the project's initial technological objectives have been
achieved. This occurs when all identified technological uncertainties have been resolved,
and the application of standard operating practices permits the achievement of the
technological performance objectives which were established when the project was
defined.

The work generally associated with trouble-shooting, debugging, and fine-tuning after the
start-up of any new equipment, process, or technology refers to those activities where
the outcome is reasonably predictable, and is often carried out when the equipment,
process, or technology is installed to ensure that it meets all the established technological
specifications agreed upon. Such work is ineligible.

However, if it can be shown that in the process of trouble-shooting and debugging a new
technological uncertainty occurs, then the work which is directed at resolving this specific
uncertainty, but not including the trouble-shooting and debugging activities, is eligible.
This work should be claimed as a new project identifying the new technological
uncertainty involved.

4.9 System uncertainty

System uncertainty is addressed in Part 4.8 of the circular, as follows:

"Work on the combination of standard technologies, devices, and/or processes is eligible

if non-trivial combinations of established (well-known) technologies and principles for
their integration carry a major element of technological uncertainty; this may be called a
"system uncertainty"...".

This concept recognizes that even though behaviours of individual components may be
well understood or documented, the combination of components may fail to perform as
expected. This type of uncertainty is frequently encountered in the context of this
industry, where known components are selected, but the combination of these
components may produce unexpected or undesirable results (such as vibration,
overloading of components, controls instability, etc.). Often these system uncertainties
can be the cause of a development project to determine the reasons for undesirable
behaviour, and eliminate it.

Identifying and assessing system uncertainty can be a very complex exercise. A high
degree of technical experience and training is required. Essentially, the exercise becomes
one of identifying the major components within the system then assessing the
interdependence and interaction of the various components.

If it is necessary to redesign closely related components to meet the specifications for the
system, as well as make significant modifications to provide interface of various
components, and efforts in the integration of components go beyond that which could be
usually determined as routine engineering, then a system uncertainty would exist. The
degree of system uncertainty can range from minor (only one component or aspect of the
system requires redesign) to major (many components of the system require redesign)
depending on the system specifications. In a system configuration, the components or
subsystems that require redesign to resolve the system uncertainty are known as
associated established components. Only those activities related to redesigning the
associated established components are eligible. As a result, only portions of an overall
project may be eligible SR&ED. The group of eligible activities, including all directly
supporting activities, becomes part of the "envelope of SR&ED." The "envelope of SR&ED"
is defined in the "Glossary" to this paper.

Documenting the combination of standard technologies, devices, and/or processes, and

assessing the degree of triviality associated with the combination and integration
becomes paramount. Identifying the "envelope of SR&ED" can pose significant problems
due to system complexity. The documents must clearly show what activities are related
to the redesign of the associated established components. Only the current costs of the
"envelope of SR&ED" may qualify.

As stated previously, in a complex system, identifying the "envelope of SR&ED" may not
be a simple task. This task should be handled by individuals who possess the appropriate
technological knowledge and training. Therefore, it is the responsibility of the science
advisor or technical expert, when reviewing the eligibility of the project, to determine the
"envelope of SR&ED."

The claimant's accounting system must be detailed enough in these situations to

segregate costs associated with every major technical component, as well as identifying
costs and expenditures associated with the integration and redesign activities.

Typical characteristics

The following characteristics will be present in an eligible project, but they do not in
themselves establish project eligibility:

 designing new applications for existing equipment that require the redesign of
components to achieve technological specifications;

 substituting components with new parts or components to improve performance

or increase capability;

 discovering some uncertainty concerning the interface and integration of

components; and

 requiring complex analysis to select components.

4.10 Prototypes, custom products/processes, and commercial assets

It is common in this industry for members to construct equipment or machinery to meet

market-dictated technical requirements. The equipment or machinery ultimately ends up
being sold or put into commercial use. Frequently, such equipment and machinery are
labelled as prototypes. For the purposes of section 37 of the Act, and 2900 of the
Regulations, it is important to distinguish between prototypes, and equipment or
machinery developed for sale or put into commercial operation. To apply the provisions of
the Act and Regulations, it is necessary to determine the intent for which a particular
asset is constructed. The definition of scientific research and experimental development
(SR&ED) in subsection 2900(1) of the Regulations, and the definition of SR&ED
expenditures in section 37 of the Act, essentially govern the tax treatment in these
situations. The following paragraphs differentiate between the tax treatment for a
prototype, and for a custom product/process and commercial asset.

4.10.1 Prototypes

The Act does not define prototypes or specifically provide for their treatment. However,
prototype is defined in the glossary of terms (Appendix A) of the circular.

A prototype is an original model on which something new is patterned, and of which all
things of the same type are representations or copies. It is an experimental model
possessing the essential characteristics of the intended product to test the feasibility of
the concept or hypothesis. It is not being constructed for commercial use or sale, and it
has no lasting value. The design, construction, and testing of prototypes generally fall
within the scope of experimental development and, when this is the case, the costs would
usually be an eligible current SR&ED expenditure.

4.10.2 Custom products/processes and commercial assets - custom

development

As stated in Part 4.10, it is quite common in this industry for members to construct
equipment or machinery to meet a customer's technical requirements with the intention
of an ultimate sale. Such an undertaking is referred to as a custom product/process.
Another common practice for claimants is to construct equipment and machinery to meet
their own technical requirements and which are intended for their own commercial
operations. Such equipment and machinery are referred to as commercial assets.
Generally, developing custom products/processes and commercial assets may involve
both eligible SR&ED and ineligible activities. Subsection 2900(1) of the Regulations
excludes any activities considered to be the commercial production or commercial use of
a product or process. Therefore, only a portion of the development of a custom
product/process or commercial asset (custom development) may be eligible SR&ED since
not all the activities fall within the "envelope of SR&ED." Within this custom development
is the claimant's SR&ED project which consists of those activities that fall within the
"envelope of SR&ED." For the purpose of section 37 of the Act, and 2900 of the
Regulations, the issue is how much of the custom development is the eligible SR&ED
project? It is the claimant's responsibility to separate the eligible SR&ED project from the
custom development and claim only the eligible SR&ED project. In addition, the claimant
should isolate the costs associated with the eligible SR&ED project from the total cost of
the custom development. It is important to note that some costs, particularly material
costs, of custom development relate partly to SR&ED activities and partly to non-SR&ED
activities. The costs that relate to SR&ED activities will generally only be considered to be
eligible to the extent that they can be directly attributable to carrying out SR&ED (see
Regulation 2900(2)-(4)). Also, the documentation must clearly show how the SR&ED
activities are related to resolving technological uncertainties.

5 Documentation

The need for adequate documentation is dictated in Part 3 of the circular - "Requirement
for scientific and technical content and documentation." It is essential to emphasize that
the documentation to support an eligible claim should be of a technical nature. A business
plan, set out to promote the initiation and approval of a particular project, does not meet
the documentation requirements. The lack of adequate technical documentation will lead
to the disallowance of the claim.

The following discussion is merely a guide on how traditional documentation could be

used to substantiate a claim, and is not intended to dictate to SR&ED performers what
documentation they should keep.

Documentation to support the technical uncertainty incorporated in the project should

address either the uncertainty of achieving the technological goals at all, or identifying
the possible alternative approaches that have been considered as a potential solution. It
should also include an analysis of their feasibility (based on technical and cost target
considerations) showing why a particular path was selected. It would also be necessary to
identify the resulting technological advancement that the claimant would make within the
business context of the firm.
The project plan, and documentation of the plan, should initially describe the
investigative methods to be used, the personnel and services to be allocated to the
project, and the indications or measurements to be used in determining the success or
failure of the various experiments and/or analysis.

As the plan is being carried out, the progress must be documented on a periodic basis,
including the various successes and/or failures experienced along the way. These include
test results, test reports, notes on experimentation, etc. Evidence of changes in
methodology or the selection of alternative strategies, routes, etc., must be identified
and documented to record a complete tracking of the plan through to its conclusion.

Once the plan has been completed, or perhaps aborted due to a failure, the conclusions
must then be documented. The conclusions should use the results of the experimentation
or analysis to measure the degree of success in achieving the technological objectives.

Costs incurred on the project should be identified and appropriately allocated when
necessary. If there are payments to other parties, access to any contracts is essential, as
are the technological studies or plans on which the work was based and the maintenance
of all records in the transaction. When there is a proliferation of activities in the
"envelope of SR&ED," it becomes necessary to be able to quantify the costs allocated to
each activity.

5.1 Technical information requirement for claims: Form T661

Form T661, Claim for Scientific Research and Experimental Development Expenditures
Carried on in Canada, is a prescribed form that we require for filing SR&ED claims. Guide
T4088, Claiming Scientific Research and Experimental Development Expenditures - Guide
to Form T661, is available to help claimants complete Form T661. It is the claimant's
responsibility to maintain records that are adequate and can support a claim. A general
outline of a typical narrative that would generally be sufficient is provided as follows:

A) General information about your business

 name of the business or company;

 name, telephone number, and title of the person or persons responsible for
scientific research and experimental development;

 a brief description of the nature of your business;

 key words describing the fields of technology of your project or projects (e.g.,
robotics, metal and alloys, electrical engineering, etc.);

 names of other businesses, if any, that your business is associated with through
inter-linking management, joint ventures, ownership, partnerships, etc., which
could have a significant bearing on the conduct of your SR&ED; and

 the taxation year of previous claims, if any.

B) Technical narrative for each project

Each project's technical narrative should include the following:

  project title:

- name of project or project number;

- start date and actual or estimated completion date;

 brief description of project in technical terms;

 the technological advancement sought;

 the technological uncertainties associated with the project:

- identifying the possibility of achieving technological goals;

- identifying the different paths, approaches, configurations, etc., to be tested, if any, to

meet desired specifications and/or cost targets;

 brief description of technical work done:

- progress made to date;

- key findings and conclusions, if any;

 identifying activities (e.g., engineering, design, computer programming, data

collection, etc.) directly in support of the experimental development project;

 names, qualifications, and experience of key personnel involved in the project;

 technical reports:

- significant internal technical documentation;

- published reports or other records that relate to the technical aspects of the project;

 summary of approximate resources allocated during the year:

-number of hours allocated to project;

- estimate of amount of current expenditures;

- estimate of capital expenditures.

6 Examples of self-assessment of a claim

In this section we present a typical custom product development that contains both
SR&ED and non-SR&ED activities as an example of the self-assessment of a claim. The
intent is to help claimants identify and claim the SR&ED work (project) that is present in
the custom development. This example will also illustrate how the criteria of scientific or
technological advancement, scientific or technological uncertainty, and scientific and
technical content are applied.
Note

In this example all activities are carried on in Canada.

Objective of the project

To build a machine that uses electric motors and servos rather than hydraulic power to
reduce the mechanical complexity and the size of the machine, as well as to enhance the
throughput of the machine.

Company background

ABC, a Canadian company, is a manufacturer of speciality machines using hydraulic

power to form steel. These machines are sold to, and used by, customers in a production
facility. The company identified an opportunity with one of its customers to develop a
product with enhanced capabilities (e.g., productivity and output in pieces per hour). The
customer agreed to purchase a machine that met its specifications at a fixed price
(regardless of ABC's development costs).

The company was quite certain that these new specifications could not be met using the
company's current hydraulic technology. However, the company believed that the new
specifications might be met if they replaced the hydraulic drive with an electric one. The
electric drive technology represented a new technology to the company. It potentially
could be applied to the company's other products.

Based on the following, the company believes that there is eligible SR&ED work (project)
within the custom development:

 Scientific or technological advancement

Electric drive technology represented a new technology to the company, which could
have application to other products in its existing product line. The company had not used,
and was not aware of electric technology being used, in a similar application. In the
business context of the company, the success or failure of such an undertaking would
represent an advancement for the company. Success would mean an advance in
technology (e.g., enhanced capability using electric drive) while failure would mean an
advance in technological knowledge (e.g., limitations of electric drive technology as a
replacement for hydraulic drive technology in this particular application).

 Scientific or technological uncertainty

The company had examined the technical requirements, and by simple testing of existing
products, concluded that the specifications could not be met using a hydraulic system. As
an alternative, the company conducted a feasibility study that identified that an electric
drive and an electronic control system might have the capability of meeting the
performance requirements. However, it was uncertain that an electric drive and an
electronic control system would meet the following goals:

 physical space: the new drive system must have dimensions of not more than 2m
long by 1m wide by 0.5m high;

 speed: must achieve more than 300 presses per hour; the current hydraulic
system was capable of 240 presses per hour;
  power (electric systems might not be capable of providing sufficient power/force):
must be sufficient to form steel parts; and

 control: drive system must have sufficient control to achieve the mechanical
tolerance desired in the pressing.

 Scientific and technical content

The company identified a project team to perform this assignment. The team was led by
a senior electrical technologist who had several years of experience with electric power
machinery and the development of hydraulic machinery. He was responsible for
developing a project plan, and monitoring progress throughout the project.

Plan

The project leader developed a project chart showing key project steps and milestone
dates. During the development of the plan, the project leader identified the need for
outside expertise in the area of electric motors and electronic controls. An independent
qualified electrical engineer was contracted to provide the expertise required for the
project.

The plan also identified modelling opportunities for a new control system, and stationary
testing of key components. The result of the testing would be to assess the suitability of
key components in the final machine design.

Analysis/experimentation

The designer assigned to the project developed the alternative equipment configurations
to meet the customer's requirement. By using the company's computer-aided design
(CAD) system, design time was minimized, and down loading to computer-aided
manufacturing (CAM) and the building of certain components was simplified. Several
design iterations had to made to achieve the physical size constraint. The design
iterations were based on the results of the mock-up experiments and the
recommendations of the electrical engineer.

The electrical engineering consultant, in a report, recommended three possible motors

based on the force requirement for pressing the work piece, the speed of the drive
system, and the physical size constraint. Each motor had a different speed-torque
characteristic. The final selection would be made after experiments were conducted using
a scaled-down model of the drive unit, and the prototype logic system as the
programmable logic controller (PLC). The engineer also developed the functional
specifications for the PLC.

The project team assembled a prototype logic system to model the PLC behaviour; the
ultimate implementation of this system would be a micro chip. Experiments were
performed to simulate the fine control required to achieve the mechanical tolerance on
the work piece. Several modifications had to be made to the PLC design before the
required results were achieved.

The project team also built a scaled-down model of the drive system and coupled it to the
prototype logic system to investigate whether sufficient force could be developed to form
steel parts; and the speed of the drive system. The results from these prototyping tests
would also dictate which electric motor would be selected for the final system. Many tests
were performed, and several modifications to the PLC design had to be made before fine
control of the drive was achieved. The results of these tests seemed to indicate that the
motor that had a mid-range speed-torque characteristic should be the one selected for
the final system. However, this could only be confirmed by building and testing the actual
system.

System construction and testing

The results from the prototype tests were fed back to the designer for the design of the
actual system. Various modifications had to be made to the original design configuration
to achieve the dimensional specification of the system now that the choice of the motor
was made. The new electric drive system using the selected motor and the new control
system was constructed, assembled and retrofitted to an existing hydraulic model. This
custom model was then installed at the customer's site and tested to meet the
technological specifications.

As a result of those tests, the need for a number of modifications became obvious:

 The control system was too complex; fewer features would make the system
simpler for operators to use. The control system was modified to make it simpler
to use.

 The control system needed to be modified to eliminate hysteresis due to the

inertia of the motor. This problem was not evident in the prototyping tests using a
scaled-down drive model.

 The drive system appeared to work, but was noisy under high-load conditions.
Extensive acoustic damping was required to correct this problem.

 The motion of the drive system was not smooth under load, which resulted in
unacceptable variance in the mechanical tolerance specification for the pressing.
It took several modifications to the drive system by trial and error before the
problem was corrected.

 Several relays had to be replaced with ones with higher ratings, and line filters
were added to the control system to eliminate line spikes.

 Initially, the system was operating intermittently. Further investigation showed

that dust from the environment was interfering with the operation of some
position sensors and interlock switches. The problem was eliminated when dust
covers were installed over the sensors and switches.

Results and summary

As a result of the modifications done on-site, the system was finally able to achieve all its
technological objectives. Typically, a standard machine (i.e., hydraulic version) is
installed and commissioned in a one-week period. Installing and commissioning the
electric drive model took six weeks, during which required modifications were made in
the field.

Identification of the SR&ED project

The task in self-assessing this claim is not just to determine that the SR&ED project
meets the eligibility criteria (uncertainty, advancement, and content), but also to identify
those activities that fall within the "envelope of SR&ED" since the custom development
contains both SR&ED and non-SR&ED activities. The SR&ED project then consists of the
activities that fall within the "envelope of SR&ED." Based on the development described,
an eligible SR&ED project exists since the three criteria are met. The issue is how much
of the development is the SR&ED project?

a) The SR&ED project

The following activities constitute the SR&ED project (i.e., "envelope of SR&ED"):

 the activities relating to the new drive and the new control system, time, and
materials consumed (resolving technological uncertainties);

 project management of the SR&ED project, time only (support activity);

 planning, time only (support activity);

 design of alternative equipment configurations and iterations to meet physical

constraint requirement, time only (support activity and resolving technological
uncertainty);

 outside consultant study (support activity);

 prototype logic system to model the PLC behaviour, including experiments to

simulate the fine control of the drive and modification to the PLC design, both
time and materials consumed (resolving technological uncertainty);

 construction of scaled-down model of drive system and investigations of

sufficiency of force to form steel parts and speed of system, both time and
materials consumed (resolving technological uncertainty);

 testing at customer's site to meet technological specifications (validating and

demonstrating technological advancement), including modification work to the
control system to eliminate hysteresis, and modification work to the drive system
to correct uneven motion under load, both time and materials consumed
(resolving technological uncertainties required to achieve technological
objectives).

b) Activities that are not considered to be part of the SR&ED project

The following activities do not fall within the "envelope of SR&ED" and cannot be claimed:

 The activities relating to the interface between the new drive and the existing
components (did not involve any technological uncertainty, and, therefore, fall
outside the "envelope of SR&ED.")

 final design (the last redesign using the results of the last prototype test) of the
actual system (a one-time routine engineering activity related to commercial
activity);
  construction and assembly of new drive, both time and materials, including new
electric motor (related to commercial activity);

 construction and assembly of new electronic control system, both time and
materials (related to commercial activity);

 the acoustic damping work during testing at customer's site, both time and
materials (standard practice not related to resolving technological uncertainty);

 control system modification to make it simpler to use, both time and material
(standard practice not related to resolving technological uncertainty; not required
to achieve technological objectives, but required to satisfy customer's need;

 all work related to replacing relays and installing line filters during testing at
customer's site, both time and materials (trouble-shooting and debugging not
related to resolving technological uncertainty);

 all work related to investigating intermittent operation due to dust, and installing
dust covers during test at customer's site, both time and material (trouble-
shooting and debugging not related to resolving technological uncertainty).

This example illustrates a development involving technological enhancement of current

machinery. The claimant in this case would claim only the SR&ED project identified.

In general, each custom development within this industry sector has to be considered on
a case-by-case basis regarding the identification of how much of the development
constitutes the SR&ED project.

Second example

As a second example, assume the same facts as those described in the first example.
However, in this case, there was uncertainty about whether integrating the new electrical
drive system into the current machine structure could be achieved without major
modifications to the machine structure. In carrying out the integration, it was learned
that major modifications had to be made to the current machine structure before the
integration would meet technological specifications. These modifications required both
new construction materials and significant changes to the basic design and interface of
standard components.

In this example, system uncertainty exists about whether integrating standard

components to the new electric drive can be achieved without major modifications while
still meeting the required technological specifications. Although the operation of individual
components may have been known, the result of the interactions among them as a whole
was unknown, and could only be resolved through a project that incorporated a
systematic investigation to determine the result of the interactions. Therefore, the SR&ED
project would include those activities identified in the first example, as well as all those
activities related to modifying all related components.

In the examples, to ensure a smooth review of their claims, claimants must properly
allocate the expenditures to the SR&ED project.

7 Glossary
Activity

An activity is a small increment of work within a project. The activity is usually the lowest
level of accountability, and can refer to a technical specialty (e.g., logic design) or
process (e.g., infrared spectrum analysis). It clearly defines the specific work performed,
and can be attached to a specific individual or piece of equipment.

Analysis

Analysis is a method used to determine or describe the nature of a thing by separating it

into its component parts.

Envelope of SR&ED

The "envelope of SR&ED" contains basic research work, applied research work,
experimental development work, and activities that are necessary to resolving
technological uncertainties, as defined in subsection 2900(1) of the Regulations.

Experimentation

Experimentation is an act or operation designed to discover, test, or illustrate a truth,

principle, or effect - to make a test or trial.

Increment

An increment is the level of small improvement or "continuous improvement" by which a

machine or piece of equipment can be improved (as opposed to radical improvement).

Process development

Process development is the design of a new method of converting one material into
another, either by transforming it or adding material to it, as used in the context of
manufacturing.