Current R&D tax issues

By Denis Lajoie
Illustration: Gary Clement

Canada’s scientific research and experimental development program is in a state of continuous improvement with a number of recent evolutions

The Scientific Research and Experimental Development (SR&ED) program is a tax incentive program to encourage research and development in Canada. The federal government is granting tax credits of approximately $1.8 billion a year to about 11,000 claimants, 70% of which are small to mid-size businesses. Since the end of 2003, the program has been in a continuous improvement mode.

The Canada Revenue Agency (CRA) introduced some administrative policies and guides (including sector-specific guides) aimed at clarifying its position on specific technical issues, as well as providing guidance on filing and supporting information requirements. On the legislative front, two small changes have been introduced to fix unintended results from the law as it stood. The courts have heard few cases dealing with SR&ED issues during that time, although the Alcatel case [2005 TCC 149] will have a significant impact in certain situations. From a program administration perspective, CRA recently published a strategic business plan for the SR&ED program, outlining where it will focus over the next three years. The plan was developed by the joint CRA and Industry Partnership Committee. The priorities are effective delivery (including consistency in claim reviews and improving timely claim processing standards), increased awareness and small business accessibility.

Legislative changes
Associated corporations and the expenditure limit
Small Canadian-controlled private corporations (CCPC) can earn investment tax credits (ITC) at an enhanced rate of 35% instead of 20% on SR&ED expenditures up to the corporation’s expenditure limit. The expenditure limit of a CCPC is generally $2 million, subject to adjustments that take into account the prior year’s taxable income and taxable capital of the corporation as well as the corporations with which it is associated. The expenditure limit must also be shared among associated corporations. The March 22, 2004 budget amended the SR&ED ITC rules. Small CCPCs that have a group of common investors (a group the CRA is satisfied was not formed to gain access to multiple expenditure limits) will not have to share the expenditure limit solely because two or more investors collectively have a majority interest in the shares of each corporation. Since venture capital organizations have a tendency to co-invest, thus often forming a control group, certain companies that had never heard of one another ended up, under the old rules, being associated by virtue of being controlled by the same group of people. Quebec had introduced a similar change in late 2000. This change, which is still draft legislation, should help a number of venture capital funded high-tech startups.

Definition of “in Canada”
Anything related to taxation relies heavily on definitions. Until recently, SR&ED undertaken outside the 12-nautical mile territorial sea was not considered to be performed in Canada, therefore not eligible for the SR&ED incentives. The 2005 budget proposes to extend the SR&ED incentives to include expenditures incurred within Canada’s 200-nautical mile exclusive economic zone, including the airspace, seabed and subsoil in respect of that zone. This change should help such industries as fisheries and oil and gas that might carry on SR&ED on a vessel or an offshore platform.

Application policies and guidance documents
Application policies and guidance documents introduced since December 2003 include guidance on methods to allocate SR&ED labour expenditures, an application policy paper on prototypes, pilot plants/commercial plants, custom products and commercial assets (replacing the one published in 1997), as well as new application policy papers discussing filing requirements, and CRA’s position on the treatment of retiring allowances.

Labour expenditures
In July 2004, the CRA released the Allocation of Labour Expenditures for SR&ED Guidance Document. Its purpose is to guide claimants in using appropriate labour allocation methodologies in cases where formal tracking systems have not been implemented. The document recognizes that different methods can be used in different SR&ED environments. In all cases, however, there is a requirement for documentation of the labour effort and related financial information to support the claim. A newly introduced timeliness requirement may have a significant impact, in many cases, on the way future SR&ED claims are prepared.

Information can be summarized at different levels, for instance the corporate/ strategic concept (high level), project (me- dium level), and activity (low level). A combination of the above may be required to support the claim.

Information may also come from different sources, including: development plans, supervisors’ summaries, time sheets, and many types of information generated in the normal course of business, such as contracts, project specifications, resource allocation records, meeting minutes, notebooks and organizational charts. Again, information from more than one source may be required to support the amounts claimed. The presence of internal controls inherent in a given source of information would normally reduce the number of different sources to be provided.
We are pleased to see that information coming from the claimant’s existing information systems is recognized as being acceptable. This makes the implementation of an allocation method somewhat less onerous than to implement a separate, parallel SR&ED tracking system.

As mentioned, one element that may have a significant impact on the way future SR&ED claims are prepared is the re- quirement to have an allocation system that is timely (i.e. functional throughout the  year). Many claimants currently gather the information relative to their SR&ED claims well after the work subject to the claim has been performed. The guidance document clearly states that once CRA in- forms the claimant in writing that it must keep proper supporting information (and explains the types of information required), that a failure, following the date of the letter, to adequately support the SR&ED expenditures may cause such expenditures to be disallowed, and that CRA may also visit the claimant to confirm that proper documentation is being kept. As CRA is not in the business of information systems design, one hopes it will communicate its requirements to claimants in a specific and relevant manner (as opposed to form letters) and will provide the resources on a timely basis to help claimants comply.

Filing requirements
Keeping with the timeliness theme, the application policy paper on filing requirements clarifies what is required for a complete claim, as well as the consequences of not filing a complete claim near or at the 18-month deadline, being that all or a portion of the claim may be disallowed. In such cases, with the exception of invoking the fairness provisions, the ability to claim tax credits on all or part of the SR&ED expenditures for a given taxation year is forever lost.

CRA clarifies that claims filed using estimated amounts, partially completed or a letter expressing intent to file is not considered to meet the filing requirements. CRA will advise the claimant of any deficiencies in the claim and states it should be able to advise the claimant before the deadline if the claim has been filed more than 90 days before the reporting deadline. However, the CRA makes no guarantee it will be able to do so and also clarifies that the onus is on the claimant to file complete claims.

Of interest to tax return preparers using commercial software packages is that RSI 32, the RSI format of Form T661, may not contain all the prescribed information requested on Form T661. As a result, where a claimant files a RSI 32, it will also be required to file a printed copy of form T661 as well as all the supporting schedules and project descriptions, failing which it will not be considered to have met the filing requirements.

The two application policies discussed will likely result in forcing claimants who have not already done so to introduce processes to track their projects and to file their claims sooner than they would have otherwise. While this may feel more restrictive at the outset (and therefore contrary to the incentive nature of the program), it may result, in time, in claims that are reviewed and assessed sooner, thus providing a shorter time frame between the performance of the SR&ED and closure on the amount of the incentive.

Retiring allowances
Of interest to claimants who have, or expect to experience, significant employee departures is that retiring allowances may be eligible for the SR&ED incentives under specific (and narrow) conditions, namely:

• allowable only to taxpayers who do not elect to use the proxy method to calculate overhead;
• it is part of the written employment contract of the employee (negotiated before the employee began employment) and the employee becomes a member of the retiring allowance plan;
• it is paid to an employee performing hands-on SR&ED work at the time of retirement or the loss of an office or employment; and
• it meets the all, or substantially all, attributable or directly attributable test (i.e. directly related and incremental), required to claim an overhead or other expenditure when a claimant does not use the proxy method.

Regarding the requirement that the re-tirement allowance be part of a written employment contract, such payments are often paid pursuant to the common law, the civil code or other written legal obli-gations. One could argue that the absence of a written agreement entered into prior to commencing employment may not always invalidate the link between the retiring allowance and the SR&ED. A thorough discussion of all, or substantially all, attributable and direct relationship tests is beyond the scope of this article. Readers are cautioned to refer to the application policy paper, and/or get professional advice before claiming such amounts.

Prototypes, pilot plants/commercial plants, custom products and commercial assets
Application Policy SR&ED 2004-03, Prototypes, Pilot Plants/Commercial Plants, Custom Products and Commercial Assets, replaces a version published before the introduction of the recapture rules and is updated, among others, to take them into account. The recapture rules were introduced in 1998 to claw back ITCs or a portion thereof, claimed on property acquired that is later either sold or converted to commercial use.

It also reminds claimants that CRA has its own definition of prototype and each of the above terms. It outlines CRA’s policy relative to several possible situations involving prototypes (including mul- ti-company projects), as well as in situations where the building of a plant, specialized product (developed for sale), or asset (developed for internal use) involves the performance of SR&ED and non-SR&ED work. The opinion of the CRA research and technology adviser will play a key role in the treatment and quantum of SR&ED expenditures allowable in each situation.

Sector-specific guidance documents
Several sector-specific guidance documents, including pulp and paper, plastics, and chemical processes have also been published since December 2003.

While a discussion of each is beyond the scope of this article and may appear too specialized at the outset to those not directly involved in those specific industries, they remain a recommended reading to anyone involved in the SR&ED program as they (particularly the pulp and paper sector guidance document) contain principles that can be applied to other industries.

Jurisprudence
Stock options
The recent Tax Court of Canada decision in Alcatel Canada Inc. v. The Queen [2005 TCC 149], which has not been appealed, provides an opportunity for companies to increase their SR&ED tax credit claims to include a portion of their employees’ stock option benefits.

The court allowed Alcatel’s claim for ITCs on the value of stock option benefits provided to its employees. The opportunity for companies to earn ITCs on a noncash compensation vehicle may increase the attractiveness of granting stock options to employees performing SR&ED, although we understand that Finance is considering possible amendments to the act to exclude stock option benefits from the ITC base in the future. Until then, claimants should review their compensation programs, taking all variables into account, in light of this opportunity. And immediately, claimants should reflect stock option benefits in their current claims or those open for amendment. 

Summary
Recent evolution of the program mainly consisted of various clarifications in CRA’s interpretation of issues, filing and support requirements. The most significant clarifications are evident in the allocation of labour expenditures for SR&ED guidance document, and the pulp and paper sector guidance document. The program has been essentially in its present form for the past 20 years and has more or less entered a maturity phase. Compared with the turmoil of the latter half of the 1990s, it has become more stable and predictable, therefore much more effective as an incentive program.

This stability and predictability requires a fair amount of effort on the part of all the program’s stakeholders to maintain. We now see more occurrences of extended claim reviews and differences of opinion than were observed two years ago. Much of this is directly linked to the new clarifications and the natural learning pro- cess of the SR&ED community inside and outside of CRA.

The challenge ahead of CRA is to maintain the program’s stability and predictability, which includes the consistent application of those recent clarifications at the field level across the country while also maintaining the incentive nature of the program.