Canada’s Federal Scientific Research and

Experimental Development Tax Incentive Program

(SR&ED)

Vania Karam, CPA, CRM, MA Econ, 2016

Overview…

1

Why? The SR&ED is a popular tax measure for SMEs

What? The SR&ED provides broad-based R&D support, with targeted support for SMEs

Who? Benefits available through the SR&ED vary by type and size of business

How? Simple examples to show how the federal SR&ED works

Eligibility? There are a number of different activities that qualify for the SR&ED

Issues? The significant burden with preparing claims is a longstanding concern for SMEs

Changes? Further to the Jenkins Panel recommendations, Budget 2012 made improvements to the SR&ED

The SR&ED is a popular tax measure for SMEs…

2

SR&ED is viewed as a cost-effective way to incentivize R&ED and promote ICT adoption. SR&ED produces an 11% return on investment to the Canadian fiscal system1. SMEs tend to invest proportionately more of their revenue in R&D than larger firms. ICT accounts for 35% of private-sector R&D in Canada and SR&ED is often used by ICT firms2.

A company does not necessarily have to be profitable to benefit from the SR&ED. There is a refundable component that provides ‘cash-in-hand’ to incentive R&D expenditures, a

key point for cash-strapped start-ups. For very small start-up technology companies that are not yet earning profits, the SR&ED can

cover almost half of their R&D budgets and improve their working capital position. Many smaller companies are bought and sold for the sole purpose of taking advantage of

accumulated SR&ED credits.

Provinces have similar tax incentives that complement the federal SR&ED (see Annex).

1 Source: M. Parsons and Phillips, “Tax Incentives for Scientific Research and Experimental Development,” Consultation Paper, Finance Canada, 2007.2 Source: Information Technology Association of Canada, “The Issue: The Importance of the SR&ED to ICT R&D”, 2012.

The SR&ED provides broad-based R&D support, with targeted support for SMEs…

3

The SR&ED is the largest federal program for supporting R&D in Canada, and provides over $3.1 billion in tax assistance to Canadian firms, including $1.37B in cash credits.

The rationale for the SR&ED is two-fold: In the absence of the SR&ED, firms would perform less R&D than is optimal; and R&D results in spillover effects that benefit other firms and sectors of the economy.

The SR&ED is particularly useful for SMEs and start-ups that conduct R&D to create new, improved, or technologically advanced products and processes.

SR&ED expenditures can be applied as a deduction against business income taxes payable, with any unused amounts carried forward indefinitely.

SMEs may also qualify for an investment tax credit (ITC) against taxes payable. Unused non-refundable ITCs can be carried back three years and forward 20 years.

For small firms, after reducing taxes to zero, any remaining ITC may be refunded in cash.

Benefits available through the SR&ED vary by type and size of business…

Small and medium-sized Canadian-controlled private corporations (CCPCs) receive a fully refundable ITC at an enhanced rate of 35% on the first $3 million in qualified SR&ED expenditures, and a 40% refundable ITC on qualified expenditures in excess of $3 million.

If taxable income exceeds $500K, or taxable capital exceeds $10 million, access to the fully refundable ITC is restricted (For example, the $3 million expenditure limit is reduced by $10 for each dollar by which the prior year’s taxable income exceeds $500K).

Larger CCPCs with taxable income over $800K or taxable capital over $50 million cannot receive the refundable ITC.

For non-CCPCs, the general ITC rate is 15% in 2014 and subsequent taxation years, and they are generally eligible for a 40% refund.

Where a CCPC is part of a group of associated corporations, the annual expenditure limit for purposes of calculating the ITC must be shared amongst the group of corporations.

4

Simple examples to show how the federal SR&ED works…

5

A small CCPC has $4 million in SR&ED expenditures (where the CCPC is not part of an associated group of corporations).

The CCPC would receive a fully refundable ITC at an enhanced 35% rate on the first $3 million in qualified expenditures and a 40% refundable ITC at a 35% rate on the additional $1 million in expenditures.

Thus, the total ITC value is $1.19 million. 100% x $3 million x 35% = $1.05 million 40% x $1 million x 35% = $140K

Assuming the CCPC had no tax payable, the entire $1.19 million would be paid out as a refundable tax credit (credits are paid out 3-4 months after the tax filing date).

A medium-sized CCPC has $600K in taxable income and $10 million in qualified SR&ED expenditures.

The $3 million expenditure limit to access the fully refundable 35% ITC is reduced by 10 x $100K = $1 million.

Thus, the total ITC would be $1.82 million. 100% x $2 million x 35% = $700K 40% x $8 million x 35% = $1.12 million

If the CCPC had $1 million in tax payable: The ITC reduces tax payable to zero; and The remaining ITC is then paid out as a

refundable tax credit of $820K.

There are a number of different activities that qualify for the SR&ED…

SR&ED eligibility is assessed according to three criteria: Scientific or technological advancement; Scientific or technological obstacle/uncertainty; and Scientific or technological content.

SR&ED activities must involve systematic investigation or search carried out in science and technology by means of experiment or analysis.

Activities that qualify: Experimental development; applied and basic research; engineering; design; mathematical analysis; computer programming; and testing.

Activities that do not qualify: Market research; routine testing and data collection; research in social sciences or humanities; commercial production; and style changes.

SR&ED allows for firms to claim previously allocated spending on R&D (versus a program like IRAP that is focussed more on the pre-activity R&D stage)

6

While the SR&ED is an important incentive for Canadian corporations that carry out internal R&D activities, many SMEs have raised concerns over the administrative burden associated with filing claims.

Businesses must provide a record of the percentage of time their staff spent on eligible activities, explain the R&D that was conducted, how it advanced its understanding of the issue being addressed, and how the R&D helped it to overcome a technical obstacle.

Companies often use accounting firms to prepare SR&ED claims. They may also incur significant legal expenses to prove eligibility of expenditures.

CRA is taking steps to reduce the tax compliance burden associated with the SR&ED, including:

A pilot to assess the feasibility of a formal pre-approval process for SR&ED claims; and Online and in-person services to help claimants better understand the program’s eligibility

requirements.

7

The significant burden with preparing claims is a longstanding concern for SMEs…

Further to the Jenkins Panel recommendations, Budget 2012 made improvements to the SR&ED…

The “prescribed proxy amount” used to compute overhead expenditures was reduced from 65% to 55% of direct labour costs to limit instances where credits are granted for overhead costs that exceed the actual costs incurred.

The percentage of contract payments used for calculating SR&ED credits was reduced to 80% to remove the profit element from arm’s length contract payments.

Capital was removed from the expenditure base, while other elements (salary & wages, materials, overhead and contract payments, remain eligible). This change was met with mixed reviews:

Capital expenditures were one of the most complex components of the SR&ED and so their removal from the list of eligible expenditures simplified the claims process.

However, for firms that incur significant capital expenditures for R&D purposes, the loss of this element has diluted the value of the tax measure for those firms.

The general ITC rate was reduced from 20% to 15% to address the issue of growing pools of unused ITCs.

8

ANNEX: Provincial R&D/SR&ED Tax Measures

R&D tax incentive Description Limits Availability Eligible Expenditures

Ontario R&D Tax Credit (ORDTC)

Non-refundable 4.5% credit for eligible expenditures

Can be carried back 3 yrs and forward 20 yrs to reduce ON corp. income tax payable (but not to a tax year that ends before Jan. 1, 2009)

Corps with a permanent establishment in Ontario after Dec. 31, 2008

Expenditures eligible for the federal SR&ED credits carried out in ON

Ontario Innovation Tax Credit (OITC)

Refundable 10% credit for qualified expenditures (any OITC in excess of tax otherwise payable will be refunded)

Annual expenditure limit of $3M of qualified expenditures phased out when a corp’s taxable paid-up capital for preceding tax yr exceeds $25M (eliminated at $50M in capital). Limit also phased out when taxable income for the preceding tax yr over $500K but not over $800K

Ontario Business Research Tax Institute Tax Credit

(OBRITC)

Refundable 20% credit for qualified expenditures (any OBRITC in excess of tax otherwise payable is refunded)

$20 million annual cap that must be allocated within an associated group of corps

Corps, incl. those that are members of partnerships (other than specified members) with a permanent establishment in Ontario

Qualified expenditures on SR&ED work performed in ON under contract with eligible research institutes

Quebec SR&ED tax measures

100% tax deduction for current and capital SR&ED expenditures

On Dec. 3, 2014, introduced new minimum thresholds starting at $50K per claim for SR&ED in QC. SR&ED spending below a specified threshold that starts at $50K are excluded for corps with assets of more than $50M

Corps with a permanent establishment in QC

Expenditures eligible for the federal SR&ED credits carried out in QC

Refundable 17.5% SR&ED credit Expenditures for wages paid in QC

Refundable 35% SR&ED credits

Expenses pursuant to: university, public research centre or research consortium contracts; pre-competitive research contracts; and dues and fees paid to an eligible research consortium

* Filing deadlines: AB–15 months after filing due date; Federal/BC/NS–18 months after corporate year-end; MA/YK/NL–12 months after filing due date** For all regions except Newfoundland & Labrador, eligible expenditures are reduced by government and non-government assistance, but not the related

provincial credit. The provincial credit will also reduce the federal pool of deductible SR&ED expenditures and qualified SR&ED expenditures. In most cases, any recapture will crease or increase provincial tax payable.

9

R&D tax incentive

Description Limits Availability Eligible Expenditures

Alberta SR&ED tax credit

Refundable 10% credit on up to $4M in eligible expenditures

--

Corps with a permanent establishment in Alberta, for SR&ED activities carried out in Alberta after Dec. 31, 2008

Expenditures eligible for the federal SR&ED credits carried out in AB. For years ending after Dec 31, 2012, eligible expenditure is amended to follow the federal reduction in the prescribed proxy amount

British Columbia

SR&ED tax credit

Refundable 10% credit for CCPCs up to the $3M expenditure limit

 

Otherwise, 10% non-refundable credit for qualified SR&ED expenditures

Can be carried back 3 yrs and carried forward 10 yrs to reduce BC tax payable

Corps with a permanent establishment in BC. Credit has been extended to allow corps that are members of partnerships to claim their proportionate share of the partnership’s SR&ED carried on in BC, for qualified expenditures after Feb 20, 2007

Rules parallel the federal SR&ED rules relating to the definition of SR&ED, qualifying expenditures, and the expenditure limit. SR&ED expenditures must be carried out in BC

Manitoba R&D tax credit

Non-refundable 20% credit on eligible expenditures incurred after Mar. 8, 2005, and 15% on eligible expenditures before Mar. 9, 2005

 

Refundable credit for eligible expenditures after 2009 for corps that work with eligible institutes in Manitoba

Non-refundable credits can be carried back 3 yrs and forward 10 yrs for yr ending after 2003 and carried back 3 yrs and forward 7 yrs for yr ending before 2004 and applied against MA tax payable

 

Manitoba’s 2010 budget extended refundability of the credit to in-house R&D expenditures (not undertaken by an institute in MB). Refundable portion is ¼ in 2011 and ½ in 2012.

 

Corps, incl. trust beneficiaries or that are members of a partnership with a permanent establishment in MB

Effective Jan 1, 2014, eligible expenditures amended to: follow the federal reduction in the prescribed proxy amount; not to follow the federal change to SR&ED provisions disallowing capital expenditures; and follow the federal reduction to 80% of the claimable portion of contract payments with exception of contract payments to eligible education institutions in MA

10

ANNEX: Provincial R&D/SR&ED Tax Measures

R&D tax incentive

Description Limits Availability Eligible Expenditures

Saskatchewan R&D tax credit

Non-refundable 15% credit for eligible expenditures before Mar. 19, 2009, and refundable 15% credit for eligible expenditures after Mar. 18, 2009

Effective for qualifying R&D expenditures incurred on or after Apr. 1, 2012, the refundable R&D credit for CCPCs is subject to a max. annual limit of $3M qualifying expenditures; qualifying expenditures in excess of this annual limit and qualifying expenditures by non-CCPCs will be eligible for a 15% non-refundable R&D tax credit

Non-refundable credits can be carried back 3 yrs and forward 10 yrs against SK tax payable

Corps, incl. trust beneficiaries or members of a partnership, with a permanent establishment in SK

 

Expenditures eligible for the federal SR&ED credit carried out in SK

Yukon R&D tax credit

  --

Corps with a permanent establishment in YK at any time in the yr, individuals that are resident in the YK on last day of the yr, incl. trust beneficiaries and members of a partnership

Expenditures eligible for the federal SR&ED credit carried out in YK

Nova Scotia R&D tax credit

Fully refundable 15% credit on eligible expenditures

--

Corps, incl. those that are beneficiaries of a trust or that are members of a partnership, with a permanent establishment in NS

Expenditures eligible for the federal SR&ED credit carried out in NS

Newfoundland & Labrador

R&D tax credit

Fully refundable 15% credit on eligible expenditures

--

Taxpayers, incl. corps and individuals, beneficiaries of a trust, and members of a partnership, with a permanent establishment in NL

Expenditures eligible for the federal SR&ED credit carried out in NL

New Brunswick

R&D tax credit

Fully refundable 15% credit on eligible expenditures after Dec. 31, 2002, and 10% non-refundable credit on eligible expenditures before Jan. 1, 2003

Non-refundable credits can be carried back 3 yrs and forward 7 yrs

Corps, incl. trust beneficiaries or members of a partnership, with a permanent establishment in NB

Expenditures eligible for the federal SR&ED credit carried out in NB

11

ANNEX: Provincial R&D/SR&ED Tax Measures