Airzone One Ltd. vs. Her Majesty the Queen: New Court Case Expands SR&ED Eligibility

The modern Scientific Research and Experimental Development (SR&ED) tax credit program was created by the Income Tax Act (ITA) in 1986 as a way to incentivize Canadian businesses into initiating research and development projects within Canada. The SR&ED program was codified by subsection 248(1) of the ITA, and over time, the Tax Court of Canada has opined on key matters to clarify eligibility criteria. Most recently, the Court released its decision in Airzone One Ltd. vs. Her Majesty the Queen (2022 TCC 29) which has important ramifications for taxpayers looking to file SR&ED claims.

Summary of Airzone One Ltd. Case

Airzone One Ltd. (Appellant) appealed the assessments of their 2014 and 2015 taxation years’ SR&ED claims. The Minister of National Revenue (Minister) disallowed all the Appellant’s claimed SR&ED projects on the basis that they did not meet the definition of SR&ED pursuant to subsection 248(1) of the ITA. The Minister relied on several factual assumptions relating to:

1. The methods used by the Appellant to carry out the work (how factors); and
2. The reason for the Appellant carrying out the work (why factors).

At the end of the hearing, the Minister acknowledged that there was evidence that the work carried out by the Appellant satisfied the how factors; however, the Minister maintained that the Appellant used standard procedures and methods to resolve the why factors, and as such, the claimed work was not SR&ED eligible.

Justice Hogan then determined that this issue was a question of fact and, based on the evidence, was satisfied that the Appellant met its evidentiary burden and that all the 2014 taxation year projects and one of the 2015 taxation year projects should be accepted as SR&ED. This has major implications for future SR&ED claims as outlined further in the post.

The Airzone One Ltd. Claimed SR&ED Projects

The Appellant claimed six projects across both 2014 and 2015 taxation years:

• Project One related to optimizing the detection of 52 low-concentration compounds in residential settings.
• Project Two related to improving detection of highly reactive sulfur compounds (RSCs) unique to oil sands operations.
• Project Three related to improving detection of new brominated and fluorinated airborne contaminants at low levels in an arctic environment.
• Project Four related to identifying and quantifying compounds emitted from smoldering coal piles without being able to directly sample the material.
• Project Five related to quantifying low levels of phosphate and other contaminants in sub-Saharan regions of Africa.
• Project Six related to identifying and quantifying unknown emissions from high-temperature plastics processing.

SR&ED Project Eligibility

A project is deemed eligible for SR&ED if it meets the requirements of subsection 248(1) of the ITA. The findings of Northwest Hydraulic Consultants Ltd. vs Her Majesty the Queen (98 DTC 1839) included the “Five Questions,” which formalized how SR&ED eligibility was to be assessed:

1. Was there a technological risk or uncertainty which could not be removed by routine engineering or standard procedure?
2. Did the person claiming to be doing SR&ED formulate hypotheses specifically aimed at reducing or eliminating that technological uncertainty?
3. Did the procedure adopted accord with the total discipline of the scientific method including the formulation testing and modification of hypotheses?
4. Did the process result in a technological advancement?
5. Was a detailed record of the hypotheses tested and results kept as the work progressed?

The Canada Revenue Agency (CRA) has published guidelines over the years for determining SR&ED eligibility focused on the Five Questions; however, in August 2021, new guidelines were issued which broadened eligibility determination by examining the following:

1. How the work was undertaken (that the work was carried out systematically through experimentation), and
2. Why the work was undertaken (to resolve technological uncertainties that could not be resolved through standard procedures and methods to achieve a technological advancement).

As part of the review of the Appellant’s SR&ED claim, the CRA issued a SR&ED Review Report (SRR) in which they concluded that the work done by the Appellant was known in the public domain or consisted of standard practice in which no new knowledge was created and, therefore, none of the projects met the eligibility criteria. The basis for this conclusion came from internet searches conducted by the CRA technical reviewer which uncovered general references that described types of procedures and methods of air quality monitoring.

Legal Findings

Justice Hogan commented that, for the Appellant’s work to be considered experimental development, the Appellant had to demonstrate that it carried out the work to overcome technical uncertainties for the purpose of gaining know-how or technical knowledge not already known or publicly available. He also observed that the notion of “experimental development” included work undertaken to achieve incremental improvements to existing processes.

Justice Hogan referenced the Five Questions and related questions two, three and five to the “how factors” and questions one and four to the “why factors.” Indeed, the Minister ultimately conceded that the way the Appellant conducted the claimed projects satisfied the “how factors.” Justice Hogan opined that while each of the Five Questions needed to be considered separately, if the way a project was carried out was consistent with the “how factors,” this may help tip the SR&ED eligibility balance in favour of the taxpayer when the line associated with standard methods and procedures was unclear. He further opined that it was unlikely that a taxpayer would undertake experiments consistent with the “how factors” if the purpose of the work was not to achieve a technological advancement.

With reference to the SRR, Justice Hogan pointed out the following:

• Under cross-examination, the CRA acknowledged that the references were general in nature, did not provide much insight on the nature of the Appellant’s work, and that the specific sources uncovered were not cited in the SRR.
  • Justice Hogan believed that the sources were not cited because they were not particularly relevant.
• In addition, the Minister’s factual assumptions were that the Appellant encountered technical challenges in achieving detectable results and that the tests were aimed at determining suitability and optimizing each technique using standard approaches rather than developing new methodologies.
  • Justice Hogan disagreed and opined that the phrase “technical challenges” was synonymous with “technical uncertainty,” and that the phrase “optimizing existing methods” appeared to be an acknowledgment by the Minister that the Appellant undertook work for the purpose of improving existing processes “including incremental improvements thereto.”
  • Justice Hogan pointed out that this type of work is expressly recognized in subsection 248(1) of the ITA as a technological advancement in the context of experimental development work. He further expressed surprise at the CRA’s basis for disallowing the projects in light of the CRA’s updated SR&ED guidelines in which the “why” requirement for experimental development included identifying problems that may suggest that the technological knowledge was insufficient, involved too many variables or unknowns, or that the data were not available.
  • Justice Hogan opined that the uncertainty faced by the Appellant specifically included too many variables or unknowns and that information on how to extract all these compounds from the air was not publicly known. Justice Hogan further stated that the Minister’s characterization of the Appellant’s work was an oversimplification and ignored the novel techniques and challenges it faced.

Based on the evidence adduced, Justice Hogan ruled that Projects One, Two, Three and Five met the eligibility requirements for SR&ED.

The Impact on Future SR&ED Claims

The Airzone One decision is of particular importance to existing and potential SR&ED claimants for several reasons:

1. This is the first Tax Court decision to reference and apply the CRA’s updated SR&ED how and why eligibility guidelines. Having the Court state its opinion of the meanings of the new guidelines will provide clarity to SR&ED claimants and a better understanding of what activities would qualify for SR&ED tax credits.
2. Carrying out a project consistent with the “how factors” could help establish SR&ED eligibility when the delineation between standard procedures and methods is unclear. The Court stated that it was unlikely a claimant would undertake systematic experimentation if they weren’t trying to achieve a technological advancement. At times, some claimants get their SR&ED claims disallowed when they cannot effectively articulate a technological advancement, although their work was conducted in a systematic manner.  Therefore, they can rely on this case to help win their argument.
3. Activities associated with optimizing products or processes are no longer ineligible. The Court stated that optimizing exiting methods was consistent with making incremental process improvements which is specifically recognized in subsection 248(1) of the ITA. At times, SR&ED claims get disallowed when the reviewers feel that the work being claimed was optimization of current products and/or processes. 
4. The Court recognized that a project which encompasses insufficient technological knowledge or faces too many variables or unknowns is evidence of a technological uncertainty. Articulating these factors during the claim review process will help establish that a project meets the “why factors” of SR&ED eligibility.

The Canadian federal Government offers a wide range of R&D tax credit and grant programs. The largest tax credit program is Scientific Research and Experimental Development (SR&ED) while the largest grant program is the Industrial Research Assistance Program (IRAP). To learn the difference between these two programs and when your business should apply for each, download our free IRAP vs. SR&ED slide deck.