Canadian SRED Tax Credits
The SR&ED or R&D Tax credit, which is referred to as the Scientific Research and Experimental Development (SRED) Tax Credits in Canada, provides Canadian companies with money to undertake capital expenditures to reduce costs and generates marketing dollars to promote commercialization efforts. Governments realize that tax relief in the form of refunds or tax credits encourages companies to undertake projects with risk.
Governments in western countries such as Canada understand that in order for companies to remain competitive in a global market, technology and innovation is their greatest asset, not cheap labour. Companies that spend the most on technical product and process development are the ones that are most likely to remain in business, hire skilled labour, and contribute to the local economic tax base.
These same companies tend to also be more resilient in bad economic times. All members of G7 countries have an R&D tax credit program in place. Canada’s SRED tax credit program however happens to be one of the most generous and rewarding in the world, offering Canadian companies up to a 45% tax refund in some provinces. The Canadian research incentive has been available since 1944.
The SRED tax credit is an immediate source of income that contributes directly to your bottom line. To generate this type of profit, a company typically has to generate sales at least 10 times the refund amount.
Scientific Research and Experimenal Development Overview
The basic structure of the current Canadian federal system of income tax incentives for Scientific Research and Experimental Development was put in place between 1983 and 1985. The policy objectives underlying these incentives were also introduced in 1983. While adjustments have been made to the tax incentives since 1983, the policy objectives have not changed.
These objectives are to:
- Encourage research and development activities to be performed in Canada by the private sector through broadly based support.
- Assist small businesses to perform research and development. Provide incentives that are, as much as possible, of immediate benefit i.e. immediate cash flow contribution.
- Promote research and development that conforms to sound business practices.
The USA program approximates the Canadian, however it is not a refund but a tax credit. In all cases, the definitions are consistent with the internationally accepted definition used by the Organization for Economic Co-operation and Development (OECD).
Till 1986, in Canada, and 1994, in USA, the interpretations of the definition tended to lean towards research carried out in the laboratory sense. In Canada the program was called Scientific Research, and commonly known as R&D. That had lead to, still the case, many to believe that only basic research projects would qualify. In 1986 the Canadian ITA was amended to change the name from Scientific Research to Scientific Research and Experimental Development “SR&ED”.
The addition of the magic phrase “Experimental Development” corrected the understanding of the gesture of the incentive program. Admittedly, some pure academics are still having hard time to comprehend the difference. The magic word “ED”, however, opened the door for the Canadian and American Industries at large to take advantage of the tax credits. USA followed suit in 1994.
Scientific Research and Experimental Development eligibility is defined as work that achieves a technological advance, through a process of systematic investigation, overcoming a technological uncertainty, and conducted by qualified people.
3 Criteria must be met to qualify for a Tax Credit:
- Scientific or technological advancement: Occurs when the goal of the project is to achieve a new technical improvement or a cost reduction through a technological application that is new to your business, not the industry. The knowledge and information gained from this project will generate an advanced understanding of this technology.
Example: If the work performed is custom and cannot be purchased off the shelf or if there is no specific “how to” instructions available in the public domain such as in textbooks, Internet, or industry journals, then the work would qualify as technological advancement.
- Scientific and Technological Uncertainty: Occurs whether the end result or the objective at the onset of a project can be achieved. If your company is unsure as to how the objectives will be met and has to undertake a process of experimentation to determine the best technical path to meet the customer’s requirements, then the likelihood of uncertainty exists.Routine engineering however does not qualify under this program. Routine engineering occurs when a series of publicly known steps and instructions are faithfully followed to successfully produce the desire results without error or experimentation. Important to note that “routine engineering” that supports a qualified technical advancement is eligible.
Example: If a mold maker produces a mold that has to achieve extremely difficult and tight tolerances as set by the customer, and they are unsure that they can be met, then the mold maker is confronted with uncertainty.
- Scientific or Technological Content: Occurs when work is undertaken in a systematic and investigative process by qualified personnel with relevant experience to solve the scientific or technological uncertainty. There must be an initial consideration of options and engineering sound choices to determine the best course of action.
Example: You receive a request for quotation with detailed specifications that your project must meet. You review the criteria and come up with your quotation on how you are going to build it utilizing which components. This work is your initial hypothesis, the work that then takes place to complete the project and de-bugging shows the testing and changes that you went through to make it work.
Work performed may be:
- Basic Research, namely work undertaken for the advancement of scientific knowledge without a specific practical application in view,
- Applied Research, namely, work undertaken for the advancement of scientific knowledge with a specific practical application in view, or
- Experimental Development, namely, use of the results of basic or applied research for the purpose of creating new, or improving existing materials, devices, products or processes, work with respect to engineering, design, operation research, mathematical analysis, computer programming, data collection, testing and psychological research where that work is commensurate with the needs, and directly in support of the work described in (a), (b), or (c).
Regulation 2900 of the Canadian Income Tax Act
Many companies develop new products and processes to keep ahead of the competition, to improve their existing products, and/or to reduce their costs. Their objective is not necessarily to improve the Knowledge State of the public domain. They achieve their objectives through Experimental Development “ED” activities rather than Basic Research. Their motives are related to the global competitive position in the market and there is nothing wrong with such a motive. To the contrary, the ITA requires that the activities must be related to their business.
Typical Qualified Experimental Development activities may include work on developing prototypes, custom designed machinery, software, new manufacturing processes, developing new materials and manufacturing techniques. The techniques of such projects are neither available in the public domain, nor known as standard practice in their industry. Many of these activities may be perceived as “routine” engineering, yet certain aspects may qualify as R&D, in part or in total, due to their complexity. To qualify, they must lead to the evolution of new Technologies, Methodologies, or the resolution of Technological Uncertainty. If your company is involved in the following activities, you may be eligible for the SRED tax credit:
- Manufacture products
- Develop new, improved, or more reliable products and processes
- Develop prototypes or models
- Experiment with new materials
- Design of custom machinery, tooling, dies, and molds
- Apply for patents
- Develop custom software or implemented new systems
- Built new manufacturing facilities
- Automate internal process
- Pay outside consultants and subcontractors
- Value of Tax Credit
The Canadian Federal Government provides a tax credit of either 20% or 35% of the total eligible costs, depending on the profitability of your company and whether you are publicly or privately Canadian controlled. If you are privately held and have not paid taxes for that year, you may carry forward the tax credit for several years. When you do reach a point of profitability, you can offset your corporate taxes that you paid with your credit and receive a refund. If you are a small to medium sized Canadian Privately Controlled Corporation, CRA will issue you a 35% refund cheque regardless if you paid or did not pay any corporate taxes.
Here is an example of how significant the tax credits can be for your business. A typical claim for one project could look similar to this:
$100,000 Total Salaries and Wages
$55,000 Overhead Proxy @ 55%
$10,000 Subcontractors (80% of expenditure is eligible)
$173,000 Total Eligible Expenditures will get you a
$17,300 10% Provincial Investment Tax Credit*
$23,655 SR&ED tax credit @ 15% Federal, or
$55,195 SR&ED tax credit @ 35% Federal
The total tax credit ranges from $40,955 to $72,495 dependent upon the company’s corporate status. This shows with out-of-pocket expenses of $120,000 you could get back over 60% of your money. If you only claim labour expenses, you could receive a refund of 64.3% of your costs.
*Provincial Refund Amount varies from Province to Province
Note: The tax credit is an immediate source of income that contributes directly on to your bottom line before taxes. To generate this type of profit, a company typically has to generate sales at least 10 times the refund amount.