What is SR&ED?

Businesses across Canada are getting refunds for their R&D expenditures. Are you?

The Scientific Research & Experimental Development (SR&ED) program provides very generous tax incentives for businesses engaged in research and development activities in Canada. It aims to boost R&D activity across all sectors and is the single largest federal program supporting R&D in Canada. If your business is eligible, you can qualify for a tax refund and/or tax reduction that can cover a large part of your R&D budget.

SR&ED is a complex subject with plenty of technical narrative. This guide walks you through the basics to help you understand how to qualify and join the thousands of Canadian businesses benefiting from the program.

What is the SR&ED program?

SR&ED is an acronym for the Scientific Research and Experimental Development Tax Incentive Program, commonly pronounced "SHRED." Each year, the program provides more than $3 billion in tax incentives to close to 20,000 claimants — around 75% of which are small businesses — whose claims for R&D expenditures generally range from $20,000 to $2,000,000.

To claim the tax credit, you have to undertake activities inside Canada that qualify as "Scientific Research and Experimental Development." Examples include:

• Developing new product prototypes
• Developing new technologies
• Finding new applications for an existing technology
• Developing or improving products and processes

The SR&ED program is a federal initiative; however, most provinces also have corresponding SR&ED programs. The basic guidelines of the federal SR&ED program also apply to the provincial programs.

The Canada Revenue Agency (CRA) administers the SR&ED program on behalf of the Government of Canada, with a mandate to ensure businesses are aware of the program and can access its benefits if eligible.

What Tax Incentives are Available for SR&ED?

The SR&ED program provides two major tax incentives:

• Businesses can pool SR&ED expenditures and deduct them from current-year income to reduce their income tax liability. Expenditures may also be carried forward and deducted in future years.
• An investment tax credit (ITC) that can be used to reduce an organization's tax bill. When the tax credit is greater than tax payable, the excess can be refunded — so you get a welcome cheque.

Most small incorporated businesses in Canada are Canadian-Controlled Private Corporations (CCPCs), and they are also eligible for the highest tax credit rate. CCPCs are generally able to obtain a 35% federal ITC on the first $3 million of SR&ED expenditure, provided the CCPC's taxable capital employed in Canada was less than $10 million in the prior tax year.

Provincial credits vary by jurisdiction and provide an additional boost to your claim — enough that they deserve an article in their own right. Luckily, we have one for you right here.

Who Can Claim SR&ED?

If you're doing R&D in Canada, the SR&ED program may be an untapped source of funds to support your efforts. The tax credit is available to businesses with various structures, including:

• CCPCs
• Non-CCPCs, such as public companies
• Sole proprietorships
• Partnerships
• Trusts
• Foreign corporations

Businesses across many industries qualify for the SR&ED program, including manufacturing, IT and software, health sciences, oil and gas, biotech, construction, agriculture, cannabis, food and beverage, and more. It is the nature of the R&D work you're doing — not the business sector — that determines eligibility.

What R&D Work is Eligible?

Section 248(1) of the Income Tax Act defines "Scientific Research and Experimental Development" by way of a densely packed, 250-word definition. If the R&D work you're doing meets the definition, then you are likely eligible to make a claim.

Breaking it down, there are two main aspects you have to address in order to claim the SR&ED tax credit:

• How the SR&ED is carried out
• Why the SR&ED is being carried out

Let's look at each in turn.

How are you carrying out the SR&ED?

The first part of the definition describes how SR&ED is performed — it must be a "systematic investigation or search that is carried out in a field of science or technology by means of experiment or analysis."

Basically, your work may be considered SR&ED if:

1. You have to try to overcome one or more scientific or technological problems.
2. You have to conduct trials, experiments, or analyses to solve these problems. In other words, it is not possible to solve the problem or achieve the goal based on your existing knowledge — you need to experiment.
3. The experiment must take the form of a systematic investigation: you start with a problem you cannot solve, create a hypothesis, design an experiment around that hypothesis, test rigorously, and develop logical conclusions based on the results. It's an iterative process, with documentation.

Why are you performing the R&D?

The second part of the definition describes why the SR&ED is being performed — it must be done to advance scientific knowledge or to achieve technological advancement. Eligible work falls into one of three categories:

• Basic research — work done to advance scientific knowledge without a specific practical application in view. This is usually done by universities or research institutes.
• Applied research — work done to advance scientific knowledge with a specific application in mind (for example, figuring out the properties of semiconductors with a view to developing a semiconductor amplifier).
• Experimental development — work done to achieve technological advancement: developing new products, materials, devices, or processes, or improving existing ones. This is by far the most common type of SR&ED work.

There are also eight categories of support work covered by the program. You can claim these expenses as long as they are commensurate with the needs of the core SR&ED project:

• Engineering
• Design
• Operations research
• Mathematical analysis
• Computer programming
• Data collection
• Testing
• Psychological research

The following activities are not eligible:

• Market research or sales promotion
• Quality control or routine testing of materials, devices, products, or processes
• Research in the social sciences or humanities
• Prospecting, exploring, or drilling for (or producing) minerals, petroleum, or natural gas
• Commercial production of a new or improved material, device, product, or process
• Style changes
• Routine data collection

Technological Uncertainty vs. Commercial Risk

"Technological uncertainty" is a key piece of jargon in the SR&ED guidelines. It's a test that helps differentiate between work done to advance scientific knowledge (potentially eligible) and work done for commercial gain (not eligible). What the CRA is looking at is the difference between a technical problem and a technological uncertainty.

For example, suppose you're a glue manufacturer. You've developed an adhesive that sticks labels to wet bottles, but the glue runs "dirty" — so manufacturers who use it have to stop production periodically to clean their machines.

Time is money on a production line, so there's a clear commercial imperative to make the glue run cleaner. How might you achieve that goal?

One option is to experiment with the machines and the adhesive — trying different combinations of temperature, pressure, and glue quantity to get the machines to run longer between clean-downs. But as far as the CRA is concerned, all you're doing is experimenting within the available parameters of the equipment and the glue. There's no advancement of technology, just experiments within the limits of current knowledge. This type of work is not SR&ED eligible.

If, on the other hand, you changed the entire formulation of the glue to allow for cleaner running, then you are going beyond the limits of current technical or scientific knowledge. As long as you follow a systematic experimental process, this type of work would most likely qualify for SR&ED.

The Five Questions

Figuring out whether your work is eligible for SR&ED can be complicated. To make life easier, the CRA uses five questions to determine whether a project meets the program criteria. There is SR&ED if the answer to each question is "yes."

1. Was there a scientific or technological uncertainty? The CRA wants you to demonstrate that you had reached the limits of your current technological understanding and needed to perform the R&D to take your knowledge to the next level.
2. Did the effort involve formulating hypotheses specifically aimed at reducing or eliminating that uncertainty? A hypothesis is your proposition for how you'll solve the problem, and it must be the basis for your experimentation. (Our glue manufacturer might hypothesize that a combination of chemical X and a cleaning agent could reduce gumming in the tanks.)
3. Was the overall approach consistent with a systematic investigation — including formulating and testing the hypotheses by experiment or analysis? You need evidence that you used a well-thought-out, iterative process to prove or disprove your hypothesis using established research techniques.
4. Was the overall approach undertaken for the purpose of achieving a scientific or technological advancement? If all you're doing is solving a business problem within the limitations of your current knowledge, the work will not be SR&ED eligible.
5. Was a record of the hypotheses tested and the results kept as the work progressed? All research activities are expected to be thoroughly documented, with written evidence that is contemporaneous with the activity, dated, and designed to show why the R&D was required and how it fits into the project. (More on this below.)

What Expenses Can You Claim?

Businesses can claim a broad range of expenses related to SR&ED. In particular, owner and employee salaries related to R&D can play a big role in boosting the amount of the credit. The scope of eligible expenses and the tax credit rates make Canada's SR&ED program one of the most generous in the world.

Eligible expenses include:

• Wages and salaries of employees directly engaged in the SR&ED work (excluding taxable benefits, bonuses, and profit-based remuneration).
• Materials consumed or transformed in the SR&ED project — raw materials, substances, or other inputs used to test a new or improved process.
• Contract and third-party payments where you've engaged someone else to perform SR&ED on your behalf. Since 2012, only 80% of contract and third-party expenditure qualifies for the investment tax credit.
• Overhead expenses related to SR&ED, such as office supplies, utilities, property taxes, and maintenance of the R&D facilities.

Expenditure must be of a current nature and paid during or within 180 days after the tax year. Prior to 2014, capital expenditures (machinery, equipment, and buildings) were eligible for the SR&ED incentive; today they are not.

Calculating Your Expenses: Traditional vs. Proxy Method

Calculating your SR&ED expenditures can be done using one of two methods: traditional or proxy.

With the traditional method, your eligible expenditures incurred during the tax year are identified and added up. This can be complex and time-consuming because you need to segregate overhead costs directly attributable to supporting SR&ED work — but for businesses with high overhead costs, the extra effort can be worth it.

The proxy method is generally simpler. Your salaries, materials, and other eligible direct expenditures are included as before, but rather than tracking overhead, your eligible salaries are grossed up by an additional 55% (the "proxy amount") as an estimate of overhead. So a business with $100,000 of SR&ED-eligible salaries would get $55,000 for overhead and support costs.

For labour-intensive SR&ED projects, the proxy method can save time and boost the value of the claim, because the 55% overhead added may be higher than the actual overhead incurred. A tech startup, for instance, often invests heavily in people and has relatively low overhead.

Below is a comparison for Small Tech Inc., a CCPC with an ITC rate of 35% and the following SR&ED expenses during the tax year (for simplicity, we omit provincial credits):

As you can see, the proxy method clearly comes out ahead here because the salaries are high relative to the overhead costs.

How Is a Claim Filed?

The claim is typically submitted with your tax return and includes some extra schedules that aren't regularly included:

• Form T661, containing much of the core SR&ED information (financial and technical).
• Schedule 31 (or T2038 for individuals), related to the ITC calculation.
• Provincial schedules, which depend on the provincial or territorial jurisdiction.

If you're interested in the nitty-gritty details of Form T661, the CRA's publication T4088 is the go-to guide.

What Do I Have to Document?

A rigorous review process underpins the SR&ED program, and claims have a relatively high review rate. You should get all your ducks in a row before submitting if you want to defend your claim during a review or audit — inadequate documentation can reduce your claim or lead to an outright rejection.

If requested, you may need to submit documentation to prove:

• The limits to base knowledge and technology
• Technological advancement objectives and hypotheses at the outset
• The project planning process
• The sequence of events and timelines
• The testing methodology
• Hard numbers and metrics
• Why labour was required and how it was used during the period

Document requirements are substantial, so don't leave your document-gathering to the last minute. Ideally it's a year-round process, with documentation created contemporaneously with the R&D activity. The more you document, the more defensible your claim will be.

What's the Deadline for Filing?

Corporations have 18 months from the end of the fiscal year to claim (17.5 months for individuals). Miss the deadline and you lose your right to claim.

When the opportunity to file becomes available, the sooner it's done the better. We recommend filing at least 90 days before the deadline — this gives the CRA time to do a preliminary review and issue a request for information if the claim has deficiencies. File later than that and you may miss this valuable opportunity for correction.

When Will I Get My Refund?

Once a complete claim is filed, you can expect the following processing timelines:

• If your claim is accepted as filed, the CRA is committed to processing it within 60 calendar days.
• If your claim is selected for review/audit, the CRA is committed to processing it within 180 calendar days.

Both timelines assume a complete claim — meaning all required information is included in the filing.

What is Involved in a CRA Review/Audit?

Working with your SR&ED advisor to have the proper documentation to support your claim is key to a successful outcome. Around 13–20% of claims are selected for review or audit each year.

The CRA may conduct a desk review or an on-site review, including a visit to your premises. There may be separate experts involved — a financial reviewer (FR) and a research & technology advisor (RTA) — who work together to evaluate the financial and technical aspects of your submission. Below are some examples of items that may be evaluated.

Technical

• Project planning documents
• Documents on the design of experiments
• Records of trial runs
• Project progress reports
• Test protocols, data, results, analysis, and conclusions

Financial

• Accounting records
• Purchase invoices and proof of payment
• Records of resources allocated to the project — time sheets, activity records, payroll records
• Contracts and lease agreements

Extra Resources

The rigour of the SR&ED claim process — eligibility, documentation, and the review process — is daunting to many businesses, especially those new to the program. Luckily, there are some excellent resources to help you learn more (and you can always contact us for a complimentary session):

• First-Time Claimant Advisory Service — a free in-person service connecting new claimants with SR&ED program staff for a better understanding of the program.
• Pre-Claim Consultation Service — a free, on-demand service you can initiate in advance of a claim to get feedback from SR&ED reviewers on eligibility, documentation, and specific questions, plus a decision report.
• Self-Assessment and Learning Tool (SALT) — an online tool designed to help you understand the SR&ED eligibility requirements and calculate allowable expenditures.
• SR&ED Success Stories — a collection of real-life stories highlighting how SR&ED tax incentives are helping Canadian businesses grow.

The above information has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. It cannot be relied upon to cover specific situations, and you should not act upon the information contained here without obtaining specific professional advice.