What is the SR&ED Program?
Administered by the Canada Revenue Agency (CRA), the Scientific Research & Experimental Development (SR&ED) program is a federal tax incentive designed to encourage Canadian businesses of all sizes and sectors to conduct scientific research and experimental development in Canada. The SR&ED program offers two key benefits:
- SR&ED expenditures are deducted from your income for tax purposes, resulting in lower income tax.
- You are provided with an SR&ED investment tax credit (ITC) that can be used to either reduce your income tax payable if it exists or, in some cases, the remaining ITC is refunded.
With around $4 billion in ITCs provided to over 18,000 claimants each year through the program, the SR&ED tax incentive is the government’s largest single support program for Canadian research and development (R&D). Of the 18,000 aforementioned claimants, approximately 75% are small businesses.
Specifically, the SR&ED program provides two levels of refunds: a base federal rate and a provincial / territorial top-up in addition to the federal rate.
Federally, the maximum ITC depends on the legal status of the company and the amount of qualified expenditures for SR&ED carried out in Canada. In reference to corporate structure, there are two key distinctions:
- Canadian-controlled private corporations (CCPCs) can earn a refundable ITC at the enhanced rate of 35% on qualified SR&ED expenditures, up to a maximum threshold of $3 million. An ITC of 15% is earned on any amount in excess of $3 million.
- All other Canadian corporate structures (corporations, proprietorships, partnerships, and trusts) earn a non-refundable ITC at the basic rate of 15%.
In addition to the federal ITC, each province or territory may also provide provincial or territorial tax credits to qualifying corporations carrying out SR&ED in their respective province or territory. The Provincial and Territorial rates are in the below table as follows:
|Newfoundland and Labrador||15%|
|Prince Edward Island|
Further, provinces and territories may also offer alternative or supplemental investment programs pertaining to research and development. For example, the Northwest Territories and Nunavut provide a 15% tax credit under the Risk Capital Investment Tax Credits Act.
Qualifying costs include wages, material costs, equipment leases, and overhead that are directly related to the research and development process, as well as 80% of the cost of eligible work by contractors. Whether expenditures are qualified depends on whether they are deemed eligible as established by the definition of SR&ED in the Income Tax Act, section 248(1). Details regarding SRED qualification requirements are outlined below.
SR&ED Qualification Requirements
What Qualifies as SR&ED?
For tax purposes, the Income Tax Act defines SR&ED as a systematic investigation or search that is carried out in a field of science or technology by means of experiment or analysis. Under this definition, there are four distinct categories that SR&ED can fall under: basic research, applied research, experimental development, and eligible support work. Each is discussed in detail below.
Basic research is work undertaken without a practical application in mind. Instead, basic research focuses on the general advancement of scientific and technological knowledge. Such research is usually carried out in a laboratory setting and often includes the support of third parties such as universities and research institutes. The results of basic research studies are often published in scientific journals.
Applied research is work undertaken for the advancement of scientific and technological knowledge, but with a practical application in mind. While also undertaken to further the scientific and technological knowledge base, applied research often is conducted for the purpose of creating new or improving existing materials, devices, products, or processes, including major and incremental improvements.
Experiential development is work undertaken for the purpose of achieving technological advancement for the purpose of creating new, or improving existing, materials, devices, or processes including major and incremental improvements. Applied research is often followed by experimental development. While applied research focuses on advancing scientific knowledge for the purpose of some practical application, experimental development doesn’t create new scientific knowledge, but does improve the state of technology.
Eligible Support Work
While support work does not constitute SR&ED on its own, if it is in proportion with the needs and directly in support of basic research, applied research, or experimental development work undertaken in Canada, eligible support work falls under the definition of SR&ED and is therefore subject to the program’s benefits.
In order to qualify for SR&ED ITC, the support work must meet three conditions:
- It must correspond in the amount, size, extent, or duration of the work that is necessary to carry out basic research, applied research, or experimental development undertaken in Canada.
- It must be directly in support of basic research, applied research, or experimental development undertaken in Canada.
- It must be with respect to engineering, design, operations research, mathematical analysis, computer programming, data collection, testing, or psychological research.
What Doesn’t Qualify as SR&ED?
“Research and development” (R&D), as it’s generally understood, is not necessarily SR&ED. While R&D is work directed toward general innovation, introduction, and improvement of products and processes, SR&ED is carried out in a certain way and for specific reasons. The following fields are not included as a part of SR&ED:
- Market research or sales promotion
- Quality control or routine testing of materials, devices, products, or processes
- Research in the social sciences or humanities
- Prospecting, exploring, or drilling for, or producing, minerals, petroleum, or natural gas
- The commercial production of a new or improved material, device, or product or commercial use of a new or improved process
- Style changes
- Routine data collection
In addition to being categorized as basic research, applied research, experimental development, or eligible support work, there are a series of other criteria that the work must meet in order to be deemed SR&ED.
Methodology to Determine if Work Meets the Definition of SR&ED
In addition to identifying with one of the four aforementioned categories (basic research, applied research, experimental development, or eligible support work), how and why the work is carried out must strictly meet criteria outlined by the Income Tax Act in order to qualify as SR&ED.
How SR&ED is Conducted
As previously mentioned, SR&ED is defined as a systematic investigation or search that is carried out in a field of science or technology by means of experiment or analysis. To understand the requirements of this definition, it is best to consider what each part of the definition means individually.
To begin, the work in question must be carried out systematically. This means that the work must follow known design methods, techniques, procedures, standards, and other practices.
The fact that the work must consist of an investigation or search means that the approach must consist of defining a problem, advancing a hypothesis towards resolving that problem, planning and testing the hypothesis by experiment or analysis, and developing logical conclusions based on the results.
Additionally, the work must be scientific, related to engineering, or to other development. Specifically, within these fields, it must relate to design, operations research, mathematical analysis, computer programming, data collection, testing, or psychological research.
The systematic investigation carried out in one of the above mentioned fields must be evaluated by way of experiment or analysis. For example, building and testing a prototype to attempt to answer a hypothesis could be a part of the experiment or analysis.
In addition to being carried out in accordance to the definition, consideration must also be given as to why the work was carried out in order for work to be eligible for ITC from the SR&ED program.
Why SR&ED is Carried Out
By definition, for work to be considered SR&ED, it must be undertaken for the purpose of advancing scientific and technological knowledge, or for the purpose of achieving technological advancement. Therefore, for work to be SR&ED, it must attempt to resolve scientific or technical uncertainty. In other words, the work undertaken must be for the purpose of omitting previous obstacles in science and technology that exist due to lack of availability of scientific or technical knowledge or experience.
Determining if there is SR&ED
If the work in question meets the above mentioned criteria, it is put through a test to determine if it is eligible. This test is conducted by examining the work to the point where the following five questions can be answered. If the answer to each of the following questions is yes, then there is SR&ED.
1. Was there a scientific or a technological uncertainty?
Recognition of uncertainty is a crucial step in the systematic investigation or search as it indicates the need for advancement. In SR&ED, uncertainty can exist in two forms: scientific uncertainty and technological uncertainty. Scientific uncertainty pertains to basic research and applied research while technological uncertainty pertains to experimental development.
In addition to scientific or technological uncertainty being present, one must be able to identify specifically what is lacking in the scientific or technological knowledge base that is creating the uncertainty. This is a necessary step in formulating the hypothesis for further investigation.
Consideration should also be given as to whether the problem that arose was due to technological uncertainty or a technical problem. For the purposes of recognizing work as SR&ED, there is a very clear distinction between the two:
- With a technical problem, the existing base of scientific or technological knowledge is sufficient to resolve the problem.
- With a technological uncertainty, the solution or method of finding a solution is unknown based on the existing scientific or technological knowledge base. Technological uncertainty therefore requires the undertaking of experimental development to resolve the problem.
Making this distinction is critical as only work that is resolving a technological uncertainty is considered to be SR&ED. To aid in identifying the uncertainty, a detailed description of the work leading up to the uncertainty is often helpful. Doing this serves two key purposes:
- Explaining why the particular uncertainty could not be resolved on the basis of generally available scientific or technological knowledge.
- Explaining the scientific or technological knowledge base of the company.
In consideration to economic feasibility of projects, specifically cost targets, cost targets alone do not create scientific or technological uncertainty. However, if a means to achieve a cost target requires a novel and potentially technologically uncertain path, then the work required to develop a product or process to achieve the cost target may be considered SR&ED.
While the fact that a large, complex system was developed cannot warrant the inference that an uncertainty existed, a form of technological uncertainty called systems uncertainty can arise from or during the integration of technologies. This is true even if the individual components used are generally well known. The reason that systems uncertainty exists in such cases is that it may be difficult or impossible to predict how the integrated system will perform due to unforeseeable interactions between the system’s components.
Lastly, it is important to consider the application of techniques, data, and procedures that are generally known and available as well as troubleshooting in how they relate to SR&ED. While the aforementioned activities do not constitute SR&ED on their own, they may be eligible if the work was used to support SR&ED.
2. Did the effort involve formulating hypotheses specifically aimed at reducing or eliminating that uncertainty?
Forming hypotheses requires the observation and understanding of the subject matter of the problem being solved. As it’s defined for SR&ED purposes, a hypothesis is an idea that is consistent with known facts that serves as a starting point for further investigation to prove or disprove the hypothesis idea. For work to be SR&ED, the efforts must have involved the formulation of a hypothesis specifically aimed at or reducing the identified uncertainty.
3. Was the overall approach adopted consistent with a systematic investigation or search, including formulating and testing the hypotheses by means of experiment or analysis?
In order to be considered a systematic investigation or search, an approach must be formulated that includes the following:
- Formulating at least one hypothesis that aims to reduce or eliminate uncertainty
- Planning and executing the testing of the hypothesis by way of experiment or analysis
- Developing logical conclusions based on the results of the experiment or analysis
In order to achieve the requirements of the above mentioned approach, the objectives, indicators, and measures that will be used to determine if those objectives have been met must be clearly defined at an early stage in the process. Additionally, it is expected that the work conducted is undertaken by qualified individuals who are knowledgeable in the field.
Furthermore, the work undertaken to test the hypothesis must be strictly experiment or analysis. Experiment and analysis are defined for SR&ED purposes as follows:
- Experimentation involves structured and organized tests and studies to obtain information in order to address hypotheses.
- Analysis refers to the detailed examination of information to differentiate the various aspects of the information, determine their attributes, or explain their relationships.
When solving problems, sometimes trial and error is used. Trial and error involves executing a series of tests in no particular order and not as a part of a systematic plan. As no experimentation or analysis are included in the framework of trial and error, trial and error is not considered to be a systematic approach to the testing of a hypothesis.
4. Was the overall approach undertaken for the purpose of achieving a scientific or a technological advancement?
In achieving scientific or technological advancement, a key implication is that the new knowledge could be useful to other situations or circumstances beyond the current project in which the advance was made.
So long as the research was undertaken systematically as per the requirements in the above question, the rejection of a hypothesis is considered advancement because a possible solution becomes eliminated. This holds true so long as the reason for failure is understood.
A distinction must be made between technological advancement and the benefits of a new material, device, product, or process created as a result of SR&ED. Realizing benefits of a new material, device, product, or process as a result of SR&ED alone does not constitute technological advancement.
The reason for this is that materials, devices, products, or processes can be improved without moving the scientific or technological knowledge base of a company to a higher level through the understanding of technology. For technological advancement to hold, there must be an improvement in the existing scientific or technological knowledge base.
Additionally novelty, innovation, uniqueness, feature enhancement, or increased functionality alone does not imply technological innovation.
5. Was a record of the hypotheses tested and the results kept as the work progressed?
The record of hypothesis must be recorded, clearly showing why each major element is required and how it fits into the project as a whole. It is also necessary that predetermined indicators and measures will be used to assess whether the goals of the work are met.
The progression of work is built on the ability to analyze results from step to step. This organized record of results is the basis for being able to capture, communicate, and if necessary, repeat the work in question.
In order to for work to be eligible, all of the above criteria discussed must be satisfied.
How to Apply for SR&ED
After determining what work is eligible for SR&ED, it is time to go about filing for tax incentives. Before going about the filing process, it is recommended that you consult a qualified SR&ED consultant prior to filing deadlines to determine which projects are eligible.
As mentioned previously, there are two ways individuals can benefit from SR&ED tax incentives:
- Expenditures on SR&ED can be claimed as part of the pool of deductible SR&ED expenditures to reduce income for tax purposes.
- A taxpayer can receive SR&ED ITCs on qualified SR&ED expenditures in the form of a cash refund, reduction in income tax payable, or sometimes both.
To claim these above mentioned tax incentives, the claimant must meet certain filing requirements. Whether the claimant wishes to deduct an allowable SR&ED expenditure or earn an ITC on a particular SR&ED expenditure, they must meet the appropriate filing requirements by specified dates. The below section will discuss each in further detail.
1. Filing Requirements for Deducting an Allowable SR&ED Expenditure
In order to successfully deduct an SR&ED expenditure from income for tax purposes, the claimant must have done the following:
- Identified the expenditure on the prescribed form (Form T661)
- Included all prescribed information on the prescribed form
- Have filed the form on or before the day that is 12 months after the claimant’s return filing due date for the year that the expenditure was incurred
Prescribed information refers to information requested on a prescribed form. This includes any attachments or schedules that are supplemented to provide the information required on any particular form. Specific details regarding Form T661, supplementary forms, and prescribed information are discussed below.
Form T661 and Other Supplementary Prescribed Forms
Otherwise known as the Scientific Research and Experimental Development (SR&ED) Expenditures claim, Form T661 is the prescribed form for the purposes of determining the pool of deductible SR&ED expenditures. This form must contain the prescribed information with respect to the expenditure on or before the day that is 12 months after the claimant’s return filing.
The due date in question depends on the corporate structure of the claimant. For example, individuals and corporations do not have the same SR&ED reporting deadline. Specific deadlines will be discussed later in this report.
Depending on the situation, there may be other forms required to supplement Form T661: these include Forms T1145, T1146, T1174, and T1263. Inclusion of these forms may be necessary to ensure that all prescribed information with respect to the expenditure is filed.
Prescribed Information for Form T661
The information requested in Form T661 can be effectively broken up into 10 parts. During the review of the claim however, the CRA may request additional information for clarification and confirmation purposes regardless of whether or not a submission has met the SR&ED filing requirements. The below contains a general overview of the information requested in the 10 parts of Form T661:
- General information
- Project Information
- This part requires the technical information about the work claimed through a series of fields, check boxes, and questions. A separate part 2 is required for each project being claimed.
- All claimants must complete and maintain a Part 2 to Form T661 for all projects claimed, even though Part 2 is only submitted for the 20 largest projects in dollar value. Upon request, claimants should be prepared to submit a completed Part 2 for any project to the CRA.
- Calculation of SR&ED expenditures
- Calculation of qualified SR&ED expenditures for ITC purposes
- Calculation of prescribed proxy amount (PPA)
- This is relevant if the individual elects to use the proxy method – an alternative to the traditional method in calculating SR&ED expenditures.
- Project Costs
- Additional Information
- Claim Checklist
- Claim Preparer Information
- This information must be provided by each claim preparer that has accepted consideration to prepare or assist in the preparation of the SR&ED claim.
For greater detail or instruction on how to complete the above mentioned parts of Form T661, refer to the guide to Form T661.
2. Filing Requirements for Earning an Investment Tax Credit on an SR&ED Expenditure
In order to earn an ITC on a particular SR&ED expenditure, the claimant must also file a prescribed form containing prescribed information by a given due date. Before earning an ITC on their expenditures, the claimant must have met the filing requirements for SR&ED expenditures.
The prescribed forms and prescribed information provided vary depending on whether they pertain to corporations or individuals. Each is discussed in further detail below.
Investment Tax Credit for Corporations — Schedule T2SCH31
Also known as the Investment Tax Credit — Corporations, Schedule T2SCH31 is the prescribed form that must be completed for corporations filing an ITC. Depending on whether there is need for additional, supplementary information, a corporation may be required to file Schedule T2SCH49.
Prescribed Information for Schedule T2SCH31
The information provided by corporations filing for an SR&ED ITC must provide the following information:
- corporation name
- business number
- tax year end
- relevant information requested in parts 2,3,8,17,29, and 30 of Schedule T2SCH31.
For greater detail on the contents of Schedule T2SCH31, consult the relevant documentation.
Investment Tax Credit for Individuals — Form T2038(IND)
The prescribed form for both individuals and trusts is Form T2038(IND).
Prescribed Information for Form T2038(IND)
Individuals or trusts claiming an SR&ED ITC must provide the relevant information requested in parts A through F of Form T2038(IND).
Filing Due Dates for a return for Individuals, Trusts, and Corporations
If returns are filed late, then the claimant is subject to penalties. It is therefore important that relevant due dates are met. The table below outlines the relevant due dates and SR&ED reporting deadlines for individuals, trusts, and corporations.
|Taxpayer||Return||Filing Due Date of Return||SR&ED reporting deadline|
|Individuals||T1, Income Tax and Benefit Return||June 15 of the following year||17 ½ months after the calendar year end|
|Trusts||T3, Trust Income Tax and Information Return||No later than 90 days after the trust’s tax year end||15 months after the tax year end|
|Corporations||T2, Corporation Income Tax Return||No later than six months after the tax year end||18 months after the tax year end|
The information covered regarding SR&ED qualification requirements and the application process was intended to provide insight towards these processes. As such, the information discussed above does not exhaustively cover the all of the relevant information necessary to file for SR&ED. As such, prior to filing for SR&ED tax incentives, it is strongly advised to consult a legal professional to ensure proper due diligence is conducted in the filing process.
The remainder of this report will focus on practical considerations of SR&ED including common mistakes made in the filing process, success stories with SR&ED, and a comparison of the SR&ED program with other similar programs.
Many mistakes associated with SR&ED are costly but can be avoided by understanding the SR&ED process and following best practices throughout the filing process. Below will consider what industry experts find to be the most costly mistakes associated with the preparation, filing, and defending of SR&ED tax incentive claims.
Understanding Eligibility and Consulting With a Tax Professional
As mentioned in the earlier part of this report, there are strict qualification criteria regarding eligibility of SR&ED funding. Without fully understanding the scope of these criteria, it is easy to claim ineligible projects or to not claim eligible projects simply due to misunderstanding the qualification process.
The best way to ensure that all expenditures being filed are qualified is to amass all ambiguous expenditures and consult a SR&ED expert as to which expenditures will likely qualify for reimbursement. By understanding the legal criteria to the point where you can gather expenditures that may qualify, and having a tax professional recommend further which expenses likely will and will not qualify, you can most effectively streamline the SR&ED filing process.
Having Adequate Documentation
The more a claim is worth, the more documentation is required in filing for SR&ED. Preparing and collecting adequate documentation throughout the SR&ED process is therefore crucial in both assessing eligibility and defending your claim. Many companies are doing eligible work, but lack of documentation provides a hinderance, and in some cases prevents them from capitalizing off of the benefits offered by SR&ED.
High quality documentation is key in highlighting the systematic and rigorous process that was undertaken in SR&ED. There is strong emphasis placed on how development occurred. A best practice is to provide continuous documentation throughout the SR&ED process that highlights the link between the activity, the time involved, and the performer. Further, such documentation further improves the ability to illustrate that experiment and analysis took place – a key consideration in determining whether the SR&ED is eligible.
Always Be Prepared for Audits and CRA Requests
In applying for SR&ED tax incentives, it is important to always be ready for an audit or review from the CRA. To successfully prepare for a CRA audit, you must be able to prove eligibility for the SR&ED undertaken as well as present employees who possess experience with the work being claimed and who understand the program requirements
Additionally, it is crucial that CRA replies are prompt and informative. As delay in providing pertinent information can complicate or even cause denial of SR&ED reimbursement, updating the CRA on any inquiries they might have is vital in fully benefiting from the SR&ED tax incentive program.
The 18-month deadline is a statute barred deadline, meaning that it cannot be overturned as the limit imposed by the limitations act has been exceeded. Any information received past this deadline can therefore be turned down by the CRA. In order to prevent this from happening, it is a best practice to submit all required documentation well before the deadline. This way, even if the CRA requests additional information on top of what was already submitted, there is sufficient time to address all inquiries.
Often times companies are not comprehensive enough in their project descriptions. The most effective way to deliver information in the project description is to concisely and simply convey all content requested by the CRA. Consult the published CRA guide to fully understand what information is expected to be provided and ensure you cover all of it in your project descriptions.
How Canada’s Program Compares Internally With Other Similar Programs
Recently, innovation has been identified by the Canadian government as an area of investment to fuel economic growth. To aid innovation, a variety of research and development grants as well as loans and tax credits are offered through the government to help promote innovation in Canadian based companies.
In order for small and medium sized Canadian companies to understand the funding landscape available for research and development, it is useful to look at how the SR&ED tax incentive program compares internally with other R&D programs.
As SR&ED and the Industrial Research Assistance Program (IRAP) are two of the most popular programs related to R&D, the following section will compare key features of each. With both SR&ED and IRAP offering unique advantages, it is important to understand when and how to use each program.
Timelines and Application Processes
SR&ED is retroactive in nature as it considers tax credit or incentives on already incurred expenditures. In contrast to IRAP which offers funding prior to undertaking the project, SR&ED bears more risk.
As mentioned previously in this report, SR&ED requires the successful answering of 5 questions pertaining to the work undertaken. If any of these criteria are not met, there is the chance that work undertaken may not be eligible under SR&ED.
Opposite to SR&ED, companies receiving funding from IRAP will have already received a defined amount prior to undertaking any work. Due to the way IRAP funding is offered, it entails much less risk in comparison to SR&ED.
Due to its reduced risk and flexibility, IRAP is well suited to help companies that bear technical risks and uncertainty afford projects that they would otherwise not have the cash flows to take on.
IRAP offers a significant cash flow advantage in comparison to SR&ED. While SR&ED can take up to 4-12 months to reimburse, IRAP offers monthly reimbursement based on the outlined budget in the IRAP application.
For large projects that consist of extensive payroll and subcontract costs that may affect company cash flows, it is advantageous to choose IRAP over SR&ED.
Eligible Costs and Contributions
Depending on the province the company operates in, corporate structure, and eligible expenses, SR&ED will typically cover between 35%-45% of an overall project’s costs while IRAP will typically cover 50%-80% of eligible expenses.
While IRAP covers more at face value, a key consideration must be given to the actual costs covered between each program. In terms of eligible costs, IRAP focuses specifically on salary costs and costs of Canadian subcontractors related to an R&D project. SR&ED however will cover these costs as well as relevant overhead costs.
Since IRAP cannot be stacked with SR&ED, it is important to consider the cost structure of the project prior to choosing IRAP or SR&ED and which expenditures would be better covered under which program.
While SR&ED is a viable option to fund eligible work, it is important to consider all available funding. Assess the nature of your operations and determine the importance of various funding aspects such as reimbursement rates, timeliness, and viability of various R&D projects. Ultimately, the most strategic R&D funding decisions will come from thoroughly understanding the scope of available government funding and choosing the funding program that is most appropriate for the specific R&D work in question.
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