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. The program 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 tons of technical narrative. We’re going to walk you through the basics to help you understand how to qualify and join thousands of Canadian businesses benefiting from the program. Here are the sections we will cover, but feel free to jump to any section that interests you:
What is the SR&ED program?
What Tax Incentives are Available for SR&ED?
Who Can Claim SR&ED?
What R&D Work is Eligible?
Technological Uncertainty vs. Commercial Risk
The Five Questions
What Expenses Can You Claim?
Calculating Your Expenses: Traditional vs. Proxy Method
How is a Claim Filed?
What do I Have to Document?
What's the Deadline for Filing?
When Will I Get My Refund?
What is Involved in a CRA Review/Audit?
SR&ED is an acronym for 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 claim 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. CRA has a mandate to ensure that businesses are aware of the program and can access its benefits if eligible.
The SR&ED program provides two major tax incentives:
● Businesses can pool SR&ED expenditures and deduct them from current-year income to reduce the income tax liability. Expenditures may also be carried forward and deducted in future.
● 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, there can be a refund so you get a welcome cheque!
Most small incorporated businesses in Canada are Canadian-controlled Private Corporations (CCPCs), and fortunately 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 is less than $10 million in the prior tax year.
Provincial credits vary by jurisdiction and provide an additional boost to your claim, and as such they deserve an article in their own right. Luckily, we have one for you right here!
If you’re doing R&D in Canada, then 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:
● Non-CCPCs such as public companies
● Sole proprietorships
● Foreign corporations
Businesses across many industries qualify for the SR&ED program, including manufacturing, IT and software, health sciences, oil and gas, biotech, construction, agricultural, cannabis, food and beverage and more. The business sector is less relevant than the nature of R&D work you’re doing that determines eligibility for the program.
Section 248(1) of the Income Tax Act defines “Scientific Research and Experimental Development” by way of a 250-word, densely packed 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 SR&ED is carried out
● Why 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. This means that 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 that’s done to advance scientific knowledge without any clear goals or a practical application in view. This type of work is usually done by universities or research institutes – it’s the sort of stuff that gets published in science journals.
Applied research: Work that’s done to advance scientific knowledge but this time, there’s a specific application in mind. For example, where you’re figuring out the properties of semiconductors with a view to developing a semiconductor amplifier.
Experimental development: Work that’s done to achieve technological advancement. Any work that’s done to help you develop new products, materials, devices or processes – or improve existing ones – would fall into this category. Experimental development is by far the most common type of SR&ED work.
There are eight categories of support work also covered by the program. You can claim these expenses as long as they are commensurate with the needs of the core SR&ED project:
● Operations research
● Mathematical analysis
● Computer programming
● Data collection
● Psychological research.
The following activities are NOT eligible for benefits:
● Market research or sales promotion
● Quality control or routine testing of materials, devices, products or processes
● Research in social sciences or the 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” is a key piece of jargon in the SR&ED guidelines. It’s a test to help differentiate between work that’s done to advance scientific knowledge (which may be eligible for SR&ED credits) and work that’s done for commercial gain (not eligible for SR&ED).
What the CRA is looking at is the difference between a technical problem and 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” such that manufacturers who use the glue have to stop production periodically to clean down their machines.
Now, time is money on a production line. There’s a clear commercial imperative to making the glue run cleaner, as this should increase the sales of your product.
How might you achieve that goal?
One option could be to experiment with the machines and the adhesive themselves. By trying different combinations of temperature, pressure and glue quantity, you can see if you can get the machines to run longer between clean downs.
However, while you may consider your efforts to be part of your organization’s research and development initiatives, as far as the CRA is concerned, all you’re actually doing is experimenting within the available parameters of the equipment and the glue product. There’s no advancement of technology, just experiments performed within the limits of current knowledge. This type of work is not SR&ED eligible.
If, on the other hand, you holed up in the workshop and 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, then this type of work would most likely qualify for SR&ED.
Figuring out if the work you’re doing is eligible for SR&ED can be complicated. To make life a little easier, the CRA uses five questions to determine whether a project meets the SR&ED program criteria.
There is SR&ED if the answer to each of the questions is “yes.”
1. Was there a scientific or a technological uncertainty?
The CRA wants you to demonstrate that you had reached the limits of your current technological understanding, and you needed to perform the R&D project in order to take your knowledge to the next level.
2. Did the effort involve formulating hypotheses specifically aimed at reducing or eliminating that uncertainty?
For the purposes of SR&ED, a hypothesis is your proposition for how you will solve the problem. The hypothesis must then be used as a basis for your experimentation. For example, our glue manufacturer could hypothesize that using a combination of chemical X and a cleaning agent could reduce gumming in the tanks.
3. Was the overall approach adopted consistent with a systematic investigation or search, including formulating and testing the hypotheses by means of experiment or analysis?
Business owners may have a confused look on their faces right now, but anyone who is trained in the scientific method will understand where the CRA is coming from. What’s needed is evidence to verify that you have 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 a technological advancement?
This is our glue problem – the CRA wants to know if there was a technical uncertainty that you’re trying to resolve. If all you’re doing is solving a business problem within the limitations of your current knowledge, then your work will not be SR&ED eligible.
5. Was a record of the hypotheses tested and the results kept as the work progressed?
It is expected that all research activities are thoroughly documented, with written evidence that is:
● Contemporaneous with the research activity
● Dated, to prove that the activity occurred in the fiscal year you are claiming
● Designed to highlight why the R&D activity was required and how it fits into the project.
There’s more on this in the “What Do I Have to Document?” section below.
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 credit. The scope of eligible expenses and 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 remuneration based on profits).
● Materials consumed or transformed in the SR&ED project, such as raw materials, substances or other inputs used to test a new or improved process.
● Contract payments 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 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 including machinery, equipment and buildings were eligible for the SR&ED tax incentive however today they are not.
Calculating your SR&ED expenditures can be done via one of two methods: traditional or proxy.
With the traditional method, your eligible expenditures incurred during the tax year are identified and simply added up. This method can be complex and time-consuming given that you need to segregate overhead costs that are directly attributable to supporting SR&ED work. However, for businesses with high overhead costs the extra effort can be worth it.
The proxy method generally will be a simpler method of filing the claim. Similar to the traditional method, your salaries, materials and other eligible direct expenditures are included. However, rather than tracking overhead expenditures, your eligible salaries are grossed up by an additional 55% (the proxy amount) and used as an estimate of your overhead expenses. So, a business with $100,000 of SR&ED eligible salaries would get $55,000 for overhead and other expenses such as support staff.
For SR&ED projects that are labour-intensive, choosing the proxy method can not only save time but really boost the value of the claim because the 55% overhead added may be higher than the actual overhead costs incurred. For instance, a tech startup will often invest heavily in people and incur relatively low overhead costs compared to salaries.
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 will omit provincial credits.
|Total pool of allowable SR&ED expenditures||$145,000||$120,000|
|Proxy amount (55%)||$0||$55,000|
|Total qualified SR&ED expenditures||$145,000||$175,000|
|Total qualified SR&ED expenditures||$50,750||$61,250|
As you can see in the above example, the proxy method clearly comes out ahead because the salaries are high relative to the overhead costs.
The claim is typically submitted with your tax return and includes some extra schedules that are not regularly included:
• Form T661, containing much of the core SR&ED information (financial and technical).
• Provincial schedules, which depend on the provincial or territorial jursidiction.
If you are interested in learning more about the nitty-gritty details of Form T661, CRA’s publication T4088 is the go-to guide.
A rigorous review process underpins the SR&ED program and claims have a relatively high review rate. This means that you should get all your ducks in a row before submitting if you wish to defend your claim during a review/audit. Your claim may be reduced if you have inadequate documentation, or you may get 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
● Sequence of events and timelines
● Testing methodology
● Hard numbers and metrics
● Why labour was required and how it was used during the period
Appendix 2 of Guide T4088, reproduced below, contains a helpful list of the type of supporting documentation required.
Document requirements are substantial, and the best advice is, don’t leave your document gathering to the last minute. Ideally, it should be a year-round process with documentation created contemporaneously with the R&D activity. The more you document, the more defensible your claim will be.
Corporations have 18 months from the end of the fiscal year to claim (17.5 months for individuals).
Miss the deadline, and lose your right to claim.
When the opportunity to file becomes available, the sooner it is done the better. We recommend filing the claim at least 90 days before the deadline, as 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.
Once a complete claim is filed, you can expect the following processing timelines:
If your claim is accepted as filed, CRA is committed to processing the claim within 60 calendar days.
If your claim is selected for review/audit, CRA is committed to processing the claim within 180 calendar days.
It should be noted that both of the above timelines assume a complete claim, which means all required information is included in the filing.
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/audit each year.
CRA may conduct a desk review or an on-site review including a visit to your premises. There may be separate experts involved including a financial reviewer (FR) and a research & technology advisor (RTA). These experts work together to evaluate the financial and technical aspects of your submission.
Below are some examples of items which may be evaluated.
• Project planning documents
• Documents on design of experiments
• Record of trial runs
• Project progress reports
• Test protocols, data, results, analysis and conclusions
• Accounting records
• Purchase invoices and proof of payment
• Records of resources allocated to the project, time sheets, activity records, payroll records.
• Contracts, lease agreements
The rigour of the SR&ED claim process – including eligibility, documentation and the review process – is daunting to many businesses, and especially those that are 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
This free in-person service connects new claimants with SR&ED program staff to provide a better understanding of the program. We encourage clients to take full advantage of the introduction.
Pre-Claim Consultation Service
The PCC is a free on-demand service that can be initiated in advance of a claim to receive feedback from SR&ED reviewers regarding eligibility, documentation, specific questions and a decision report.
Self-Assessment Learning Tool
SALT is an online tool that is designed to help you understand the SR&ED eligibility requirements and help you calculate allowable expenditures. Based on your information, the tool will generate a report to help you understand why your R&D work is potentially eligible (or not) for the SR&ED program.
SR&ED Success Stories
A collection of real-life success stories, highlighting how SR&ED tax incentives are helping Canadian businesses grow and reach their goals.
The above information has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act upon the information contained therein without obtaining specific professional advice.
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