Will the SR&ED tax credit changes have a meaningful impact?

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By Terry Lavineway

The Scientific Research and Experimental Development (SR&ED) program was one of the long-anticipated and highly debated areas expected to be addressed in the 2012 Federal budget. Politically, the government needed to show they were listening to their taxpayers over the last number of years given the amount of consultations, the amount of press and discussion about the SR&ED program and certainly “Innovation Canada: A Call to Action,” also known as the Jenkins Report.

The biggest change introduced relates to the tax credit rate available to SR&ED claimants that are not Canadian Controlled Private Corporations (CCPCs). The tax credit rate for non-CCPCs will decrease from 20 percent to 15 percent. This is a significant reduction. The government’s view is that the reduction of the corporate income tax rate since 2007 along with the corporate tax restructuring of non-CCPCs has resulted in growing pools of unused tax credits; these corporations are not generating enough taxable income in Canada to make use of all the SR&ED investment tax credits that they are generating. Therefore, the government reasons that they can reduce the rate from 20 percent to 15 percent without much impact. While this may be true in many cases, there are definitely large taxpayers in Canada that will be significantly impacted by this reduction.  Only time will tell how this change will impact the amount of R&D performed in Canada by multinational corporations or even medium-sized corporations that do not qualify for the CCPC enhanced rate.

The other changes proposed are categorized as:

1. Simplifying the tax credit base

The budget proposes to eliminate capital expenditures starting in 2014. Definitely, with some exceptions, capital expenditures in SR&ED tax credit claims are a small percentage of the claim. And often, because of the complex rules around the eligibility of the capital expenditures, none of the capital costs end up qualifying as capital expenditures. So, yes, this is a simplification but really only a fraction of SR&ED claimants will be affected by this.

2. Increasing the cost effectiveness of the program

Increasing the cost effectiveness of the program in this budget means decreasing eligible expenditures used in computing the amount of the tax credit. First, the budget is proposing to reduce the prescribed proxy overhead amount from 65 percent to 55 percent of direct labour costs, fully phased in by January 1, 2014.

A taxpayer filing an SR&ED claim gets the benefit of adding an overhead component to their eligible expenditures that was the lesser of 65 percent of direct labour costs (that is, eligible salaries) and actual prescribed overhead expenditures. Reducing the prescribed amount from 65 percent to 55 percent affects those claimants whose overhead would have previously reached the 65 percent proxy overhead cap. This could certainly affect a significant number of claimants.

The option still exists to claim overhead in the traditional fashion of evaluating precisely what overhead expenditures are attributable to the SR&ED. This would not be subject to the 55 percent proxy overhead cap. This is a more difficult and time-consuming process. Depending on the business and the amount of overhead expenditures involved, it might be worth examining.

A second proposal to increase the cost effectiveness of the program relates to contract payments made to third parties to perform SR&ED on the claimant’s behalf. Until now, these payments were eligible at 100 percent. The budget proposes to reduce the eligibility of those payments to 80 percent, effective January 1, 2013. In the government’s view, this is to provide a tax credit on the expenditures incurred instead of on the amount that includes a profit margin.

Whether 80 percent reflects an accurate profit margin or not is an endless debate considering the vast number of industries representing a vast number of companies with different business models from which claimants are filing SR&ED claims.

What continues to be a confusing issue with regards to contract payments is who is entitled to claim the tax credit when a contract payment is involved. Does the payer have automatic entitlement? Does the receiver of the contract payment have an opportunity to claim the credit? It is often not clear and very frequently a source of mistakes by claimants. This budget has proposed nothing that will help alleviate this confusion.

3. Enhancing predictability

A number of items are mentioned in the budget to improve predictability. This is in response again to the consultations with stakeholders over the last number of years where a common complaint was lack of predictability of the timing and outcome of filing an SR&ED claim. Many taxpayers across the country have experienced, and continue to experience, frustrations with unpredictable results in terms of outcome and timing.

The budget mentions a few points of interest in this regard:

  • Consolidation of administrative policies from approximately 70 different policy documents is expected to be released in December, 2012. The intent here is to simplify the interpretations of what is eligible from scientific and expenditure perspectives.
  • Enhancement of an online eligibility self-assessment tool.
  • Changes to the Notice of Objection process such that a scientific eligibility can be re-examined. Until now, a Notice of Objection filed on a scientific eligibility issue was only examined from a due-process perspective, not a re-examination of the decision on scientific eligibility itself. It is not clear when this change would be effective and whether it would apply to notices of objections already filed. For those taxpayers that have claims at this dispute level, or are, unfortunately, heading that direction with current claims under review, this is an important change.

A final point raised in the budget was the announcement that the government will perform a study of contingent fees charged by SR&ED claim preparers. Again, going back to the feedback collected through consultations and certainly as depicted in the press, the perception is that SR&ED claim preparers are charging exorbitant fees to the claimants. The perceived result of this is a reduced benefit of the tax credit if the benefits of the tax credit are being paid in fees to claim preparers. This is a complicated, and heated, issue with so many questions and counterpoints. Certainly the discussions and results of the study will be interesting to follow.

Further budget analysis regarding other impacts to the business incentives landscape is forthcoming.

Broader analysis of the budget can be found at www.welchllp.com.

Terry Lavineway is director of business incentives at Welch LLP, where he helps clients navigate the landscape of tax credits and other government incentives.

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