INNOVATION July-August 2017

EXPENDITURE LIMIT FIGURE 1: EXPENDITURE ENVELOPE 3,500,000 $ 3,000,000 $ 2,500,000 $ 2,000,000 $ 1,500,000 $ 1,000,000 $ 500,000 $ 10M$

20M$

30M$

40M$

50M$

Taxable Capital

0 $

800,000 $

750,000 $

500,000 $

450,000 $

700,000 $

400,000 $

300,000 $

550,000 $

200,000 $

650,000 $

100,000 $

600,000 $

TAXABLE INCOME

Canada. Even after legislative changes introduced in 2012 reduced its disbursements by 14 percent, the program has easily preserved its status as the government’s most intensive R&D subsidy. As the name implies, you apply for tax credits by reporting your eligible SR&ED expenditures on your T2 Corporation Income Tax Return and receive a federal Investment Tax Credit of between 15 percent (the general non-refundable rate) and 35 percent (the enhanced refundable rate), with the provinces kicking in another 10 to 30 percent. Eligibility is governed by the depth of the technological uncertainties your team faced and by the knowledge they had to develop outside the public domain—the greater the resources devoted to addressing technological limitations (successfully or otherwise), the greater the expenditures that fall within the ambit of SR&ED support. The SR&ED is a retrospective program that is triggered by your fiscal year-end—you apply for a refund for activities already completed and expenditures already committed. Yet despite years of experience filing SR&ED returns, many companies are still caught by surprise by the changing amount of tax credits to which they are entitled from one year to the next. Expenditures may increase while tax credits stagnate or even decrease. What explains the discrepancy? How SR&ED Works To resolve the confusion, let’s explore the principle of the expenditure limit. Assuming your organization is a Canadian controlled private corporation (CCPC)—that is, at least 50 percent of company shares are owned by Canadian individuals or other CCPCs—the extent of the tax credit that can be applied against your eligible expenditures shifts with the changing fortunes of your company. The expenditure limit defines the envelope within which you have access to the enhanced refundable tax credit of 35 percent and is bounded by the total taxable income and total taxable capital of the associated group of companies in the previous tax year (Figure 1). If both the taxable income is below $500,000 and the taxable capital is below $10 million, you are entitled to the 35 percent enhanced credit against eligible expenditures up to a limit of $3 million, beyond which you receive the 15 percent general credit on the excess. If either the taxable income exceeds $800,000 or the

taxable capital exceeds $50 million, the expenditure limit drops to $0, you lose all access to the 35 percent enhanced credit, and all eligible expenditures are entitled to only the 15 percent general credit. If your taxable income and taxable capital fall between these thresholds, your expenditure limit will fall between $0 and $3 million. For example, you spend $900,000 of eligible expenditures on SR&ED activities and your associated group of companies realized $650,000 in taxable income and $30 million in taxable capital in the previous tax year. As per Figure 1, your expenditure limit is $750,000, meaning you receive the 35 percent enhanced credit against the first $750,000 of your $900,000 of eligible expenditures and 15 percent against the remaining $150,000—for a total tax credit of $285,000. So what conclusions can be inferred from the discussion thus far? First, all CCPCs, regardless of their size or success, are entitled to apply for and receive substantial tax credit support for their qualifying SR&ED work. Even if the higher tax credit rate favours smaller, less profitable companies, the program remains extremely lucrative for large, established organizations, many of whom are part of the 10 percent of claimants that historically capture more than 50 percent of the tax credits each year. Second, tax credit eligibility is strongly influenced by the stage of product development. In the early to middle stages, technological challenges are numerous and expand the scope of eligible expenditures. As development proceeds towards marketable products, uncertainties are resolved and the extent of eligible activities falls away. Third, tax credit efficiency is influenced by the stage of company development. Organizations with a history of successful product launches normally exhibit taxable incomes that breach expenditure limit thresholds, thereby reducing the share of expenditures that receive federal Investment Tax Credit support at the enhanced rate. Four, there are always exceptions to the rules. Technology companies that fail to entrench a culture of continuous development find they have few, if any, SR&ED expenditures. Early-stage development may include a large proportion of routine engineering with negligible technological uncertainty and SR&ED eligibility. And mature companies operating in highly competitive industries may realize only marginal profitability that preserves

19

J U LY/AU G U S T 2 017

i n n o v a t i o n