SR&ED tax incentives
Government assistance can play a vital role in the financing of a startup corporation. One program of particular importance to Canadian technology companies is the Scientific Research and Experimental Development Program (also known as SR&ED).
SR&ED is a tax incentive program designed by the Canadian government to encourage research and development activities in Canada. It is administered by the Canada Revenue Agency (CRA) and is the largest single source of federal government support for industrial research and development.
(i) Program incentives
The two main program incentives are the deduction of current and capital SR&ED expenditures to reduce income for tax purposes, and investment tax credits (ITCs) that can also be used to reduce tax liability or, in some cases, can result in a cash refund. Qualified SR&ED expenditures are immediately deductible. There is no requirement for the claimant to repay the money, provide guarantees or other security, or surrender any intellectual property rights to the Canadian government.
A. Deduction of current and capital expenditures
The claimant can deduct current and capital SR&ED expenditures in computing income for tax purposes to reduce tax liability in the current year, or carry expenditures forward indefinitely to reduce income for tax purposes and thus tax liability in future years.
B. Investment tax credit refunds
The claimant can receive investment tax credits on qualifying expenditures through a cash refund, a reduction of taxes payable, or both. Unused investment tax credits can be carried back three years or forward 20 years (however, if the investment tax credits were earned prior to 1997, they may only be carried forward 10 years). The amount of the ITC will depend on whether or not the claimant is a qualifying Canadian-controlled private corporation (CCPC).
- A CCPC with CA$500,000 or less of taxable income can generally receive an ITC for 35 percent up to the first CA$3 million of qualified SR&ED expenditures carried out in Canada and 20 percent of any excess amount.
- ITCs must first be applied against taxes payable in the year of the claim, after which cash refunds can be received in two ways: (1) a full cash refund on tax credits calculated on qualified current SR&ED expenditures or (2) a 40 percent cash refund on tax credits calculated on qualified capital SR&ED expenditures.
- A non-CCPC can receive an ITC of 20 percent for both current and capital qualified SR&ED expenditures. These credits are non-refundable and may be carried back three years, or carried forward 10 years to reduce tax liability.
- Proprietorships, partnerships, and certain trusts can earn ITCs at the rate of 20 percent of the qualified current and capital SR&ED expenditures. After applying ITCs against payable taxes, cash refunds can be received on 40 percent of the balance.
(ii) Qualifying SR&ED expenditures
A. General expenditures
- the salaries and wages of employees performing SR&ED work;
- materials that are consumed or transformed;
- machinery and equipment that is rented or purchased;
- some overhead expenses; and
- certain third-party payments and other SR&ED contracts.
All or substantially all (i.e., 90 percent or greater) of such expenses must have been incurred for SR&ED purposes. In addition, repayments of government or non-government assistance can also increase the pool of deductible SR&ED expenditures.
B. Stock options
In Alcatel Canada Inc. v. The Queen, a decision rendered by the Tax Court of Canada (TCC) on February 24, 2005, stock options given to employees engaged in SR&ED activities were also considered expenditures incurred for SR&ED purposes. The court found that “[t]he expenditure consists of the consideration which [the company] foregoes when it issues its shares for less than market value,” and that the cost of the stock option program was an ordinary current expense.
In other words, although there was no cash disbursement, the stock option program was part of an employee incentive plan and was, thus, an expense incurred for the salary or wages of an employee rather than a means of raising capital.
Prior to the January 2006 federal election, draft legislation (section 143.3 of the Income Tax Act (Canada)) was introduced as a direct response to the Alcatel decision. The proposed legislation, if enacted, would make it clear that stock options granted or issued on or after November 17, 2005, would not be considered expenditures incurred for purposes of the SR&ED tax incentive program.
Parliament dissolved before the legislation was passed. Similar draft legislation was reintroduced in 2007, but again failed to pass before Parliament was dissolved. The July 16, 2010 Draft Legislation re-introduces section 143.3, effective November 17, 2005.
A. What projects qualify as SR&ED?
In order to qualify for the SR&ED incentive program the project must be carried out in Canada. In some cases, a Canadian corporation may execute only one phase or stage of a larger project directed by a global network of corporations. In either case, the contribution of the Canadian
corporation must meet the three following criteria to be eligible for SR&ED benefits:
- Scientific or technological advancement – The project must generate information that advances the understanding of scientific relations or technologies. Routine engineering development will not be eligible.
- Scientific or technological uncertainty – Whether the desired result or objective can be achieved, or how to achieve it, must be unknown or undetermined based on commonly available sources of scientific or technological knowledge or experience before the project begins.
- Scientific and technical content – There must be evidence that qualified personnel with relevant experience are responsible for directing or performing a systematic investigation of the project hypothesis through experiments or analysis.
B. What work qualifies as SR&ED work?
Not all work done by a corporation carrying out a SR&ED project will be considered a qualified SR&ED expenditure.
The legislative definition of SR&ED includes the following four types of work:
- Experimental Development – work done to achieve technological advancement to create, or improve, new materials, devices, products or processes, including incremental improvements.
- Applied Research – work done to advance scientific knowledge with a specific practical application in view.
- Basic Research – work done to advance scientific knowledge without a specific practical application in view.
- Support work – work that directly supports and is commensurate with the above three, that is undertaken in Canada by, or on behalf of, the taxpayer (the corporation). This includes only the
following eight types of work: engineering, design, operations research, mathematical analyses, computer programming, data collection, testing, and psychological research.
Eligible work may be done by the corporation itself, or on behalf of the corporation. However, only SR&ED carried on in Canada qualifies. When work is carried on both inside and outside Canada, only expenditures for work done in Canada will be eligible for the incentive program. Ineligible work includes:
- Research in social sciences or humanities;
- Commercial production of new or improved material, device, or product, or the commercial use of a new or improved process;
- Style changes;
- Market research or sales promotion;
- Quality control or routine testing of materials, devices, products, or processes;
- Routine data collection; and
- Prospecting, exploring, or drilling for or producing minerals, petroleum, or natural gas.
Applicants must complete the Form T661, Scientific Research and Experimental Development Expenditures (SR&ED) Claim, and either Form T2 SCH 31, Investment Tax Credit – Corporations or Form T2038 (IND), Investment Tax Credit (Individuals). Generally, corporations have a total of 18 months from the end of the taxation year in which to file the forms.
When filing, claimants must include a comprehensive technical description of the SR&ED work being performed. This description must include details regarding worker qualifications, project planning, project process, and project progress. Essentially, claimants need to convince CRA that the project and associated expenditures meet the requirements described above.
To be eligible for the SR&ED tax incentives, the forms must be filed no later than 12 months after the filing-due date for the tax return in respect of the taxation year in which the expenditures were made.
(v) Processing targets
CRA has various targets for completion of the review process, depending on the type of claim:
- Refundable claims – the review should be complete within 120 days of receiving the claim;
- Non-refundable claims – the review should be complete within 365 days of receiving the claim;
- Refundable claims related to adjustments for previously filed income tax returns – the review should be complete within 240 days of receiving the claim; and
- Non-refundable claims related to adjustments for previously filed income tax returns – the review should be complete within 365 days of receiving the claim.
In order to ensure that the above deadlines are met, the claims must be complete; sufficient technical and financial information must be provided to CRA; and requests for additional information should be answered in a timely manner.
(vi) CRA claimant services
CRA provides several services to facilitate SR&ED claims. These include the First Time Claimant Service, the Preclaim Project Review Service, and the Account Executive Service. For more information on these and other CRA services, visit the SR&ED web site at www.cra-arc.gc.ca/txcrdt/sred-rsde/menu-eng.html.
(vii) Maximizing benefits
US companies can also benefit from SR&ED. There are several ways for a US company (USco) to structure its Canadian operations in order to maximize SR&ED benefits:
- A US parent company can undertake SR&ED activities in a Canadian subsidiary;
- SR&ED can be contracted out to a Canadian company (Canco), that will factor the tax benefits, such as refundable ITCs, into the contract price;
- The USco could become a minority shareholder in a CCPC. Typically, other shareholders would include Canadian VC funds, researchers, hospitals, and universities. In this case, the USco cannot control, or have future rights to control, the company in order to maintain CCPC status; and
- The USco could enter into a joint venture with a Canco.
Generally, a Canco is established to perform the Canadian research and development. The USco then contracts with the Canco for the Canco to perform the SR&ED activities on its behalf. Ownership of any resulting intellectual property will depend on the negotiated contractual relationship.
For example, it is possible for the following relationships to be established:
- The USco enters into an R&D agreement with the Canco, by which the Canco will perform qualifying R&D activities for the USco. Any resulting intellectual property will accrue to the USco, with the exception of those Canadian rights that are necessary for the Canco to be eligible for the SR&ED program;
- The Canco will licence any existing intellectual property to the USco that is necessary for the USco to have the beneficial interest in the new intellectual property; and
- The Canadian rights that remain with the Canco for SR&ED purposes will be licensed to the USco for a royalty payment.
(viii) Provincial incentives
The various provinces in Canada offer additional tax incentives. For example, in Ontario, small-to-medium sized corporations may be eligible for a 10% refundable credit (Ontario Innovation Tax Credit) on SR&ED expenditures, for which the corporation is eligible for a federal SR&ED ITC, provided the SR&ED is carried on in Ontario. Provincial and territorial R&D assistance should be accounted for when applying for federal tax incentives, as they may result in a reduction of the pool of deductible SR&ED expenditures.
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