Plan, Do, Check, Act (PDCA) and SR&ED
*** This information is presented for educational purposes only and does not constitute legal advice. You should retain legal counsel if you require legal advice regarding your individual tax situation. ***
Many software companies follow the format for the Plan, Do, Check, Act (PDCA). Unfortunately, this alone does not satisfy the definition of the scientific method. This article looks at PDCA and how a recent ruling was impacted by following this cycle.
On July 7, 2020, the Tax Court of Canada (TCC) delivered a ruling on a software-related Scientific Research and Experimental Development (SR&ED) investment tax credit (ITC) claim. In the case of National R&D Inc. v. The Queen, Justice Dominique Lafleur denied the SR&ED ITCs of National R&D, stating that the company did not conduct a systematic investigation to reduce or eliminate uncertainty, could not show the scientific method was used, and lacked contemporaneous documentation.
This article will take a closer look at this case to provide the following:
- PDCA and SR&ED
- An overview of the case against National R&D Inc. (“Appellant”)
- Key arguments & lessons learned from Justice Lafleur’s ruling
PDCA & SR&ED
The PDCA cycle is used by businesses and software companies. On the Business Analysts Learnings website they state:
The Plan – Do – Check – Act (PDCA) methodology, also known as the Deming Cycle, is a 4-step model for continuous improvement that can be applied on business process management and software development projects. It can be used for improving the effectiveness of business processes within diverse domains and solving quality management problems.1
This cycle can be used on SR&ED eligible work if the work is documented and the scientific method is followed. Detailed records of the meetings, the hypotheses, and tests are needed to help satisfy the definition. To be eligible for SR&ED ITCs, work must be approached through a systematic investigation where hypotheses formed using the existing knowledge base are tested through experimentation and analysis and documentation is kept throughout the process.
National R&D Inc. v. The Queen: An Overview
The Appellant, National Research & Development Inc., a Canadian-controlled private corporation (CCPC), provided consulting services to clients in the areas of engineering, information technology, scientific research and experimental development tax credits and Ontario interactive digital media tax credits. They filed an appeal to the assessment of their F2011 SR&ED ITC assessment. The CRA denied their project titled Project Tracking System (PTS Project), stating that it did not meet the criteria of SR&ED. The CRA denied ITCs for this project in the amount of $23,810.2
The project in dispute was a PTS Project, a computer program that would automate certain portions of filing SR&ED claims with the CRA. According to the ruling, “The objective of the PTS Project was to develop a web-based, cross-platform and cross-browser framework to track claimable SR&ED projects for National’s clients.” The Appellant required that the PTS Project be secure and involved a configuration referred to as multi-tiered architecture. It specifically utilized ADO, Classic ASP, COM+ and Microsoft SQL Server 2000 (the MTA
).3
The judge used criterion from C W Agencies Inc. v. Canada (2001) to determine if the Appellant’s work was SR&ED eligible. The judge ruled that there was technological uncertainty present as the Appellant was:
[…]uncertain as to which of several alternatives would work or would feasibly meet the desired specifications of the PTS Project. One has to take into account the MTA, which was the framework within which the PTS Project was being developed, as well as the fact that National had access to SQL Server 2000 and not to SQL Server 2005 during the 2011 taxation year.4
Additionally, the judge ruled:
[…]did formulate hypotheses specifically aimed at reducing or eliminating the technological uncertainties raised by the PTS Project. However, as indicated below under the analysis of the third criterion, Mr. Saini failed to convince me, on a balance of probabilities, that methodical and systematic testing of the hypotheses was conducted by National. Accordingly, the second criterion is not met as it requires the methodical and systematic testing of the hypotheses[…]5
The judge also ruled that the Appellant was unable to provide evidence that the scientific method was followed. The Appellant provided documentation in the form of the Project Timeline, the Letter, a document titled “Trials to Achieve Sorting & Paging With Set Constraints” and various pieces of source code for portions of the PTS Project. The judge stated that the Project timeline document:
[…]this document does not explain what experimentation was conducted, how many experiments were conducted, or how the experimentation was conducted, nor does it set out the results in any detail….does not specify how hypotheses were tested, or if they were modified as a result of the testing[…]6
The judge stated that the Letter:
[…]the Letter specifies that hypotheses were formulated, that over 50 experiments were conducted and that the hypotheses ultimately proved to be correct[…]
[…]states only that several experiments were done, but does not provide much detail on the number of experiments conducted, how experiments were conducted or the results of the experiments. Moreover, the Letter does not specify how hypotheses were tested, nor does it specify if or how the hypotheses were modified as a result of the tests[…]7
Additionally, the judge stated that the document titled “Trials to Achieve Sorting & Paging With Set Constraints”:
[…]a table outlining 50 experiments and their outcomes. I do not find this table very helpful. Several of the experiments are grouped together; what is being tested is unclear; how testing is being conducted is also unclear; and the results listed are vague. Furthermore, there does not appear to be any reference to the testing or modification of the hypotheses[…]8
The judge also ruled that he could not determine if the source codes provided are early versions or the finished products:
[…]there is no explanation regarding if or how experimentation was conducted in order to advance from one version to the other and which is the later version, nor is there any evidence as to whether or not the experimentation proceeded in accordance with the scientific method. With respect to the other pieces of source code, I am not able to deduce a trend from a single data point and I do not see any evidence of an advancement of the source code nor is there any evidence as to whether or not it progressed in accordance with the scientific method[…]9
Next, the judge stated that because the scientific method was not followed it was not possible for technological advancement to be achieved:
[…]in order to find that a technological advancement was achieved, I would have to first find that technological uncertainties were removed through a process of systematic investigation, which I do not. Having concluded that National did not carry out systematic investigation to remove technological uncertainties, I cannot find that this criterion is met.10
The judge ruled that the Appellant did not provide contemporaneous documentation. The judge also stated, “I cannot conclude that any of the documents provided by National can be considered contemporaneous documentation that details any of the tests and the results of those tests.”11 He also explains that the Appellant’s testimony did not make up for the lack of documentary evidence.
Finally, the judge ruled that the Appellant’s work was not SR&ED eligible and the appeal was dismissed.
Justice Lafleur’s Ruling: Key Arguments & Lessons Learned for Software and SR&ED
There are a few key takeaways that stand out regarding software and SR&ED.
- Scientific Method, Formulating, Testing, and Modifying a Hypotheses: The Appellant was unable to prove they used the scientific method to remove a technological uncertainty through the formulation and testing of hypotheses; consequently, Judge Lafleur ruled that the Appellant did not follow the scientific method. The burden of proof lies with the taxpayer to prove that SR&ED related activities have been carried out. The burden of proof of the five questions used to determine SR&ED ITC eligibility applies to computer science like the other fields.12 This ruling could impact future SR&ED eligible claims.
- Technological Advancement: Judge Lafleur ruled that while there was a technological advancement in relation to the objectives of the project if the scientific method was not followed it was not possible to achieve a technological advancement within the meaning of SR&ED.13
- Contemporaneous documentation: The Appellant was unable to provide documentation showing the formulation, testing, or modification of any hypothesis. The Appellant was also unable to provide how testing was conducted and did not show any experimentation or the results of any experimentation. While the Appellant did provide source code, they could not provide a revision history, how the code was derived, or an explanation of advancement.14 Maintaining a well-organized and complete collection of documentation is imperative for the success of SR&ED applications.
The computer science and software development fields conduct many important SR&ED eligible projects. While the way experimentation is conducted may be different than in other fields of technology, the same standards apply regarding what is eligible for SR&ED (The Five Questions). It is imperative that rulings such as this one are carefully monitored, as they can have a significant impact on how software-related claims are processed at the CRA.
*Note: The fiscal year in question was 2011 and the ITC in dispute was $23,810; it is unclear why the Appellant went to court over an amount that would not have covered their legal fees. When one decides to take a case to trial, the benefit of winning the claim may not outweigh the associated legal fees.
To view the ruling in its entirety please see National R&D Inc. v. The Queen (2020).