Qualified scientific research expenditures

Write-offs and tax credits above and beyond your usual business deductions are possible if you conduct scientific research that relates to your business. Scientific research and experimental development (SR&ED) consists of pure research, applied research and experimental development. Of these three activities, experimental development is often the most difficult to evaluate. Part of the problem is the difficulty in defining what constitutes development. It’s equally difficult to distinguish exactly when development ceases and production begins—and production doesn’t qualify as research and development. Your accountant can assess if your SR&ED qualifies and tell you what you may have to do to ensure that your SR&ED activities are recognized by the CRA.

What can you deduct?

For purposes of determining the amount that qualifies as a SR&ED expenditure, all qualifying research expenditures of a current nature may be deducted in full the year they are incurred. However, a current-year deduction won’t be permitted for accrued amounts that are not paid within 180 days of the end of the taxation year. In addition, prior to 2014, new equipment purchased solely for qualified research in Canada qualified for a 100% SR&ED write-off in the year of acquisition; however, capital expenditures incurred in 2014 and subsequent years no longer qualify for this treatment.

Tax tip: You don’t have to claim the full amount of eligible SR&ED expenses in the year in which they were incurred. It may make better business sense to carry forward and deduct the amounts in a subsequent year. However, to deduct an amount for SR&ED, you must be carrying on the business to which the research relates in the year you make the claim. Unlike non-capital losses, undeducted SR&ED expenses can be carried forward indefinitely.

Claiming SR&ED

TTo claim special treatment for scientific research expenditures, you must complete Form T661. This requires you to provide a breakdown of the expenditures made, as well as details of the types of projects undertaken, such as the scientific or technological aspects they contained, the advancements they made and the uncertainties they pursued. It’s vital that descriptions of projects are complete. Failure to describe the projects properly could result in a rejection of the claim or, at best, a significant delay in processing.

For claims filed on or after January 1, 2014, the SR&ED T661 claim form requires the completion of new Part 9, “Claim Preparer Information”, which requires more detailed information about SR&ED program tax preparers and billing arrangements. If any of the prescribed claim preparer information is missing, incomplete or inaccurate, a penalty of $1,000 may be assessed. For claim preparers who have concerns about the confidentiality of their information, the CRA has introduced an administrative measure to permit Part 9 of the Form T661 to be filed separately.

Outlays will not qualify for the beneficial tax treatment afforded research and development expenditures unless Form T661 is filed within 12 months of the filing due date for the taxation year. In other words, if a corporation with a December 31 year-end incurs SR&ED expenditures, Form T661 (for the 2016 taxation year) must be filed by June 30, 2018.

If your company plans to submit a claim, you should be aware that the CRA is not lenient with taxpayers who file claims late. The claim will be rejected if it is not complete within the 18-month deadline. For this reason, it’s important to file your claim early, ideally with the corporation’s income tax return for the year. If any information is missing, the claim will still be accepted, as long as it’s complete within the 18-month period. If you file a claim at or near the deadline, it will be essential to ensure that the form is complete at the time it’s filed, since it may not be possible for the CRA to advise you in time if anything is missing. The end result is that the tax credits will be lost.

Investment tax credit (ITC)

Prior to 2014, both current and capital expenditures on scientific research also qualified for a business investment tax credit (ITC). As of January 1, 2014, however, capital expenditures for SR&ED activities are no longer included in the base of eligible expenditures and no longer qualify for ITCs.

A Canadian-controlled private corporation (CCPC) is entitled to claim a 35% ITC on up to $3 million of qualifying expenditures if it meets certain conditions (generally based on the prior year taxable income and taxable capital— those of the corporation and all associated corporations). However, an individual carrying on SR&ED qualifies for only a 15% rate, which is why it’s generally recommended that SR&ED be carried on by a private corporation. Other corporations and partnerships also earn tax credits at the 15% rate.4

The amount of the ITC is first claimed as a deduction from federal taxes payable for the year. If there’s any amount remaining, the excess can generate a refund. However, this refundable system is available only to individuals
and certain CCPCs. SR&ED ITCs earned at the 35% rate are eligible for a 100% refund if the ITC relates to current SR&ED expenditures. Capital expenditures no longer qualify for ITC treatment. ITCs are included in income in the year following the year the credit is claimed. Other corporations and partnerships earn tax credits at a 15% rate, which must be applied to reduce taxes payable and are not refundable. Alternatively, if it’s to your advantage, you can carry unused credits back for up to three years or forward for up to 20 years (10 years for credits earned prior to 2006).

4 For taxation years ending before 2014, the rate used to calculate SR&ED tax credits for all entities other than CCPCs was 20%.

Proxy amount

Two methods are available to calculate qualifying SR&ED expenditures for overhead costs. The traditional method requires that you identify each of your overhead expenditures throughout the tax year. The proxy method alleviates the burden of identifying actual SR&ED overhead costs by allowing a proxy amount for overhead expenditures, which is calculated based on a percentage of the total of the eligible portion of SR&ED salaries and wages. The proxy method is simple to use because you don’t have to track your SR&ED overhead during the tax year. It’s also simple to file because you don’t have to itemize all of your expenditures. Due to this simplicity, it’s the most popular method used.

The proxy amount percentage is 55% of eligible expenditures5. Even though the proxy method has been the most popular for filing SR&ED claims, it’s worth the time to evaluate which method is best suited for your particular situation. For example, the traditional method may result in higher ITCs where salaries and wages are low but overhead costs are high.

5 60% for 2013, 65% prior to 2013.

SR&ED contract payments

In some cases, a taxpayer may contract to have SR&ED performed by another party. The entitlement to claim SR&ED tax credits for contract payments made to a non-arm’s-length person is restricted to the amount of the qualified SR&ED expenditures incurred by that person in fulfillment of the contract. This rule ensures that ITCs are not earned on the profit element of non-arm’s-length SR&ED contracts.

Where contract amounts are paid to an arm’s length party, 80% of the amount paid qualifies for SR&ED tax treatment.

Effective January 1, 2014, amounts paid for capital expenditures incurred in fulfillment of the contract will reduce the amount of the contract payment before the 80% rate is applied.

Filing due date

To claim an ITC, a completed form giving details of the qualifying cost or expense must be filed within 12 months of the due date of the return for the taxation year in which the ITC arises. This filing deadline is the same as the filing deadline for SR&ED expenditures. The details are reported on Schedule 31 (for corporations) and Form T2038 (for individuals). To have proof of timely delivery, it’s recommended that the claim be sent by registered mail to the appropriate Tax Services centre.

Some of the provinces also offer ITCs and other tax incentives for SR&ED. The qualifying activities must be carried out in the province that grants these tax benefits.

The rules involved in claiming SR&ED expenditures and related ITCs are extremely complex. Consult your tax adviser to determine if you qualify and ensure that you get the maximum benefit from these tax incentives.