Filing for SR&ED tax credits today in Canada is facing a new reality. CRA now screens over 60% of SR&ED claims and carries out site audits on at least 20% of them. Moreover, depending on your geographic location, when site audits are carried out, claims are reduced by over 20%, and in certain district offices, the reduction is ratcheted up by as much as 40%. As noted by CATA, the Finance Department’s projection is that SR&ED tax credits in 2017 would total $1.8 billion, a 24 percent decrease from the department’s previous year forecast. That follows a C$4.2 billion decline in SR&ED tax credits over 2009-2010 to the 2014-2015 period.
Is CRA Right?
Any company that has experienced a CRA SR&ED audit in the past few years has noticed that CRA is advocating a much narrower definition of what is eligible. Moreover, detailed documentation to support the SRED claim is required.
So, is CRA right? Is their application of the definition in the Income Tax Act correct? Is CRA becoming too strict on documentation or its interpretation of SR&ED eligibility?
A FinTech Example
Let’s take the fintech industry as an example. You are a Fintech startup in Canada and you have been asked by an incumbent financial institution to develop a solution to better identify risks on mortgage applications. The first thing you do is to understand the existing processes and the ways the bank calculates and determines risk. Then you start considering improvement in those processes. This can be a combination of merely improving workflow by revising ineffective tasks; asking better questions on the mortgage application, or using economic data to set new benchmarks (business innovation). You then take this information and start coding your solution (technical innovation). During this process, you may have to deal with performance issues such as:
- Cross-platform operability
- Integration of incompatible systems
- Generic algorithm as opposed to a specific one
Both the business innovation and technology development efforts here are very complex and difficult to achieve. However, CRA will take the position that the business innovation will not qualify. The technical innovation will qualify if there is a technological uncertainty present (generally overcoming one of the performance issues cited above). So, the question arises as to whether CRA is correct.
Most countries that offer R&D tax credit programs, Canada included, base their definition on the recommendations made by the OECD, in particular, the Frascati Manual. This manual has been in place since 1963, which is updated periodically. The criteria used in Canada is based on technological uncertainty, technological advancement and systematic investigation, all of which originate from the Frascati manual. This manual is the global gold standard that helps define R&D and the ways its definitions are used in different geographic articulations.
Here are some examples of R&D definition from the Frascati Manual as they pertain to computer and information sciences:
Basic research: Research on the properties of general algorithms for handling large amounts of real-time data.
Applied research: Research to find ways to reduce the amount of spam by understanding a spam’s whole structure, business model, what spammers do, and what their motivations are.
Experimental development: A start-up company obtains codes developed by researchers and develops a business case for the resulting software product for improved online marketing.
It is noteworthy that the Frascati Manual makes it clear that these examples are in the field of natural science and engineering, not social science. I believe that CRA would have a difficult time accepting these examples as SR&ED yet they are acceptable by the world standard body that put them together.
Furthermore, the Manual positions the following areas as examples of R&D in the banking and insurance sector:
- mathematical research related to financial risk analysis;
- development of risk models for credit policy;
- experimental development of new software for home banking;
- R&D related to electronic banking, insurance, Internet-related services, and e-commerce applications
Again, we believe CRA would have difficulty with many of the above areas qualifying as SR&ED.
By no means are we suggesting that there should not be checks and balances to ward off abuse of the SR&ED program. However, our international experience suggests that other countries prevent this abuse by utilizing more effective practices that result in far fewer audit rates or prolonged audits than there are in current CRA practices.
More importantly, Canada is losing out on the world stage by not recognizing and funding R&D in line with world standards. If other countries are following OECD recommendations and incentivizing their companies accordingly, our SR&ED program may not be internationally competitive. Have we lost sight of policy in our SR&ED program?
The 2017 federal budget stated that Finance was going to review the SR&ED program. Let’s hope they take into consideration what policies and R&D guidelines the OECD are recommending so that Canada remains competitive while incentivizing and rewarding Canadian companies that out research and innovation.
If you are in FinTech and would like to learn more about changes to the SR&ED program and their impact on your eligibility, contact us:
Brian Cookson is President and Managing Director at RDP Associates.