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Deloitte & Touche LLP Submission in Response to Joint Finance Canada Canada Revenue Agency Consultation Improving the Scientific Research and Experimental Development Tax Incentives:

Tax Incentives for Scientific Research and Experimental Development

Deloitte is pleased to present our recommendations in response to the request for submissions issued by the Honourable Jim Flaherty, Minister of Finance, and the Honourable Gordon O'Connor, Minister of National Revenue on the scientific research and experimental development (SR&ED) incentive program. The government is interested in how to make the SR&ED program more effective for Canadian business and to allow it to play an even greater role in fostering a more competitive and prosperous economy. We believe that the SR&ED program is an important tool of the federal government to promote industrial R&D in Canada. The take-up of the program with over 19,000 companies accessing the program in 2004 and in excess of $3 billion in assistance provided to corporations in 2006, demonstrate the importance of the program to Canadian industry.

This is an opportune time for the government to consult on the SR&ED program for the following reasons:

  • Canada's SR&ED program once considered the leading R&D tax incentive program in the world is facing much more intense global competition as now over 30 countries have R&D tax incentive regimes as well as other forms of assistance;
  • R&D investment is much more mobile today. With current technology, R&D can occur virtually anywhere in the world with a pool of highly skilled workers;
  • The impact of the rising dollar has weakened Canada in the competition for incremental investment in R&D by global multi-nationals;
  • There is increased competition for R&D investment from other countries with lower wage rates, large pools of highly educated professionals with advanced degrees and government support (both direct and indirect). This has eroded Canada's advantage;
  • The SR&ED program has been overly complex for the Canada Revenue Agency to administer and taxpayers to comply with. Simplification would reduce the compliance costs for both.

Our submission will make recommendations for improvements to the program, focusing on increasing immediate access to the SR&ED tax incentives to both Canadian controlled private corporations (CCPCs) and all other corporations; and alternative methods to deliver the incentives. A summary of these recommendations is as follows:

Canadian Controlled Private Corporations

Small business represents the bulk of SR&ED performers in Canada. While many of these corporations meet the ownership, taxable income and taxable capital tests in order to qualify for refundable credits, a significant number fail to do so. In order to provide increased access to the credits for CCPCs, Deloitte recommends that the limits for refundable credits be increased immediately as follows:

  • The SR&ED expenditure limit for the high rate refundable credits should be increased to $ 10 million per annum;
  • The taxable income limits should be increased from the current $400,000 to $600,000 for purposes of computing the high rate refundable investment tax credits for 2008 and subsequent years and;
  • Change the grind of the expenditure limit from a $10 reduction in the expenditure limit for every $1 of taxable income in excess of the business limit to a ratio of $25 for every $1. This would effectively increase the phase-out range from $600,001 to $1,000,000. It would allow taxpayers to access the fully refundable credits with taxable income up to $600,000 and proportionately reduced amounts with taxable incomes between $600,001 and $1,000,000; and
  • Eliminate the capital tax restrictions.

These recommendations will increase immediate accessibility to the incentives for CCPCs and adjust limits such as the expenditure limit that have remained unchanged since inception to reflect inflation. It will also promote the reinvestment of earnings in emerging forms to assist them in successfully commercializing the results of their SR&ED.

All other corporations

Deloitte recommends that the government consider in the longer term:

  • Eliminating the CCPC requirement for refundable credits. The government can further stimulate SR&ED in small businesses by removing the current ownership restrictions and by increasing the size limits for all small and medium sized enterprises (SMEs). An example of such a system can be drawn from the United Kingdom where there are no ownership restrictions and the size tests for an SME is less than 250 employees and either sales of under ‚¬50 million or gross assets not exceeding ‚¬43 million. These limits are due to increase to 500 employees and sales of ‚¬100 million and assets of ‚¬86 million. In addition, both Ontario and Quebec have eliminated the CCPC restriction for their respective refundable credits which are available to all corporations within limits. We believe that the current Canadian ownership and size restrictions unnecessarily impede the growth of SMEs and should be revised.
  • Allowing refundability within limits to all corporations. One of the objectives of the SR&ED program is to provide incentives that as much as possible are of immediate benefit. Currently, taxpayers in a loss position; certain of those with foreign parents located in a country with a foreign tax credit regime such as the United States; and those operating in the limited partnership form have difficulty accessing the immediate benefits of the program.

Deloitte recommends that the federal government introduce refundable credits within limits for all corporations. There are a number of ways to introduce such a regime:

  • Allow investment tax credits to be offset against a limit. One such limit could be the employers portion of Employment Insurance premiums or;
  • Introduce a refundable mechanism such as the one in France where the government will refund the credits up to a maximum of ‚¬16 million per year provided that the incentives are not used in the following three years.

Of the $3 billion in support to business through the SR&ED program in 2006, over $1 billion represents tax credits earned in previous years but claimed in 2006. Therefore, part of the cost of this recommendation is a timing issue with taxpayers receiving their incentives on a current basis rather than at unspecified time in the future.

Companies that can only claim the benefits when they are taxable greatly discount these benefits in planning their R&D investment. Additional refundability will provide taxpayers with greater certainty that they will be able to access the credits on an immediate basis which in turn will stimulate additional R&D investment in Canada.

Other legislative changes

  • Proposed section 220(2.2) of the Income Tax Act which will prevent the Minister from accepting SR&ED claims filed after the 18 month deadline should be repealed and replaced with a provision allowing the claims but subject to a penalty;
  • To reduce the number of issues over the contract payment rules, introduce an election to allow the parties to a contract to elect who is entitled to claim the SR&ED incentives;
  • Change the definition of SR&ED to clarify the difference between the inclusions and the exclusions; and
  • Amend the legislation on SR&ED and partnerships. The current legislation is overly restrictive and places partnerships at a disadvantage to corporations.

These recommendations would alleviate some of the current compliance issues.

Other alternatives

Additional alternative proposals exist to increase R&D investment in Canada. It is recognized that these alternatives would require further study and consultation prior to implementation. We are not recommending these alternatives; however, we believe that they should be included in the discussions. These alternatives include:

  • The use of flow through share mechanisms to allow corporations that are unable to utilize their investment tax credits to sell the credits to their investors. It is recognized that such measures were implemented in 1983 and then shut down due to abuse. Any such measure must be structured differently from the 1983 alternatives.
  • The use of an Innovation Account to recognize that R&D is not conducted in a linear fashion. Companies could contribute to such an account and receive a current deduction provided that the funds were spent on eligible SR&ED within a prescribed time frame.
  • Allow companies to elect on an annual basis to choose between the current system and a refundable wage tax credit system such as the one used by Quebec. It is recognized that such a system favours labour intensive SR&ED and is not favourable to capital intensive SR&ED.

The outcome of these consultations has the potential to radically improve Canada's SR&ED tax incentive program. We recommend that action be taken now to reshape the SR&ED program to provide more effective tax incentives to R&D performers. This in turn will stimulate additional R&D in this country with all of the proven spill over effects to the economy.


Policy rationale

The policy principles underlying the current system of income tax incentives for SR&ED were first set out in a 1983 budget document[1] and continue to remain in effect. As stated in that document, these principles are:

"The private sector is in the best position to determine the amount and type of industrial research and development that it should undertake. Any firm's research and development projects have to make business sense; the results need to be marketable, and the project should be profitable. Thus, the incentive structure for research and development should continue to contain general measures, such as broad-based tax incentives, that leave day-to-day decisions on research and development projects in the hands of the private sector. While there will also continue to be a role for grant programs targeted to research and development in industry, the tax system is best suited to delivering general incentives.

The goal of research and development policy is not to create research and development solely for its own sake. To be effective, the results of research and development have to be used – to create jobs, to improve productivity and competitiveness, to develop new products that Canadians can sell to other Canadians and to the world. To a large extent, the responsibility for this must rest with the private sector.

The objectives of the policy are to:[2]

  • encourage SR&ED to be performed in Canada by the private sector through broadly based support;
  • assist small businesses to perform SR&ED;
  • provide incentives that are, as much as possible, of immediate benefit;
  • provide incentives that are as simple to understand and comply with and as certain in application as possible; and
  • promote SR&ED that conforms to sound business practices.

As noted in the current Department of Finance Consultation Paper, "the rationale for this tax support is that the benefits of SR&ED extend beyond the performers themselves to other firms and sectors of the economy. The existence of these spillovers, or externalities, means that, in the absence of government support, firms would perform less SR&ED than is optimal for the economy."[3]

Our submission will focus on three areas within these policy objectives:

  • In assisting small business to perform SR&ED are the current ownership, SR&ED expenditure limit, taxable income limits, and taxable capital limits overly restrict the assistance to small R&D performers?
  • Do the current incentives provide as much as possible an immediate benefit?
  • Are the incentives simple to understand and comply with?

We believe that improvements can be made in each of these areas.


The SR&ED program offers tax incentives in the form of investment tax credits (ITCs) which are earned on a taxpayer making eligible SR&ED expenditures and a 100% write-off of both eligible current and capital SR&ED expenditures. Alternately the expenditures may be placed in a pool and written off in a future year. The rates of the ITCs range from 20% to 35%. These ITCs can be utilized to offset federal taxes payable on a dollar for dollar basis. In addition, CCPCs are entitled to refundable ITCs to the extent that the credits are not used to offset taxes payable and within limits. These ITCs are taxable as income in the year following the year that are refunded or utilized to offset federal taxes payable.

In addition, many of the provinces offer additional incentives for SR&ED performed in that province. These provincial incentive systems piggyback the federal system with some differences.

The definition of SR&ED is modelled after the one contained in the Frascati Manual[4] and is consistent with the definition used in most of the R&D tax incentive regimes around the world. CRA has published extensive documentation to assist taxpayers in understanding what SR&ED is within their industry sectors. Much of this documentation was developed with the assistance of industry.

Eligible expenditures include both current and capital expenditures in respect of SR&ED carried on in Canada and performed by the taxpayer or undertaken on its behalf and related to the taxpayers business or a possible extension thereof. Again, CRA has published guidelines on what expenditures are eligible as well as how to allocate expenditures to SR&ED projects from a taxpayers business records.

International competition

For companies operating on a multi-national basis, the R & D tax incentives can be one important factor that influences the location of their R & D activities. There are now over 30 countries with established r & d tax incentive regimes, including new regimes in South Africa, New Zealand and many states in the United States. In addition, China has announced a new regime and both the United Kingdom and the United States have enhanced their regimes.

Despite this proliferation of regimes, Canada's still rates as one of the world's best systems when considering the following criteria:

  • Is the system volume-based or incremental-based? Incremental-based systems are less attractive.
  • What is the effective rate of the credit on an after-tax basis? Canada's federal 20 percent pre-tax rate for large companies compares favourably to that of many regimes, including the United Kingdom at 7.5 percent (to be increased to 8.4% in 2008) on an after-tax basis and the United States federally at 6.5 percent on an after-tax basis on incremental expenditures only.
  • Is all or a portion of the credit refundable? For example, in France, unused credits are refundable to a maximum of ‚¬16 million a year, are refundable after three years, and can even be sold to a bank on a discounted basis.
  • What types of activities qualify? As a general rule, most regimes use the definition of research and development contained in the Frascati manual[5] and has consistent views on what is and is not r & d. What types of expenditures qualify? The Canadian regime has one of the broadest bases of allowable expenditures, including r & d capital and overhead. An example of a restrictive regime would be the United Kingdom where only salaries and limited amount of materials and subcontracts can be included as eligible expenditures.
  • Can a taxpayer be certain of obtaining the credits and how arduous is the process?

While it is true that Canada's regime compares favourably to other regimes, Canada has lost its distinct advantage that it had in this area. The Department of Finance statistics show that large corporations conduct the bulk of SR&ED in Canada. These companies have a choice as to where to make to make their R&D investment. A regime that fails to offer distinct advantages and certainty that the incentives applied for will be received without going through an arduous process, will not be a deciding factor in making that investment decision.

By introducing greater refundability and improving the administration of the program, Canada once again will have a distinct advantage over many other R&D tax regimes.

Recent changes to the program

In the recent years the government has made or proposed a number of legislative changes to the SR&ED program. Some of these changes have been to enhance the program and others to fix perceived abuses. These changes include:

  • Changes as a result of the Alcatel case to exclude the value of stock options of SR&ED employees from being included as SR&ED expenditures
  • Proposed section 220(2.2) of the Income Tax Act which will prevent the Minister from accepting SR&ED claims filed after the 18 month deadline.
  • Increase the carry forward period for investment tax credits to 20 years
  • Increase the small business limit to $400,000
  • Introduction of a deemed year end for CCPCs on a change of control caused by signing an agreement to sell shares at a future date

However, one major beneficial change was recently proposed by the federal government and that is the decrease in the corporate rates. This impacts the SR&ED program as the investment tax credits earned are taxable in the year following the year that they are refunded or used to offset federal taxes payable. Therefore, the value of the credit increases as the corporate rates decrease as follows:

After-tax value of the Canadian investment tax credits

  2007 2008 2009 2010 2011 2012

Credit 20% 20% 20% 20% 20% 20%
Existing Tax Rate 22.12 20.5 20.0 19.0 18.5 18.5
Value of the Credit 15.576 15.9 16 16.2 16.3 16.3
Proposed Tax Rate 22.12 19.5 19.0 18.0 16.5 15.0
Value of the Credit 15.576 16.1 16.2 16.4 16.8 17.0

Between 2007 and 2012, the absolute value of the after-tax value of the credit will increase by 1.424%.

It should be noted that in addition to the value of the credit shown above, there is additional value to corporations in being able to write-off eligible SR&ED capital equipment on a current basis rather than over time through the capital cost allowance provisions of the Income Tax Act.


The focus on our submission in respect of legislative changes is to provide enhanced immediate access to the SR&ED tax incentives for taxpayers and to suggest certain other legislative changes to improve the program.

Canadian Controlled Private Corporations

Deloitte is proposing both immediate and longer term changes to the access to the incentives for SMEs. We believe that the government should immediately increase the limits for refundability for CCPCs and in the longer term remove the ownership restrictions and make the incentives refundable to all corporations within limits.

Immediate recommendations

Many CCPCs conduct significantly higher amount of R&D as a percentage of their total spend when compared to the average of all companies. For many of them, one key issue is lack of cash flow which impinges on their ability to spend as much on R&D as they would want to. For many of them, the support received through the federal refundable investment tax credit system and from certain of the provinces with parallel programs has been a key factor in assisting them to fund their R&D and to grow and prosper by exploiting their technology. Deloitte believes that while the current system is an important source of cash to these corporations that the current limits to access the refundable credits hamper this important phase of business development for CCPCs and we recommend that each of these limits be increased.

We recommend that:

  • the SR&ED expenditure limit for the high rate refundable credits be increased to $10 million;
  • the taxable income limit for these purposes be increased to $600,000
  • the grind of the expenditure limit from current $10 of reduction in the expenditure limit for every $1 of taxable income in excess of the business limit would be changed to a ratio of $25 to $1;
  • the capital tax restriction be removed.

Issue Recommendations

Erosion of Expenditure Limit

Currently, CCPCs are limited to a maximum of $2 million a year in eligible SR&ED spending that is eligible for the high rate of refundable investment tax credits (ITCs). This $2 million expenditure limit was introduced in 1985. However, in the 20 years since its introduction, the Consumer Price Index has risen by over 80%. On this basis alone, the expenditure limit would need to be in excess of $3.5 million for an SR&ED claimant to receive the same benefit as envisioned by the legislators when the legislation was drafted.

An increase in the expenditure limit to $10 million.

Clawback of Investment Tax Credit (ITC) at Enhanced Rate after $400,000 of Taxable Income

The $2 million expenditure limit referred to above is reduced as the taxable income in the immediately preceding year of an associated group of companies, including the particular CCPC, exceeds $400,000 (assuming that the current proposal is passed into law) of taxable income. The expenditure limit is reduced by $10 for every $1 by which the taxable income of the associated group exceeds $400,000 for calendar year 2007 and afterwards. Therefore, the expenditure limit is reduced to NIL when the taxable income of the associated group reaches $600,000 for 2007 and afterwards.

Currently, owners can re-invest a limited amount of income in the corporation (and in SR&ED) since the taxable income limit forces them to extract earnings from the corporation in excess of $400,000 in 2007 and afterwards.

(1) Increase the taxable income limit for these purposes from $400,000 in 2007, to $600,000. Thus, the threshold for subsequent years where no high rate ITCs could be claimed would be $1,000,000 (including the proposed additional $200,000 phase out as set out below) and;

(2) Change the grind of the expenditure limit from $10 of reduction in the expenditure limit for every $1 of taxable income in excess of the business limit to a ratio of $25 to $1. This would effectively increase the phase-out range from $600,001 to $1,000,000 and would allow taxpayers to access the fully refundable credits with taxable income up to $600,000 and proportionately reduced amounts with taxable incomes between $600,001 and $1,000,000.

The increases in SR&ED incentives due to these measures will be partially offset by increases in the corporate tax on income generated by the taxability of the ITCs in the subsequent year.

Capital Restriction

The current legislation also reduces the $2 million expenditure limit where a corporation's taxable capital computed under the large corporations tax rules is greater than $10 million and is reduced to $NIL when taxable capital reaches $15 million.

Taxable capital is primarily comprised of debt financing obtained by the corporation and equity and earnings that are retained and reinvested in a corporation. The purpose of the enhanced ITC and its refundability is to aid CCPCs that are in need of cash to survive and to continue funding their research and development activities.

The taxable capital restriction penalizes companies that have the ability to either raise financing or retain earnings in their corporation by limiting those taxpayers' access to the high rate refundable ITC.

The taxable capital restriction be completely removed from the calculation of the expenditure limit for SR&ED purposes or at least that the threshold at which the restriction applies be significantly raised.

Longer term recommendation

Canada has 2 tier incentive program, where a higher rate of refundable incentive (35%) is provided to small CCPCs within limits and a lower rate (20%) of non-refundable incentives to companies who fail to meet the limits. Deloitte questions the need to restrict the higher rate refundable credits only to CCPCs. In addition, we recommend that the current limits on how much can be refunded annually and the definition of a small medium sized enterprise should be raised dramatically.

Other Canadian corporations-high rate incentives

While we recognize that the limitation for refundable SR&ED incentives is based on the current legislation for the lower rate of income tax, we don't believe that there is economic rationale to distinguish between a CCPC and a SME. We recommend that the requirement for CCPC status in order to be entitled to high rate refundable credits should be eliminated.

One of the crucial factors for R&D intensive companies is cash flow. For many companies growing from the start-up stage lose their CCPC status when raising funds by:

  • Listing, directly or indirectly via a reverse takeover, on a public exchange such as the TSX-Venture exchange.
  • Raising equity from investors, such that after the transaction, less than 50% of the shares are held by a combination of CCPCs and Canadian individuals.
  • Raising equity from a foreign investor that requires, as a condition of investment, that the parent holding company be incorporated in a foreign jurisdiction such as Delaware.

None of these events makes the quality of the R&D undertaken in Canada any less valuable to the Canadian economy. It is noteworthy that other Government programs – such as IRAP and TPC – do not distinguish between private and public companies in the assessment of eligibility for funding.

The government has recognized that the loss of the CCPC status can create difficulties for SMEs and has introduced over a number of years measures to soften the blow of the loss of CCPC status. These include the 2006 draft legislation to create a deemed year end when shareholders sign an offer to sell sufficient to shares so that the company will lose its CCPC status. However, these measures although of a relieving nature fail to deal with underlying problems and add additional complexity to the system. One of the basic underlying problems is that the CCPC status is all or nothing.

Other countries recognize the benefits of providing additional support to small companies and have no ownership restriction. For example:

  • The United Kingdom has also has a 2 tier system of R&D tax incentives to encourage innovation. The R&D incentives in the UK are proposed to be increased to the following:
  • for small companies, a tax deduction of 175% of their qualifying spend on R&D with an option for loss making companies of receiving cash refunds of up to 24% of their qualifying spend
  • for large companies, a tax deduction of 130% of their qualifying spend with no cash option

The definition of a small corporation in the UK is vastly different from the Canadian definition. There are no ownership restrictions and the size tests for an SME is less than 250 employees and either sales of under ‚¬50 million or gross assets not exceeding ‚¬43 million. These limits are due to increase to 500 employees and sales of ‚¬100 million and assets of ‚¬86 million. In considering if a company meets these limits, similar to the Canadian associated company rules, one needs to consider 100% of the figures for any companies with a greater than 50% ownership link and the relevant percentages of companies with an ownership link between 25% and 50%. There are exemptions for venture capital or institutional investors with more than 25% but less than 50% ownership. There is no need to include any figures for companies with an ownership link of less than 25%.

  • In the Australian system, all small firms (without ownership restriction) can claim a refundable credit which is net of any other tax owing before it is refunded. This offset supports small companies including those in a tax loss situation who are unable to get immediate access to the incentives.
  • In Austria, all companies can forgo the additional deduction from their R&D tax allowance and receive cash instead. The cash is computed as 8% of the qualifying expenditures. There is no restriction on ownership or size.

Of the $3 billion in support to business through the SR&ED program in 2006, over $1 billion represents tax credits earned in previous years but claimed in 2006. Therefore, part of the cost of this recommendation is a timing issue with taxpayers receiving their incentives on a current basis rather than at unspecified time in the future.

We recommend that the government consider opening up access to the high rate refundable credits to all companies without limits except a size test based on the number of employees and sales.

Other Canadian corporations-refundability

When other Canadian Corporations plan their R&D investment, they take into account a number of factors:

  • Can they access the SR&ED tax incentives on a current basis? Companies in a loss position will severely discount the value of the incentives in planning their R&D investment. Currently, the Department of Finance estimates that the manufacturing sector earns slightly less than 50% of all SR&ED ITCs. Clearly, the rapid rise in the Canadian dollar has negatively impacted the profits in this sector and therefore, companies' ability to access the ITCs. This is at time when companies will ever more need to innovate to survive and prosper.
  • For companies, either Canadian owned or foreign owned, or operating in a loss position are refundable R&D incentives available in the countries in which they operate? For example, in France, unused credits are refundable to a maximum of ‚¬16 million a year, are refundable after three years, and can even be sold to a bank on a discounted basis. Other jurisdictions such as Austria offer unlimited cash back at a rate of 8% of qualifying R&D expenditures in lieu of the super deductions offered on such expenditures.
  • For foreign owned companies, will the SR&ED incentives actually lower the group's effective tax rate? Foreign parent companies are generally able to reduce the Canadian corporate income tax payable by the Canadian company, in the form of a foreign investment tax credit against tax otherwise payable on the distributed earnings of the Canadian subsidiary. This recovery is generally allowable to the extent that the Canadian taxes payable don't exceed the foreign investor's local income tax. As the SR&ED ITCs reduce the Canadian corporate taxes payable, this in turn reduces the foreign tax credits generally available to the foreign investor. Thus for some companies, Canadian SR&ED ITC's have no overall benefit to the corporate group.
  • For foreign owned companies, where should they locate their R&D on a cost effective basis? One factor in this consideration is what R&D incentives are available in other jurisdictions. There are now over 30 countries with established R&D tax incentive regimes. South Africa and New Zealand have recently implemented R&D tax incentive regimes. Other countries such as China and the United States have recently enhanced their programs and France has announced further enhancements. As noted by the Department of Finance, Canada's federal system of R&D tax incentives is among the most advantageous in the world and Canada would rank in the top five if provincial measures were included in the OECD indicator. However, there is increased foreign tax competition which has diminished our advantage to the point where in many cases; our advantage may be insufficient to sway R&D investment to Canada.

One of the stated objectives of the SR&ED program is to provide incentives that are, as much as possible, of immediate benefit. Currently, for many companies, the R&D tax incentives aren't providing an immediate benefit. While one option would be to allow full refundability on all future ITCs earned, we recognize that full refundability is not possible at this time. Therefore, Deloitte recommends that the government consider implementing refundability of SR&ED ITCs within limits to all corporations.

This recommendation would have a number of benefits:

  • Provide companies with immediate access to cash to fund additional R&D investment in Canada;
  • Put the Canadian regime on a par with other regimes such as France which offer refundable incentives within limits;
  • Remove the foreign tax credit issue at least for U.S. corporations. Under a U.S. Letter Ruling, refundable credits don't reduce the quantum of foreign taxes credited in the United States to earnings repatriated to the United States. Therefore, the group's overall taxes are reduced and therefore, the Canadian incentives will have value to the group;
  • It would partially eliminate the overhang of unused credits that will accumulate if the system remains unchanged.

A number of alternatives on how to design refundability for other Canadian corporations have been proposed including:

  • Introduce refundable SR&ED ITCs up to a limit, such as the employer's portion of Employment Insurance premiums. The employer's portion of Employment Insurance premiums is only used as a limit and we are not recommending an offset against the Employment Insurance fund.
  • Introduce a cap on refundability such as France (‚¬16 million a year).
  • Allow companies to choose between a refundable wage credit (similar to the one in effect in Quebec today) and a non-refundable SR&ED credit as it now exists. The choice could be made in each taxation year. As noted below, we don't favour this alternative.

Introducing additional refundability would allow companies immediate access to the SR&ED tax incentives and would spur additional R&D investment in this country at a time that is sorely required.

Other legislative changes

1. Proposed Section 220(2.2) of the Income Tax Act

Currently, taxpayers must file their r & d claims by 12 months after the taxpayer's filing due date for the year.[6] In order for a claim to be complete, taxpayers must file all of the prescribed information on prescribed forms (T661) and Schedule 31. The quantum of the prescribed information has increased markedly since the deadline was introduced in 1994. It is important to note that this is an all or nothing requirement; if a taxpayer has missed filing one piece of prescribed information by the 18 month deadline, all rights to claim the sr & ed tax incentives (deductions and investment tax credits) are lost forever. Partly, it is complexity of these filing requirements that has led to the issues of late filings.

However, until the introduction of the new proposed section 220(2.2) of the Income Tax Act, taxpayers missing the filing deadline could request, under the fairness provisions, that the minister waive the timely filed provisions of the filing requirement.[7] However, the information still had to be provided. If the minister failed to grant the waiver, then the taxpayers could appeal to the courts. The all or nothing filing deadline, coupled with the minister's ability to waive the deadline, lead to a number of court cases related to late-filed sr & ed claims.

The government responded to "the increasing pressure as taxpayers have sought to file additional claims"[8] by introducing proposed legislation to ensure that there will be no exceptions to the filing deadline for sr & ed claims for both the deduction and investment tax credit purposes.[9]

What is interesting about this issue is that there are numerous deadlines contained in the Act. All of them contain provisions for late filing, some of them with penalties and some without. It is unclear why the sr & ed program has been singled out for this treatment or what recourse is available if, for example, an sr & ed claim was filed in a timely manner but one piece of the prescribed information was misplaced by the cra leading to the denial of a claim. We understand that while the retrospective filing of claims needs to be discouraged to promote the influence of credits as investment incentives, the proposed legislation is overly punitive. We recommend that the proposed legislation be modified to allow late filing with a penalty.

2. Contract payments

The contract payment rules were introduced in 1986 to ensure that only the payer or the performer of subcontracted SR&ED can claim the incentives on SR&ED work performed in Canada under contract. CRA has issued guidance in this area to assist taxpayers in understanding which party may claim. These rules don't apply to taxpayers dealing at non-arms length. There is a very complex set of rules dealing with this issue.

Unfortunately, most contracts are written to deal with the commercial issues and aren't clear as to how much of the work is SR&ED and who is entitled to claim the credits. Despite the CRA guidance, the task of determining who claims the incentives is often very onerous to taxpayers, their advisers and to the CRA when reviewing claims.

The United Kingdom has dealt with this issue by legislating that as a general rule the performer claims the incentives. There are exceptions for personnel hired on contract who work in-house and for SMEs hired by non-SMEs. Our experience has shown that while this is a simplistic fix to the issue, it penalizes R&D performers who outsource a significant portion of their R&D investment. Also, often, the ability to claim SR&ED is lost when for example, an R&D performer outsources specialized testing which would be R&D for it but is routine work for the performer.

Our recommendation is that the Department of Finance amend the legislation to permit, on an elective basis, those non-related parties to a contract to formally designate which of the parties to a contract has the right to claim the SR&ED associated with that contract.

The result of this legislative change will not only clearly specify which party to the SR&ED contract is entitled to claim the SR&ED incentives but will also simplify the administration of the program and interpretation differences and inconsistencies in application that are currently being experienced will be minimized.

3. The definition of SR&ED

Currently, a number of taxpayers are experiencing interpretative problems with CRA on the definition of SR&D. The legislation reads as follows:

"scientific research and experimental development " means systematic investigation or search that is carried out in a field of science or technology by means of experiment or analysis and that is

a. basic research , namely, work undertaken for the advancement of scientific knowledge without a specific practical application in view,

b. applied research, namely, work undertaken for the advancement of scientificknowledge with a specific practical application in view, or

c. experimental development, namely, work undertaken for the purpose of achieving technological advancement for the purpose of creating new, or improving existing, materials, devices, products or processes, including incremental improvements thereto,

and , in applying this definition in respect of a, includes

d. work undertaken by or on behalf of the taxpayer with respect to engineering, design, operations research, mathematical analysis, computer programming, data collection, testing or psychological research , where the work is commensurate with the needs, and directly in support, of work described in paragraph (a), (b), or (c) that is undertaken in Canada by or on behalf of the taxpayer,

but does not include work with respect to

e. market researchor sales promotion,

f. quality control or routine testing of materials, devices, products or processes,

g. researchin the social sciences or the humanities,

h. prospecting, exploring or drilling for, or producing, minerals, petroleum or natural gas,

i. the commercial production of a new or improved material, device or product or the commercial use of a new or improved process,

j. style changes, or

k. routine data collection;

The definition sets out what work is eligible in paragraphs (a) through (d) and excludes work in the field of social sciences and humanities in paragraph (g) and routine work that by itself is not SR&ED in paragraphs (e) and (f) and (h) through (k). For example, testing that is in support of SR&ED although routine in of itself is eligible work under paragraph (d) but routine testing that is not support of SR&ED is ineligible under paragraph (f). Another example would be the exclusion under paragraph (i) of the commercial production of a new or improved product or device. There is extensive CRA guidance on how to differentiate between experimental production and commercial production. CRA policy recognizes that experimental production may be sold and yet the work to produce the experimental production is still eligible and not subject to the exclusion under (i).

However, taxpayers are experiencing situations where CRA personnel are denying work that is in support of eligible SR&ED such as testing or experimental production because of the exclusions in (f) and (i).

One solution to this issue is to clarify the legislation to ensure that valid support work can be claimed and that paragraphs (e) and (f) and (h) through (k) are meant only to deny eligibility on work listed therein if it is not in support of eligible SR&ED.

4. The partnership rules

The government has passed legislation to allow the allocation of unallocated partnership ITCs. This legislation is welcome as it removes one of the differences to the SR&ED incentive program between operating as a partnership and in corporate form. However, we feel that there are still aspects of the current rules that discourage R&D investment by those who carry on business in the partnership form. Many companies house their operations in a partnership form for valid business reasons. This is particularly true in the oil and gas industry.

We recognize the history of the differences which arose because of the abuses that occurred in the 1980's. However, at this point, given the current legislative protections and a number of decisions favourable to the government in court cases on SR&ED and partnerships, we feel that it is time to equalize the playing field. Five areas to change are as follows:

  • Corporations SR&ED expenditures are placed in a pool and can be deducted currently or deferred until future years only subject to the corporation carrying on the same or similar business restrictions. SR&ED in a partnership must be deducted on a current basis by the partners with no ability by the partners to defer their SR&ED deduction to future years. We recommend that corporate partners be allowed to place SR&ED expenditures allocated to them into their SR&ED pool.
  • ITC's allocated from partnerships to CCPCs are earned at the rate of 20% rather than at the 35% rate and are not refundable. This penalizes CCPCs that operate in a partnership form and we see no rationale for such a penalty.
  • ITC's refunded to corporations or utilized to offset corporate taxes payable are included in taxable income in the year following the year that they are refunded or utilized. ITCs allocated to partners are included in the calculation of the partnerships income or loss in the year they are earned. We fail to understand the rationale of the difference in the timing of taxation of the ITC's. In some cases, there could be a 21 year difference between ITCs earned in a partnership and taxed currently and ITCs earned in a corporation and not claimed for 20 years. We recommend that corporate partners be allowed to defer taxability of the credits to the year after the year that they are refunded or utilized to offset taxes payable.
  • Although the recent legislation allowed a limited partner's share of SR&ED ITC's to be allocated to non-specified members of the partnership, any partnership loss resulting from the deduction of SR&ED expenditures is lost. We believe that the either the loss should be allocated to the limited partner or alternately be allowed to allocated to non-specified members of the partnership.
  • The recent legislation allowing a limited partner's share of ITCs to be allocated to non-specified members of the partnership is welcome but only is of value if the non-specified members of the partnership have sufficient federal taxes payable to be able to utilize the ITCs. We recommend that the government consider eliminating the distinction in the legislation between partnerships and limited partnerships in respect of SR&ED allocations of expenditures and ITCs.

Other alternatives

We recognize that these other alternatives will require further study and consultation but are offered as alternatives to be considered:

1. Use of a flow through share mechanism

As discussed above, one of the themes of our submission is to increase immediate access by SR&ED performers to the tax incentives. As noted above, there are many taxpayers who are unable to access the credits on an immediate basis and therefore discount their value severely in planning their R&D investment.

One method to increase immediate access to the SR&ED incentives would be to introduce a flow through share mechanism which would be to allow some or all of the benefits of existing SR&ED tax incentives to be transferred to new equity investors. It would help companies that are not currently tax-paying to raise new equity. The model of flow through shares currently used by various oil and gas, mining and certain renewable energy companies is viewed as a possible example for the flow through of SR&ED incentives. Flow through shares have been used successfully for many years in the non-renewable resource sectors as a means to raise risk capital to carry out mineral and oil and gas exploration. Investors are also now showing more interest in various flow through share issues being used to finance wind energy and small hydro projects.

It is recognized that flow through shares were used from 1983 to 1985 with disastrous results. However, the program at the time allowed credits to flow through to investors prior to the actual work being done. This feature allowed some taxpayers to abuse the system by passing through the incentives to investors without performing the work. We are proposing that a flow through share program be considered with legislative safe guards instituted such that the abuses of the 1980's could not be repeated.

It should be noted the flow through share mechanism is less valuable than that which could be obtained through some form of refundability. The value received by the issuer depends on the circumstances of the issuing corporation and the willingness of new investors to pay a premium value for the shares to recognize the value of the tax incentives received. Historically, this premium has been less than a dollar for dollar increase in the value paid for the shares. However, for firms that are unable to access the tax incentives currently, there is clear value in introducing a flow through share mechanism.

2. Innovation account

SR&ED is not necessarily incurred in a linear fashion. A number of companies undertake large capital projects which have intensive phases of SR&ED. One alternate system would be to allow companies to contribute cash to an Innovation Account within limits. The company would receive a tax deduction for the contribution provided that the funds were disbursed for projects focused on undertaking SR&ED within a specified time limit. Such a regime would assist companies in planning for and funding their large innovation projects.

There are other examples of such an account in the Income Tax Act. For example, corporations can make contributions to a "mining reclamation trust" (recently replaced by the broader reference "qualifying environmental trust") of which the taxpayer is a beneficiary. The contributions are deducted in the year in which they are made. Likewise, the cost of the acquisition of an interest in a mining reclamation trust is deductible in the year of acquisition. These investments are typically in support of large capital intensive projects and the immediate write-off is an incentive for investors to contribute to the development of this industry.

3. Refundable wage tax credit

Another alternative design to enable immediate access to the incentives would be to allow companies to choose between a refundable wage credit (similar to the one in effect in Quebec today) and the current system. The choice could be made in each taxation year. The wage tax credit could be set at a discounted level which gives taxpayers the choice of a smaller amount of cash today versus a large tax credit in future years.

This alternative would benefit companies in a loss position with significant R&D labour in Canada. We don't favour such an alternative as it penalizes companies undertaking SR&ED in the process industries where a significant portion of their claims are for materials consumed or transformed in trials.


Deloitte is pleased to make these recommendations on the SR&ED program. We believe that by enhancing access to high rate refundable credits; making a portion of low rate credits refundable; and introducing changes to the legislation to deal with some of the current issues will make Canada more globally competitive.


1. Department of Finance Canada (1983) Research and Development Tax Policies: A Paper for Consultation. April 19.[Return]

2. The Federal System of Income Tax Incentives for Scientific Research and Experimental Development: Evaluation Report. Department of Finance Canada and Revenue Canada. December 1997. [Return]

3. Tax Incentives for Scientific Research and Experimental Development, Consultation Paper, Department of Finance, October 2007[Return]

4. Organisation for Economic Cooperation and Development: Frascati Manual 2002 (Paris, OECD,2002) [Return]

5. Ibid [Return]

6. Subsection 37(11) [Return]

7. Subsection 220(2.1) [Return]

8. Kenneth J. Murray, "CRA on Alcatel" (August 2005), Volume 13, Number 8 Canadian Tax Highlights, [Return]

9. Subsection 220(2.2) [Return]