No one wants to leave money on the table, especially when the money is coming from the Canadian government. I’ve had many discussions with entrepreneurs and founders who are missing out on the Scientific Research and Experimental Development (SR&ED) program. The main reasons are that they are unaware of the program, do not have any expenses to claim, or are intimidated by the process.
We created a calculator to give every founder the tools they need to make an informed decision on when to pay themselves and the benefits the SR&ED program will provide. In many cases, as a technical founder, it makes sense to pay yourself a salary so that you can receive SR&ED tax credits on that salary. Continue reading to learn more, and try out our tool to do the calculation for yourself.
SR&ED Program Overview
We have many blogs on the SR&ED program. This overview of the SR&ED program is specifically focused on founders who are starting their entrepreneurial journey. The program will refund up to two-thirds of the salaries of people who are working on SR&ED-eligible activities. This is a meaningful and material number.
The SR&ED program is administered by the Canada Revenue Agency (CRA). The program is encoded in the Income Tax Act, which means it is the right of all taxpayers to participate in the program. The SR&ED tax laws were officially introduced in 1986, so the program is almost 40 years old. Despite rumours that the program will be terminated every few years, it continues to be a cornerstone of Canada’s innovation policy. Around $4B in investment tax credits (cash and credits) are issued each year, making it the largest tax incentive program in Canada.
To qualify for the SR&ED program, it is best that you have a company, but sole proprietors can also claim SR&ED on their personal tax returns. However, it is far better to be a Canadian Controlled Private Corporation (CCPC) as this typically qualifies the business for the enhanced federal credit. Very simply, if your company is a CCPC, you’ll qualify for a 35% refundable federal tax credit, whereas if you’re not, the tax credit is 15% and non-refundable. This SR&ED calculator will provide more information about how much SR&ED you can expect to receive based on your business expenses.
The SRE&D program allows for salary, contract payments, and materials to be included as costs in the SR&ED claim. For a majority of Canadian companies, salaries will make up a bulk of the expenses. This is especially true because the CRA provides for a proxy allowance of 55% of the salary to account for overhead. This means for every dollar spent on salary, it is worth $1.55 of SR&ED expenses. By contrast, if the same work were done by a contractor who billed the company $1.00, only $0.80 would be allowed as an SR&ED expense. Material expenses are included without any adjustment. On top of the federal refund, most provinces have an incentive that increases the SR&ED refund to 50% to 70% of eligible expenses.
It is possible to claim SR&ED without involving a consultant. However, approximately 80% of taxpayers rely on a consultant to file their SR&ED claims. The challenge is that there are very few quality consultants who will file very small SR&ED claims.
The biggest barometer of the size of the claim is the amount of salary expenses. This article will explain when it makes sense to pay yourself and when it does not. There is no right answer, and individual circumstances will differ for everyone. However, the math behind determining when it makes sense to pay yourself is relatively clear.
Personal Taxes as a Founder
If you’re a founder/owner and are considering paying yourself, you may ask: “Why pay myself just so I can generate T4 employment income and pay taxes on that income?” The answer lies in your ability to claim SR&ED and your personal tax rate.
Your personal tax rate will depend on your total personal income. Therefore, if your new business is one of a number of sources of income, the CRA will add up all your T4 income to determine your personal tax rate. Each province and territory has a different provincial tax rate. In total, your personal tax rate will be different depending on your province of residence and the total amount that you earn in a calendar year. This is important because even if your new business pays you only $30k per year, if you generate other income, it can more than double your marginal tax rate. The Canadian graduated tax system provides individuals with less income to pay a lower tax rate than those with more income. Therefore, if your new venture is your only source of income, chances are you will be at a lower tax rate.
Risks when Filing SR&ED
Benjamin Franklin wrote in a letter in 1789, “In this world nothing can be said to be certain, except death and taxes.” This is still true today in Canada, where paying either corporate or personal tax is certain. There are ways to minimize tax, but overall, if there is an income, then there are taxes.
On the other hand, an SR&ED claim refund is not as certain as taxes. It is highly probable that the SR&ED claim will be approved by the CRA if it is prepared professionally, but it is never 100% certain. The longer the track record in filing SR&ED and the more recent the CRA reviewed the SR&ED claim, the higher the likelihood that one can count on an SR&ED claim refund. However, because this article is targeted at founders who may have never claimed SR&ED or submitted a small SR&ED claim, the certainty of receiving the refund is less than the certainty of paying personal taxes.
Doing a risk-adjusted return analysis on paying yourself a salary and claiming SR&ED is possible, but the extra level of complication is most likely not worth it because it is difficult to assign a probability that the SR&ED claim will be approved as filed.
When to Pay Yourself as a Founder
When to pay yourself as a founder is an important question. There are many factors that one should consider. For instance, having a salary helps with applying for credit cards and other forms of credit. However, let’s focus exclusively on the cost-benefit of paying personal tax vs receiving an SR&ED refund.
There are a number of variables that make the analysis a bit more difficult, and that is why we have created a calculator tool to support your decision-making. In order to use this tool, you need to know:
- Salary that qualifies for SR&ED
- Percent of time spent on SR&ED-related activities
- Province of employment
Knowing these data points allows you to see if it makes sense to pay yourself and make an SR&ED claim.
There are other factors to consider when analyzing the results. For instance, will you pay an SR&ED consultant to prepare the SR&ED claim? Where will you get the money from to pay yourself? How much will it cost to prepare your personal tax return? Is there a risk that the CRA will significantly reduce or deny the claim? These are just some of the questions that you should consider when determining how much to pay yourself.
Generally, if you are a technical founder who spends more than 30% of your time on SR&ED-eligible projects, it makes sense to pay yourself. In the first few years of a startup, there is a significant focus on R&D to build the solution. This is often a prime time to claim SR&ED. However, you need expenses in the company to claim SR&ED, and therefore, paying yourself is the best way to maximize your cash flow.
Conclusion: Salary vs SR&ED as a Founder
For technical founders working on R&D, most of the time it makes sense to pay yourself a salary and to claim SR&ED. Carefully consider your financial position, the probability of a successful SR&ED claim and how you can tap into Canada’s largest tax incentive program. Filing a SR&ED claim can be complicated, and determining when and how much to pay yourself has a number of variables that need to be closely analyzed. Reach out to us at [email protected] if you have any questions.
