Just as there are pitfalls to watch out for when Canadian businesses form partnerships, contract agreements can also significantly impact SR&ED claims both positively and negatively.
When a business pays third-party contractors to perform SR&ED work on their behalf, the amount paid under these contracts is eligible for SR&ED, and 80% of the total qualifying expenditure can be claimed for Investment Tax Credit (ITC) purposes.
However, a carefully-worded contract agreement will have to be in place if the client wants to claim SR&ED on the qualifying activities performed by this other entity.
By making clear that the entity paying for the work is explicitly asking the contractor to perform SR&ED on its behalf, the contract will preserve the paying business’s ability to successfully claim the contract expenses.
The Canada Revenue Agency (CRA) frequently scrutinizes formal contract agreements to establish whether the work performed is directly related to the SR&ED claimed.
Even if a subcontractor is used, it remains the responsibility of the SR&ED applicant (the claimant or payer) to prove that the work performed on its behalf was SR&ED carried out in Canada and that it was directly related to the business of the claimant.
If an entire contract relates to SR&ED activities carried on outside Canada, then no portion of the contract amount qualifies for ITCs. Where some of the work is carried out in Canada, only this portion of the contract is allowable under a SR&ED claim.
The method used to allocate the contract amount between domestic activity and that carried out in other countries must be reasonable. Calculating the fair market value of the work, for example, would be acceptable but the claimant must be able to demonstrate to the CRA how the costs were allocated between locations. Once it has done so, the CRA will look at the contract to determine the type of expenditures incurred, and calculate the claimant’s qualifying SR&ED expenditures.
Contractors who are independent and have no corporate or personal relationship to a business are classed as Arm’s Length contractors. On the other hand, special rules apply when a claimant (payer) enters into a SR&ED contract with a Non-Arm’s Length (NAL) party. Here, the claimant’s expenditures under the SR&ED contract do not qualify for ITCs. It is not possible to circumvent these rules by inserting an arm’s length party in between the SR&ED claimant (payer) and the NAL.
When you consider engaging a third-party contractor to perform SR&ED project work on your behalf, keep in mind that you will not be able to include any NAL contractor expense in your SR&ED claim.
Some companies also pay approved universities, colleges, and research institutes to perform SR&ED work on their behalf. These are commonly known as third-party payments, and they represent a distinct class of SR&ED expenditures. Unlike contractor payments, 100% of the total qualifying third-party expenditures qualify for ITCs. With third-party payments, the payer does not actually control the SR&ED being performed but is entitled to exploit the results.
There are a few exceptions to the rules concerning contractors or suppliers that aren’t taxable (e.g. are not registered for GST/HST).
SR&ED ITCs cannot be claimed where the contract payment goes to, or will benefit, a person or partnership that is not a taxable supplier.
Richard Hoy is President of specialist tax consultancy Catax Canada. You can reach him at firstname.lastname@example.org.