SR&ED Tax Credit Eligibility: A Complete Crash Course

Introduction

Innovation should be a prime motivator of any great business strategy. Time and time again, investments in research and development (R&D) prove to be long-term drivers of success.

The catch: it can be difficult to innovate if you don’t have the necessary funds.

For a growing company, it can be even harder because you have short-term obligations (e.g. quarterly or yearly revenue objectives) and limited resources.

Thankfully, the government, at all levels, is here to help.

To incentivize you to keep pushing the innovation envelope and compete on a global scale, an independent group within Canada Revenue Agency (CRA) is willing to give your business significant refundable and non-refundable tax credits.

But what’s a tax credit?

A non-refundable tax credit is an amount of money your corporation can subtract from taxes owed to the CRA and the corresponding provincial agencies.

What if your company is pre-revenue or unprofitable? In that case, no corporate taxes are paid, therefore refundable tax credits are cash reimbursements at your year end.

The focus of this article is to highlight one tax credit program in particular: The Scientific Research & Experimental Development (SR&ED) Tax Incentive Program.

Read on to get a simple and thorough understanding of the program. If you’ve never applied for SR&ED in the past, you could be eligible for some significant funding.

Best of all, SR&ED funding is non-dilutive, which means you keep all your equity.

Overview of the Program

SR&ED is the largest source of federal government support available to businesses in Canada. The program provides over $3.5 billion in tax incentives annually to over 20,000 claimants, of which 75% are small businesses (<500k in revenues). It is designed to encourage businesses to invest in research & development, so they can compete on a global scale.

To qualify, you need to be doing one of three things:

1. Experimental development – trying to achieve technological advancement
2. Applied research – trying to advance scientific knowledge with a practical application in mind
3. Basic research – trying to advance scientific knowledge, but is not directly applicable in the short-term

Objective of the SR&ED Tax Incentive Program

Simply put, the main focus of the program is deliver a reliable and predictable source of funding to eligible businesses of all sizes.

The technical details of the program are quite extensive, but the CRA works hard to simplify the process as much as possible.

Benefits to Your Company

The advantages of this program are three-fold:

1. It funds technically innovative projects, which helps you gain a competitive advantage in the marketplace
2. You can deduct R&D expenditures from income to reduce your corporate income tax owed, also known as your tax liability
3. Receive an investment tax credit (ITC) to reduce taxes payable, and in some cases, earn a cash refund if the ITC is greater than your tax liability.

SR&ED Tax Credit Rates

Tax credit rates vary depending on two main factors: ownership type and taxable income in the previous fiscal year.

Ownership type, or corporation type, determines whether your business is entitled to certain rates. The most common types are:

1. Canadian-controlled private corporation (CCPC) – see here why it pays off to be a CCPC
2. Other corporations, such as foreign controlled corporations
3. Proprietorship, partnerships and trusts

According to the CRA, a CCPC can earn a minimum ITC of 35% of qualified SR&ED expenditures, up to a maximum of $3M. Moreover, the entire ITC of 35% is 100% refundable.

In some cases, anything above the $3M threshold, a CCPC can earn a 15% ITC, of which only 40% is refundable.

Of course, this is an oversimplification of the rate schedule, so be sure to speak to a tax expert to get answers based on your unique situation.

Eligibility to the SR&ED Tax Credit Program

All this funding is nice, but do you qualify?

That’s the golden question.

The main component that determines SR&ED eligibility is based on the three technical criteria for the project:

Project Eligibility

Ask yourself the following 3 questions. If you answer yes to all (or most), there is high probability that there is eligible SR&ED work:

1. Was there an attempt at technological advancement?
2. Was there technological uncertainty?
3. Did you have a systematic approach when investigating the assumptions / hypotheses?

Note that “technological uncertainty” does not equate to a lack of internal capability or know-how. If this project has been validated in the past, to a point where it is commonplace in your industry, there is low probability of eligibility.

Notice that eligibility criteria does not depend on success. In fact, the more uncertainty there is, the more potential for technological advancement.

More technological uncertainty = higher chances of eligibility = higher claims = bigger returns.

Extent of Eligible R&D Costs

Here is a short list of expenses that can be used to compile total credits owed to you:

• Salaries and wages
• Materials consumed or transformed
• Subcontracting fees
• Overhead

An integral part to calculating the extent of your eligible expenses is to track your time. The right time tracking software for SR&ED depends on whether you work in a lab setting or if most development is done in the browser.

Sample of an Eligible Project

Here’s an abbreviated sample case of a fictional IT company that was published by the CRA in co-operation with CATA Alliance & contributors from the software industry.

Project Name: Compression Algorithm

Field of Technology: Software engineering and technology

1. Project Objective:

Develop a new compression tool for Geographical Information System (GIS) data with the capability of compressing a 1MB map down to 30KB with less than 2% data loss.

2. Technological Uncertainty:

The current state-of-the-art algorithms can only achieve compression of a 500KB map with 10% data loss. It was unknown whether a 2X increase in compression would be possible while simultaneously minimizing data loss by 5X, given there were no known or documented approaches.

3. Systematic Approach:

Through five iterative prototypes, the company managed to develop a compression tool using a data communication standard, and a method of analyzing the maps and overlays, synchronizing them into a single image and then using a modified version of MPEG 3 compression. The final iteration resulted in a compressed size of 30KB for a 1MB map, with a 1.8% data loss.

4. Technological Advancements:

Through the experimental work done, we gained a better understanding of various factors affecting data compression and integrity. We developed a modified software compression approach to allow for easier separation of the map from the overlay once the data is transferred from the hand-held unit to the desktop PC, which led to a compressed size of 1MB to 30KB (100% achieved), and data loss of 1.8% (109% achieved).

While the project was eligible, there is still room for improvement when it comes to defining the systematic process.

For example, “five iterative prototypes” – how were they different?

Also, what specific roadblocks did they encounter that made this project so challenging?

Don’t leave anything to chance – you need to document your progress and be as accurate with your description as possible. Otherwise, you run the risk of getting reviewed by the CRA, at which point your ROI on the claim is reduced.

Red flags when claiming SR&ED

Remember, to qualify for funding, the project needs to demonstrate:

1. An attempt at technological advancement: Intent to push knowledge of a process, product, material;
2. A technological uncertainty: Uncertain or no standard approach available to achieve a given objective; and
3. A systematic approach: Formulating hypotheses, adopting a scientific method, and documenting progress.

Below are fictional excerpts that would likely flag a project as ineligible to the program:

“While doing the preliminary technical feasibility work, we discovered a company in the US that has a tool ideally suited for our needs. We are currently working out a licensing agreement for resale. With a couple of parameter changes, their tool will give us our target improvement.”

Rationale for ineligibility: A routine solution was found elsewhere and was implemented without any uncertainty with regards to integration.

“In the early part of the technical feasibility study portion of the project, we learned that one of the senior software engineers had resigned from a competing company. We hired her, and she is now redeveloping their algorithm for our application. We have decided that matching our competitor’s benchmark will be adequate.”

Rationale for ineligibility: By hiring an employee from a competing company that previously held proprietary knowledge, this company effectively inherits that knowledge base, and the « technologically uncertainty » factor associated with the work no longer exists.

Conclusion

While the SR&ED Tax Incentive can provide significant funding to high-growth companies, it is imperative to have a systematic approach when considering the program. Far too often, companies scramble last minute to find eligible work. This creates massive uncertainty and can cost the company hundreds of thousands.

How R&D Partners Can Help

If you have questions or comments about recapturing your research and development expenses, please do not hesitate to contact Sahar Ansary at 1-800-500-7733 for more information.