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How to Calculate your SRED tax credits

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

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.

Materials

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.

Subcontracts

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.

Summary

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.

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Deductions from SRED

Certain payments that a company receives are subsidy payments under the SRED program.  Therefore, these payments must be deducted from SRED expenditures under the principle that the government doesn’t want to subsidize the same activity twice (or more!).

There is something important to keep in mind when multiple subsidies might be available.  It is always in a company’s best financial interest to take all subsidies available even though they may reduce the SR&ED subsidy.  Why?  Subsidy payments are deducted from SRED expenditures, not directly from SRED credits. This means that subsidy payments reduce, or grind SRED subsidies, but they don’t reduce SRED on a dollar-for-dollar basis.  Say a company gets $100 of IRAP subsidy which must be deducted from SRED.  The IRAP reduces the SRED expenditures by $100.  But this reduces a CCPC’s SRED credits by only the percentage amount that a company earns for qualifying expenditures.  So, in our example, a $100 IRAP subsidy will reduce an Ontario CCPC’s SRED credits, not by $100, but by $43.  So, the company is ahead overall by $57 by taking advantage of both credits.

There are two types of subsidies to consider which grind SRED credits.  Government subsidies and non-government subsidies.  Most of the subsidies which grind SRED are government programs.  Here we will describe the most common government subsidies: IRAP, CEWS and believe it or not, provincial SRED credits themselves.  There are other government subsidies which grind SRED credits, but they are smaller, regional programs, for example Quebec’s e-business credits.

IRAP

IRAP is a long-time federal government program (it pre-dates SRED) which incents companies to carry out high technology research.  IRAP typically pays for a percentage of technical staff salaries, agreed to in a business plan jointly developed between the company and its government IRAP advisor.  IRAP will also occasionally fund marketing or business development (BD) staff, typically where the high-tech company is trying to penetrate a new foreign market.  This type of IRAP subsidy brings up an important consideration regarding all subsidies and SRED.  Only subsidy payments that directly overlap SRED expenditures must be deducted from SRED.  This can be clearly seen with IRAP BD funding.   SRED never funds marketing or BD activities.  So, there can be no overlap between IRAP BD funding and SRED funding for a given project.  It is critical for companies to carefully match up different subsidies to SRED so that they deduct only overlapping subsidies.  Otherwise, the company will be reducing its SRED receipts by an unnecessarily large, incorrect amount.

CEWS

CEWS is the federal government $77B (and counting) pandemic program to incentivize companies not to lay off staff.  CEWS was introduced in March 2020, and it runs until at least September 2021.  CEWS pays a subsidy amount up to $3800 per staff member to all employees for a given period (roughly a month) that the company qualifies for the incentive.

It was unclear for several months of the pandemic whether CEWS would be considered a government subsidy with respect to SRED.  In June, the CRA confirmed that CEWS was a subsidy and indeed it would claw back SRED funding.  The government re-confirmed this position in January 2021 and is now making CEWS deductions a point of emphasis for all SRED reviews.

CEWS is a mammoth program vs SRED.  $77B spread over 16 months vs $3B annually.  Because of this size difference, it is critical to apply the principle of overlap to only deduct the required amount of CEWS subsidy from your SRED claim.  If you have more than approximately 10 SRED practitioners in your company, the only practical way to arrive at the legally correct minimum CEWS deduction, is to engage the service of a consultant with specialized CEWS-SRED software.

Provincial SRED credits

Just as an interesting side note, provincial SRED credits are themselves considered to be government subsidies with respect to SRED.  This seems circular, but it’s the rules.  If you’ve ever filed a SRED claim, your federal ITC credits were automatically ground down by the provincial SRED credits that you received.

Non-government subsidies – Subcontracts

There is one more subsidy which is important to be aware of due to its potential impact on your SRED claim.  That is subcontract payments.  The official term for this type of subsidy is “subcontract payment in respect of SRED”.

What happens here is that you may engage the services of a subcontractor to carry out some specialized technical work in support of your SRED project.  Possibly unbeknownst to you, that subcontractor files his own SRED claim for all, or part of the work performed for you.  This is a big no-no called double dipping.  The government does not want to pay twice for the same piece of SRED work.

The subcontract payments in respect of sred must bed deducted from the subcontractor’s SRED claim.  He may still be able to claim partial expenses for the work due to proxy considerations or if he undercharged for the work performed.

 

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R&D vs SR&ED

Research and Development is a general term for a very broad range of activities related to the pursuit of all types of science knowledge and technology.  The development part of R&D is generally considered to be applied science.  That is, the application of scientific knowledge and principles to produce working solutions which are of benefit to humans.  Einstein’s work to explore the properties of light and gravity is basic research.  The Manhattan Project in World War II led by Oppenheimer and many others took Einstein’s E=MC squared and produce the atom bomb in a massive development exercise.

SR&ED is a Canadian federal government program which incents Canadian technology companies to carry out specific types of R&D activities.  Companies which meet the criteria for these activities are performing qualifying work which is highly incented by the Canadian government.  Small business corporations, called CCPCs, can earn up to 68 cents on the dollar of salary paid to staff engaged in SRED qualifying work.  SRED money for CCPCs is paid out as refundable tax credits.  That means the credits are cash.  A start-up or a money losing firm receive their SRED credits regardless of whether they earn profits or pay corporate taxes.  Approximately 20,000 Canadian companies receive funding annually under this $3B program.  Each province has a piggyback program which kicks in an additional approximately $1B aggregate for work carried out in individual provinces.

So, some differences between R&D and SR&ED are immediately apparent.  SR&ED is a subset of R&D.  The Program has been in place since 19984 and the exact definition of what constitutes work which qualifies as SRED has been refined over the years.  SR&ED definitions are laid out in the Income Tax Act.  The SR&ED program is administered by specialized CRA personnel called Research Technology Advisors, RTA’s, and Financial Advisors.  A percentage of the 20,000 claims are reviewed each year to ensure that the work claimed meets the definition of SRED qualifying work.

Here are some examples of work which are R&D but do not qualify as SR&ED.  All testing to certify a new product for use in a new market or application.  So getting a CSA sticker for a new toaster is R&D work but it is not SR&ED.  All quality control work is considered a production activity by SRED so it is not qualifying work.  Much QA work is R&D of course.  Routine software programming is R&D.  For SRED software programming is considered to be a support activity.  It only counts as SRED when it is necessary to be carried out in the course of a qualifying experiment.  Market research, product and vendor selection are more examples of work which is certainly R&D but is not SR&ED.

SRED qualifying work focuses on experimental work.  The government want to pay companies for work which has a risk of technological failure.  It is the government’s belief that carrying out this sort of difficult, risky work will, over time, raise a company’s technology base.  This technology base increase will result in competitive advantage for Canadian technology companies.

SR&ED work is heavily centered around ED work, that is experimental development.  The government says that 95% of SRED funding each year goes toward ED versus only 5% toward basic research.  This makes sense when you consider that SRED is only available to for-profit corporations.  Most of the basic research in Canada is carried out by universities, government facilities, research organizations and other non-profits who do not qualify for SRED funding.

SR&ED tax treatment

What is a SR&ED Tax Credit

The Scientific Research & Experimental Development (SR&ED) Tax Credit is a Federal tax incentive administered by the Canada Revenue Agency (CRA). Its purpose is to encourage Canadian businesses of all sizes and in all sectors to conduct research and development in Canada.

The SR&ED program is Canada’s largest industry innovation focused tax credit program, with $3 billion being claimed by 20,000 Canadian businesses annually. The overarching goal is to incentivize organizations to conduct research and development (R&D) activities in Canada. For SR&ED qualified projects, companies can claim the following expense in arrears: payroll (66%), materials (42%) and subcontracts (34%). All provinces and territories, except Alberta, have corresponding SR&ED programs but vary with the reimbursement amounts. Companies will receive the provincial portion of SR&ED according to the rule of the province where the SR&ED is performed.

The program is targeted towards small and medium enterprises, sometimes defined as a Canadian Controlled Private Corporation (CCPC), as they receive amore lucrative credits. Across all Canada, except for Alberta, there are various Provincial and Territorial SR&ED programs that have been harmonized with the Federal program. This just means that when you qualify for the Federal program, you will also qualify for the provincial / territorial programs where the business activities occurred. Funding is provided as a tax credit to reduce income tax payable. In some instances, SR&ED tax credit rates may be fully or partially refundable, resulting in a cash reimbursement.

For a business activity to be considered eligible for SR&ED, it must meet two conditions:

  • It occurs in Canada; and
  • It must include basic research, applied research or experimental development.

The latter bullet can be refined further for clarity. Section 248(1) of the Income Tax Act describes it as “…systematic investigation or search that is carried out in a field of science or technology by means of experiment or analysis…”.

We can apply some principles to judge if work can qualify or not. In order to secure credits you must demonstrate that you have carried out “qualifying work”. SRED qualifying work means you’re your project faced technological uncertainty. Another way to look at this is that the project must have had a chance of failure as in you were not sure if it would work

Other requirements include being systematic and documenting the process but technological uncertainty is the meat of the matter.

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SR&ED in Oil and Gas

There is a continued challenge within the oil and gas sector to find and produce energy to meet global energy demands, whilst facing the challenges of easy oil decline and difficult to explore resources in areas of limited accessibility. The top three drivers of research are improving operational efficiency, improving safety and reducing costs. These must also take into consideration tighter environmental and safety standards.

Some key areas of research include subsurface imaging; hydrocarbon production and reusing produced water; carbon capture and sequestration; well injection; water management; implications of nanotechnology; subsea production and development of remote technology for deepwater facilities. R&D claims have been made for activities undertaken during the exploration, appraisal, development (including front end engineering design (FEED)) and production phases of a project.

Below are some eligible R&D activities in the oil and gas industry.

Examples of Eligible R&D activities:

  • Developing technologies to optimise wellbore position;
  • Advancing extraction techniques e.g. fracturing technology;
  • Extending the operation of mature oil fields and aging reservoirs through development of new technology;
  • Developing new or improved detection method to identify and / or prevent cracking or corrosion oil pipelines;
  • Extending processing techniques e.g. for lighter oils;
  • Developing new technologies to increase production yield and throughput of midstream and downstream processing plants;
  • Undertaking and interpreting geotechnical studies on a prospective site in challenging environmental location to enable design, development and construction of a new plant;
  • Developing tools for modelling and simulation of different fields in varying conditions over life;
  • Real-time troubleshooting and diagnosis offshore and remote environments;
  • Developing technology for autonomous underwater vehicles (AUVs) coupled with better imaging technologies to allow information on what’s going on near the seafloor to be seen by operators at the surface;
  • Developing software to improve interpretation and performance of reservoirs at exploratory and development stages.
Ontario Canada

The Innovation Economy in Canada

The Innovation Economy in Canada is composed of many sectors and verticals.  Many of these sectors are comprised of small but rapidly growing companies.  These firms are known as start-ups, which is a term for innovative early formation companies coined in Silicon Valley in California in the 1960’s and 1970s.  Canadian start-ups are clustered in a few specific geographies in Canada.  Toronto has the largest absolute number of start-ups but they tend to get lost/mixed in to the general business environment in TO.  The largest standalone group of start-ups in Canada is in Kitchener/Waterloo.  These start-ups congregate there in part because of proximity to the University of Waterloo and its renowned engineering and computer science staff, graduates and alumnae.  Waterloo is also start-up friendly because housing costs and commercial real estate costs are about half those of Toronto.  This makes it easier for start-ups to retract and retain talent without having to pay them Toronto-sized wages just so the employees can afford rental accommodations.  Waterloo also benefits from a strong alumnae effect from large, successful tech firms like Research in Motion/RIM/Blackberry, COMDEV and OpenText.

Three more hubs of start-up activity in Canada are Montreal, Ottawa and Vancouver.  Each of these cities, just like Toronto and Vancouver, are blessed with excellent universities and colleges which produce a continuous stream of STEM graduates every year.  Many of these grads have been exposed to start-up life/culture in summer jobs and work terms and they do not want to go work in a large corporate environment with lots of HR, hierarchy and slow-moving access to roles with autonomy and responsibility.  Montreal has a large innovation ecosystem centered around telecom.  There are hundreds of isp’s, calling card providers, wholesalers, rebillers, telecom overlays etc in Montreal.  This is partly because of the large immigrant population in Montreal.  These people are entrepreneurial, plus they form businesses to serve the unique requirements of their customers for communication services to North Africa, Europe and Asia. Ottawa is an innovation hub with many firms spun out of Nortel, BNR, Cognos and other large software shops. Vancouver has large numbers of communications and software companies.  Vancouver is a gateway city for Canada to Asia.  It also draws on large pools of technical talent from UBC and other universities in BC.

The Canadian innovation economy is nurtured greatly by Canada’s unique SR&ED program.  One of the things which makes Canada’s SRED program so powerful is its focus on small firms.  Small companies, called Canadian controlled private corporations (CCPCs) can take advantage of funding rates  that attract credits at over the double the rate of those received by large, public corporations participating in the SRED program.  This funding model is wise.  It’s easy to see that nurturing 2, 5 or 50 person start-ups can lead to business growth where company headcounts double triple or grow 5x over a periods of only a few years.  Firms are emboldened to take on technology risk and attempt cutting edge innovation when they know they can rely on up to 65% funding from the Canadian government for qualifying STEM salary expenditures.