The Official Rules on Claiming SR&ED Using Contractors
Sep 11, 2018
When companies develop new software, it is not unusual to hire a subcontractor to perform some or all the work. This is particularly common in early-stage companies. Many entrepreneurs praise the merits of outsourcing development work, while others have sworn off it due to horrible experiences.
In both cases, SR&ED is often at the center of the work performed. Knowing that generally dollars spent on R&D expenditures can only be claimed under the SR&ED tax incentive programs by one entity, subcontractors or dev shops being hired to work at arm’s length need to know when they have the right to claim SR&ED. Similarly, companies hiring subcontractors need to know their rights with regards to their SR&ED claim.
A Quick Primer on SR&ED Rates in Canada
The SR&ED tax incentive program works well because it has attracted many large foreign companies – Facebook, Google, and Thales, for example – to set up research teams in Canada. A common misconception about the SR&ED program is that if a corporation is pre-revenue, it is not eligible or able to benefit from the program. This could not be further from the truth. Start-ups can receive a significant cash refund on eligible R&D expenditures (also called a refundable tax credit) regardless of whether they pay taxes or not. In fact, the refundable (or the cash refund on eligible expenditures) portion of the tax credit is significantly more advantageous for small Canadian businesses.
Eligible costs include salaries, subcontractor fees, and materials consumed or transformed. Here is a simplified breakdown of tax credit rates associated to each cost depending on whether the corporation is Canadian Controlled Private Corporation (CCPC) or foreign controlled – these figures represent the combined rates (federal and provincial) in the province of Quebec.
Examples are for the province of Quebec and do not consider the provincial exclusion amounts.
*Federal taxable income <$500K* and prior year's capital <$25M* and expenditures <$3M and total assets <$50M*.
Right away, we see a first opportunity based on the rates associated to salaries versus those associated to subcontractor fees. Corporations are always encouraged to hire employees over subcontractors from this perspective.
Defining an Eligible Subcontractor When Claiming SR&ED
Simply put, an eligible subcontractor is a Canadian company or individual that performs eligible SR&ED work in Canada on behalf of the corporation claiming the credit. We are assuming third-party subcontractors in this article, as related-party subcontractors are claimed differently.
Also service fees paid to accredited research institutions like universities, colleges, research centers, and consortiums can still qualify as subcontractor fees, but are also treated differently (see third-party payments for more context). Be sure to distinguish these expenditures from other subcontractor payments when filing for the SR&ED tax credit.
Who Gets to Claim the SR&ED Tax Credit?
For the corporation to be able to claim the SR&ED tax credit, the work performed by its subcontractor must be undertaken on behalf of the corporation.
The terms of the contract between both parties is a key resource that will ultimately dictate the ownership of the tax credit. Given that the agreement between two parties will determine the outcome of a SR&ED claim, it is important to address four pillars before work starts.
All four pillars are considered when determining whether the work was carried out by the subcontractor on behalf of the corporation. In other words, should one pillar not be in the corporation’s favor, that does not necessarily mean that the corporation can no longer claim the subcontractor payment under the SR&ED tax credit.
Scope of work
For the corporation to claim the subcontractor work in an SR&ED tax credit claim, it is preferable that the contract between both parties clearly state that the corporation will control the work, lead the project, and include the subcontractor as a member of its team tasked with certain deliverables.
Ownership of the subsequent intellectual property
Likewise, it is preferable that the corporation own the related intellectual property to show that the work is carried out on behalf of the corporation. If working with the federal government or universities, there are specific litmus tests that come into effect, so be sure to speak with an expert when in this situation.
Risks assumed
It is also preferable to show that the corporation assumed the project risks, if it is to claim the SR&ED tax credit. This would be likely demonstrated in pricing, guarantees, and other negotiated terms.
Service agreement rather than a sale of goods
Finally, it is preferable for the corporation to purchase services rather than a specific product to improve the opportunity of claiming related SR&ED subcontractor expenditures.
Location, Location, Location
Given that the SR&ED tax incentive seeks to encourage Canadian innovation, eligible subcontractors must be in Canada as well and follow certain rules.
Corporations must ensure that the subcontractor is based in Canada otherwise SR&ED expenditures are effectively rendered ineligible. Also, if the corporation does not have a permanent establishment in the province where the subcontractor is located, it would only be allowed to claim the federal portion of the SR&ED tax credit and would thus forego the provincial counterpart.
Finally, second level subcontractors, those hired by the first level subcontractor to perform specific tasks, are not allowed in the province of Quebec.
It is also interesting to note that there are also opportunities in certain cases for Canadian subcontractors to claim SR&ED tax credits when working with entities outside of Canada.
How R&D Partners Can Help
Thinking of using subcontractors for your next project? Already spent money on subcontractors and want to recover those costs? Please do not hesitate to contact Mike Lee, President of R&D Partners at 1-800-500-7733, x110 for more information.