Research rollbacks

Tax dollars go straight back to development with the intelligent use of the government's SR&ED program

By Victoria Hung, CMA

Although finding seed money for new research and development has become increasingly difficult in Canada, companies with a firm footing in the R&D world have various ways of keeping enough money in their own coffers to see their ideas flourish. For instance, Canada has one of the world’s most generous tax-based incentive programs for encouraging research and development — the Scientific Research and Experimental Development (SR&ED) program. It was established in 1985 and is administered by Canada Customs and Revenue Agency (CCRA). Currently, over 11,000 companies file for SR&ED claims, which generate approximately $1.5 billion in tax credits annually.

The SR&ED allows qualifed Canadian-controlled private corporations a cash refund of up to 35% on their taxes, and public companies are entitled to a 20% non-refundable tax credit. Once you’ve applied for the program, it’s impossible not to see the benefits it brings to an organization. Companies that apply for both federal and provincial programs can recover as much as 50% of their SR&ED expenditures (Alberta and PEI are the only provinces that don’t currently offer an R&D tax credit).

If a company is eligible for SR&ED expenditures, internal financial personnel can prepare a claim that generates the maximum allowable income tax credits and income tax refunds. CMAs in their role as accountants, controllers and CFOs should be actively involved in SR&ED claims for their organizations. These financial professionals can provide valuable insight into SR&ED costs and activities.

Typically, high tech R&D facilities, such as software, electronics and telecommunications companies, qualify for SR&ED credits and refunds. Companies in biotechnology, manufacturing and materials industries may also be able to recover their R&D costs through the SR&ED program. In fact, any company in any industry may qualify for SR&ED if the company meets the SR&ED eligible criteria defined in the Income Tax Act.

For eligibility, the taxpayer must carry on business in Canada and the SR&ED activities must be performed in Canada within the year and relate to the business. The taxpaying company must file a Claim for SR&ED in Canada form (Form T661), along with its income tax return, within 18 months of the tax year. For refundable SR&ED claims, CCRA’s mandate is to process, review and refund claims within 120 days of receipt.

CCRA offers various services to help clients better understand the program requirements and how to submit a successful claim. First time claimants can ask for an information kit, meet with an SR&ED representative and attend public information seminars. Prior to submitting an SR&ED claim, a business can request a Preclaim Project Review. This is a service through which the CCRA makes sure you have an eligible product for SR&ED income tax credits before the claim is filed. At the company’s request, CCRA will designate an account executive to provide ongoing assistance.

Making the claim

Form T661 is the key document of an SR&ED application. It consists of two main sections: the scientific or technological section, and the summary of SR&ED expenditures.

Scientific or technical personnel should complete the first section of the claim, which is essentially a narrative description of the technology. In this section, the claimant describes the scientific or technological advancement sought, identifies the challenges to be faced achieving this and demonstrates a scientific solution to the problem. Documentation of objectives, work, experimentation, results and analysis should be available to substantiate the work done.

Eligible works include: engineering, operations research, mathematical analysis, computer programming, psychological research, testing and data collection. Excluded works include: market research, quality control, routine testing and style changes.

Finance personnel should complete the summary of expenditures, as it explains the allowable SR&ED expenditures, calculates the SR&ED expenditure pool, and itemizes current and capital costs.

The SR&ED income tax credit and refund rates are calculated based on qualified expenditures carried on in Canada over the course of one year. Qualified expenditures include current and capital expenses less any unpaid amounts, assistance payments and non-arm’s length transactions.

Current expenditures are typically wages, materials and overhead. They also include contracts and third-party payments. Capital expenditures include items such as lab equipment, computer hardware and software licenses.

What to claim

The portion of salaries and wages for technological staff in Canada directly engaged in SR&ED activities are eligible to claim. SR&ED time includes preparation of materials and equipment, data collection, experimentation and analysis. For managers and supervisors, time spent on the technical aspects and directing the course of the SR&ED projects are allowed.

Materials that are consumed in the pursuit of R&D are allowable expenditures. Supplies to build prototypes, testing items and commercial samples are all material costs recoverable under SR&ED. Costs for materials transformed into another product for the purposes of SR&ED may also be claimed.

Expenditures incurred for contractors and subcontractors to perform SR&ED activities are eligible for income tax credits. Payments to qualified third-party organizations, such as post-secondary institutions, research centres and approved associations that undertake SR&ED activities, are also allowed.

Equipment lease costs can be claimed if at least 90% of the lease expense can be attributed to SR&ED activities. Examples of allowable lease costs include computer hardware, lab equipment and design tools.

The overhead

A claimant can elect to use either the traditional method or the proxy method to calculate the overhead costs directly attributable to the prosecution of SR&ED.

Using the traditional method, the claimant must identify actual expenditures claimed and justify the allocation method used. This method can be complex and subject to scrutiny if the business is also involved in commercial activities.

Allowable overhead costs are all other costs that are directly attributable to the prosecution of SR&ED in Canada, such as salaries of non-technological staff, statutory employer payroll expenses and taxable benefits. Other costs that may qualify are travel and training, utilities, supplies and long-distance calls.

Using the proxy method, overhead is calculated as 65% of salaries of employees directly engaged in SR&ED activities in Canada. This method is simpler, requires less tracking and estimation and, in most cases, is financially more beneficial than the traditional method.

Capital and calculations

Generally, only new, depreciable equipment that is used at least 90% of the time for the prosecution of SR&ED is included in the income tax credit calculation. Equipment that is used at least 50% for SR&ED activities qualifies for a partial income tax credit.

Eligible partnerships and public companies can earn SR&ED income tax credits at a rate of 20% to be applied against income taxes payable. Eligible individuals can also file for SR&ED income tax credits at the same rate and are eligible for 40% income tax refunds.

For qualifying Canada controlled private corporations, the income tax credit rates are 35% up to the calculated expenditure limit and 20% above that. The expenditure limit is $2 million of SR&ED expenses less 10 times any dollar amount of taxable income over $200,000. A summary of income tax credit and refund rates are summarized in Table 1, followed by a typical example.

The income tax refund rates for Canadian-controlled private corporations are based on the nature of the expenditure and the prior year’s taxable income. The non-refundable portion of income tax credits is accumulated in the pool and can be applied against taxes payable.

The review

CCRA may conduct financial and technical reviews to verify the eligibility of the work and the relationship of the expenditures to the work. It’s important to have well maintained records of SR&ED activities and reply to any requests in a timely manner.

An SR&ED claim is prepared and processed more efficiently if the technical and financial personnel involved are proactive, from R&D project initiation to income tax preparation to the final CCRA review. Any time you save going through this process will expedite your company’s refund to support ongoing or potential R&D projects that benefit the Canadian economy and your business’s bottom line.

Victoria Hung, BSc, CMA (v_hung@shaw.ca), is the controller of West Bay Semiconductor Inc. This is her first article for CMA Management magazine.

Tips:

Project Management:

• Take advantage of CCRA services prior to pursuing SR&ED  projects;
• Designate technical and financial personnel to monitor all stages of R&D projects;
• Keep accurate and clear technical and financial records;
• Review SR&ED activities and costs regularly;
• Invest in project costing software to track time and cost for multiple R&D projects.

Tax Preparation

• Use the most recent version of the T661 Form;
• Elect to have the refund directly deposited into the company’s bank account;
• Calculate and compare overhead amounts for the proxy and traditional methods before making the election;
• Check and re-check all amounts and calculations.

SR&ED Review

• Ensure technical and financial personnel are available for the review;
• Have all records organized and ready for reference;
• Review claim in advance and prepare answers for any questions that may arise;
• Forward any follow-up information to CCRA in a timely manner;
• Get advice or suggestions from the CCRA representative during the review.

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