Evolution of the SR&ED Program – a historical perspective

The Government of Canada provides tax incentives to encourage Canadian companies of all sizes and in all industry sectors to conduct scientific research and experimental development (SR&ED). These tax incentives come in three forms: an income tax deduction, an investment tax credit (ITC), and, in certain circumstances, a refund.

The SR&ED Program provides more than $3 billion in tax incentives to over 20,000 claimants annually, making it the single largest federal program that supports business research and development (R&D) in Canada. The program is administered by the Canada Revenue Agency (CRA).

The federal government provides SR&ED tax incentives for three types of research:

1. Basic research, namely, work undertaken for the advancement of scientific knowledge without a specific practical application in view;
2. Applied research, namely, work undertaken for the advancement of scientific knowledge with a specific practical application in view; and
3. Experimental development, namely, work undertaken for the purpose of achieving technological advancement for the purpose of creating new, or improving existing, materials, devices, products or processes, including incremental improvements thereto.

In applying this definition in respect of a taxpayer, it includes work undertaken by or on behalf of the taxpayer regarding engineering, design, operations research, mathematical analysis, computer programming, data collection, testing or psychological research, where the work is commensurate with the needs, and directly in support, of work described in 1), 2), or 3) above that is undertaken in Canada by or on behalf of the taxpayer.

To take advantage of tax incentives for SR&ED, a company has to be able to show that it has invested in one of these types of research. Canadian‑controlled private corporations (CCPCs) other corporations, proprietorships, partnerships, and trusts can apply for the tax incentives.

History

The Government of Canada has been stimulating research and development activities for many years through the Income Tax Act. As early as 1944, companies could deduct from their taxable income an amount equal to 100% of current expenditures in respect of scientific research. Until 1960, companies could also deduct one‑third of capital expenditures incurred for scientific research in a taxation year. The legislation was amended in 1961 to make capital expenditures fully deductible in the taxation year in which they were incurred.

From 1962 to 1966, the federal government also allowed an incremental tax deduction equivalent to 50% of current and capital expenditures exceeding the 1961 level.

This measure was replaced in 1967 by cash grants introduced under the Industrial Research and Development Incentives Act (IRDIA). These cash grants were equal to 25% of capital expenditures and 25% of current expenditures in excess of the average for the preceding five years. Their purpose was to offer the same benefits as the additional 50% deduction, while providing financial support to non-taxable companies involved in scientific research, in particular, small CCPCs previously unable to take advantage of federal tax incentives. Nearly $290 million was awarded under the IRDIA, which was repealed in 1975.

In 1977, the federal government introduced a scientific research tax credit ranging from 5% to 10% of current and capital expenditures, depending on the nature of the company and the region in Canada where its activities were carried out. A new legislative provision, whereby the tax credit had to be taken into account in calculating taxable income, was introduced.

In 1978, the basic tax credit rate was increased to 10%, with exceptions for the Atlantic Provinces and the Gaspé region, where the rate rose to 20%, and for small businesses, where it rose to 25%. That same year, the federal government introduced another tax incentive in the form of an additional tax deduction for scientific research, similar to that in effect between 1962 and 1966. Companies were allowed to deduct from their taxable income 50% of all scientific research expenditures exceeding their recorded average for the three preceding years.

As a result of reported abuses, the federal government abolished the 50% incremental deduction in 1983 and introduced new tax provisions. The tax credit rates were increased by 10 percentage points over their 1978 level. The basic rate was set at 20%; the rate in effect in the Atlantic Provinces and the Gaspé region was set at 30%; the rate for small CCPCs was set at 35%. The government also introduced carry‑forward provisions for the tax deduction and the credit.

1983 also saw the introduction of a partial refund of unused tax credits of 20% for large corporations. In the case of small CCPCs, the rate was 100% on the first $2 million of eligible expenditures, 40% on capital property, and 40% on expenditures related to research. The federal government introduced this refund to ensure that small CCPCs with no tax payable would also benefit from the tax incentives.

The last measure introduced in 1983 was the scientific research tax credit (SRTC). Companies were able to enter into research contracts on behalf of an outside investor who had acquired shares or debt securities for scientific research.

Industry had expressed concerns about the existing requirement that expenditures eligible for the R&D incentives had to be wholly attributable to R&D. This requirement was replaced in the 1985 federal budget by a provision that an expenditure that is “all or substantially all” attributable to R&D would qualify. Current expenditures of a taxpayer that were “directly attributable” to R&D also qualified for the incentives.

The tax credit earned by small Canadian‑controlled private corporations for current expenditures on R&D was made 100% refundable. The full amount of the credit earned was made available to the taxpayer, either as a reduction of tax liability or as a cash refund. This increased refund provision for R&D had no expiry date and was effective for qualifying expenditures made after the budget was tabled in May 1985.

The tax credit for small firms was changed to apply on the first $2 million of R&D performed in a year by an associated group of companies. This fully‑refundable credit applied only to current expenditures.

Revenue Canada was mandated to validate these credit claims at the time that the taxpayer’s return was assessed and to make the refunds available without undue delay. This resulted in Revenue Canada establishing a special group of assessing and audit staff to administer refund claims so that the refunds would be provided to each taxpayer as soon as possible.

To meet its commitments from the 1985 budget, Revenue Canada hired or contracted technical experts to help tax auditors in the determination of qualified R&D. These experts became involved in cases where R&D claims were in dispute between taxpayers and the regular tax auditors. With a view to aiding the audit process and to providing greater guidance to taxpayers on eligible expenditures for R&D, Revenue Canada also developed a standard prescribed form for the claiming of both the regular tax incentives and the refundable tax credit.

In an effort to broaden Canada’s tax base and to limit abuses of the tax system related to scientific research, the May 1985 budget stated that the Department of Finance would amend the existing definition of “scientific research” in the Income Tax Regulations and the Act to include the term “experimental development.” In 1986, the term “scientific research and experimental development” (SR&ED) was introduced as a new title in section 2900 of the Regulations to clearly distinguish between eligible development and simply routine engineering and routine development.

The legislation was also amended to ensure that the beneficiary of SR&ED tax incentives was directly associated with the research activities. Companies could no longer qualify for tax incentives unless the expenditures incurred were directly related or directly attributable to SR&ED activities. The government also moved to exclude expenses incurred for the purchase of buildings from the definition of SR&ED expenditures. Carry-forward provisions were enriched so that unused credits could be carried forward for 10 years. At the same time, the refundable tax credit at the basic rate of 20% was eliminated for large corporations. The 35% refundable credit for small CCPCs was not changed.

In the 1991 federal budget, the government indicated that it would be examining whether modifications to the SR&ED tax credit could ease its administration for taxpayers. This led to discussions among major industry groups, individual firms, the Department of Finance, Revenue Canada, and the Department of Industry, Science and Technology.

Two key areas for examination were revealed: (i) the treatment of capital equipment that is used for both research and production purposes, and (ii) the allocation of certain overhead and administration expenses between SR&ED and other activities.

In 1992, changes were made to the calculation of overhead expenditures, with two options being made available to claim them. Companies could choose to specifically identify the amount of these expenditures or use a proxy amount that corresponded to 65% of the salary base directly attributable to SR&ED.

Changes were also made related to capital expenditures in respect of the acquisition of machinery and equipment. Previously, only machinery and equipment that was used at least 90% of its useful life on SR&ED activities could qualify for the SR&ED tax credit. Changes were made to allow equipment primarily used for SR&ED (more than 50%) to also qualify for the tax credit. This tax credit could not be forwarded to a future tax year; it had to be claimed in two equal instalments in the two years following the year of acquisition.

In 1993, CCPCs with prior year taxable income between $200,000 and $400,000 became eligible for the enhanced refundable tax credit rate for small corporations, up to a maximum of $2M in qualified expenditures. Prior to that year, only CCPCs with taxable income of $200,000 or less in the prior year would qualify. However, the expenditure limit gradually decreased as the corporation’s prior year taxable income rose above $200,000, and, at $400,000, the expenditure limit that could earn refundable tax credits was reduced to zero.

In 1994, the special 30% tax credit rate for companies involved in SR&ED activities in the Atlantic and Gaspé regions was eliminated. The rate now depended on company size, regardless of where the company was located in Canada. In addition, the special provisions governing sole‑purpose SR&ED performers (those who derived most or all of their income from research‑related activities) were eliminated. Sole‑purpose SR&ED performers had been exempted from the rules that expressly excluded certain expenses such as legal fees, interest costs, and entertainment expenses from eligibility for the SR&ED tax credit. This change resulted in a more consistent treatment of all corporations carrying out research.

Also in 1994, a time limit was set for identifying SR&ED expenditures incurred in previous years. This change resulted from concerns expressed by the Auditor General of Canada. He had noted that some corporations were using the carry-forward provision to claim tax credits for SR&ED performed as far back as ten years, making the verification of claimed work increasingly difficult.

In 1995, additional changes to tax credit provisions were made in four specific areas: eligibility of financial institutions, contract R&D and non‑arm’s length transactions, third‑party payments, and unpaid amounts.

Changes were made to some rules governing SR&ED contracts, particularly transactions between related parties. Companies contracting out SR&ED were eligible for tax incentives applicable to the amount of the contracts, which usually included sums that would not be eligible for the tax incentives if the SR&ED were carried out internally, e.g., profits, the cost(s) of renting buildings, and interest payments. The 1995 changes ensured that expenditures eligible for the tax incentives under contracts with related parties would be limited to the actual costs incurred by the performers in carrying out the SR&ED.

SR&ED carried out under an agreement with a third party differs from other SR&ED contracts. When SR&ED is contracted out, it is carried out directly for the payer, which obtains ownership of the SR&ED. In the case of payment to a third party, the payer obtains the right to use the results of the SR&ED, but does not have control over the SR&ED itself. In addition, unlike the case for other SR&ED contracts, payments to third parties became eligible for the tax incentives when payments were made, and not when the SR&ED was carried out. Since 1995, third parties must provide information about the nature of the SR&ED they have carried out and indicate the related expenditures. As well, payments to third parties are treated like SR&ED contracts: they are eligible for the tax incentives in the year in which the SR&ED is carried out.

Before 1995, corporations claimed tax credits for amounts incurred but not yet paid. In 1995, new rules made the tax credit applicable to the year in which payment is made.

In the past, borrowers could not use expected refunds of investment tax credits as security for loans. The Income Tax Act was amended to facilitate access to this financing option for companies while not prejudicing the rights that the government currently had with respect to debts owing by the borrower to the government.

The amount of wages and salaries eligible for the SR&ED tax incentives in the case of specified employees was limited to five times the year’s maximum pensionable earnings for the purposes of the Canada Pension Plan. (Specified employees are persons who do not deal at arm’s length with their employer or who have a significant interest (>10%) in the shares of the employer.)

In 1998, eligibility for an ITC was limited to those qualifying expenditures identified by a taxpayer on a prescribed form (T2038 – Investment Tax Credit) filed with the Minister of National Revenue within 12 months of the taxpayer’s filing due date for the taxation year in which the property was acquired.

In 1999, in order to prevent unintended benefits under the regime of SR&ED tax incentives, a mechanism was implemented to ensure that when the product of an SR&ED project is sold, the overall cost of the project is reduced and investment tax credits are provided only on the net cost of performing the research. In addition, a review of the administration of tax incentives for SR&ED was undertaken and a new, simplified form for the tax credit was developed.

In 2000, the federal government modified the treatment of provincial deductions for SR&ED that were over 100% of cost to ensure that these “super-deductions” were considered to be government assistance for taxation years ending after February 2000. These super‑deductions had to be subtracted from allowable expenditures when calculating eligible expenditures for federal SR&ED tax purposes.

In 2003, the small business limit for a CCPC was raised from $200,000 to $300,000. As a result, the $2 million SR&ED expenditure limit for refundable ITCs was phased out when taxable income was between $300,000 and $500,000.

In 2004, the government amended the refundable SR&ED ITC rules. Small CCPCs that had a group of common investors (which group was not formed to gain access to multiple expenditure limits) no longer had to share the $2 million expenditure limit solely because two or more investors collectively had a majority interest in the shares of each corporation. Each small business, in such a case, had access to its own $2 million expenditure limit, which meant that each business had access to up to $700,000 in SR&ED assistance. This change came into effect for taxation years that ended after March 22, 2004.

In 2005, tax incentives were extended to SR&ED performed in Canada’s Exclusive Economic Zone, which encompasses 200 nautical miles from the coastline. The previous limit included only the 12‑nautical‑mile territorial sea.

In 2006, the small business limit for CCPCs was increased to $400,000. The $2 million annual SR&ED expenditure limit was phased out when taxable income for the previous taxation year was between $400,000 and $600,000, or when taxable capital employed in Canada for the previous taxation year was between $10 million and $15 million. In addition, the carry-forward period of the tax credit was extended to 20 years.

In 2008, the expenditure limit for CCPCs was increased from $2 million to $3 million. The upper limit for the taxable capital phase‑out range was increased from $15 million to $50 million. The upper limit of the taxable income phase‑out range was also increased from $600,000 to $700,000. The SR&ED investment tax credit was extended to salaries and wages for certain activities carried on outside Canada by Canadian‑resident employees, with eligibility limited to a maximum of 10% of the total SR&ED salaries and wages incurred in Canada for the tax year.

2008 also brought administrative changes to the SR&ED Program in the areas of accessibility, predictability, and consistency. The Canada Revenue Agency (CRA) introduced a new SR&ED claim form and guide and developed an on‑line eligibility self‑assessment tool to help businesses to determine the eligibility of their projects and to make it easier for businesses to benefit from the SR&ED Program. The CRA also began a review of the program’s policies and procedures to ensure that they were aligned with current business practices and were applied in a consistent manner across the country.

Other administrative improvements made by the CRA included increasing the number of technical reviewers who determine scientific eligibility; providing additional training and establishing coordinated technical support for the technical reviewers across Canada; increasing resources so that the technical reviewers would have more time to work with claimants to explain the review process; devoting more time to program services, including Pre‑claim Project Review, the Account Executive Service, Process Review, First‑Time Claimant Service, outreach, and information seminars; enhancing the quality assurance methodology at the national and local levels, including the real‑time review of claim decisions; and reviewing dispute resolution procedures to ensure their effectiveness.

In the 2012 budget, the government announced that capital expenditures would no longer be eligible for SR&ED investment tax credits starting in 2014. The rate for calculating the prescribed proxy amount was reduced from 65% to 60% effective January 1, 2013, with a further reduction to 55% effective January 1, 2014.

Effective January 1, 2013, only 80% of contract payments can be used for the purposes of calculating SR&ED investment tax credits. The general SR&ED ITC rate was reduced from 20% to 15% and lease costs can no longer be claimed for SR&ED purposes.

In response to other measures in the 2012 federal budget, the CRA began a pilot project to determine the feasibility of a formal pre‑approval process. The CRA also enhanced the existing on‑line eligibility self‑assessment tool, began to make more frequent and effective use of “tax alerts”, and improved the Notice of Objection process to allow for a second review of scientific eligibility.

In December 2012, the CRA announced the completion of its Policy Review Project, which resulted in the consolidation and clarification of the administrative policies that were contained in about 70 documents pertaining to the SR&ED tax incentive program.

In 2013, the Income Tax Act was modified to introduce a penalty of $1,000 per SR&ED claim if tax preparer information requested on the SR&ED claim form is missing, incomplete, or inaccurate. If a tax preparer participates in the preparation of the claim, the tax preparer will be jointly and severally, or solidarily, liable with the taxpayer for the penalty.

You can also read a brief history of the definition of SR&ED as per the Income Tax Act, as well as a brief history of the guidance on the eligibility of work.

Chronology

1944 – 100% of current expenditures and one‑third of capital expenditures for scientific research can be deducted from taxable income.

1961 – Capital expenditures become fully deductible in the taxation year in which they were incurred.

1962 – Corporations are allowed an incremental tax deduction equivalent to 50% of current and capital expenditures exceeding the 1961 level.

1967 – The incremental tax deduction of 50% is eliminated, and cash grants are introduced under the Industrial Research and Development Incentives Act. The grants are equal to 25% of capital expenditures and 25% of current expenditures in excess of the average for the preceding five years.

1975 – The Industrial Research and Development Incentives Act is repealed.

1977 – A scientific research tax credit ranging from 5% to 10% of current and capital expenditures is introduced, with the rate dependent on the size of the company and the location of the research activities. The tax credit has to be taken into account in calculating taxable income.

1978 – The basic tax credit rate is increased to 10%, with exceptions for the Atlantic Provinces and the Gaspé region, where the rate rises to 20%, and for small Canadian‑controlled private corporations (CCPCs), where it rises to 25%. Another tax incentive in the form of an additional tax deduction for scientific research is introduced: companies can deduct from their taxable income 50% of all of their scientific research expenditures exceeding their recorded average for the last three years.

1983 – The 50% incremental deduction is abolished and tax credit rates are increased by 10 percentage points over their 1978 level. The basic rate is set at 20%; the rate in effect in the Atlantic Provinces and the Gaspé region is set at 30%; the rate for small CCPCs is set at 35%. Corporations can carry forward their tax deduction indefinitely to offset future taxable income, and unused tax credits can be combined and either carried back for three years or forward for seven.

A partial refund of unused tax credits of 20% for large corporations is introduced. For small CCPCs, the rate is 100% on the first $2 million of eligible expenditures, 40% on capital property, and 40% on expenditures related to research.

The scientific research tax credit (SRTC) is introduced. Companies can enter into research contracts on behalf of an outside investor who had acquired shares or debt securities for SR&ED purposes.

1985 – The SRTC is eliminated. The tax credit for small businesses is changed to apply on the first $2 million of R&D performed in a year by an associated group of companies. This fully‑refundable credit applies only to current expenditures.

Revenue Canada is mandated to validate these credit claims at the time the taxpayer’s return is assessed. The department establishes a special group of assessing and audit staff to administer refund claims, hires or contracts technical experts to help the tax auditors in the determination of qualified R&D, and develops a standard prescribed form for the claiming of both the regular tax incentives and the refundable tax credit.

1986 – The term “scientific research and experimental development” is introduced as a new title in section 2900 of the Income Tax Regulations to clearly distinguish between eligible development and simply routine engineering and routine development.

The legislation is also amended to ensure that the beneficiary of SR&ED tax incentives is directly associated with the research activities. In addition, companies can no longer qualify for tax incentives unless the expenditures incurred are directly related or directly attributable to SR&ED activities. The government also moves to exclude expenses incurred for the purchase of buildings from the definition of SR&ED expenditures. Carry-forward provisions are enriched so that unused credits can be carried forward for 10 years. At the same time, the refundable tax credit at the basic rate of 20% is eliminated for large corporations. The 35% refundable credit for small CCPCs is not changed

1992 – Companies can choose to specifically identify the amount of their overhead and administration expenditures or can use a proxy amount that corresponds to 65% of the salary base directly attributable to SR&ED. Expenditures for the acquisition of machinery and equipment qualify for the tax credit if the equipment is primarily used for SR&ED more than 50% of the time, rather than at least 90%. This tax credit cannot be forwarded to a future tax year; it must be claimed in two equal installments in the two years following the year of acquisition.

1993 – CCPCs with prior year taxable income between $200,000 and $400,000 (formerly $200,000 or less) are eligible for the enhanced refundable tax credit rate for small corporations, up to a maximum of $2 million in qualified expenditures.

1994 – The special 30% tax credit rate for the Atlantic and Gaspé regions is eliminated. The special provisions governing sole‑purpose SR&ED performers are eliminated. A time limit is set for identifying SR&ED expenditures incurred in previous years.

1995 – SR&ED tax incentives apply to all businesses that invest in information technology, including financial institutions. Expenditures eligible for the tax incentives under contracts with related parties are limited to the actual costs incurred by the performers in carrying out the SR&ED. Third parties must provide information about the nature of the SR&ED they have carried out and indicate the related expenditures. Payments to third parties are eligible for the tax incentives in the year in which the SR&ED is carried out. Payments to third parties are eligible for the tax incentives in the year in which the SR&ED is carried out. The amount of salaries and wages eligible for the SR&ED tax incentives in the case of specified employees is limited to five times the year’s maximum pensionable earnings for the purposes of the Canada Pension Plan.

1998 – Eligibility for an investment tax credit is limited to those qualifying expenditures identified by a taxpayer on a prescribed form (T2038 – Investment Tax Credit) filed with the Minister of National Revenue within 12 months of the taxpayer’s filing due date for the taxation year in which the property is acquired.

1999 – When the product of an SR&ED project is sold, the overall cost of the project is reduced, and investment tax credits are provided only on the net cost of performing the research. A review of the administration of tax incentives for SR&ED is undertaken and a new, simplified form for the tax credit is developed.

2000 – Provincial deductions for SR&ED that exceed the actual amount of the expenditure are deemed to be government assistance and are excluded from the calculation of eligible expenditures for federal SR&ED tax purposes.

2003 – The small business limit for a CCPC is raised from $200,000 to $300,000, so the $2 million SR&ED expenditure limit is phased out when taxable income is between $300,000 and $500,000.

2004 – The Income Tax Act is amended to ensure that unconnected small businesses that engage in SR&ED do not have to share the enhanced 35% tax credit solely because they receive investments from the same venture capital investors.

2005 – Tax incentives are extended to SR&ED performed in Canada’s Exclusive Economic Zone, which encompasses 200 nautical miles from the coastline.

2006 – The small business limit for CCPCs is increased to $400,000 and the $2 million annual SR&ED expenditure limit is phased out when taxable income for the previous taxation year is between $400,000 and $600,000. The carry‑forward period of the tax credit is extended to 20 years.

2008 – The expenditure limit for CCPCs is increased from $2 million to $3 million and the upper limit for the taxable capital phase‑out range is increased from $15 million to $50 million. The upper limit of the taxable income phase‑out range is increased from $600,000 to $700,000. The SR&ED investment tax credit is extended to salaries and wages for certain activities carried on outside Canada by Canadian‑resident employees, with eligibility limited to a maximum of 10% of the total SR&ED salaries and wages incurred in Canada for the tax year.

2012 – The base of eligible expenditures is narrowed by removing capital expenditures starting in 2014. The “prescribed proxy amount” that is used to compute overhead expenditures is reduced from 65% of direct labour costs in 2012, to 60% in 2013, and to 55% effective January 1, 2014. Only 80% of contract payments can be used for the purposes of calculating SR&ED investment tax credits effective January 1, 2013. The general SR&ED investment tax credit is reduced from 20% to 15% effective January 1, 2014, and lease costs can no longer be claimed for SR&ED purposes.

2013 – The Income Tax Act is modified to introduce a penalty of $1,000 per SR&ED claim if tax preparer information requested on the SR&ED claim form is missing, incomplete, or inaccurate. If a tax preparer participates in the preparation of the claim, the tax preparer will be jointly and severally, or solidarily, liable with the taxpayer for the penalty.