Article by Kamleh Nicola and Damien McCotter1
It can fairly be said that a successful research and development (R&D) program cannot have reward without risk. Reward is the incentive that drives the risk of investment necessary for developing a new product or service; but, at the same time, the importance of understanding and managing the risks, while pursuing the reward, should not be underestimated.
Pursuing tax incentives and protecting the intellectual property that results from R&D are essential components of any investment and commercialization strategy. Businesses engaged in R&D in Canada can maximize the benefits of tax strategy and patent protection and minimize the risk of lost investment by maintaining a current understanding of tax and patent law in Canada. It is essential to document the R&D efforts undertaken and to record the pursuit of invention as it is happening. This is important not only for claiming tax credits, but also for drafting patents and, if necessary, for subsequently enforcing patents. Recent decisions made by Canadian courts provide important guidance to researchers and patent drafters with respect to documenting the invention process and disclosing the invention to the public.
This article briefly examines the tax and intellectual property incentives available to those conducting R&D in Canada and explains in practical terms the importance of documenting the pursuit of invention. In particular, we emphasize the importance of evidencing the prediction or demonstration of usefulness of an invention (or "utility") during the course of R&D. The protocols established to comply with provincial and federal R&D tax programs can equally be relied upon to record and archive information that may be needed years later if the usefulness of a patented invention is challenged in court.
Tax Incentives for Conducting R&D
In Canada, the pursuit of reward associated with scientific innovation is supported by both new and well-established tax incentives for those engaged in R&D. From a cross-border perspective, given President Obama's proposed amendments to the US tax code regarding deferral rules on foreign income and the Research and Experimentation Tax Credit, the R&D environment in Canada is becoming a more attractive and more competitive option for both US and Canadian companies.
This is particularly true in Ontario where companies may benefit from recently introduced business and innovation tax incentives. In addition, industry forums hosted by Canada's Minister of Industry indicate the federal government's renewed emphasis in supporting Canada's technology industries.
The primary governmental incentive for R&D in Canada is the Scientific Research and Experimental Development (SR&ED) tax incentive program. The objective of the SR&ED program is to encourage businesses of all sizes in all sectors to conduct R&D in Canada.2 The program offers immediate tax write-off or indefinite carryforward for allowable SR&ED expenditures as well as investment tax credits (ITC) that can be offset against federal taxes otherwise payable.
This tax program may be of particular interest to US businesses that are considering their options for foreign-based R&D. The US tax code currently allows US businesses with foreign operations to make immediate deductions on their US tax returns for expenses supporting their foreign operations. However, businesses with foreign operations can also defer paying US taxes on the profits they make in those foreign jurisdictions. The Obama administration views this as a tax loophole that deprives the United States of tax revenue that should be payable on foreign income. President Obama has therefore proposed a reform of the tax code that will ensure that companies cannot receive deductions on their US tax returns arising from their foreign operations until they pay taxes on their foreign profits. The only exception to this will be foreign research and experimentation expenses, meaning that US companies can still deduct their foreign R&D expenses when filing their US tax returns. As a result, one of the only remaining tax deferral strategies for US companies with foreign subsidiaries is to spend on R&D abroad, set that expense against their income and defer paying tax on certain profits made in those jurisdictions. This reform to the tax code will encourage US companies to carefully choose where to conduct foreign R&D. The federal and provincial governments in Canada should recognize this as an opportunity and continue to strengthen incentives for businesses conducting R&D.
Understanding these tax incentives is important to existing businesses and those that may indeed be considering establishing operations in Canada. At the federal level, the current SR&ED regime is governed by the Income Tax Act (ITA), specifically section 248(1), which provides the definition of SR&ED and the categories of work that qualify as SR&ED under the program. SR&ED means systematic investigation or search that is carried out in a field of science or technology by means of experiment or analysis for the advancement of scientific knowledge or for achieving technological advancement. The categories of work that qualify under the SR&ED program are basic research, applied research, experimental development and certain technical work undertaken in Canada by or on behalf of the taxpayer that is commensurate with and directly in support of these categories of SR&ED. Section 2900(1) of the Income Tax Regulations sets out eligible expenditures that are directly attributable to engaging in SR&ED. These expenditures include the cost of materials, salary and wages that can reasonably be considered to be necessary for the work, and other expenditures that are directly related to such work and would not have been incurred if the SR&ED had not been conducted.
The SR&ED program is not a grant program but a tax benefit available after the work has been done and the expense incurred. Generally, the ITA provides that a taxpayer carrying on business in Canada in a taxation year may deduct, in calculating income from the business for that year, expenditures of a current or capital nature for SR&ED carried on in Canada that relate to the business of the taxpayer (which can also be carried forward and deducted in subsequent years subject to certain limits). In addition, a taxpayer may deduct expenditures (of a current nature3) for SR&ED carried on outside Canada that is directly undertaken by or on behalf of the taxpayer and that relates to the business in the year the expenditure was made (sections 37, 45−47 of the ITA). In addition to deductions in computing income, an investment tax credit for SR&ED is also available.
The federal tax benefits available to businesses conducting R&D in Canada will be bolstered by proposed legislation to be introduced in the province of Ontario. On March 26, 2009, a number of proposed measures relating to the Taxation Act, 2007 were announced in the 2009 Ontario budget. The proposed legislation will reduce the corporate income tax rate, beginning July 1, 2010, to 12% from 14%, to be further reduced to 10% over the following three years. The combined provincial and federal general corporate tax rate in Ontario for general active business income will be 30% in 2010, decreasing to 25% by 2013.4 The Ontario government has also proposed to amend the Ontario Innovation Tax Credit, which is a 10% refundable tax credit for small and medium-sized corporations performing eligible SR&ED in Ontario by extending the taxable income phase-out range to between $500,000 and $800,000. Other incentives include the Ontario Interactive Digital Media Tax Credit and the Ontario Computer Animation and Special Effects Tax Credit, both designed to enhance Ontario's digital media industry.
These new Ontario incentives are in large part linked to the federal SR&ED program to confirm eligibility and successfully submit a claim. With respect to SR&ED, when a claim is submitted to the Canada Revenue Agency (CRA) it is verified as to eligibility in accordance with the ITA and with respect to the nature and amounts of the expenditures claimed. For verification purposes, CRA requires that the claimant keep dated documentation and evidence of original technological goals, the work carried out, the progress made and the conclusions reached.
Obviously not all SR&ED efforts need to result in a patentable invention – "experimental development" includes "incremental improvements" (section 248(1) of the ITA). The Tax Court of Canada has itself stated, "Most scientific research involves gradual, indeed infinitesimal, progress. Spectacular breakthroughs are rare and make up a very small part of the results of SR&ED in Canada."5 This language, though relating to eligibility under the SR&ED program, is similar in nature to the Federal Court's comments on patentable inventions, noting that new ideas can result from a lucky spark or a eureka moment, or equally can be discovered by the patient searcher. Invention is simply finding out what has not been found out by other people.6 CRA has published a list of three criteria to be used in evaluating whether or not a project qualifies as SR&ED: (1) scientific or technological advancement, (2) scientific or technological uncertainty, and (3) scientific and technical content.7
As discussed further below, parties engaged in R&D in the pursuit of invention are strongly advised from both a tax and a patent perspective to keep detailed records from the very beginning of an R&D project.8 The use of electronic record keeping for the purposes of documenting invention has also been previously advised.9 From a tax perspective, proper record keeping will better facilitate successful claims and will minimize the risk of claim denial or tax litigation if CRA were to reject a particular expenditure claim. If the taxpayer maintains detailed contemporaneous records of the work undertaken, it will have a better case to make to CRA in the context of a notice of objection. If the conflict proceeds to litigation, the taxpayer, with records in hand, can rely on the Tax Court's previous determination that the SR&ED legislation must be given such fair, large and liberal construction and interpretation as best encourage scientific research in Canada.
Although records should be kept for both tax and patent purposes, the two legal regimes obviously diverge as the R&D efforts mature. It is notable that expenditures made by a taxpayer to acquire patents are not deductible under section 37 of the ITA regardless of whether the taxpayer has participated in the SR&ED program. However, significant tax benefits can be gained through domestic and international tax planning as it relates to patents and other intellectual property.10 In this and many other regards, the value of patents is unquestionable, and as discussed below, businesses engaged in R&D should have a number of patent issues in mind from the outset.
Protecting the Results of R&D: Guidance on Patenting in Canada
A fundamental goal of R&D is innovation – or invention. Not invention simply for the sake of invention, but invention in the sense of discovering, developing or enhancing a product, service or technology that can be successfully commercialized. Obtaining patent protection for innovative results of R&D is a reward that has become an integral aspect of commercialization in both the Canadian market and markets abroad.
Patent protection is intended to encourage R&D by offering a time-limited monopoly in exchange for full public disclosure of the inventor's discoveries. In this way, society may benefit from advances in science and technology. This public disclosure has often been described as the quid pro quo for the 20-year term of patent protection that is granted to patentees.
Certain substantive requirements must be met if the results of R&D are to be protected as a patented invention. Canada's Patent Act requires that a claimed invention be new, useful and not obvious. In addition, the Act obligates patentees to meet certain technical requirements, such as correctly and fully describing the invention.
Recent Canadian cases have shown that parties making patent challenges are focusing on the usefulness (utility) of patents. A relatively new development in litigation strategy in Canada has been the increased frequency of asserting both a substantive lack of utility and a lack of proper description of that utility in the patent. In April 2008, Justice Hughes of the Federal Court (i.e., trial division) remarked, "There has not been a great deal of discussion by the higher Courts in Canada as to the concept of 'utility'".11 However, since this statement, the Federal Court has considered a number of cases involving an assertion that the patent at issue lacks utility. There has been a significant shift in focus with patent challengers placing greater emphasis on the concept of utility. Given this evolving jurisprudential landscape, individuals and companies undertaking R&D and pursuing patent protection in Canada should bear in mind, and soberly reflect on, the obligations that the requirement of utility imposes on inventors.
The utility of an invention exists if, as of the date of filing the Canadian patent application,12 there was a demonstration in fact of the invention's utility (the inventor has established that the invention will work). The doctrine of sound prediction operates to justify a patent's claims where utility has not actually been demonstrated, but is otherwise based on a sound prediction supported by the tests the inventors had undertaken and based on what was known in the public domain. The courts have articulated a three-part test for sound prediction as follows:
- Is there a factual basis for the prediction?
- Does the inventor have an articulable and sound line of reasoning from which the desired result can be inferred from the factual basis? and
- Is there proper disclosure in the patent document?13
The level of utility that has traditionally been required to sustain a Canadian invention has been relatively low.14 It has been said that a "mere scintilla" of utility will suffice."15 The patent is said to lack utility if "the invention will not work, either in the sense that it will not operate at all or more broadly, that it will not do what the specification promises it will do."16 With this test in mind, rather than attack the actual working utility of an invention, patent challengers have frequently argued in recent cases that the utility promised in the patent document had not been achieved or could not have been predicted at the Canadian filing date..
Although the substantive issue of utility of an invention employs a relatively low threshold and has not garnered much controversy, the more technical aspect of the nature and scope of the disclosure of the invention in the patent document has tended to dominate recent judicial discussion. This issue of disclosure has centered on the extent of information that is necessary to support the invention's demonstrated utility, or the factual basis for the sound prediction of its utility. How much information is required? Now, more than ever, considering whether sufficient information is disclosed in a patent is important for individuals and businesses conducting R&D and pursuing patent protection.
Traditionally, it has been unnecessary for the patent disclosure to contain the theory of why the invention works.17 It is thus understood that there is no need to discuss the scientific theory underpinning the invention. The Federal Court of Appeal has confirmed that only two questions are relevant to the question of proper disclosure under section 27(3) of the Act: What is the invention? How does it work? If the patent specification answers these questions, the inventor has held his part of the bargain.18
However, there has been confusion in reconciling the low "scintilla" threshold of utility with the technical requirement to fully disclose the invention and its operation or use in the patent document.19 Recent cases have held that an invention is sufficiently described if persons skilled in the art are able, with only the patent document, to use the invention as successfully as the inventor.20 Indeed, there has been a suggestion that the requirement to disclose an invention's utility may be a requirement separate and apart from the general section 27(3) requirement of sufficient disclosure. In 2008, a decision of the Federal Court framed the disclosure concept as follows:
Thus the question here is whether there is enough data to support the utility of the claimed invention. That data ... must be in the description in the patent, to repeat: "The description must also give all information that is necessary for the successful operation of use of the invention.21
These comments were interpreted by some patent challengers as incorporating a super avid disclosure requirement, meaning that the patent needs to disclose something more than simply the invention and how it works, and more than a simple statement of the invention's utility. It was suggested that the patent also needs to provide "all information," including data, to support its utility. This is a controversial point. But assuming this to be the case, the difficulty lies with knowing how much data is enough.
Subsequent attempts to clarify this issue of disclosure suggest that for inventions that have demonstrated utility (as opposed to a sound prediction of utility), there is no requirement in patent law that evidence of the demonstrated utility be included in the patent. This is in line with the traditional view. In such a case, the patent disclosure need not set out supporting data so long as the patent contains a statement describing the demonstrated utility.22
However, this is not so for inventions based on sound prediction. It appears that a level of disclosure different from that of demonstrated utility is required. The Federal Court of Appeal recently described this requirement as "a heightened obligation to disclose the underlying facts and the line of reasoning for inventions that comprise the [sound] prediction."23 If the invention had not been reduced to practice and its utility had not been demonstrated as of the Canadian filing date, it appears that the patent must disclose the factual basis for soundly predicting the invention's utility.24
In reviewing this issue, the Federal Court has adopted the view that it is not confined to an objective examination of the invention through the eyes of persons skilled in the art. Rather, the knowledge, activities and endeavors of the inventors themselves will also be considered.25 This subjective analysis will require that the information that was available to the inventors, as well as their thinking and the data generated in the pursuit of the invention, all become relevant. This heightens the need to be able to retrieve records and information from the relevant time period. This also points to a need, more than ever, to maintain records and information on an ongoing basis in order to track current R&D work, which could subsequently become the subject of a patent.
How do these disclosure requirements reconcile with the practical realities facing patent drafters? For patents that are based on demonstrated utility, ensuring that there is a description of the utility is key. For patents based on sound prediction, it is important to disclose the full factual basis and line of reasoning for the prediction. This may include available data, literature, and for life sciences and pharmaceuticals, even clinical reports.
At the same time as ensuring sufficient and proper disclosure, there is the need to avoid going too far in the description of the utility. Caution should be employed to avoid overstating the promise of utility or its value to society. A balance needs to be employed between the need to fully describe the invention's utility and the basis for its sound prediction, on the one hand, and the need to avoid superfluous terminology or over-claiming, on the other. For instance, in the context of pharmaceutical patents, it is important to ensure that there is sound support for the utility of all the compounds covered by a particular patent claim. If the utility of all the compounds had not been demonstrated by the Canadian filing patent, there needs to be a factual basis to support the claim disclosed in the patent. Finding one compound of a class of compounds to possess the promised utility may not be sufficient unless a sound line of reasoning based on available literature, data generated by other testing, or even clinical reports can support the prediction that the other compounds also possess the utility.26 Consideration can also be given to including a specific claim to the compound that was tested, separate and apart from a claim to the other compounds. Including the experimental data to support the promised utility of that compound should also be considered.
Although tax and intellectual property incentives are well established and available in Canada on a macro scale, it is also important to understand that there are underlying risks of both on a micro scale. If these risks are well-understood and properly managed, innovative companies operating in Canada will gain a significant competitive advantage in an attractive R&D environment.
The tax-related risks can be minimized by a sound understanding and compliance with the relevant tax programs to avoid denial of tax credits, audit or litigation. To this end, it is essential to contemporaneously document the R&D efforts undertaken and to record the pursuit of invention.
Recording the innovative effort is important not only to support a claim for tax credit, but also for the drafting of any related patents and, if it becomes necessary, for the subsequent enforcement of patents in any ensuing litigation. Maintaining a detailed record of the work done and the results obtained in development could , years later, minimize the risk of a patent (the reward of R&D) from being attacked on the ground of lack of utility. Recent court decisions have directed much attention to scrutinizing the work of inventors that resulted in a patented invention. This scrutiny of innovative effort has been driven by patent challengers seeking to exploit the invention for themselves while attacking the invention's utility and advancing the usual attacks of novelty ("this is nothing new") and obviousness ("this is not inventive"). Patent challengers have found a fertile field in arguing that patents lack utility or usefulness, which has taken on two major themes: (1) the invention is not useful; and (2) the patent fails to disclose sufficient information to support the utility of the invention. In light of the recent court cases discussed in this article, the concept of utility, and its proper disclosure in a patent, are important considerations for those conducting R&D in Canada.
Kamleh Nicola is a partner at Torys LLP. Her practice focuses on litigation and dispute resolution, with an emphasis on all aspects of patent and trademark matters, and pharmaceuticals.
Damien McCotter is an associate at Torys LLP. His practice focuses on intellectual property litigation and the protection and management of IP assets.
1.The authors wish to acknowledge the valuable input and comments they received from their colleagues Andrew Shaughnessy (IP litigation partner), Richard Johnson and Saira Bhojani (tax associates) and Vincent de Grandpre (IP litigation associate); The authors also acknowledge Arjeta Meneri (summer law student) for her research assistance and for compiling some of the information cited.
2.Canada Revenue Agency, Scientific Research & Experimental Development – What It Is and How it Works (CRA, 2008).
3.For purposes of SR&ED, a "current expenditure" is an expenditure that does not result in the acquisition of land, a leasehold interest in land, or property that would otherwise be depreciable property to the taxpayer.
4.The combined federal and provincial general corporate income tax rate for general active business income in Alberta and British Columbia will be 25% by 2013, down from 29% and 30%, respectively, for 2009.
5.Northwest Hydraulic Consultants Ltd. v. The Queen, 98 DTC 1839 (Tax Court of Canada) at para. 10.
6.Pope Alliance Corporation v. Spanish River Pulp and Paper Mills, Ltd.,  1 D.L.R. 209 at 216-7 (H.L.); Farbwerke Hoechst AG v. Halocarbon (Ontario) Ltd.,  2 S.C.R. 929 at 943-5.
7.Information Circular 86-4R3, Scientific Research and Experimental Development, May 24, 1994.
8.Guidance on record keeping and eligibility can be found in CRA's Interpretation Bulletin 151R5, Scientific Research and Experimental Development Expenditures [Consolidated], July 28, 2003, and in Information Circular 86-4R3, supra note 7.
9.D. McCotter, P. Wilcox, "Using Electronic Records in Patent Proceedings," World IP Contacts Handbook, 14th ed. (London, U.K.: Managing Intellectual Property, 2007) 82.
10.D. McCotter, R. Johnson, "Canadian Tax Strategies for Managing Intellectual Property Assets," The 2007/2008 Lexpert CCCA/CCJE Corporate Counsel Directory and Yearbook, 6th ed. (Toronto: Carswell/Thomson) 267.
11.Pfizer Canada Inc. v. Canada (Minister of Health), 2008 FC 500 at para. 93 [emphasis in original].
12.Sanofi-Aventis Canada Inc. v. Apotex Inc., 2009 FC 676 at paras. 143-4 [Sanofi-Aventis Canada].
13.Apotex Inc. v. Wellcome Foundation Ltd.,  4 S.C.R. 153 at para. 56 [Apotex].
14.Consolboard Inc. v. MacMillan Bloedel (Saskatchewan) Ltd.,  1 S.C.R. 504 at 525 [Consolboard].
15.Aventis Pharma Inc. v. Apotex Inc., 2005 FC 1283 at para. 271.
16.Consolboard, supra note 12.
17.Apotex, supra note 11 at para. 70.
18.Pfizer Canada Inc. v. Minister of Health (2008), 67 C.P.R. (4th) 23 (F.C.A.) at para. 59.
19.Section 27(3)(a) of the Patent Act requires that the specification of an invention must correctly and fully describe the invention and its operation or use as contemplated by the inventor.
20.Consolboard, supra note 12 at 526.
21.Pfizer Canada Inc., supra note 9 at para. 97 [emphasis added].
22.Pfizer Canada Inc. v. Novopharm Limited, 2009 FC 638 at para. 82.
23.Eli Lilly Canada Inc. v. Apotex Inc., 2009 FCA 97 at para. 14.
24.Ibid. at paras. 15, 18; Sanofi-Aventis Canada, supra note 10 at para. 213.
25.Sanofi-Aventis Canada, ibid. at para. 151.
26.Ibid. at paras. 194, 218, 220, 225.
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