Maximizing your tax incentives and cash flow

This article was previously posted in TaxNet Pro and is reproduced with permission.

Scientific Research and Experimental Development (SR&ED) tax credits are available to Canadian corporations that are actively involved in research and development work that meets certain qualifying criteria pursuant to subsection 248(1) of the Income Tax Act (“Act”). In particular, SR&ED-qualifying work must meet the requirements for… “systematic investigation or search that is carried out in a field of science or technology by means of experiment or analysis and that is” …

1. Basic research;
2. Applied research, or
3. Experimental development; or
4. Relates to technological advancement for the purpose of creating new, or improving existing, materials, devices, products or processes.

Eligible corporations can benefit from refundable cash and/or non-refundable investment tax credits (“ITC”), which can further be applied towards current or future taxes owing per subsection 127(5) of the Act . Where a corporation’s activity meets the requirements as defined above, it can benefit from a reimbursement of up to 73 percent (via ITCs) on its qualifying expenses. The refund percentage quoted here is for a Quebec resident Canadian controlled private corporation (CCPC) that is a small business corporation as defined in subsection 248(1)of the Act.

This article will discuss observations form the recent court rulings for SR&ED tax credits and the lessons to be learned, specifically on what activity is likely to qualify. In this respect, the article also outlines some simple alternative sources which can be useful to maximize the overall cashflow for a technology corporation while simultaneously lowering the fixed costs (such as from salary expenses etc).

Welcome Measures From 2019 Federal Budget

A key proposal released in the March 19, 2019 Federal budget is a repeal of the use of prior year taxable income when determining a CCPC’s annual expenditure limit for the purpose of calculating the SR&ED tax credit at the enhanced rate of 35 percent. Consequently, small to mid-level CCPCs with taxable capital of up to $10 million can benefit from this enhanced refundable SR&ED tax credit, independent of their prior year’s taxable income. As taxable capital begins to exceed $10 million, there is a gradual reduction to the refundable tax credits in the same manner as before the 2019 budget announcement. This new measure will apply to taxation years that end on or after March 19, 2019.

Pursuant to section 37 of the Act, a taxpayer can claim a SR&ED ITC on qualifying expenses incurred in the current taxation year. As well, a CCPC can access a refundable ITC at an enhanced 35% rate, up to a maximum of $3 million in qualifying expenses. The available ITC varies based on the nature of the taxpayer’s status as a CCPC and size; this is determined pursuant to subsection 127(10.2) (A) and (B) of the Act which considers two factors: (i) prior year taxable income; and (ii) the prior year taxable capital. Both factors are extended to associated groups where applicable. For instance, there can be a significant reduction to the ITC for a CCPC with taxable income levels in the range of $500K to $800K, with an eventual loss altogether of refundable tax credits. Principally, the 2019 federal budget repeals subsection 127(10.2) (A) of the Act, and hence eliminates the dependency between taxable income and the expenditure limit. To illustrate this impact, consider a CCPC with a taxable capital at $10M and prior taxable income at $500K and eligible SR&ED expense of $3M. At the enhanced Federal rate of 35%, the expected refundable tax credit is $1,050,000. For the same corporation, if prior year taxable income is at $600K, then the refundable portion of the $3M in expense limit drops to $2M leading to $700,000 in refundable tax credits. This is a decrease of $350K in actual refundable tax credits. With the proposed changes to the Federal budget, this limit is removed, hence allowing the corporation to fully benefit from the full $3M expense limit for refundable tax credits.

While the new proposals in the 2019 Federal budget are a relief measure for tax planning purposes, there are many court cases involving SR&ED claimants and there has been continued challenges in understanding the application of the law and how the Canada Revenue Agency (“CRA”) have administered the tax credit program.

SR&ED Credits - Challenges and Tax Court Rulings

On a number of occasions, claimants have resorted to court intervention when SR&ED ITCs have been denied by the CRA, and courts have specifically ruled either in favor of or against the taxpayer. Generally, the court examined if there is an existence of a technological uncertainty (“TU”), amongst other requirements, as one of the key criteria; this is also the starting and leading criteria when determining if there is a SR&ED eligible tax credit for the expenses claimed. Let us briefly look at some of the recent court rulings. These cases succinctly highlight the important need for a TU when a taxpayer is seeking SR&ED ITCs.

Recent Case Rulings

In the case, Laforest Marketing International Inc v. Queen, 2019 TCC 34, the judge concluded that the activities performed did not meet the definition of SR&ED activities. The Appellant had claimed ITCs in the amount of $7,043 for development of excess water recovery mists for indoor plants. Absence of a TU was the main criteria in assessing the lack of eligibility for SR&ED investment tax credits.

In Concept Danat Inc. v. Queen, 2019 TCC 32, the appellant claimed ITCs in the amount of $13,862 for three different projects related to printing and manufacturing of sports clothing that, according to the appellant, qualified as SR&ED activities. In this case, while the court was not convinced of the existence of a TU, it did reference the appellant’s ingenuity, existence of technical constraints and challenges and use of existing methods as resolution. The court also cited the lack of accurate record keeping among other issues. The whole case was dismissed without costs.

In the case of Flavor Net v. Queen, 2017 TCC 179, the appellant failed to demonstrate to the court the existence of a TU that could not be resolved from new methods, and the court (as noted in para 37 of the ruling) was satisfied to dismiss the eligibility for SR&ED ITCs (even though the other criteria as laid out in the Northwest Hydraulics case, discussed below, were analyzed).

In addition to the above, there are several other cases from the past where lack of a TU has been central to denial of an ITC - see for example, Jentel Manufacturing Ltd. v. Canada, 2012 D.T.C. 503, 2011 FCA 355, where the judge ruled against the taxpayer due to lack of a TU.

In all of the above cases, the courts have cited the seminal and often-quoted case, Northwest Hydraulics Consultants, 3 C.T.C. 2520 TCC (1998), which provides a guideline to subsection 248(1) of the Act and the five criteria that are noted at the beginning of this article. Specific to these criteria is the existence of a TU. In Northwest Hydraulics Consultants, Justice Bowman stated that technological uncertainty is … “something that exists in the mind of the specialist” … “that cannot be removed by routine engineering or standard procedures…”

As has been demonstrated in the above court rulings, successful appeals have been able to demonstrate the existence of a TU, while also satisfying all the other conditions as laid out in subsection 248(1) of the Act.

Successful Appeals

In the case of A&D Precision Limited v. The Queen TCC 48 (2019), the taxpayer won the claim (in part) where the work performed had encountered a technological uncertainty. Interesting to this case is that the merit of the claim was judged based on whether there is a TU in existence - this was the starting point of the analysis before addressing the other criteria as laid out in subsection 248(1) and in the Northwest Hydraulics case. In paras 62 and 86, the judge concludes that A&D did indeed encounter a technological uncertainty (which in this case) was related to a system uncertainty; further as noted in para 79, parts of the work performed were disallowed for SR&ED tax credits as there was no evidence for TU.

In the case of CRL Engineering Ltd. v. The Queen, 2019 TCC 65, the taxpayer was successful in demonstrating the existence of a TU and hence was able to satisfy the opening criteria for eligibility for SRE&ED tax credits. The taxpayer won the appeal.

In the case of Les Abeilles Services, 2014 (TCC) 313, while the Judge cited the five criteria listed in Northwest Hydraulics, there was specific reference to the importance of TU. In para 142, the Judge stated:

“ It must be borne in mind that these criteria are used to help determine whether or not a technological advancement has occurred. The first criteria, technological uncertainty, is one way of dealing with the technological advancement criteria; there can hardly be a technological advancement if one already knows how to achieve the end result; the second and third criteria are, inter alia, one way of ensuring that the work was undertaken for the purpose of achieving technological advancement and that it was not, for example, an advancement achieved by accident rather than work undertaken for the purpose of achieving technological advancement.” Overall, a key lesson from the court rulings is that failures by the claimant to demonstrate a TU results in denial of the tax credits and the incurred development expenses are re-characterized as non-capital losses (pursuant to subsection 111(1) of the Act), which is clearly not as beneficial for the claimant/taxpayer in comparison to receipt of an ITC.

Lessons Learned From Court Decisions

The conclusions from court rulings introduce an important question that relates to understanding the “current” activity of a corporation; specifically, what is the state/phase of the corporation’s research and development process? Often, it is not an easy task to isolate the activities and analyze their eligibility for SR&ED tax credits. However, the court rulings offer useful and key insights, and this can be essentially summarized to asking a focus question:

• What is the “nature” of the activity that determines eligibility for SR&ED tax credit specifically, does the work performed by the taxpayer require going beyond what would otherwise be considered standard process and not routine; while there can be some subjectivity to this, there are well established benchmarks that can be used as defense to establish non-standard and non-routine methods.

Unique to the nature of the activity is that failures are also eligible for SR&ED tax credits.

Activity Test as a Key Indicator

For the purposes of the following discussion, let us define three generic categories where a technology corporation can broadly divide its activities performed during its fiscal year period: (i) design/planning; (ii) development and/or (iii) implementation. In such a classification, and without being detailed, often it is easier to appreciate that a planning or an implementation phase may not likely lead to activities that can fall within the requirements of SR&ED tax credits - in particular, there may not be an existence of TU. Here are a few illustrated common examples (and options) to give an understanding of such a categorization.

Design Phase: This type of work often draws heavily on planning, blueprinting, some initial testing, and a clear TU is likely not identified;

Development Phase: Prototyping, testing, activities that follow from an initial analysis and/or design follow up;

Implementation Phase (usually known and identified TUs have been resolved): Field testing and deployment of prototype.

Of course, there can be very specific cases where such generalization as stated here may not be fully applicable and the reader needs to be aware of this caveat; however, such a discussion is beyond the scope of this article. This does lead to a pertinent question: what is the appropriate incentive to consider with respect to an activity-based classification?

SR&ED and Alternative Sources of Funding

As we shall see below, once a corporation can categorize its activities into one of the three activity categories/phases (as stated above), it paves a path to identify if there are other sources of cash inflow in cases where an activity may not meet SR&ED eligibility criteria. Indeed, there are alternative sources for grants and tax credits (both at the federal and provincial levels) applicable for Canadian corporations that can be taken advantage of, even when the current activity of a corporation does not support eligibility for SR&ED tax credits. Within this context, there can be instances where expenses incurred for activities are (i) either funded by a government grant; and/or (ii) expensed for potential tax credits. In certain cases, there may be a potential recapture of some or all the expenses which were funded by government grants when there is also activity eligible for SR&ED tax credits. To understand this distinction, let us identify the key elements that are distinct between the following sources of cash inflow.

SR&ED: Some Key Aspects of Qualifying Activities:

• Encountering technological uncertainties that leads to several developments, prototyping and testing phases;
• The tax payer has used non-standard methods and practices as resolutions for a TU and either have succeeded or failed. There are some fair interpretations of what is non-standard, and one accepted approach is your work activity has demonstrated methods which are over and above what would be conventional - such as, easily accessed from internet, chat forums, white paper articles or research documents which are readily available (this is key).

Direct Tax Incentives:

Example tax credits are digital media, film tax credits, e-business, apprenticeship tax credits, etc. Key activity characteristics for these can be as follows:

The tax payer is working on new products with uncertainties and risks that can be resolved by standard operational even though there are challenges in their development cycle. Examples may include static modifications to your product lines, prototyping new geometries such as via Computer Aided Design or solid edge tools, or performing design alterations involved in multimedia activities, video production etc.

Often such activities can be stand alone and per se may not immediately advance your level of technology base, though they lead to a new product and process.

Grants:

Examples (not exhaustive) may include, IRAP, MITACS (a Federal funding program), etc. Typical situations and activities could be:

The tax payers’ business operation thrives on being innovative, uses classroom and experience-based knowledge and your work presently has a novelty value; it could have been patented or can result in patents or other intangible assets to your business.

In such cases, the tax payer may have a precursor for R&D tax credits, but this requires further investigation. In the interim, there are grants and incentives based on your specific business activities.

In terms of the activities/phases discussed earlier:

• Design Phase: In the potential absence of a SR&ED qualifier (due to likely absence of a TU), consider direct tax incentives, grants etc.; Development Phase: Consider both direct tax incentives, grants and SR&ED(especially, if there were TU’s
• realized during prototyping or testing phase); Implementation Phase (usually known and identified TUs have been resolved): consider available
• Implementation Phase (usually known and identified TUs have been resolved): consider available government grants.

Can Different Incentives and Grants be Optimized with SR&ED?

In many cases, the taxpayer may be involved in activities where there can be co-mingling of SR&ED and other development work (which may not fully qualify for SR&ED ITCs) for which the taxpayer is accessing other available credits/incentives/grants. In such situations, often the taxpayer can mistakenly choose not to consider the possibility of filing for SR&ED tax credits by way of reasoning due to recapture rules that follow when accessing other credits/incentives. However, with clear delineation of activity and with appropriate contemporaneous documentation, there is always an overall benefit. In certain cases, a recapture may not be required at all; and in other instances, based on how tax credits are estimated, a recapture from other funding sources may still yield a beneficial result for the claimant. Once again, the key to determining such recapture comes from understanding the nature of the activity and whether such activity is also within an eligible expense for tax credits. There can be situations where activities of different phases may co-exist, and such cases can lead to a potential recapture when calculating tax credits. Regardless, one must consider taking advantage of both SR&ED tax credits and other government assistance to benefit from, and even maximize, the recovery of expenses (often fixed costs).

A well-known example of this discussion is where a claimant has utilized popular government assistance, such as the IRAP, and also claimed SR&ED tax credits. It is often a misconception that claiming SR&ED is not beneficial due to recapture rules applied for SR&ED tax credit calculation. While it is true that the recapture rules will lower the SR&ED ITC, it can be demonstrated that these differing incentives can be combined (even when accounting for any applicable recapture) to optimize overall costs for a corporation which is active in R&D activities.

Consider the following example where an Ontario corporation has expensed $100K in salaries and as part of this has received $50K in IRAP grants. In this simple example, it can be shown that with the inclusion of IRAP, the overall cash inflow to the corporation can be up to 94% as opposed to 65% when only SRED is considered. Clearly, in this simple example, in order to optimize on the overall cash inflow, we must consider both SRED and other incentives or grants.

In summary, there are clearly several key avenues and opportunities for a corporation to consider with respect to cash inflow via government assistance and legislated tax credits. The time-and-again message delivered by several court rulings has been centered in understanding whether an activity can lead to a qualifying criterion and if so, whether the corresponding qualifying expenses (when documented) can become eligible for SR&ED tax credits.

Disclaimer: This article is only for information purposes and is not a substitute for an actual tax planning or to be considered as a tax advice.

For more information, contact:

Bal Katlai, Manager,

Canadian Corporate Tax,

514.228.7858

[email protected]