The world of the Canadian Scientific Research and Experimental Development (SR&ED) program is complicated, and just about has its own language. The goal of this blog is to explain SR&ED terminology and commonly misunderstood terms within the SR&ED Tax Credit program and give you the resources you need to be able to navigate the program.
Proxy vs Traditional SR&ED Calculation Method
When applying for SR&ED you have a choice if you want to use the “Proxy” or the “Traditional” method to calculate your SR&ED expenditures. The difference in the methods specifically pertains to how overhead costs (such as employee benefits, rent, utilities or maintenance costs that are directly related to SR&ED eligible expenses) are accounted for.
The Proxy method is the much simpler option of the two. With the Proxy method, all overhead costs are assumed to be equal to 55% of the salary costs, this is known as the Prescribed Proxy Amount (PPA). For example, if your company has $100,000 in SR&ED-eligible employee salaries, the Proxy method estimates that the overhead costs are equal to 55% of $100,000 or $55,000. No further calculations, documentation or proof is required.
For the Traditional method, the calculation is much more complicated. All overhead costs need to be broken out, and then costs that are directly attributable to your SR&ED projects are calculated. This method required significantly more documentation and proof, such as details about how your overhead costs are divided (i.e. rent allocated based on floor space or time allocation, etc.). There needs to be strong proof and supporting evidence for how and why overhead costs are divided, as well as bills, receipts, and depreciation schedules to support the overhead allocation.
We almost always recommend our clients to use the Proxy method. Unless you have overhead costs that ultimately add up to significantly more than 55% of your salary expenses, for which you have adequate supporting evidence, there is no reason to use the Traditional method. An example of a time where it might make sense to use the Traditional method is a manufacturing company that has few employees but significant rent, machinery and other overhead costs that are easily attributable to the SR&ED project. If you do proceed with the Traditional method, we highly recommend giving us a call at GrowWise, to review your SR&ED application and ensure your supporting documentation is adequate.
SR&ED: Arm’s Length Vs. Non-Arm’s Length Contractors
This pertains to the definition of the relationship between a company and the contractor that they hire to complete SR&ED-eligible work on their behalf. The CRA defines arm’s length as “a situation where two parties that deal with each other are not related to each other and no control exists between them.” This inherently implies that if there is control over one another or a relationship between the company and the contractor, that is a non-arm’s length contractor.
A situation we see often is that company A is applying to SR&ED and is paying company B to do testing on a specific aspect of their product, or other similar related work. If companies A and B have a mutual founder, or executive director who has control over the decisions the companies make, then the relationship between them is considered non-arm’s length. The CRA boils it down to a definition of control, if there is a common party that has control over both companies, then the relationship is non-arm’s length.
SR&ED is much less lucrative for non-arm’s length contractors. As defined in this CRA T661 Guide Document, non-arm’s length SR&ED expenditures are deductible but do not qualify for SR&ED investment tax credit (ITC) purposes. What this means in plain English is that the expense paid to a non-arm’s length contractor can be used to reduce your income for tax purposes, but you are not eligible to receive a cash refund through the SR&ED investment tax credit program for those expenses. If that is confusing, read the next section about the two different aspects of the SR&ED program.
SR&ED: Deduction Against Income vs. Investment Tax Credit
Within the SR&ED program, there are two completely different tax incentive programs. The first is claiming a deduction against your income, and the second is the Investment Tax Credit (ITC) in the form of a cash refund and/or a reduction in tax payable.
Firstly, the SR&ED program allows companies to reduce their taxable income by deducting eligible expenditures related to scientific research and experimental development. The eligibility for this aspect of the SR&ED program is slightly less strict than the investment tax credit aspect. For example, all non-arm’s length contractor expenses, arm’s length contractor expenses third-party payments are eligible to be used to reduce your taxable income, whereas they are not 100% eligible for the ITC.
This deduction can be applied in the current tax year, offering an immediate reduction in the taxable income of the company, which directly reduces the amount of tax payable for that year. Alternatively, if the company doesn’t need to apply the deduction right away, it can carry these expenditures forward to offset income in future years. This flexibility provides companies with the ability to manage their tax situation by choosing the most beneficial timing for applying their SR&ED deductions, depending on their current and future income levels.
In addition to the taxable income deductions, the SR&ED program offers an Investment Tax Credit (ITC) on qualified expenditures. The ITC can be claimed as either a reduction in the company’s tax payable or as a cash refund, depending on whether the company has income tax due or not. The amount eligible for the ITC is more strict than the deduction in taxable income, for example, it doesn’t refund for non-arm’s length contractors and doesn’t refund 100% of the other contractor expenses.
If the ITC cannot be fully utilized in the current tax year, it can be carried back three years to offset past tax liabilities or carried forward for up to 20 years to reduce taxes in future years. This credit provides valuable financial relief to companies investing in R&D by either providing immediate cash value or offering a long-term benefit through tax reductions in subsequent years.
SR&ED: Specified Employee vs Non-Specified
Specific rules apply to SR&ED-eligible wages, depending on the relationship between the employee and the company. The CRA defines a specified employee as “an employee who does not deal at arm’s length with the employer or who is a specified shareholder of the employer. A specified shareholder is a person who owns, directly or indirectly, at any time during the year, 10% or more of the issued shares of any class of the capital stock of the employer or of any corporation related to the employer. A specified employee could also be someone related to a specified shareholder; e.g. a sister, a brother, a spouse, etc.”. Non-specified includes all other employees.
For a specified employee, no more than 75% of their salary is eligible for SR&ED, even if they spend for example 85% of their time on SR&ED eligible tasks, the max is 75%. For non-specified employees, 100% of their time can be allocated to SR&ED and is included within the ITC salary expense.
We hope this clears up some of the SR&ED terminology confusion. If you have any questions about SR&ED or need help submitting a strong SR&ED claim, learn more about the GrowWise advantage here, or reach out to us today at contact@growwise.ai.
