Subsection 247(2.1) establishes that transfer pricing rules take precedence over other tax provisions when determining transactions for Canadian corporations with related non-residents. This subsection outlines three ordering rules, introduced in Budget 2019 and legislated under Bill C-30 – these rules can be pertinent to Canadian technology firms participating in Scientific Research and Experimental Development (“SR&ED”) initiatives, particularly when a related non-resident company is involved. Specifically, if SR&ED tax credits are determined based on expenditures supplied by a related non-resident entity and subsequently adjusted through transfer pricing (“TP”) regulations, such revisions to eligible SR&ED expenses may impact the SR&ED investment tax credits (“ITC”) available to the taxpayer. This article addresses potential uncertainties associated with applying these ordering rules when calculating ITCs – and subsequent sale/disposition of a developed asset via SR&ED activities.
Subsection 247(2.1) – the Ordering Rule
For the purpose of applying a TP adjustment under subsection 247(2) alongside other provisions, subsection 247(2.1) prescribes a sequence of three steps. In the following, "initial amounts" refer to the original values or figures determined before any TP adjustments are made. The application of the rule is preive and as follows:
1. First, determine each of the initial amounts for the relevant transactions or items - paragraph 247(2.1) (a);
2. Once the initial amounts have been identified, the next step is to make any necessary adjustments to reflect the arm’s length values required by transfer pricing rules. These adjustments ensure that the values used align with what would have been agreed to between independent arms-length parties - paragraph 247(2.1) (b);
3. After the adjustments are complete, other provisions are applied using the adjusted amounts. This includes, for example, section 245, which is the general anti-avoidance rule (GAAR) designed to prevent abusive tax avoidance transactions - paragraph 247(2.1) (c);
The above steps guarantee that TP adjustments are prioritised, ensuring all subsequent tax calculations and the application of relevant provisions are based on corrected, arm’s length figures.
Application of the Rule – SR&ED
Canadian companies transacting with related non-residents and subject to TP agreements must use arm’s length pricing. If otherwise, subsection 247(2) corrects prices to arm’s length standards before other tax rules apply. The impact of these rules on SR&ED expenditures under subsection 37(1) and related ITCs is discussed below.
The Scenario:
Canco, a Canadian private company, carries out SR&ED activities with eligible salary and material expenses. Its U.S. parent, USco, provides for resources including supply of materials to Canco for its development work; note, discussions about USco loans, equity, and impact from subsection 247(2.1) are beyond the scope of this article.
Canco may eventually spin off Canadian-developed asset using a tax-deferred section 85 transfer – this scenario is not atypical in cross-border technology development activities. Since Canco has a TP agreement with USco and files schedule T106, it is subject to subsection 247(2.1).
Impact on SR&ED:
If Canco pays more than arm's length for SR&ED expenses to USco, a downward adjustment reduces its tax benefits; if less, an upward adjustment increases deductions and ITCs. Therefore, only arm's length payments qualify for SR&ED credits—excess amounts are excluded for the purposes of calculating the ITC.
Relevant Provisions: Expenditures Directly Attributable to the Prosecution of SR&ED
Regulation 2900(2) specifies the categories of eligible current expenditures attributable for SR&ED activities relevant to clause 37(8)(a)(i)(B) and subclause 37(8)(a)(ii)(A)(II), which include the following:
1. Costs related to materials consumed or transformed during the prosecution of such activities.
2. For employees who directly undertake, supervise, or support these activities, the portion of salary or wages reasonably attributable to the prosecution.
3. Other expenditures, or portions thereof, that are directly associated with the prosecution and would not have been incurred in its absence.
What are the implications for Canco, with particular focus on wage expenses and material costs incurred as part of SR&ED activities.
SR&ED Wage Expense – Non-Arms Length Correction – the Trivial Case:
Assume Canco pays USco $300,000 for R&D wage cost for performing R&D services in Canada - but the arm’s length cost is determined to be $100,000 – if so, subsection 247(2.1) requires the payment to be adjusted to $100,000. Therefore, only the adjusted amount qualifies for SR&ED treatment, while the remaining $200,000 does not. As a result, SR&ED tax credits will be reduced accordingly. Applying a federal tax credit rate of 15% this will reduce the ITCs by $30,000 – for simplicity, this result has ignored provincial credits and also overhead proxy costs that add to the tax credits – if included will further magnify the overall loss in ITC.
SR&ED Wage Expense – Arms Length - Prorated:
Canco pays USco an arms-length wage cost of $100,000 for 2,080 hours (based on a 40-hour week for 52 weeks) – this translates to hourly rate of $48/hour. Assume 4 weeks vacation and 10 statutory holidays - if excluded from available work time, the pro-rata rata hourly rate increases to $54.34/hour—reflecting a 13% rise. This adjusted rate is used for qualifying SR&ED wage expenses -- also see CRA SR&ED Policy section 5.2 (2025-01-28A). Note the policy does not address or reference to subsection 247(2.1).
Is there a Practitioner Dilemma?
SR&ED practitioners often adjust wage costs to determine pro-rata values (as above) before calculating SR&ED expenses – an uncertainty is whether the increased pro-rata amounts align with paragraph 247(2.1)(c), which requires applying each provision of the Act using amounts from paragraph 247(2.1)(b) – this is a provision applied literally without reference to any other section of the Act. In our illustration, the ordering rule operates as follows:
- identifying the initial amounts which in our example is the pro-rata hourly rate - paragraph 247(2.1)(a);
- make the adjustments, if any, to each of the initial amounts – move the pro-rata amounts which is higher than the arms-length hourly rate to be the adjusted amount - paragraph 247(2.1)(b);
- Use the adjusted amount for qualified SR&ED expenses for paragraph 37(1)(a) - subsection 247(2.1) (c).
Some observations are in order:
It is to be noted that the CRA SR&ED Salary and Wages Policy's adjustments are not explicitly supported by the Act – subsection 37(1) references “expenditure of a current nature,” with the meaning to be expenditures incurred in a given taxation year. Consistent with the CRA SR&ED Policy, when applied in the context of subsection 247(2.1), is it safe to assume “expenditure of a current nature” to be the same as “available time” converted to eligible expenses for SR&ED activities. After all one might argue that the adjustments are to the arms-length amounts – is there a risk? Interesting enough, if Canco is not subject to TP rules, the taxpayer appears able to select the higher rate. Further review is recommended.
On the other hand, the CRA has confirmed that subsection 247(2) rules take precedence over other provisions – see Views Doc No 2017-0691071C6; Notice to Tax Professionals: International Transfer Pricing Administrative Guidance, 2020-02-26A). A clear administrative guidance would help with SR&ED ITC calculations and clarify the continued relevance of the CRA’s SR&ED Salary and Wages Policy.
Example 2 – Materials Cost – Valuation Issue?
Consider where Canco is using USco to provide with specialized purpose materials for SR&ED activities – under many circumstances, the materials are unique and produced for specific R&D activities and can also involve intangible know-how from USco used in producing such materials for Canco’s SR&ED activities; all of which factor in to a material cost - hence, it will be difficult to estimate fair arms-length prices. The alternative is for Canco to solicit multiple quotes from other arms-length vendors. This approach can be limiting (especially where the materials produced for Canco SR&ED is unique) – overall, be time inefficient leading to delays in development activities. In certain cases, Canco can loose its competitive advantage from such delays. Hence, determining the arms-length material cost can be a challenge – fortunately, there may be a due diligence defence argument for Canco – see short note below.
Example 3 – Asset Transfer and Disposition
Canco transfers an IP developed via SR&ED to Newco through a section 85(1) tax-deferred rollover, receiving Newco shares as consideration. An issue is valuing the ACB of these shares – here, the ACB is tied to the SR&ED costs (net of ITCs) and may not reflect arm’s-length pricing – see issues discussed above. Should the CRA review the ACB for arm’s-length compliance, this can jeopardize tax deferral if valuation is unclear. This uncertainty remains even if Newco shares are later sold to an arm’s-length or Canadian-resident buyer, due to continued cost base ambiguities.
Penalties and Reasonable Efforts
Subsection 247(3) imposes a penalty of 10% on net transfer pricing adjustments if they exceed the lesser of $5,000,000 or 10% of the taxpayer’s gross revenue. This penalty is waived if Canco made reasonable efforts to determine and apply arm’s length prices or allocations. This is particularly relevant where determination of a fair price may be an issue.
Relief for Canco?
Canco may be able to show reasonable efforts—particularly demonstrate the unique, proprietary nature of SR&ED activities. According to CRA’s TPM-09, penalties focus on compliance with arm’s length pricing requirements, not just accuracy. If Canco maintains proper contemporaneous documentation that reflect reasonable efforts in establishing what would be arms-length prices, it is likely that no penalty may apply – needless to say, if there is a dispute, it is ultimately up to the tax courts to define what constitutes a reasonable effort.
Can there be Negligence?
Demonstrating what is reasonable can be challenging and if the CRA assesses a negligence, it will be an uphill task for the taxpayer. However, recently, there has been jurisprudence where the the Tax Court has found taxpayers to be liable to gross negligence penalties under s. 163(2) of the Act resulting from unsuccessful SR&ED claims. In the Elements Chauffants Tempora Inc. 2025 TCC 173 decision, the Tax Court determined that the burden of proving these penalties are on the Minister of National Revenue and penalties would be imposed only where the evidence justifies it. Any benefit of the doubt should be given to the taxpayer – this is certainly a relief for a taxpayer being assessed under grosss negligence. Two elements are required for the penalty to apply: (1) a mental element (“knowingly, or under circumstances amounting to gross negligence”) and (2) a material element (“has made...a false statement or omission in a return, form, certificate, statement or answer”) on a reasonable person standard. As such, it is unlikely that these elements would be found against a taxpayer who has conducted themselves at the level of a reasonable person in the same circumstances in verifying, preparing, and claiming SR&ED expenditures and corresponding ITCs. In this context, it is responsibility of the taxpayer to act in a prudent manner and undertake whatever steps a reasonable person would do.
What efforts can Canco take - Compliance Considerations
Documentation for SR&ED-Specific Requirements
Canco must prepare and keep documentation proving its cross-border transactions, including R&D services or materials, are at arm’s length to reduce transfer pricing penalty risks – reasonable efforts to demonstrate a watertight TP study must be undertaken.
Some Practical Steps Include:
- Review transfer prices for cross-border R&D to ensure arm’s length pricing with strong documentation;
- Update SR&ED claims by recalculating eligible expenses to reflect any TP adjustments – if there is an uncertainty and seek advanced CRA rulings – although this may be costly and time-consuming;
- Collaborate and communicate with SR&ED and transfer pricing specialists to confirm compliance and identify eligible credits and pricing risks;
As a passing remark, where applicable, show trade tariffs or countermeasures change transaction prices, and document their impact on arm’s length pricing in TP analyses.
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