The Scientific Research & Experimental Development or SR&ED Tax Incentive program is a popular federal tax incentive program of the Canada Revenue Agency (CRA), which is used to encourage businesses in Canada, of all sizes and in every sector, to invest more in research & development (R&D). This incentive is the single largest source of federal government support for industrial R&D in Canada. The R&D Tax Incentive program works by giving eligible businesses cash refund and/or tax credits on the expenses incurred by them on research and development carried out in Canada.
Calculation Methods for Claiming R&D Tax Incentives
To participate in the SR&ED tax incentive program, companies have to calculate their eligible expenditures. The Income Tax Act (ITA) allows two methods to calculate the SR&ED expenditures for companies: the Traditional method and the Proxy method.
The eligible expenditures depend a lot on which of the two methods they choose for a particular tax year, and they are not allowed to change the method in the middle of the tax year. We discuss both the Traditional and Proxy methods here, and mention the advantages and disadvantages of each.
Companies that use this method must transparently identify all the overhead costs that are eligible to be deducted as SR&ED expenditures. These costs must be in a direct relationship with the claiming projects, and are incremental to it. The traditional method can get very complicated at times, which requires the use of an expensive record keeping system – something which only the biggest corporations can afford to have. Companies use this method when they have higher contractors, overheads and prototype costs, and lower employee salaries.
The advantages of the Traditional Method are that both the overhead and the expenditures can be added to the pool of the deductible SR&ED expenditures. Investment Tax Credit (ITC) can be earned on both overhead and other expenditures, which is another advantage. Plus, companies are exempted from calculating the salary base and overhead caps under this method.
The big disadvantage of the traditional method is the difficulty involved in explaining the relationship between the overhead and other expenditures with that of the SR&ED expenditures.
The proxy method is much simpler than the traditional method when it comes to the application process for the R&D Tax Incentive. The calculation of the SR&ED tax credits is also a lot easier. In this method, the companies may include a percentage of the salaries of employees who are involved in the SR&ED activities as PPA or Prescribed Proxy Amount for the overhead costs. For 2016, the PPA was as much as 55%. PPA is approximation of overhead and other expenditures and is deducted as a regular business expense under the ITC, not as SR&ED expenditures.
The proxy method is preferable to the traditional method as it is less complicated – you don’t have to track the overhead and other expenditures of the SR&ED. The ITC for this method depends on PPA, which is simple enough to calculate if the salary base is known. In most cases, the proxy method yields much higher tax credits.
The biggest disadvantage of using the proxy method is that the PPA and the expenditures included under the PPA cannot be included in the pool of SR&ED expenditures. Calculating the salary base may involve some work. It is also possible in many cases that the PPA may be lesser than the overhead and other expenditures, which considerably reduces the R&D Tax incentive received.
It makes a lot of sense for companies make their calculations using both the traditional as well as the proxy methods, so that it gives them a better idea of which method to choose to get higher SR&ED expenditures for the current tax year.