The Scientific Research and Experimental Development Tax Incentive Program (SR&ED) – A Cash Incentive to Innovate
SR&ED is a generous tax credit offered by the Canadian government to businesses operating in Canada attempting to advance technology in some way. This program helps grow businesses by making R&D more affordable and boosting the competitiveness of their business.
A typical SR&ED (Scientific Research and Experimental Development) claim looks something like this: the corporation spends money on staff time, contractors and consumed materials in an attempt to improve their technology in some way. There is no way of knowing in advance what the solution to their problem is, if any. They experiment with different approaches and not everything they try works. They do learn more about the subtleties of the technology along the way, even when their experiments fail.
By the end of the year, a significant sum has been spent on the project. The SR&ED program rebates a generous proportion of these expenses, mostly in cash and partly in credits against tax owing.
SR&ED can be summarized as an incentive for businesses to take risk by conducting a systematic investigation to overcome a technological uncertainty, which advances technology in some way, including learning what fails and should not be repeated.
The Connection Between SR&ED and Patents
There is a close correlation between patentable work and SR&ED-eligible work. A patent protects the rights in a solution to a problem as practically applied from being exploited by others, where as SR&ED helps to offset the cost of the R&D that lead to the solution.
Both patents and SR&ED must cover new technical ground. A patentable technology must be novel, useful and non-obvious; SR&ED must raise the base technology over what is available in the public domain and within the corporation. The work done to advance technology (which may be patentable) is generally SR&ED-eligible. Unlike with patents, in which the technology must be novel and inventive over the prior disclosures of competitors, SR&ED can cover the same ground as a competitor providing the competitor has not made their advances known to the SR&ED filer directly or via the public domain. The SR&ED program requires that a systematic investigation was carried out whereas a patent is not concerned with the manner in which research is conducted but instead focuses on the solution.
When looking for SR&ED work, look well beyond what you intend to send to the patent office. A great deal of work that may not be patentable or may not be commercially valuable enough to pursue patent protection for is most certainly SR&ED-eligible.
Who Can Apply
Any company with business operations in Canada can apply. The most generous returns go to CCPC (Canadian Controlled Private Corporation), meaning a corporation that is privately held, resides in Canada, and has sufficient Canadian ownership to ensure it is controlled by Canadians. Other forms of Canadian corporations can claim SR&ED although at a lower rate. All eligible work must be performed by Canadian taxpayers, although eligible materials may be supplied from outside of Canada.
When to Apply
SR&ED filings cover eligible work performed in the previous tax year and are made as part of the corporate T2 return.
There are two types of filings: joint filings, where the SR&ED claim is part of the original T2 filing, and amended filings, where SR&ED is filed as an amendment to a previously filed T2 return.
Joint filings are by far preferential because payment is made much sooner after filing than with amended filings. SR&ED must be filed no later than 18 months after the financial year end, otherwise the opportunity to file is lost. In my experience, companies that consistently file towards the 18-month deadline struggle to gather the relevant details and claims are smaller than they should be due to forgotten details and face a higher risk of audit. File at the 18-month deadline to catch up if you must; but your corporation is best served by sticking to joint SR&ED filings going forward.
SR&ED filing requirements include both technical and financial aspects. A 1,400-word technical report is included in the filing that describes eligible activities and why they meet the SR&ED requirements. Expenditures must be costed according to SR&ED rules. Finally, adequate documentation must be available to support the technical and financial aspects to the claim in case there is an audit.
The technical report has three sections describing: the technological uncertainty, the work performed to overcome the uncertainty, and the advancements made during the reporting period. The technological uncertainty describes the technological obstacles preventing the technology from performing in the desired way. The work done to overcome the technological obstacles must be described as a systematic investigation. The technological advancements describe the results of the systematic investigation and the progress made towards finding a solution to the technological obstacles. This may be the discovery of what doesn’t work.
Staff working to resolve technological problems often follow this process without being aware of it. A real effort is sometimes necessary describe the work in the way the Canada Revenue Agency (CRA) likes to see. The results are well worth the effort however and can lead to tens or hundreds of thousands of dollars in SR&ED tax credits
Costing includes staff and contractor time on SR&ED-eligible activities, and materials that have been consumed or transformed in the process of pursuing SR&ED. There are rules that must be followed when costing a SR&ED claim. Generally speaking, work performed that directly or indirectly supports the SR&ED project can be claimed. Overhead can be included if the long-form of costing is used but the long-form is rarely worthwhile and most SR&ED claims use they proxy method that simply adds 55% to eligible staff costs to cover overhead. Occasionally the long-form approach (known as the “traditional method”) really pays off; in one case, a claim that would have been worth around $200,000 using the proxy method but was worth close to $1,500,000 using the traditional method.
Documentation is the one SR&ED requirement that small businesses struggle with the most. The good news is that many forms of documentation are suitable and by combining several sources, an accurate story can be surmised. Keep in mind that you don’t have to show your documentation to the CRA unless audited, an infrequent event for properly prepared SR&ED filings. Even in an audit situation, the CRA is more relaxed for first-time audits. Work with what you have and do your best to improve corporate documentation going forward.
Documentation serves a second important purpose. By the time the SR&ED claim is put together, staff frequently forget what they did at the beginning of the year and simply leave out legitimate activities from their claim, often leading to a much less money back from the CRA.
Maintaining documentation is not onerous. Maintain even minimal, yet consistent and relevant notes as the project progresses, and organize other naturally generated documentation such as emails, time sheets, invoices, problem reports and other documentation that shows that the work was done as described in the SR&ED claim. Remember to put the date on your whiteboard and photograph it during technical meetings. Tagging and filing documentation as you go really helps when it is required in the future.
How Grants Impact SR&ED
SR&ED is just one of many forms of government assistance available to Canadian corporations. Many government assistance programs must be applied for in advance of any work taking place, where as SR&ED is always after the fact.
All forms of government assistance must be deducted from the SR&ED claim. This is less straightforward than it might seem. Many grants cover activities that cannot be claimed as SR&ED so the impact on the SR&ED claim may be reduced. The general rule is no double-dipping: you can’t claim twice for the same work. The main takeaway is that SR&ED can be combined with other grants and the sum total makes the combination well worthwhile.
There are some pitfalls to avoid when filing SR&ED. On the technical side, a report that describes irrelevant details and misses the point of SR&ED is sure to get audited. There are many pitfalls on the financial side. The most common revolve around claiming work done by business owners: specific rules prevent “specified employees” from claiming more than 75% of their wages against SR&ED. Other rules come into play when dealing with non-arms-length contractors or related businesses. Such arrangements usually allow claims to be made, if properly handled before the SR&ED claim is filed.
The SR&ED program helps Canadian businesses stay at the leading edge of technology while reducing the inherent risks with delving into uncharted territory. If a corporation has developed a patentable invention there is an excellent chance that the work done to develop the patent is SR&ED-eligible leading to substantial cash back from the Canadian government. But don’t wait until starting the patent filing process to consider SR&ED; file SR&ED every year that the corporation works on improving its technology. Make sure the work is properly described and costed and maintain good documentation to protect the claim. There is some effort to making the claim, but many businesses have found the time they spent on filing SR&ED to be one of their highest return on time investments.