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By David Horler & Winnifred Brown
Illustration: John Sapsford
SR&ED is Canada's largest tax incentive program and over the years a number of improvements have been introduced to it
Recent developments in the Scientific Research and Experimental Development (SR&ED) tax incentives call for an examination of them at three levels: the correlation between the design of the SR&ED incentive program and its policy objectives; legislative changes announced within the last year; and an update on the Canada Customs and Revenue Agency's (CCRA) administrative policies and practices. The discussion is limited to federal SR&ED issues, although there are continuing developments in provincial incentives.
Are SR&ED tax credits an incentive?
The policy objectives of the SR&ED tax incentive program are to encourage SR&ED in the private sector by offering broad assistance in financing, and to provide incentives that are of immediate benefit.
As designed, it is doubtful the program is fully meeting these objectives. A claimant that is not a Canadian controlled private corporation (CCPC) is eligible for a nonrefundable federal investment tax credit (ITC) against income tax at the rate of 20% of qualified expenditures. Most large SR&ED performers are not CCPCs. In view of the prolonged economic downturn, particularly in the technology sector, many SR&ED performers have accumulated substantial loss carry-forwards and are questioning the value of making annual SR&ED claims. For these corporations, which typically operate internationally, SR&ED tax credits are no longer a significant factor in decisions on where to locate R & D. Moreover, such decisions are often taken in times of financial pressure. This reality appears to go against the policy objectives of the program. Fortunately however, some provincial tax credits are refundable.
Given the design of the SR&ED program as noted, combined with the recent state of the economy and the limited availability of financing through public and private capital markets, a predictable consequence would be a shift in program utilization towards CCPCs, for which SR&ED tax credits are still an incentive. This is at the same time that CCRA has been working hard to reach out to small business as part of its partnership with industry. And there seems to be a shift toward a higher proportion of CCPCs claims. To date, the federal Department of Finance has not been responsive to industry's overtures to broaden the scope of ITC refundability.
Finance has published projections of the tax expenditure arising from the SR&ED investment tax credit, as shown in the table on page 51. It is notable that the expenditures and use of ITC drop significantly in 2001, and only enter into a slow growth after that. The slow growth is consistent with the situation described above whereby corporations are unable to utilize their annual ITC and may ultimately lose it through expiry after the 10-year carry-forward period.
The data in the table do not give a full accounting of the potential cost of the SR&ED program because they do not indicate the size of the ITC pool or of the undeducted SR&ED expenditure pool on a national basis.
Legislative changes
On December 20, 2002, the Minister of Finance released draft legislation containing proposed changes to the SR&ED provisions, notably in the areas of qualifying materials and the recapture rules. Furthermore, the 2003 federal budget provided increases to the taxable income and taxable capital limits for CCPCs.
The effect of the amendment regarding materials is that there is now no difference between the traditional and proxy claim methods. Previously, the determination of allowable materials under the proxy method was more restrictive. This change is retroactive to February 22, 1998. Practically, this change removes complications from claims and claim reviews, but will not make a substantial impact in most cases. However, there are some instances where materials "transformed" into a property are subsequently sold or converted to commercial use for proceeds or at a fair market value that is less than the cost of the materials transformed, and only part of the ITC earned on the materials transformed would be recaptured. This situation would render the change beneficial to the claimant.
Changes have been made to the rules for the recapture of ITCs under subsection 127(27). These rules apply when property upon which ITCs have been earned is disposed of or converted to commercial use. Shared use equipment is now treated more favourably. It is proposed that, effective December 21, 2002, recapture on shared-use equipment will apply on only 25% of the proceeds of disposition (or fair market value, depending on the circumstances) for dispositions of first term shared-use equipment, and on 50% for second term shared-use equipment. Previous to this amendment, recapture was based on the lesser of the ITCs earned on the shared-use equipment and the ITC percentage applied to the entire proceeds of disposition (or fair market value) of the shared-use equipment that was disposed of.
Furthermore, the recapture rules apply regardless of the 180-day-unpaid-amount rule in subsection 127(26) of the act. This is likely to prevent situations where the taxpayer would have paid for expenditures in a taxation year subsequent to the year in which the disposition or conversion to commercial use took place, thereby escaping recapture.
Changes to prescribed information
On April 8, 2003, the CCRA issued a revised version of Form T661, which is used to claim SR&ED in Canada. The use of the new form has been mandatory for all claims filed after June 30. The main impact of the changes is that all information on the form, including the statistical information in Part 4, is now prescribed and is thus required for a complete claim; and the required format of the technical project descriptions has changed.
The prescribed information requirement interacts with the 18-month rule, under which, in respect of an SR&ED expenditure, a taxpayer must file a prescribed form containing prescribed information, on or before a day that is 12 months after the taxpayer's filing due date for the corporate return (subsection 37(11) of the act). It is therefore important that any claims filed at or near the 18-month deadline be complete according to Form T661 information requirements, as the CCRA might not advise the taxpayer of deficiencies in sufficient time to refile a revised SR&ED claim. The tax credits could then be irrevocably lost.
The changes to the Detailed Project description (Part 2, Step 1) primarily concern two of the five questions. Question B (technology or knowledge base level) has a new focus that is intended to define the benchmark of the technology or knowledge at the outset of the SR&ED project, against which to compare the technological advance sought. This concept was previously included in the question on technological advancement but was not being well-addressed by claimants. The CCRA's interpretation of the technology or knowledge base level includes all technological resources within the company as well as all knowledge available in the public domain.
Question C (scientific or technological advancement) is similar to that of the previous form but is now intended to address both scientific or technological advancement and scientific or technological uncertainty. The uncertainty criterion is not mentioned on the form but is the focus of the questions on problems or challenges to overcome to achieve the objectives and is considered by the CCRA to be the key to determining the extent of the SR&ED project. The three eligibility criteria for SR&ED projects remain as defined in information circular 86-4R3. As CCRA has stated in its guide Recognizing Experimental Development, there is a close relationship between technological advancement and technological uncertainty.
New CCRA application policies and guides
The CCRA has published several application policies and guides on its website recently. A number were in the pipeline at press time and will be posted on the CCRA website when approved. Because of the wide range of issues covered, we are not attempting a review here.
Conclusion
As a closing observation, the present SR&ED management team at the CCRA appears to be placing an increased emphasis on compliance. Examples mentioned above are the strict enforcement of the 18-month rule and the administrative decision that all information on Form T661 is prescribed. To avoid being tripped up by such rules, claimants should not regard SR&ED as an exercise to be dealt with after the year end. Rather, it is prudent for SR&ED claimants to ensure that they have a proactive SR&ED claims management process in place and to file well in advance of the deadline.
Finally, we need to distinguish between a tightening with respect to administrative compliance and a tightening with respect to interpretations of the eligibility of work. At the present time, the authors do not believe the CCRA is tightening technical eligibility; however, the CCRA is being more particular in collecting the facts and ensure their files are properly documented to demonstrate fiscal responsibility.
Winnifred Brown, PEng., is leader of Ernst & Young's national SR&ED practice and is a member of the CCRA SR&ED Partnership Committee. David Horler, PhD, is director, Technology Evaluation in Ernst & Young's national SR&ED team. Other members of the national SR&ED team also contributed to ideas expressed in this article.
Technical editor: Michel Lanteigne, FCA, Managing Partner Tax for Canada Ernst & Young LLP | 
