Companies earn SR&ED tax credits by performing qualifying work. SRED credits are calculated in arrears, for work performed during a fiscal year. Companies earn credits from three types of expenses.
Payroll expenses are the principal way that companies earn SRED credits. For a CCPC, companies earn 35% federal Investment Tax Credits (ITCs) for each hour of qualifying work. For salaried workers, an employee’s hourly rate is derived by taking that person’s T4 box 14 earnings and dividing by the number of hours worked in the year. This number of hours is often deemed to be 1920 or 2000 hours. For non-owner employees, bonuses can be included in calculating the hourly rate.
An overhead amount is also calculated as part of the payroll figure to determine SRED credits. A 55% markup, called proxy, is applied to employees’ hourly rate to account for overhead. Therefore, the effective ITC credit rate for CCPCs for employee payroll is over 54%. For public and foreign-owned corporations the corresponding payroll rates are 15 and 23.25%.
There is a second method, called the traditional method, for calculating overhead related to SRED. This method is much more cumbersome and involves identifying actual overhead amounts that are attributable to SRED activities. This traditional method is not used often, but it can be used in special cases, for example when a firm does not have payroll expenses to which the proxy calculation can be applied.
Payroll expenses by business owners and employees related to owners qualify for SRED credits, but they are subject to more scrutiny and some restrictions. Owners are not arms-length to the business so the government wants to ensure that payroll rates for these individuals, called specified employees, are commensurate with the work performed. Specified employees can claim a maximum of 75% of their annual wages as SRED expense. Another restriction is that specified employees can each claim payroll to a maximum of 5 times the Yearly Maximum Pensionable Earnings amount. The YMPE is used for CPP calculations. It is $58,700 for 2020. So, the maximum payroll (before proxy) that an owner can claim for SRED in 2020 is $293,500.
Companies earn SRED credits based on material costs incurred in performing SRED work, too. There are two types of allowable material costs, scrap materials and prototype costs. Scrap materials are those materials that are consumed or destroyed during SRED experimentation. An example would be a printer who is experimenting upgrading a printing press. As he performs test runs, printing materials produced have no commercial value. The printer can calculate the cost of these materials, including delivery to the site of experimentation, and include these costs as SRED material expenses. One tricky area for scrap materials is consumables. In general consumables don’t qualify as scrap costs because the government considers them to be accounted for as part of the overhead expense calculation. So in the printing example, electricity to run the printing press is a consumable, not a scrap expense. Inks and toners can be either consumables or SRED scrap depending on the project circumstances.
The second type of material expense for SRED are prototype costs. Any prototypes claimed for SRED must be used for experimental purposes then scrapped. If the prototype is later used in production or for a secondary commercial purpose it cannot be considered as a SRED expense. IN complex prototyping, often the base assembly enters production but a number of subassemblies are trialled and scrapped. These Subassemblies would be valid prototype expenses.
The third and last type of SRED expense is subcontracts. There are two types of allowable subcontracts, contract employees and arms-length subcontractors. Contract employee qualifying work is accounted for in the same way that employee payroll is handled. However, the SRED credits earned for contract employees are not as lucrative as payroll expenses. Contract employees receive no proxy. In fact, contract employee payments (all subcontract payments) are reduced by a 0.8 factor when calculating SRED expenses. Finally lower credit rates are uses to turn contract expenses into SRED credits versus payroll. For these reasons, companies are incented to put contract staff directly onto the payroll if those staff spend a significant portion of their time each year engaged in SRED qualifying work.
Once a company has summed up all its SRED qualifying expenses for the year, those expenses are turned into SRED credits by applying the particular rates for the type of expense, either payroll, material or subcontract. This will give you the dfederal SRED credits earned. Federal SRED credits for CCPCs are refundable credits, that is they are cash regardless of a company’s profit and tax situation. Credits for large and foreign companies, on the other hand, are non-refundable. Therefore, the company must pay tax to turn the SRED credits into cash. SRED credits can be carried back 3 years or held for 20 years if they cannot be applied against tax in the year they are earned.
Each province (except Alberta in 2020…) offers piggyback SRED credits for qualifying SRED work carried out in its jurisdiction. These credits vary widely by province and the provincial credits also vary based on company type. For the last 10 years, all the provincial credits (with the exception of Quebec) have been harmonized with the federal SRED program. This means your provincial credits are earned and paid out automatically once your federal credits are approved.