The Scientific Research & Experimental Development (“SR&ED”) program has been around in Canada for decades, providing refundable and non-refundable tax credits to Canadian corporations conducting R&D in Canada. For many Canadian tech startups, the SR&ED credits help keep them afloat in their early years when they are pre-revenue and building their R&D programs.
SR&ED credits consist of the federal investment tax credit (“ITC”) and the provincial tax credit, depending on the location of the corporation’s permanent establishment (“PE”) and the location in which the R&D work is performed. Canadian-controlled private corporations (“CCPC”) can benefit from the refundable federal ITC’s, up to $3 million of expenditures, which has an enhanced credit rate of 35%; this is known as the federal expenditure limit. For corporations with a PE in Ontario, there is also a separate, Ontario expenditure limit of up to $3,000,000 for the refundable Ontario Innovation Tax Credit (“OITC”), at a credit rate of 8%. For many tech startups, it’s assumed their SR&ED claim will not reach this expenditure limit and therefore enjoy full refundability on their SR&ED expenditures. However, as the corporation grows and starts to earn revenue and build capital, these expenditure limits may start to decrease or be eliminated, resulting in less to no refundability from their SR&ED expenditures, and only being able to claim non-refundable credits at a much lower rate. During this growth process, ownership should be aware of what items can reduce the expenditure limits to allow them to plan accordingly for future cash flows.
The federal expenditure limit calculation is based on the corporation’s prior year taxable capital in Canada; if the corporation is associated for tax purposes with other corporations, the expenditure limit is based on the prior year taxable capital of the entire associated group. Taxable capital of a corporation, at a high level, is the sum of its retained earnings, contributed surplus, and indebtedness, less its investments in other corporations and loans to other corporations. When the associated group’s prior year taxable capital reaches $10 million, the current year federal expenditure limit starts to decrease and is eliminated when it reaches $50 million. In other words, corporations claiming SR&ED with prior year taxable capital of at least $50 million will only be able to claim the non-refundable federal ITC at the 15% rate.
For example, in the prior year, a CCPC’s taxable capital in Canada was $20,000,000, putting it in the middle of the lower and upper limits of taxable capital where the federal expenditure limit is ground down. This results in the CCPC’s federal expenditure limit in the current year to be $2,250,000; therefore, the CCPC can claim up to $2,250,000 of SR&ED expenditures for the refundable federal ITC, meaning they can receive up to $787,500 of this credit. Any SR&ED expenditures claimed above the $2,250,000 limit will be subject to the non-refundable rate of 15%, and these credits can only be applied against federal Part I tax or carried forward for 20 years to be applied against tax.
A similar calculation is used to calculate the Ontario expenditure limit for the OITC: the expenditure limit starts to decrease when prior year taxable capital reaches $25 million and is eliminated once it reaches $50 million. However, the Ontario expenditure limit is also affected by the corporation or the associated group’s prior year taxable income. The expenditure limit starts to decrease when the prior year taxable income reaches $500,000 and is eliminated at $800,000. The taxable income of the associated group also includes the taxable income from associated, non-resident corporations. The lesser of each calculation using taxable income or taxable capital is the Ontario expenditure limit for the corporation. When a corporation has no Ontario expenditure limit, they cannot claim the OITC; the only Ontario R&D credit the corporation can claim at this point is the non-refundable Ontario R&D Credit (“ORDTC”) at a rate of 3.5%.
The federal expenditure limit calculation used to consider prior year’s taxable income, but the Department of Finance eliminated this measure for corporations with year-ends ending after March 18, 2019. This was advantageous for CCPC’s since corporations typically reach the taxable income mark before taxable capital.
From my experience, I noticed that corporations tend to assume they will get the full expenditure limits, so that their entire claim will be refundable. However, they may not be aware that an associated corporation had taxable income over $800,000, or that their associated group has become large enough that taxable capital is grinding down their federal expenditure limit. It’s best practice to review the corporations’ performance in the past year so that you aren’t going to be surprised by the next SR&ED claim’s numbers. There can also be strategies used to disassociate with a corporation that may have too much taxable income or capital, so that the R&D corporation can claim refundable credits once again. The key takeaway here is to be aware of these items that can affect the refundability of future SR&ED claims. The SR&ED advisors at Welch are always willing to help with SR&ED related questions, so give us a call if we can ever be of assistance.
