FAQs

Why Do Governments Offer Tax Credits?

Governments in many countries have noted that those companies which spend the most on technical product and process development are the ones that employ more people during the good economic times, and manage to stay in business with the fewest job losses during bad times.

 

As a result, governments in most western countries arrange ways to reward companies that engage in technical development. This is often done via the tax code, so that companies pay less tax if they undertake Research and Development (R&D).

 

This has two benefits:

  • First, companies are somewhat more likely to engage in R&D if they know there will be at least partial financial support.

  • Second, those companies that do engage in R&D find it easier to exploit the results of their efforts if they have more cash — saved from the taxes they did not have to pay — to spend on the necessary marketing, production preparations and related components of a commercialization effort.

    •

    The government therefore can be seen to be betting on the winners - those companies that engage in technical product and process development – and helping them to win again by an even greater margin.

     

    What Exactly Does The Government Mean By "SR&ED?"

    Over the past twenty years, we have come to the realization that many engineers tend to regard "R&D" as an activity associated solely with computer chips or pharmaceuticals. They tend to regard their own efforts to make new, lighter, stronger, cheaper products, or more precise, more economical and more versatile processes as "just doing my job." They often shrink from labelling their efforts "R&D."

     

    While this modesty is commendable, it runs counter to the government's efforts to reward technically aggressive companies. In looking at R&D Tax Credits, therefore, we should put aside conventional ideas of R&D, and consider only the government's definition. This definition is explained in detail on the pages which follow.

     

    There are four main criteria:


    1.  A technological advance must be targeted.

    The company must be trying to achieve a new technical improvement or a cost reduction by new technical means, which is related to the business of the company. It should not be possible to find exactly how to do this from information presently in the public domain, as from textbooks or technical journals. However, work to "catch up" with competitors' superior technology is eligible, if the competitors have kept their methodology secret or proprietary, and if the company’s starting position is not at the elementary stage.

    2.  There must be technological uncertainty.

    Uncertainty must exist — or be unhappily discovered half way through! — concerning the best technical path to achieve the desired objective. This requirement excludes "routine engineering" from eligible activity. Routine engineering is work where the outcome is known in advance, if a series of known steps is faithfully followed. However, "routine engineering” in support of a qualified technical advance is eligible.

    3.  A systematic approach must be used.

    Work to solve the technical uncertainties should proceed in a systematic, step-by-step approach. This criterion is usually met automatically by any competent technical group. It is aimed against trial-and-error, hit-or-miss procedures. Rather, it aims to support an initial consideration of options and a careful choice of the best course of action.

    4.  There must be some documentation.

    This documentation must relate in a meaningful way to the course of the experimental development work performed. This requirement for technical documentation can be filled in a variety of ways, including (but not limited to) notes, test results, CAD or paper drawings, and so on. We give a detailed list in the last two pages of this review.

    There must also be meaningful documentation relating to the costs incurred, beginning with T4 information on salaries. Also helpful — but not essential — are time cards that may identify hours, days, weeks or months spent solving problems.

     

    Additional useful documentation includes invoices for parts and for contract payments. Again we give a more complete list in the last two pages of this review.

     

    Our experience is that the Canada Revenue Agency will often accept reasonable estimates of R&D time spent by development team members for the first claim or two, but will expect to see more formal systems to track R&D costs as time goes on. We can help you identify and evaluate the documentation you already have, and can also prepare clarifying documents as required.

     

    Types of R&D supported by the SR&ED Program

    We regularly see three types of R&D situations supported by the R&D tax credit program. We can classify them as follows:

    •  

    • A. Classic R&D, resulting from a deliberate decision to develop a new or improved product or process.

    • B. Contingent R&D, planned to be contingent on receiving an order, where the company has deliberately made a bid knowing that their existing technology is insufficient to fill the order without some development effort.

    • C. Unplanned R&D, arising from the sudden discovery, part way through filling an order, that existing technology is inadequate and must be advanced by an emergency development effort if the order is to be filled.

     

    Of the thousands of projects that we have identified and successfully defended for our clients, we would say that types B and C together constitute 80% of the total.

     

    What Expenses Are Eligible?

    In Canada, there are several cost items that the government considers to be eligible. Among these we find:

  • salaries or wages of technical staff who directly work on or supervise the development projects;

  • materials, jigs, fixtures, test beds, tooling, etc., used up and/or discarded during the development project;

  • scrap created during experiments and test runs;

  • contract payments for work done by others in support of your development efforts.

    • The Canadian government also allows a minimum 65% overhead charge on top of qualifying wages and salaries for the people directly involved in doing the development work. This overhead charge is intended to cover all indirect labour; therefore, hourly paid support staff should not normally be claimed as direct labour costs unless, being specially skillful, they play a significant role in the project.

     

    In addition to all of the eligible current costs previously indicated, CRA will allow you to claim equipment capital costs provided the equipment is used at least 50% of the time for R&D activities. If the equipment is used at least 90% of the time to support R&D, you can claim 100% of the cost of the equipment. If it is used between 50% and 90% of the time for R&D, you can claim 50% of the equipment cost. Such claims must be spread over three years.

     

    The actual tax credit is then a percentage of your total eligible costs. Please see the next section for a detailed example of the financial calculations.

     

    What Percentage Of Eligible Costs Will The Government Pay?

    The Canadian Government provides a tax credit — i.e., a reduction in taxes owed — of either 20% or 35% of the total eligible costs, depending on the profitability and ownership of your company. If the company is not profitable in one year, and therefore owes no tax for that year, it can carry the credit forward for several years, until it does owe taxes. If the company is "small” and Canadian controlled, the Canada Revenue Agency will issue a check, even if no taxes are owed.

     

    Here is an example of how the costing calculations may be presented:

     

    Salaries & Wages Hours Rate/Hr. Dollars
    Employee #1 1000 $20.00 $20,000
    Employee #2 200 40.00 8,000
    Employee #3 500 20.00 10,000
    Employee #4 100 60.00 6,000
    Employee #5 400 40.00 16,000
    Employee #6 200 50.00 10,000
    Total Salaries $ Wages     70,000
    Overhead @ 65%     45,500
    Contract Payments: ABC Company 15,000  
      DEF Company 10,000 25,000
    Materials:     59,500
    Total Salaries, O/H, Contract Payments, & Materials: $200,000
    Applicable Credit @ 20% $40,000
    or: Applicable Credit @ 35% $70,000

     

    Please note: The financial benefit is bottom line before-tax dollar savings. To obtain this same profit from product sales, you may have to sell more than 10X this amount of product, depending on your profit margins.

     

    Also Note: This represents federal government support only. Several provinces also provide additional support.

     

    What Kind Of Technical Support Records Are Required?

    A. The report that the consultants can best prepare for you:

     

    The most important element of any claim is the project report, since it must be filed with your claim. Unlike the technical reports that you will normally write for internal or customer use, this report does not have to contain all technical information known to you concerning the project. Nor does it have to be written in such detail that someone could reproduce your work from the report.

     

    This report, by contrast, has only one objective: To demonstrate to the Canada Revenue Agency that the project work was R&D within the meaning of the Income Tax Act as set out in Regulation 2900.

     

    The report must therefore highlight:

  • the difficulties posed by the technical targets;
  • the uncertainties facing the development staff;
  • the unexpected difficulties encountered during the course of the development work;
  • the experiments performed in an effort to resolve the uncertainties.

    • In particular, the report should discuss some of the dead-ends down which the technical staff may have gone, as taking the wrong path is a perfect demonstration of technical uncertainty.

     

    The report must be written for three audiences:

     

    • 1. Your company: The report must be technically competent.

    • 2. Government technical auditors: The report should invoke government definitions of R&D wherever possible, without being inaccurate or overly heavy-handed.

    • 3. Government financial auditors: The report must be written in plain language. This is because the first government individual to read the report may be an accountant. Your cause is advanced if this person enjoys reading the text, even if they don’t understand the technical specifics of the project.

    In view of these demands, The Empyrean Group goes through a multi-step process in preparing each report, from obtaining the technical "story" during a conversation with a member of your technical staff, through successive drafts of a text, to mock "audits" of the text carried out by senior Empyrean Group staff members, to a final read and critique by a non-technical staff person. The report is then submitted to you for your review and approval.

    All the reports for a given year are then submitted by your company as addenda to form T661.

     

    B. The records that you must collect yourself:

     

    The formal project reports need to have some back-up. This can be in one or more of the following forms:

  • dated notes of experimental or test results taken during the project;
  • dated drawings at various stages of the project's progress;
  • dated photos of test parts at one or more stages of the project;
  • dated minutes or notes taken at meetings concerning the project;
  • dated letters, memos or e-mails between your staff, between your plants, or between your company and its customers' engineers, referring to problems;
  • actual physical test parts fabricated during the project;
  • any other dated material that refers to events, designs, results, difficulties, etc., during the project.

    • These records should be held at your company against the eventual day of review by CRA officials.

     

    What Kind Of Financial Records Are Required?

    In Canada, each project report must be accompanied by a project cost summary. These project cost summaries must also have some back-up. The extent of the back-up can vary depending on whether or not you are a first time claimant. In our experience, governments will initially accept estimates of R&D labour involved in a project. As time passes, however, the government expects you to become more structured with your cost tracking method and would expect to see some form of labour reporting system that captures hours by project.

     

    Some examples of useful back-up documentation are as follows:

  • T4 earnings documentation for each employee who was involved in the project;
  • work sheets showing how the estimated or recorded percentages of each person’s time spent in R&D have been used to calculate R&D labour costs;
  • copies of any invoices that show the cost of contract payments or companies you may have hired to help with the project;
  • copies of any invoices that indicate materials ordered and consumed during the project;
  • scrap records showing parts, jigs, fixtures or tooling discarded during the development project.

    • In the end, you should develop an easy-to-use system whereby costs that are incurred in trying to solve a technical problem are recorded in an identifiable sub-account. We will work with your financial staff, if requested, to help set up such a cost tracking system.