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Wings to Fly
A generous tax incentive program provides a boost for businesses.
FROM: MAY-JUN 2008 ISSUE | BY BILL PITRE, PHILIP RAFUSE, and CRAIG MULCAHY
Complex in detail, daunting to deliver, and the occasional target of legal challenges, Canada’s Scientific Research and Experimental Development (SR&ED) program is nonetheless one of the most generous research and development tax incentive programs in the world.
The SR&ED program encourages businesses of all sizes and in all sectors to conduct R&D that will lead to new, improved, technologically advanced products or processes. While the Department of Finance is responsible for developing SR&ED tax policy, the program is administered through the Canada Revenue Agency.
Eleven thousand claimants are issued more than two billion dollars in investment tax credits annually through the SR&ED program. Among them are savvy executives and entrepreneurs who realize that “scientific research” does not necessarily mean white lab coats and bubbling test tubes, and that the CRA definition of “experimental development” is generous.
Claim Complexities
There are numerous businesses that could claim SR&ED tax credits, but do not because they believe that their projects do not qualify for incentives, or the claims process is too complex. Such businesses may be missing out on money.
Both individuals and corporations can apply for SR&ED credits. For the cost of the legal setup of a corporation, earned credits can be raised by 15 per cent and credit status moved from non-refundable to refundable. Individuals earn at a rate of 20 per cent that is not fully refundable. Comparatively, for a Canadian-controlled private corporation (CCPC) that earns below the business limit for the year in question, the entitlements are 35 per cent and refundable. Non-CCPCs also earn credits at a 20 per cent rate and are non-refundable, but the credits can be used to reduce both current and future taxes. There are also yearly spending limits in place to reduce the rate on earned credits when SR&ED qualified expenditures are over $3,000,000 in any year after 2007. Previous to 2008 the limit was $2,000,000.
All provinces, with the exception of Prince Edward Island and Alberta, offer provincial credits that piggyback the federal program. Though the provincial rates and availability of refunds may differ between provinces, the programs are similar and usually require little more than ticking a box on the federal form.
The program does not require pre-approval and claimants have 18 months from their fiscal year end to identify all expenditures and make the claim. The 18-month limit is not negotiable; even if the CRA does not begin an audit until after the 18-month period, no additional expenditures can be identified at that time.
For a claimant with a year end of December 31, 2007, all expenditures made for SR&ED from January 1, 2007, until December 31, 2007, must be identified and claimed on form T661 by June 30, 2009. No exceptions apply and there are no relieving provisions in the Act. The CRA auditor can always reduce your claim past the 18-month limit, but there is no mechanism to upwardly adjust the claim should you have missed any expenditure.
A claim filed on time with the initial filing of a return has the fastest track to earning credits. The CRA has a three-tiered system for processing claims and thus, three service levels for claims. For refundable claims that are filed with the initial T2, the time is 120 days from complete claim receipt. If the same CCPC waits and files an amended claim, the CRA’s mandated time jumps to 240 days. For non-refundable claims, the CRA has 365 days to approve the credit, which does not change whether an initial or amended claim.
The best way to ensure you are able to claim your complete entitlement is to be proactive and file the SR&ED forms as part of the yearly tax return. The basis for a claim is the filing of form T661 along with Schedule T2SCH31 corporations or form T2038 for individuals. An SR&ED filing must always be accompanied by an original or amended tax return.
Service Standards
While the SR&ED program has received much praise for its contribution to Canadian competitiveness, it has also faced significant criticism, primarily for the backlog of unresolved claims. A number of recommendations have been issued over the years, most notably by the auditor general and the Standing Committee on Public Accounts (chaired by John Williams, FCGA, and Member of Parliament for Edmonton-St. Albert) that have resulted in service standard improvements.
For example, the entire program was removed from the audit directorate of the CRA and became its own directorate. Program employees received greater independence as a result, and became more responsible for the direction of the program. The directorate established sector-specific expertise, a new communications package, and an informal process for resolving disputes.
Part of the communications package was an ongoing survey developed to provide claimants’ feedback on SR&ED service standards. The latest survey (2005) suggested that most respondents were satisfied with the program, the staff, and the results of their review. But many claimants were less than satisfied with the time it took to complete the review and with the usefulness of the CRA’s SR&ED publications. The final criticism was that only 40 per cent of respondents found the primary claim form (T661) easy to understand; 46 per cent stated it was easy to complete.
This is significant, as the purpose of the program is to promote research and development through financial assistance, yet claimants reported difficulties in completing claims. As mentioned, the CRA has a timed service standard, but the clock only starts ticking after a complete claim is received – meaning a claim with form T661, which includes financial data and project descriptions.
Legal Challenges
The dispute process, although improved, cannot resolve every situation. Take the case of Alcatel Canada, which dates back to 1994 and was not resolved until 2005.
In calculating its 1994 SR&ED expenditures, Newbridge Networks (the predecessor of Alcatel Canada) included the value of stock option benefits derived by employees directly engaged in SR&ED. The value used for calculating the expenditure was the benefit included in the employee’s income per the Income Tax Act, which was calculated as the difference in market value of the shares on the day the option was exercised and the exercise price. The CRA denied the inclusion, stating “in allowing its employees to buy shares for less than market value as contemplated by the option program, [Newbridge] conferred a benefit on them without making any outlay and therefore did so without making any expenditure.”
An appeal was granted to Alcatel (which acquired Newbridge in 2000) because the Tax Court noted that the stock option benefits in question fell within the meaning of salary or wages as defined in section 248 of the Act. Indeed, it’s hard to see how salary or wages can flow from employer to employee without an expenditure by the employer.
In February 2005, the Tax Court of Canada held that employee stock option benefits, although not deductible for Canadian income tax purposes, were expenditures of the employer that qualified for tax credits under the Act. The CRA did not appeal, and in November 2005, Finance released a Notice of Ways and Means Motion to amend the Act. The purpose was to clarify a limiting of stock options issued or exercised on or after November 17, 2005. Options exercised before that date are eligible.
One of the reasons the Tax Court allowed Alcatel’s appeal was that the Act must be applied in such a way as to ensure that the SR&ED program remains an incentive program. Given the daunting complexities of administering the program, it is not surprising that administrative and legal challenges occasionally arise. These challenges obscure the mandate of the program, which is to keep Canadian businesses competitive in the global marketplace. Nevertheless, the SR&ED program is one of the most generous funding programs in the world and the opportunity to tap those funds is one no business should ignore.
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