SR&ED Accounting Considerations Larry Johnson, BSc, CA

1. November 26, 2003 SR&EDAccounting ConsiderationsLarry Johnson, BSc, CA

2. Where Tax & Science Meet • Canada’s largest tax incentive program • Also one of the most Underused • Professional advisors often fail to identify client activities that may be eligible

3. SR&ED Benefits • Federal & Provincial benefits • Federal option to deduct 100% of SR&ED expenditures • Can claim ITC’s to reduce tax payable • BC, MB, NB, NFLD, NS, ON, QC, SK • Flexible deductions • Current and capital items • ITC’s • Enhanced rates for CCPC’s • Refundable

4. SR&ED Benefits • Cash refunds as a financing source • Lower after tax R & D • Promoted by CCRA • Forms and guides • Brochures • Interpretations • Policies and guides • Sector specific guides

5. Program Requirements SR&ED claims have 2 Components • The technical submission (the science report) • describes and supports the eligible activity • The related tax schedules -detail the qualifying expenditures and calculate the resulting ITC’s

6. Program Requirements • The technical submission is clearly the most important part of the claim because: - If the science activities are not accepted as eligible under the program, the entire claim is disallowed and the resulting ITC is also disallowed - The SR&ED expenditures stem from the eligible SR&ED activities identified in the report - Acceptance or rejection of SR&ED is not a black-or-white decision and considerable judgement may be required to interpret the merits of a project - Accountants are not scientists or engineers – they can help identify opportunity, but CCRA experts can confirm eligibility

7. Defining SR&ED • Important to distinguish between R&D and SR&ED • R&D can be many things, but SR&ED is defined in the ITA and has a narrower scope • CCRA has developed eligibility criteria through a co-operative effort with industry and the accounting profession • Information Circular 86-4R3 forms the cornerstone for the criteria for eligibility • Circulars and Bulletins for guidance found at: • http://www.ccra-adrc.gc.ca/taxcredit/sred/menu-e.html

8. Defining SR&ED SR&ED defined in ITA as a “systematic investigation or search that is carried out in a field of science or technology by means of experiment or analysis” The claimant must demonstrate that a proper scientific approach was followed - trial & error not a scientific approach First year claimants may be allowed some leeway (ie cut some slack)

9. Defining SR&ED • Claims should be properly executed • ie before undertaking a possible SR&ED activity: • Undertake proper planning procedures • Develop a hypothesis • Document all procedures for all testing and results

10. Eligible Fields of Science • Basic Research • An advancement of scientific knowledge without a specific practical application • Applied Research • An advancement of scientific knowledge with a specific practical application • Experimental Development • A technological advancement for the purpose of creating a new product or process

11. Eligible Fields of Science • Most people perceive only basic and applied research as eligible • Eg developing a cure for cancer Only 10 % of all SR&ED claims are research based • Experimental Development with a commercial focus accounts for 90% of all eligible and allowed SR&ED claims

12. Defined Ineligible Activities • Market research and sales promotion • Quality control and routine testing • Social sciences • Prospecting, exploring or drilling for minerals, petroleum or natural gas • Style changes • Routine data collection

13. Criteria for Eligibilty • To be eligible, the project must meet three criteria as set out in IC 86-4R3 • Technological uncertainty • Technological advancement • Technological content

14. Technological uncertainty • Must demonstrate that the project is not just an application of existing technologies • ie you don’t know in advance that a result was attainable • Easy to demonstrate in research • Experimental development can result in: • A totally new concept • A new way of doing things • An incremental improvement • A failure • All can be eligible

15. Technological uncertainty • Need to distinguish between routine engineering and SR&ED • Reinventing the wheel doesn’t qualify • Commercial uncertainty relates to marketing and doesn’t qualify

16. Technological Advancement • The project must contribute technological advancement to the appropriate area of science and/or engineering • The result of the research or development must lead to new or improved technologies that could benefit others

17. Technological Content • Activity must be carried out with a scientific method: • Identify a hypothesis • Set out to follow a logical series of steps to prove it • All activities must be properly documented • Must be able to prove the work was planned and organized

18. Technical Submissions • A properly prepared technical submission must: • Clearly identify the activity • Indicate how the project meets the definition of SR&ED • Fully describe how it meets the eligibility criteria CCRA has many Science Officers, but can’t cover all bases – the project description should stand on its own!

19. Technical Submissions • It is extremely important that the technical submission identify the area of science. • Recently an improperly prepared biotech claim was assessed as a computer software claim because one minor aspect of the claim involved setting up a computer database. • CCRA assigned a computer scientist to assess the claim and it was rejected because there was no advancement of computer science. • All the biotech work, which may have been eligible, was rejected.

20. Technical Submission • Each Fiscal Year must stand on its own • Just because a claim has succeeded in a prior year is no guarantee that it will continue to be eligible in the future • Do not take claims for granted

21. Identifying SR&ED Activities • Indicators to consider in determining eligible SR&ED activity: • Were qualified engineers and scientists involved in the project? • Were applications made for patents? • Does the product or process have to meet industry standards? • What is the industry? (CCRA identifies 12 technology sectors) • Did the company retain the intellectual property rights to any subcontracted work? • Is the company trying to develop a new process or product with no precedent? • Is this an improvement that requires new technologies to succeed? • Did the company go through steps that failed?

22. Accrued Expenses • Normal accrual accounting is now permitted • Tax credits are earned in the year that the work is performed but are only paid if the expenditure is paid within 180 days of the year end, otherwise the credit is received when the expenditure is paid • All accrued expenses must be reported on the T661 of the year in which the expense was incurrred to qualify for ITC’s

23. SR&ED Best Practices • Motivate staff to record eligible activities • Emphasize the importance of the program to the company • Reduce tax and increase cash flow • Individual incentives • Bottom line = bonus • Increased tax credits could increase R & D Budget

24. SR&ED Best Practices • Develop an R & D system that segregates eligible activities from routine R&D • Separate the technological issues from product development • Use coding for R&D projects and sub-codes for tasks and activities • Develop documentation that ties activities to the project plan • Develop a time system to capture eligible activities

25. Documentation • Possible sources of Evidence of Advance, Uncertainty or Content • Feasibilty studies, reviews of existing technology, beta products • Internet searches • Search for generally available info (library) • Project plan – objectives, hypothesis, plan, budget, staffing, deadlines • Notebooks and logs • Defect logs • Minutes of meetings

26. Documentation • Possible sources of Evidence of Advance, Uncertainty or Content • Designs, plans sketches, charts • Photographs, videos, prototypes • Internal correspondence (emails, memos) • 3rd party documentation – vendors, suppliers, contractors • Personnel qualifications

27. Financing Issues • Many Canadian technology companies rely on refundable ITC’s as a significant source of capital • But a company must retain its status as a Canadian Controlled Private Corporation (CCPC) to be eligible for the maximum benefits • Many growing technology companies carry forward non-capital losses, SR&ED pools and ITC’s • A CCPC can be eligible for the $500,000 capital gains exemption or ABIL’s • These tax benefits are only available if the company retains its status as a CCPC

28. Financing Issues • If a technology company is contemplating a sale of shares to become public or foreign controlled it should plan carefully to avoid losing the unused tax advantages available to CCPC’s • The tax issues facing technology firms raising capital can significantly affect the outcomes for all concerned. Professional advice should be obtained before any financing deal is finalized

29. Thank You Please do not hesitate to contact any of our offices if you have questions about any of this material. Or contact Larry Johnson, BSc, CA at the Medicine Hat office at 527-4441.