The Scientific Research and Experimental Development Tax Incentive Program (SR&ED) – A Cash Incentive to Innovate

The Scientific Research and Experimental Development (SR&ED) program is a generous tax credit offered by the Canadian government to businesses operating in Canada. The SR&ED program is directed to encouraging Canadian businesses of all sizes and industries to engage in domestic research and development (R&D). This program helps businesses innovate and grow by making R&D more affordable and accessible, thereby boosting the competitiveness of Canadian business. Annually, close to $3 billion is provided in tax incentives to over 16,000 claimants.

A typical SR&ED claim may look something like this: the corporation spends money on staff time, contractors, and consumed materials in an attempt to improve their technology in some way. 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 through tax incentives. These incentives come in three forms, namely, an income tax deduction, an investment tax credit (ITC), and, under some circumstances, a refund.

SR&ED can thus be understood as an incentive for businesses to explore and challenge market norms by conducting a systematic investigation into overcoming a technological problem or uncertainty. The aim is advancing some state of technology and discovering which prospective solutions are viable.

The Connection Between SR&ED and Patents

There is a close correlation between patentable work and SR&ED-eligible work. A patent provides legal rights that protect an innovative solution to a problem from being exploited by others, whereas SR&ED helps to offset the costs associated with the R&D that may lead to such a solution. Nonetheless, both patents and SR&ED must cover new technical ground and combining patent protection with SR&ED tax incentives is a tactful way to approach adding value to one’s business.

To start, understand that a patentable technology must be of a patentable subject matter, novel, useful, and non-obvious. Each of these pillars of patentability has its own unique legal test that is defined by patent law. In assessing the viability of pursuing patent protection, it is helpful to proactively assess the likelihood of successfully obtaining a patent by researching patent law and similar and competing products as thoroughly as possible. Patent professionals are also an invaluable resource in understanding not only how the legal standards comprising patentability are interpreted, but also in devising a comprehensive intellectual property commercialization strategy that identifies, protects, and leverages your most important intangible assets.

To qualify for a SR&ED tax incentive, the work must be predominantly in Canada and must constitute either basic research, applied research, or experimental development.

Basic research can be thought of as traditional scientific research for the purpose of discovery, carried out to advance scientific knowledge without a practical application in view (that is, the intent of your research is to build upon the existing scientific knowledge base). Basic research is the type of research commonly done at universities or research institutes.

Applied research similarly aims to advance scientific knowledge but, unlike basic research, applied research is conducted with a specific practical application in view. An example might help differentiate between basic and applied research. Basic research, for example, might involve studying a mutated virus to understand its characteristics. Applied research, on the other hand, might consist of developing a vaccine against the mutated virus by exploiting its identifiable characteristics.

Lastly, experimental development is carried out to achieve technological advancement and is the most common type of SR&ED work. Experimental development involves generating information or knowledge to advance your scientific or technological knowledge base, that will in turn help you develop new products or processes or improve upon existing ones. However, merely because something new has been developed or an improvement has been made does not invariably mean that technological advancement is being sought. In this regard, it is helpful to consider what technological uncertainties you encountered when trying to develop or improve the material, device, product, or process you wish to expand your scientific or technological knowledge of.

SR&ED must raise the base technology over what is available in the public domain and within a corporation. Unlike with patents, in which the technology must be novel and inventive over the prior disclosures of competitors and other pertinent disclosures in the public domain, SR&ED can cover the same ground as a competitor provided that 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 or search through experiment or analysis was carried out, whereas a patent is not concerned with the way research is conducted but, instead, focuses on the solution produced.

If you decide to pursue SR&ED benefits, each approach you take to resolve an uncertainty should be a planned experiment based on an idea or a concept. Try starting with a problem that you cannot solve with your existing scientific or technological knowledge base, then propose new ideas that may solve the problem and test such ideas for viability. This process generally supports an expansion of your scientific or technological knowledge base, and such work may qualify as SR&ED.

When looking for SR&ED eligible work, do not limit such an assessment to only what you intend to send to a patent office. A great deal of work that precedes patentable subject matter may qualify for SR&ED benefits, so SR&ED benefits and pursuing patent rights should be viewed as complementary pursuits that help develop and protect commercially valuable development.

SR&ED Ineligible Work

When you are trying to determine whether your work is SR&ED eligible, it is important to remember that certain work is excluded from SR&ED, particularly:

• 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
• Routine data collection

If you are unsure whether your work is SR&ED eligible, consider the following questions: Why was the work done? Was it carried out specifically to perform the scientific research or experimental development? In answering these questions, pay specific attention to the purpose. Take, for example, routine data collection. If the intent behind collecting data is supporting normal business operations, such work will likely be ineligible for SR&ED. If, on the other hand, the work is supporting the SR&ED work, it may be eligible as ‘support work’ (that is, work that is not SR&ED on its own but can be part of the SR&ED if it is commensurate with the needs and directly in support of basic, applied, or experimental development work undertaken in Canada).

Finally, it may be helpful to consult the list of excluded work after identifying eligible SR&ED work. Distinguishing between eligible and ineligible work is critical to ensure you only claim expenditures for eligible work.

Who Can Apply

Any company with business operations in Canada can apply. All eligible work must be performed by Canadian taxpayers, although eligible materials may be supplied from outside of Canada.

The most generous returns go to Canadian Controlled Private Corporations (CCPCs), meaning corporations that are privately held, reside in Canada, and have sufficient Canadian ownership to ensure control by Canadians. CCPCs can earn a refundable ITC at an enhanced rate of 35% on qualified SR&ED expenditures of $3 million. CCPCs may also earn a non-refundable ITC at the basic rate of 15% on an amount over $3 million. A qualifying corporation may also earn a refundable ITC at the basic rate of 15% on an amount over $3 million.

Other forms of Canadian corporations can claim SR&ED at the lower, basic rate on qualified SR&ED expenditures, which can be used to reduce tax payable. Individuals and trusts can earn a refundable ITC at the basic rate of 15% on qualified SR&ED expenditures, but first must apply the ITC against tax payable before the Canada Revenue Agency (CRA) can refund 40% of the unclaimed balance of ITCs earned in the year. Lastly, members of a partnership cannot earn an ITC because a partnership is not a taxpayer, but the ITC may be calculated at the partnership level then allocated to eligible members (such as individuals, corporations, or trusts). If you are considering making a partnership claim, reviewing the SR&ED Claims for Partnerships Policy may help with understanding the best approach to making a claim.

When to Apply

SR&ED filings cover eligible work performed in the previous tax year and are made as part of the T2 corporation income tax return for corporations, the T1 income tax and benefit return for individuals who have a business, and the T3 trust income tax and information return for trusts.

There are two types of filings: joint filings, where the SR&ED claim is part of the original filing, and amended filings, where SR&ED is filed as an amendment to a previously filed return.

Joint filings are generally preferred because payment is made sooner after filing than with amended filings. For corporations, SR&ED must be filed no later than 18 months after the tax year end, otherwise the opportunity to file is lost. For individuals who have a business, the deadline is 17 ½ months after the calendar year end, whereas the deadline for trusts is 15 months after the tax year end. Understand that entities that consistently file near these deadlines generally struggle to gather the relevant details and claims are smaller than they otherwise may be due to forgotten details, and may face a higher risk of audit. Thus, filing near these deadlines should be viewed as option to catch up if you must, but your interests may be best served by sticking to early joint SR&ED filings.

Application Requirements

SR&ED filing requirements include both technical and financial aspects. A 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. A general rule is to keep all required records and supporting documents for a period of six years from the end of the last tax year they relate to.

The technical report has three sections describing: the technological uncertainty the claimant attempted to overcome, the work performed in the tax year to overcome the uncertainty, and the scientific or technological advancements made during the reporting period. The technological uncertainty describes the problem, such as the technological obstacles preventing particular technology from operating in a desired way or meeting a certain need. 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 include the discovery of what does not work. Note that the outcome of the work (that is, whether it is successful or failure) is not relevant to determining its eligibility.

Staff working to resolve technological problems often follow this process without being aware of it. A real effort is sometimes necessary to describe the work in the way the CRA likes to see. Nonetheless, the results are well worth the effort and can lead to significant sums, like 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. However, 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 not always worthwhile, and most SR&ED claims use the 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 was worth close to $1,500,000 using the traditional method.

Documentation

Documentation is the one SR&ED requirement that small businesses commonly struggle with. 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 do not 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 can be more lenient for first-time audits. Work with what you have and do your best to continuously improve corporate documentation.

Documentation serves a second important purpose. By the time the SR&ED claim is assembled, staff frequently forget what they did at the beginning of the year and are prone to inadvertently excluding legitimate activities from their claim, often leading to 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 helps when such document is ultimately required at a later time.

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, whereas 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 cannot claim twice for the same work. The main takeaway is that SR&ED can be combined with other grants and the total makes the combination worthwhile.

SR&ED Pitfalls

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 more at risk to get audited. There are many pitfalls on the financial side as well. The most common pertain to claiming work done by business owners: specific rules prohibit “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.

Staying up to Date with the SR&ED Program

The SR&ED Program often makes a few changes to the program each year, which may or may not impact the way your business makes use of the program. These changes can be found on the SR&ED Program’s “What’s New” page, which lists the changes and updates made by date. Most recently, for example, there has been an update to the mailing address associated with ‘Third-Party Payments’, as well as updates to the ‘Recapture of SR&ED Investment Tax Credit Policy” and “SR&ED Overhead and Other Expenditures Policy”.

Conclusion

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. In this regard, innovative businesses ought to consider regularly evaluating whether they have patentable intellectual property and should use programs like the SR&ED to more easily secure advantageous legal rights. Furthermore, it is prudent to file SR&ED every year that your corporation works on improving its technology. In doing so, make sure any work is properly described and costed and maintain good documentation to protect the SR&ED 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.