Denied: Do you need time tracking for SR&ED?

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The Canada Revenue Agency (CRA) may instigate an audit related to a particular SR&ED claim for any number of reasons, and when they do, they will request supporting evidence to ensure a claim is legitimate. One of the primary focuses of an audit is salary and wage expenditures in relation to projects that prove the amounts being claimed are indeed for eligible SR&ED activities. Technical eligibility isn’t the sole determining factor here, and there is an immediate risk of the claim being denied if a claimant’s financial records are deemed inadequate by the CRA.

The CRA often makes two document maintenance recommendations to claimants during an audit:

  1. Ensure documentation demonstrates the process of a systematic investigation including formulation of a hypothesis and the associated activities of testing in an identified field of science or technology;
  2. The documentation demonstrates when and who was involved in the activities to link the salary and material expenses to eligible SR&ED activities.

It is quite common for claimants to maintain time sheets that identify the names of employees who were directly engaged in the SR&ED project with attributes such as date, work order number, vacation time, estimated hours worked, overtime hours, and total hours. In practice, it seems CRA auditors look for a far more granular, activity-based time tracking method that is not necessarily normal for claimants conducting experimental development outside of a laboratory environment. Failure to specifically provide activity-based time tracking when requested can lead to a determination by the CRA that a claimant’s records are not adequate. This assessment approach, however, is duly shown to be inconsistent with both CRA policy and Tax Court of Canada (TCC) jurisprudence on the matter of record keeping, including supporting salaries and wages expenditures.

A recent TCC decision was made in favour of the Quebec claimant, where the judge held that “the existence of contemporary literature or contemporary documents with special content is not a condition for the recognition of scientific research or experimental development [emphasis added].”

The CRA’s published policy considers numerous kinds of “cost allocation methods,” including but not limited to “estimates.”  The SR&ED Salary and Wages Policy (Section 13.1) defines a cost allocation method as “a systematic approach to determining which expenditures, or portion of expenditures, relate to SR&ED work. A claimant must be able to show that the cost allocation method used is based on a systematic approach, and provide a reasonable level of accuracy in calculating the SR&ED expenditures.”

The same section also states that the size of an organization may also be a determining factor in how sophisticated the cost allocation should be – keeping log books or detailed diaries may not be a claimant’s normal practice. CRA auditors often assert that, if a company has claimed SR&ED before, they may be expected to have a much more sophisticated system for tracking SR&ED.

According to CRA policy, there is no absolute requirement for a claimant to maintain a more sophisticated system. Informal, naturally generated information to support allocation of labor costs to SR&ED projects, coupled with other supporting documentation, should be sufficient. Time sheets that differentiate between SR&ED activities and non-SR&ED activities (whether by project or individual tasks) are also helpful supporting evidence. It is sometimes the case that more than one form of evidence is required to support claimed expenditures, depending on the nature of the company and the claim.

Whether you are a first-time claimant or have claimed SR&ED in the past, BeneFACT provides comprehensive SR&ED services, from claim preparation and filing, to supporting Claim Justifications. We are Canada’s largest independent SR&ED firm with a full-time staff of over 60 employees. If you have any question(s), please do not hesitate to give us a call toll free at 1-855-TAX-BACK (829-2225).

Owner-Manager Compensation and How it Impacts SR&ED

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Over the years, we’ve seen any number of owner-manager compensation structures other than just taking straight payroll. The most common arrangements are:

  • Taking dividends;
  • Paying themselves as contractors rather than employees; and
  • Paying a fee-for-services to a wholly-owned holding company.

Each of these forms of payment has implications on the company’s SR&ED claim.

Dividends

Simply stated, dividends are not an eligible SR&ED expenditure, full stop. If the owner-manager is performing SR&ED work, any dividends paid will not generate SR&ED Investment Tax Credits (“ITC”).

Contractor vs. Employee

An owner-manager can be either an arm’s length or non-arm’s length contractor. In situations where the owner-manager does not have control of the business, it is possible to be considered to deal with the company at arm’s length. In an arm’s length fact pattern, the portion of the remuneration paid to the owner-manager could be claimed as a SR&ED expenditure based on the time spent on eligible activities. For ITC purposes, the amount claimed will be reduced by 20%. Contrast this with payroll which is not reduced by 20% and also attracts the Prescribed Proxy Amount at the rate of 55%. Being paid as an employee vs a contractor almost doubles the SR&ED ITC.

In a non-arm’s length fact pattern, things get even worse. The non-arm’s length rules dictate that the amount paid is not a qualified expenditure of the payer. Expenditures must be claimed by the non-arm’s length SR&ED performer. As an individual, the owner-manager has income but typically no expenditures, so the qualifying expenditures of the owner-manager are NIL.

Holding Company

Similar to the contractor example above, a holding company can be either an arm’s length or non-arm’s length contractor. The arm’s length fact pattern is the same as described above: 80% inclusion for ITC purposes and no Prescribed Proxy Amount.

In a non-arm’s length fact pattern, the expenditures must be claimed in the holding company. Presumably, the holding company will have distributed some form of remuneration to the owner-manager. If the distribution takes the form of salary or wages, a portion of the remuneration paid to the owner-manager could be claimed as a SR&ED expenditure based on the time spent on eligible activities. Dividends or return of capital paid out to the owner-manager would not be eligible expenditures.

With some additional paperwork, it may be possible to transfer the expenditures from the holding company to the payer.

The Moral of the Story

Companies enter into these compensation arrangements for purposes other than SR&ED, usually on the advice of their tax adviser and without consideration of the SR&ED implications. If your business claims SR&ED ITCs, make sure that your tax adviser and your SR&ED service provider are both involved in any conversation about compensation strategies so that all of the ramifications are considered prior to making a decision.

At BeneFACT, we provide our clients with year-round consulting and check-points to ensure they are on track to receive the highest claim amount possible for any given tax year. We are Canada’s largest independent SR&ED firm with a full-time staff of over 60 employees. If you have any question(s), please do not hesitate to give us a call toll free at 1-855-TAX-BACK (829-2225).

Utilizing Forensic & Other Techniques to Maximize SR&ED Claims

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Have you ever wondered why many firms that eligible for the SR&ED program are not maximizing their claims, year over year?

The Scientific Research and Experimental Development (SR&ED) program is the largest tax incentive program administered by the federal government for companies of all sizes and firms in virtually all industry sectors.  The CRA pays out $3.6 billion every year to approximately 26,000 claimants across Canada.  While it’s true that more companies are subject to scrutiny today than at any time in the past, they can still work on making their claims bigger and more technically sound.

Grab a notepad – here are some ways to maximize your claim that you will want to write down:

  1. When you write your technical report, it is just that, a technical report.  It should not read like you are trying to sell your idea to the CRA.  We have seen many instances where firms try to increase their claim size by writing it like a sales and marketing report.  In almost all cases, the CRA either significantly reduces or denies the claim.  Simply follow the requirements that the CRA has outlined.
  2. Take small projects that you feel are not worth your time and pool them together to make a bigger project.  Often times, firms simply do not see the forest from the trees.  In other words, they are not aware that you can take small and weak projects, and combine them to make the claim more technical and robust.
  3. Ask yourself some forensic-type probing questions, such as:
    1. When routine engineering of components were put together to create a technological breakthrough that resulted in technological uncertainty, what issues, obstacles and challenges were produced?
    2. How were the shop floor personnel involved with the prototype?  Were there challenges when installing the widget on the production line?  If so, what was done to resolve them?  Do the shop floor personnel have production meetings and what results from these meetings?
    3. Did the president / CEO get involved with the developmental / design work?  Does he/she have any input in the problems that arise as a result of introducing the prototype to the shop floor?  Who gets involved in these types of decision making?
    4. Do the technical staff discuss project issues in the lunch room or at the water cooler?  Have there been attempts to capture this information?
    5. Has the sales person been directly involved with product design / assisting with the prototype because he/she is well aware of the customers’ need and has a better idea of how to build the prototype?  What is their role when it comes to design, development or prototype work?
    6. Are you using the traditional or proxy method to calculate your overhead?  Sometimes, it may be worthwhile utilizing the traditional route to calculate overhead because you pay a huge energy bill or your insurance payment is massive.  Check with your accountant for details of the overhead bills.  We recommend to most of our clients to utilize the proxy method because 9 out of 10 times, the proxy method would be larger than the traditional method and less subject to scrutiny by the CRA.
    7. Did any projects I’ve worked on fail?  If so, do I have them captured?
  4. At the end of every week, say Friday, ask your technical staff to take 15 minutes and write down the projects they were working on and the technological challenges they faced.  Also write down the hours they spent working on the project.  If they have photographs or reports, then record supporting documentation as well.  This can all be written in a log book, which can be purchased at the dollar store and is well worth the investment if it increases the size of your claim.
  5. Did you capture all the materials consumed and transformed?  Ask your purchasing department for all the invoices for a certain period and reconcile the invoices with the SR&ED work.  This can be time consuming but not if you’re taking 10 to 15 minutes per week to reconcile.
  6. If you’re constantly utilizing a subcontractor for the development, design or to assist you in building jigs and fixtures, consider bringing them on as an employee, especially those sub-contractors that you’re paying in excess of $100,000.  The difference can be more than $30,000 in ITC if you put the sub-contractor on payroll and pay them, as an example, $100,000 per year.

At BeneFACT, we inspect every claim with a fine-tooth comb.  We utilize our forensic extraction technique to maximize every claim. We are Canada’s largest independent SR&ED with full time staff of over 60 employees. If you have any question(s), please do not hesitate to give us a call toll free at 1-855-TAX-BACK (829-2225).