Tax Planning and SR&ED

I’m often amazed that some Canadian technology companies spend a fortune on complex tax planning structures and ignore rudimentary compliance functions to support SR&ED tax incentives.

While SR&ED is becoming more difficult and less predictable, it is still the best deal around for companies investing in new and improved technologies. The benefits of claiming SR&ED successfully will generally dwarf most other tax planning strategies for early stage technology companies in Canada – particularly those with 100 or fewer employees.

In the example above, a small tech company with a 20 person development team – has $750 K in eligible costs. If planned and documented properly, the company should be entitled to a $482 K tax refund.

If they aren’t careful in managing their expenditure limit, the refund could be reduced to $ Nil – and they would restricted to claiming SR&ED against taxes otherwise payable. (cost $209 K to $482 K)

In the 3rd scenario, when the company doesn’t adequately document SR&ED activities, it loses all entitlement to SR&ED tax incentives. (cost $482 K)

HOW TO DOCUMENT SR&ED ACTIVITIES

Most companies with a 20-person development team has some form of documentation. For a software company that might mean project management software, source code repositories and/or timesheet systems.

What they don’t have is documentation of technological uncertainties faced – and how they attempted to address these. The fact is that businesses engage in R&D to build and improve products or services. They aren’t really interested in overcoming technological uncertainties – except as a by-product of their product development work.

It makes much more sense to use existing – proven – technology to build new products. Extending and/or enhancing the underlying technology is risky business. That is precisely why the SR&ED program was introduced. It was designed to help share the technological risk with innovative companies.

In order to qualify for SR&ED tax incentives, companies must be able to identify which technological uncertainties they faced – and how they attempted to overcome them. However in our experience companies do a lousy job of documenting the technological uncertainties (“TUs”) they faced. Instead they focus on functions and features that they successfully developed.

That is the biggest single problem that the CRA finds with SR&ED claims. A decade or 2 ago the CRA would do their best to infer the technological uncertainties from the product improvements described in the SR&ED claim. These days however, CRA’s technology advisers not only expect TUs to be specifically identified, they expect documentation to describe how and when a specific uncertainty was identified and how eligible costs claimed relate to the attempt to resolve the uncertainty.

This is problematic for businesses that wouldn’t otherwise consider an “activity-based costing system”:

Introducing activity-based costing is not a simple task—it is by no means as easy as ABC. For a start, all business activities must be broken down into their discrete components. As part of its ABC programme, for example, ABB, a Swiss-Swedish power company, divided its purchasing activity into things like negotiating with suppliers, updating the database, issuing purchase orders and handling com-plaints.

Large firms should try a pilot scheme before implementing the system throughout their organisation. The information essential for ABC may not be readily available and may have to be calculated specially for the purpose. This involves making many new measurements. Larger companies often hire consultants who are specialists in the area to help them get a system up and running.

The easy approach is to use ABC software in conjunction with a company’s existing accounting system. The traditional system continues to be used as before, with the ABC structure an extra to be called upon when specific cost information is required to help make a particular decision. The development of business accounting software programs has made the introduction of activity-based costing more feasible.

The Economist – June 29th, 2009

Obviously the latter approach is the only viable option for small technology companies.

We have designed a custom form that can be modified for our clients, to log TUs encountered by senior technical staff during the course of product development activities. In the video that follows I describe the form can be designed and modified using Smartsheet™.

Once built the form can easily be incorporated into a simple ABC system, layered on top of a traditional accounting system, and used for tracking SR&ED expenditures.