Where tax and science meet — part 3*
Tax aspects of the federal SR&ED program
*This is an expanded version of a summary that appeared in the December 2003 print edition of CAmagazine.
By William Stark
As noted in the previous two issues, the Scientific Research and Experimental Development program is Canada's largest tax incentive program. Yet it is also one of the most underused. Apart from the fact that the SR&ED activity must be approved from a scientific perspective, the tax legislation surrounding the program is complex. Many CAs, who are generally the first contact regarding tax matters, lack the experience in this area because it is one they do not often encounter. As a result, they often fail to identify all the tax issues surrounding an SR&ED submission. Although this article does not cover all the possible areas of the program, it will outline some of the major tax issues of the SR&ED program.
Nature of the program
The SR&ED program is different than regular tax, where we self assess the taxes owed and bear the consequences for our errors. The SR&ED is an incentive program designed to entice Canadian companies to engage in research and development. As such, it is different in that:
· There are no penalties attached to the program.
· CCRA reviews all claims and assesses them for eligibility before acceptance.
· Once accepted, CCRA will not reaudit the SR&ED claim, even if a subsequent corporate audit is performed, unless the following occur:
- fraud or gross negligence;
- unpaid amounts that can be claimed when paid;
- change in the ITC rate due to adjustments to the expenditure limit.
Fairness
The SR&ED program is also subject to Fairness Requests. These are generally heard by a special Committee comprised of SR&ED staff familiar with the program.
Non-Canadian activities
The SR&ED program is very specific in its focus – to encourage research and development in Canada as defined in Section 255 of the Income Tax Act (ITA). Expenditures for activities incurred outside Canada are still deductible under subsection 37(2) of the ITA, but are not eligible for the ITC under 37(1) of the ITA. This includes expenditures, even if they are incidental to the overall SR&ED activity, such as testing in an area outside of Canada (LGL Limited vs. MNR). It is also important to note that activities that are contracted to Canadian companies, and then recontracted to companies outside of Canada, are still not eligible under subsection 37(1) for the ITC.
Exceptions are made for expenditures related to:
· purchase of equipment or materials;
· travel to visit a customer to update him on the progress of the SR&ED being performed on his behalf;
· specific technical training outside of Canada.
The restriction in subsection 37(1) of the ITA relates to expenditures for the actual activities, but does not apply to materials, supplies and capital that are used in the SR&ED activities, as long as those activities are qualified (i.e. performed in Canada). Therefore, materials, supplies and capital do not have to be purchased in Canada.
Capital
Capital equipment on SR&ED is defined in paragraphs 28 to 31 of IT-151R5 as expenditures that result in the acquisition of depreciable property. This is similar to the general capital cost allowance rules. To be eligible for SR&ED, the capital must meet the ASA (all or substantially all) test. This test is based on intent as opposed to actual use, as follows:
· The asset would be used 90% or more of its operating time in its expected useful life for the prosecution of SR&ED in Canada, or
· 90% or more of its value would be consumed in the prosecution of SR&ED in Canada.
The intent rule is very important with respect to experimental development claims, where the ultimate intent is to make a commercially viable product. Many companies mistakenly assume the capital is not allowed because the end focus is a commercially viable product, when in reality, the focus is on engaging in an SR&ED activity first to see if a product can actually be made. If the working "prototype" is subsequently put into production, recapture of some of the ITC may occur, but generally it is still favourable to initially claim the ITC and deal with the recapture if this becomes an issue.
Subcontractors
Subcontractor expenditures generally result when the payer (the claimant) requested that the performer (the contractor) perform SR&ED on behalf of the payer under the terms of the contract. There are two major issues regarding subcontractor expenditures.
The first is the ability to claim. Generally the payer can claim the expenditures, except in the following two circumstances:
1. The payer is a nontaxable entity in Canada (e.g., a nonresident corporation or a Canadian government agency). In these instances, the payer is not eligible to claim the SR&ED activity. Therefore, by default, CCRA will allow the contractor to make the claim.
2. The payer does not own the rights to the intellectual property. This is quite often the case in IT claims, where the contractor owns the rights. In these cases, the subcontractor actually has the right to make the claim.
The second issue is related-party contractors. The use of a related company to perform SR&ED gives rise to a number of issues, as follows:
1. Election form T1146 must be filed by the related party to transfer the eligible expenses into the claimant company. If the related party fails to file the election within 18 months of their year end, CCRA will not accept the election as late filed and will then disallow the subcontractor expenses to the claimant. Therefore, it is extremely important to be aware of all related-party transactions, especially when the claimant and related party are approaching the 18-month filing deadline.
2. Management fees paid to an owner/manager's holding company in lieu of T4 wages. Generally, these amounts will be disallowed as subcontractor expenses because related-party amounts transferred through the T1146 must be based on actual costs incurred by the related party. In the case of management fees paid to the holding company, no costs will be incurred.
Overall, the SR&ED continues to be one of the best tax incentive programs in Canada, and with the improvements that are continually being made, it has become one of the best of its kind in the world.
This is the final instalment in a three-part series on the SR&ED. For more on current tax issues in SR&ED, see Current issues in R&R taxation." For more details on the program, visit www.ccra.gc.ca/sred.
William Stark, CA (bill@resdev.ca) is the president of ResDev Tax Consultants Inc. in Toronto. | 
