Various provisions of the Income Tax Act (the "Act") allow corporations to claim tax credits. This article by a Toronto Tax lawyer will discuss the legal tests used to determine if the activities of your Canadian Controlled Private Corporation ("CCPC") can qualify for the Manufacturing and Processing Tax Credit (the "M&P Credit").
The M&P Credit
Paragraphs 125.1(1)(a) and (b) of the Act allows a Corporation to claim a portion of either "corporate taxable income" or "Canadian manufacturing or processing profits" as a credit, subject to certain conditions. The M&P Credit for a CCPC is closely tied to the Small Business Deduction under s. 125 of the Act as the Small Business Deduction Limit of $500,000 must be met before the M&P Credit can be claimed. This isn't necessarily a bad thing though because the Small Business Deduction rate of 17% exceeds that of the M&P Credit. The M&P Credit rate is equivalent to the General Rate Reduction or 13%. The s.125 Small Business Deduction considerations only come into play when a corporation eligible for the Small Business Deduction is attempting to claim the M&P Credit. Corporations that are not eligible for the Small Business Deduction also qualify for the M&P credit and do not have these considerations.
The language in the M&P Credit provision with respect to the Small Business Deduction can be confusing. To paraphrase, the provision reads "the M&P Credit can be claimed on the amount that exceeds the least of three Small Business Deduction amounts." This language provides two options: 1) the least of the three amounts is not the Small Business Deduction Limit, therefore there is no excess to use to claim the M&P Credit and 2) the least of the amounts is the Small Business Deduction Limit, therefore anything exceeding the Small Business Deduction Limit is an amount on which the M&P Credit can be claimed. The Aggregate Investment Income of CCPCs is also referenced in the M&P Credit provisions and must be taken into consideration.
The Act is rife with difficult language and related provisions. If you are having difficulty interpreting the Act or tax rules that apply to you or your SME you should consult with one of our experienced Canadian tax lawyers.
Manufacturing and Processing (M&P) Defined
Another feature which makes the act a difficult piece of legislation to interpret is the way in which terms are defined. The Tax Act contains broad provisions and often the definition of a term will only explicitly define what it is not. For example, the definition of "M&P" for the purpose of "Canadian M&P profits" under subsection 125.1(3) of the Act:
"manufacturing or processing" does not include
- farming or fishing,
- operating an oil or gas well or extracting petroleum or natural gas from a natural accumulation of petroleum or natural gas,
- extracting minerals from a mineral resource,
- ore (other than iron ore or tar sands ore) from a mineral resource located in Canada to any stage that is not beyond the prime metal stage or its equivalent,....
Since M&P is not clearly defined and since the M&P Credit may be claimed on Canadian M&P profits, a Canadian tax lawyer must examine the relevant case law to determine what the definition of M&P is for the purposes of section 125.1 of the Act.
Processing – Two Legal Tests
There are two tests used to determine if taxpayer activities consist of "processing," They are, (i) whether there is a change in the form, appearance or other characteristics of the goods subject to the operation, and (ii) whether the product becomes more marketable. These tests were developed in the leading case of Minister of National Revenue v Federal Farms [ Ex. CR 410].
The second test or marketability test may be an easier bar to meet as goods may be found to be processed without undergoing a change in form. For example, in the Farms case vegetables that were selected, washed, brushed, sprayed, graded, sorted and packaged were found to be "processed goods." The product sold was still very much a vegetable. It was not minced into baby food, or pressed into juice, but still sold as a whole vegetable. The processing that occurred gave the vegetable improved keeping qualities which made it more attractive to the consumer.
If the goods in question were subject to a process where they underwent a material change in form, it is much easier to make the argument that the activities were processing activities than if the good had remained relatively the same throughout.
Application of the legal test for "processing" in tax case law
There have been numerous decisions since the Farms case that ruled on the definition of manufacturing and processing.
The Improved Marketability Test
In TDS Group Ltd. & Her Majesty the Queen [2005 TCC 40], the Tax Court of Canada ruled that the assembly and special packaging of automotive parts into vehicle assembly kits, in addition to the application of a corrosion inhibiting substance was processing. The corrosion treatment was used to better enable transport of the kits to overseas assembly plants. These activities were found to be processing for the following reasons: 1) the activities were an integral part of the overall process of assembling an automobile for sale; 2) the activities added value since the taxpayer was compensated at five times the cost for the parts; and 3) The process was more sophisticated than simply separating and counting out parts. Taken in sum, the judge held that the taxpayer fell within the improved marketability test as the activities at issue were an integral process to prepare the end product for the retail market.
The Material Change in Form Test
Other courts have taken a stricter approach to "processing." For example, in Tenneco Canada Inc v R [132 NR 62 (FCA) (1991)] the Federal Court of Appeal relied on the Farms decision regarding the improved marketability test as well as additional criteria. The judge in Tenneco ruled that processing required a change in form, appearance or other characteristic of the good. Further, the judge stated that the change in character of the goods must be significant to qualify for special tax incentives. As such, if the activities in question significantly alter the character of the goods being processed, there is a much stronger case that the activities qualify for special tax incentives.
It is important to note that, even though the Tenneco case stresses the importance of a significant change in character to the goods allegedly processed, this criterion is absent from the leading case of Farms. The idea that processing suggests a material change in the goods was explicitly rejected by Justice Cattanach in Farms as he stated that "I do not accept the definition put forward by Mr. Long that processing connotes a material change being made in the texture and structure of the product."While material change may strengthen the case for "processing," absence of material change may not be fatal to claim for the Manufacturing & Processing Tax Credit.
Utilizing both the Improved Marketability and the Material Change Test
Some cases look to both elements in order to render a decision; however, at a cursory look, there appears to be ambiguity as to whether both tests must be satisfied. In Mother's Pizza Parlour (London) & Her Majesty the Queen [85 DTC 5271], the Federal Court held that processing includes some "element of transformation or preservation". Transformation of goods would imply a material change in form, while preservation of goods would imply preparation of goods to convert them to a more marketable form. The use of "or" implies that both tests do not have to be met to find in favour of processing.
Ultimately, in Mother's Pizza Parlour (London) the assembling of pizza's in the kitchen for immediate consumption in the dining room of the parlour was held not to be processing. In particular, the judge emphasized that the pizza dough used was not made in house. If that key fact had differed, a very different analysis may have been performed.
The case law surrounding the definition of Manufacturing & Processing is nuanced. If you are unsure if the activities of your corporation are eligible for the M&P Credit, or wish to carry out income tax planning to ensure that your activities do qualify, you should consult one of our top Canadian Tax Lawyers for advice.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.