Ryan Tax Review

Hypothesis as the Cornerstone of SR&ED Eligibility

Government incentives for research and development have existed in Canada, in some form, since 1944. The modern version of this incentive was defined in section 248(1) of the Income Tax Act in 1986 as:

“…scientific research and experimental development” means systematic investigation or search that is carried out in a field of science or technology by means of experiment or analysis …”

Currently, scientific research and experimental development (SR&ED) is a $3 billion tax incentive program designed to reimburse Canadian companies for work undertaken to resolve technological uncertainties and, therefore, improve their technological knowledge base.  In order to qualify for the credit, work must follow the “scientific method”.  Generally, the steps of the scientific method are:

  1. Ask a question;
  2. Develop a hypothesis to answer the question;
  3. Test the hypothesis with an experiment;
  4. Collect and analyze data; and
  5. Draw conclusions.

However, in a business context, it is not always clear that a project aligns with the scientific method.  The key to proving that work done as part of a business project follows the scientific method, and therefore qualifies as SR&ED, is in articulating the hypotheses driving the work.  The Oxford Dictionary defines “hypothesis” as “a supposition or proposed explanation made on the basis of limited evidence as a starting point for further investigation.”[1]  In this article, we will look at how, over the years, the Tax Court of Canada has viewed and defined the term hypothesis in the context of the SR&ED program.

Establishing a Hypothesis as a Criterion for SR&ED

Prior to 1998, the courts evaluated SR&ED eligibility based on the vague concept of scientific experiment or analysis as a series of logical, systematic steps, as defined in the Income Tax Act; however, there was no explicit mention of the term “hypothesis”.  In 1998, the definition of hypothesis was more formalized by the landmark decision in Northwest Hydraulics v. The Queen.[2]  Justice Bowman expanded upon the Income Tax Act language in the form of five questions that needed to be answered in the affirmative in order for a project to qualify as SR&ED.  Questions 2 and 3 specifically reference the term “hypothesis” as a criterion for SR&ED:

“…2. Did the person claiming to be doing SRED formulate hypotheses specifically aimed at reducing or eliminating that technological uncertainty? This involves a five stage process:

(a) the observation of the subject matter of the problem;

(b) the formulation of a clear objective;

(c) the identification and articulation of the technological uncertainty;

(d) the formulation of an hypothesis or hypotheses designed to reduce or eliminate the uncertainty;

(e) the methodical and systematic testing of the hypotheses…


… 3. Did the procedures adopted accord with established and objective principles of scientific method, characterized by trained and systematic observation, measurement and experiment, and the formulation, testing and modification of hypotheses?”

This definition served to define the scientific method in the context of SR&ED.  Today, the five questions have become the basis for determining whether SR&ED occurred.  The importance of the concept of a hypothesis is evident, as it is an essential aspect of two of the five questions. 

A Hypothesis Must Be Verifiable

The definition of a hypothesis was subsequently expanded upon by the Tax Court of Canada to include the requirement that a hypothesis must be verifiable by means of observation.  The first real test of Justice Bowman’s approach came in 2000, when the case of C.W. Agencies Inc. v. The Queen[3] dealt with a project involving the development of custom software.  The claimant stated that their hypothesis was:

“... that the benefit gained from the object-oriented architecture would result in a higher productivity per person from the reusability of components and a decrease in system development time compared to procedurally based development methods.”

However, Justice Bonner was not convinced that this hypothesis was sufficient:

“I note here that it is not clear to me that this ‘hypothesis’ is one which is capable of being proved or disproved by means of scientific research. It seems to me that it is simply too vague. The word hypothesis in this context is normally considered to mean a provisional concept which is not inconsistent with known facts and serves as a starting point for further investigation by which it may be proved or disproved objectively.”

The statement that a change in programming architecture would improve the programmers’ productivity was not testable because, in a business context, one would not write the program using two architectures in order to compare the effect on development time.  A hypothesis should include a variable with a proposed quantifiable effect that can be experimentally tested.

Hypothesis vs. Trial and Error

Trial and error, in the context of SR&ED, is when experimentation is conducted without clear reasoning behind the tests.  Inthe 2003 case of Maritime-Ontario Freight Lines v. The Queen,[4] Justice Sarchuk defined a hypothesis as:

“.. a tentative assumption or explanation to an unknown problem and, as a rule, this requirement is met by the existence of a logical plan devised to observe and resolve the hypothetical problem.”

In this statement, Justice Sarchuk also commented that the proposed phenomenon that is being tested needs to be articulated in the hypothesis.  In the very recent case of Flavor Net Inc. v. The Queen,[5] where the claimant was developing a new food and beverage product, Justice D’Auray affirmed the Maritime-Ontario Freight Lines decision and added:

”Parts of the testimony and documentary evidence suggested that the testing was by and large done using the trial and error method. For example, I found that the testimony of Mr. Schmalz and the documentary evidence did not provide any clear rationale for the selection of certain nutraceuticals, other than the fact that they were widely known to have various health benefits.”

These cases confirmed that articulating the rationale behind any trials conducted is vital to differentiate experimental development from the trial and error approach. 

A Hypothesis Must Go Beyond Known Effects

When formulating a hypothesis, the relationship that is proposed cannot be the known or expected outcome.  In the 2009 case of Advanced Agriculture Testing Inc. v. The Queen,[6] the claimant was trying to assess the effectiveness of hormone implants to promote cattle growth.  In his ruling, Justice Bowie stated:

“…rather than formulating a hypothesis to be tested…There was no variation in the way the implants were used…the single difference was the particular product that was applied to each group. Neither in the documents nor in the testimony do I find that the appellant has formulated a hypothesis to be tested…It simply used four different commercial products at the pasture stage, and one at the feedlot stage, to compare their effectiveness.”

The decision in this case illustrates that, if products or processes are used in their intended manner, then the effects are well known and, therefore, no advancement can be achieved.  In order for a hypothesis to be valid in the context of evaluating a SR&ED claim, it must propose effects beyond what is typically expected.   


Since the definition of SR&ED in the Income Tax Act is vague, it has been left to the jurisprudence of the Tax Court of Canada to specify eligibility criteria.  One of the key criteria identified by the Court is the articulation of a clear hypothesis.  The definition of a hypothesis has been expanded upon in the jurisprudence to date to require that the hypothesis must:  (1) be verifiable through experimentation; (2) provide reasoning as to why the trials are conducted; and (3) propose effects beyond what is readily known.  Therefore, as part of any successful SR&ED claim, it is absolutely vital that the hypotheses developed are clearly stated and well documented in a company’s T661 technical report(s).


Shaun Button & Jeffrey Stewart

Managers, Scientific Research and Experimental Development

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[1] https://en.oxforddictionaries.com/definition/hypothesis

[2] https://decision.tcc-cci.gc.ca/tcc-cci/decisions/en/item/24675/index.do; Northwest Hydraulic Consultants Ltd. v. Her Majesty the Queen, 1998 DTC 1839.

[3] https://decision.tcc-cci.gc.ca/tcc-cci/decisions/en/item/24346/index.do; C.W. Agencies Inc. v. Her Majesty the Queen, 2002 DTC 6740.

[4] https://decision.tcc-cci.gc.ca/tcc-cci/decisions/en/item/26629/index.do; Flavor Net Inc. v. Her Majesty the Queen, 2017 TCC 179.

[5] https://decision.tcc-cci.gc.ca/tcc-cci/decisions/en/item/234967/index.do; Maritime-Ontario Freight Lines Ltd. v. Her Majesty the Queen, 2003 TCC 674.

[6] https://decision.tcc-cci.gc.ca/tcc-cci/decisions/en/item/29166/index.do; Advanced Agriculture Testing Inc. v. Her Majesty the Queen, 2009 TCC 190.