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Daily Tax Report: International

INSIGHT: Research and Development Tax Credits—Are You Eligible? (Part 2)

Sept. 13, 2019, 7:01 AM

The Scientific Research and Experimental Development (SR&ED) Program uses tax incentives to encourage Canadian businesses of all sizes and in all sectors to conduct research and development. Two basic conditions must be satisfied to qualify for the SR&ED program:

  • it must be carried out in Canada; and
  • it must be carried out in basic research, applied research or experimental development.

Scientific research and experimental development is defined for income tax purposes (section 248(1) of the Income Tax Act) as follows:

“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 and that is

(a) basic research, namely, work undertaken for the advancement of scientific knowledge without a specific practical application in view,

(b) applied research, namely, work undertaken for the advancement of scientific knowledge with a specific practical application in view, or

(c) experimental development, namely, work undertaken for the purpose of achieving technological advancement for the purpose of creating new, or improving existing, materials, devices, products or processes, including incremental improvements thereto,

and, in applying this definition in respect of a taxpayer, includes

(d) work undertaken by or on behalf of the taxpayer with respect to engineering, design, operations research, mathematical analysis, computer programming, data collection, testing or psychological research, where the work is commensurate with the needs, and directly in support, of work described in paragraph (a), (b), or (c) that is undertaken in Canada by or on behalf of the taxpayer,”

but does not include work with respect to

  • market research or sales promotion;
  • quality control or routine testing of materials, devices, products or processes;
  • research in the social sciences or the humanities;
  • prospecting, exploring or drilling for, or producing, minerals, petroleum or natural gas;
  • the commercial production of a new or improved material, device or product or the commercial use of a new or improved process;
  • style changes; or
  • routine data collection.

Main Requirements for Eligibility

On analysis of the above definition, it emerges that SR&ED must be carried out in Canada and must be either basic research, applied research or experimental development.

  • Basic research: this is work carried out to advance scientific knowledge without a practical application in view. It is generally carried out in universities or research institutes. Claims involving basic research sometimes include third-party payments to universities, research institutes, and consortia. The results of basic research are generally published in scientific journals.
  • Applied research: this is work carried out to advance scientific knowledge but, unlike basic research, it is done with a specific practical application in view. Like basic research, the results could be published in scientific journals.
  • Experimental development: this is work undertaken for the purpose of achieving technological advancement for creating new, or improving existing, materials, devices, products, or processes, including incremental improvements.

Claiming SR&ED Incentive

There are two ways in which a taxpayer can claim the SR&ED incentive:

  • Pooling of SR&ED expenditures: under this method a taxpayer can deduct them against current-year income or keep them and deduct them in a future year. Taxpayer carrying on a business in Canada in a tax year may, in calculating income from the business for the year, deduct expenditure of a current and expenditure of a capital nature for SR&ED (incurred prior to 2014) carried on in Canada that relate to a business of the taxpayer. A claimable balance in the pool of deductible SR&ED expenditures does not expire. It can be carried forward indefinitely and deducted in a subsequent tax year against any business income.
  • Claiming SR&ED investment tax credit (ITC): a taxpayer can use this method to reduce its income tax liability or claim a refund. An ITC may be earned in the year by a corporation, individual, member (partner) of a partnership, or beneficiary of a trust, on qualified SR&ED expenditures. SR&ED ITC is earned at a basic rate of 15% for tax years that end after 2013. Canadian-controlled private corporations (CCPC) can earn a refundable ITC at the enhanced rate of 35% on qualified SR&ED expenditure of CA$3 million ($2.25 million). The taxpayer can also earn a non-refundable ITC at the basic rate of 15% on an amount over CA$3 million. However, if the taxpayer is a CCPC that also meets the definition of a qualifying corporation, the taxpayer can earn a refundable ITC at the basic rate of 15% on an amount over $3 million and 40% of the ITC can be refunded. A taxpayer who is not able to offset against tax can apply for a refund.

A taxpayer is required to choose a traditional method or proxy method to claim SR&ED incentives. The taxpayer can elect any one method to fill a SR&ED claim and cannot change it. The traditional method involves identifying each overhead cost that was incurred solely because of the SR&ED work. The proxy method involves using a formula based on expenditure for salary and wages to calculate a substitute amount for SR&ED overhead and other expenditures.

Eligible Expenses

Taxpayers can claim expenditure incurred for SR&ED work, which includes salaries and wages, consumables, SR&ED contracts, third party payments and overheads. We will analyze each type of expenses:

Salaries and wages: composed of the salaries or wages (incurred and paid in the tax year or paid within 180 days of the tax year-end) of employees who are directly engaged in SR&ED, excluding taxable benefits, remuneration based on profits, bonuses, or prior years’ unpaid salary or wages paid in the tax year.

Materials (consumables): the cost of materials consumed or transformed in the pursuance of SR&ED in Canada is considered as an SR&ED expenditure. To claim the cost of a material, the expenditure must be of a current nature, i.e. revenue expenditure and paid in the tax year or within 180 days after the tax year. Expenditure such as for the purchase of equipment, data, or a software license, is not expenditure of a current nature, but treated as capital in nature.

SR&ED contract: where businesses outsource SR&ED work to another company, to perform SR&ED on their behalf, the amount payable under the contract may be an allowable SR&ED expenditure. However, only 80% of the expenditure would be allowable as a qualifying SR&ED expenditure of the taxpayer for investment tax credit purposes. Consequently, the outsourced company performing the work would be allowed to claim SR&ED expenditures in respect of the contract, but would have to reduce its qualified SR&ED expenditures for investment tax credit purposes by payments received under the contract.

Overheads: includes the cost of the maintenance and upkeep of SR&ED facilities, equipment and other expenditures, or those portions of other expenditures that are directly related to SR&ED facilities and that would not have been incurred if those premises or facilities or that equipment had not existed, and traveling and training expenses directly linked to SR&ED.

Third party payments: includes payment to approved universities, colleges, research institutes, or similar institutions, approved associations.

Capital Expenditure Incurred in Scientific Research and Experimental Development

The 2012 federal budget announced that expenditures of a capital nature made after 2013 will no longer qualify for SR&ED tax incentives, including capital expenditure made before 2014 for property that became available for use. Moreover, for SR&ED purposes, expenditure of a current nature made after 2013 excludes expenditure for capital property or the right to use capital property.

We will analyze the implications of these provisions. A taxpayer carrying on a business in Canada is eligible to deduct SR&ED related to its business carried in Canada in a tax year. It is therefore important to understand the nature of capital expenditure incurred for SR&ED before 2014 which would qualify for SR&ED credit claim.

For SR&ED purposes, current expenditure includes any expenditure made by the claimant other than an expenditure for:

  • the acquisition of capital property of the claimant; or
  • the use of, or the right to use, property that would be capital property of the taxpayer if the taxpayer owned it.

As per Canadian tax law, depreciable property is any property that has an expected useful life or benefit of more than 12 months and on which the taxpayer has claimed or would be allowed to claim capital cost allowance. Only expenditures made before 2014 that result in the acquisition of new or used depreciable property, other than a building or a leasehold interest in a building, are eligible for inclusion in the pool of deductible SR&ED expenditures. As such, expenditure for the acquisition of non-depreciable property (including land, a leasehold interest in land, etc.) cannot be included in the pool of deductible SR&ED expenditures.

Capital expenditures made before 2014 for the trial of SR&ED carried on in Canada are only those expenditures that result in the acquisition of property that would be the taxpayer’s depreciable property, other than a building or a leasehold interest in a building. Expenditure for non-depreciable property such as the acquisition of land, property that is described in taxpayer’s inventory, or eligible capital property (such as goodwill) cannot be included in the pool of deductible SR&ED expenditures as an SR&ED capital expenditure. If a taxpayer elects to use the traditional method to claim, then the taxpayer needs to ensure that capital expenditure incurred before 2014 was for the provision of premises, facilities, or equipment, and intended to use it:

  • all or substantially all, i.e. more than 90% of its operating time in its expected useful life, for the examination of SR&ED carried on in Canada; or
  • all or substantially all, i.e. more than 90% of its value, to be consumed in the examination of SR&ED carried on in Canada.

Similar rules apply if the taxpayer elects to use the proxy method to claim the SR&ED incentive.

The taxpayer must satisfy the following conditions in order to include an SR&ED capital expenditure in the pool of deductible SR&ED expenditures:

  • the expenditure must be made before January 1, 2014;
  • the capital property must be a new or used property that would otherwise be considered depreciable property;
  • the expenditure must be made by a taxpayer for examination of SR&ED carried on in Canada that is directly undertaken by, or on behalf of, the taxpayer and that is related to a business of the taxpayer; and
  • the capital property must be available for use before January 1, 2014.

The above criteria must be satisfied for a capital expenditure to be included in the pool of deductible SR&ED expenditures when the taxpayer uses either the traditional method or the proxy method to determine their SR&ED expenditures.

Planning Points

R&D tax credits provide a source of cash that a business can use towards developing new products and processes or enhancing existing ones. Businesses operating in Canada should consider the impact of the R&D credit that is available to them, which can help in reducing tax costs.

Start-ups that do not generate income, or generate insufficient income to make full use of the R&D tax deduction are entitled to receive a cash refund of the incurred R&D expenses.

Businesses should consider:

  • whether they satisfy all conditions to claim the incentive. Only direct expenses such as salaries of researchers, consumables, depreciation on assets used in development of research, etc., (as described above) are eligible to qualify as R&D expenses;
  • details of research work carried out;
  • maintenance of documentation to provide evidence during tax audits such as project planning documents, records of trial run, design documents and technical documents, etc;
  • detailed workings of the calculation.

Businesses can also explore the possibility to apply for a tax ruling to avoid any uncertainty on R&D tax credits.

Businesses should also refer to the Claim Review manual, which provides procedures for the Canadian revenue authorities to perform a technical review of scientific research and experimental claims. This will help businesses to ensure that R&D claims are provided more quickly and are in line with guidelines followed by revenue officials, in order to avoid disputes.

Rajeev Agarwal is an international tax expert.

He may be contacted at rajeagar2012@gmail.com

Disclaimer: The content of this article is intended for general information purposes. You should always seek professional advice before acting. No responsibility is taken for any loss because of any action taken or refrained from in consequence of its contents.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners

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