May 22, 2019

Audits, uncertainty, and paperwork: The bureaucratic burden of SR&ED (Brian Jackson, IT World Canada)

When Stephen Hayward, the co-founder and president of Toronto-based data and analytics solution provider Project X Ltd., applied to the Scientific Research and Experimental Development (SR&ED) tax incentive program for the first time, he hadn’t anticipated that being the owner of the firm applying for the claim would be a problem.

In 2011, Project X acquired California-based firm BigDataLabs and formed a new subsidiary, Project X Labs Ltd., focused on product development for analytics software firm MicroStrategy. Hayward rolled up his sleeves and got hands-on with the new product development. But he never realized that his work, and that of another owner, wouldn’t be counted towards the SR&ED program until after being audited for the first time — a process that took more than a year and a half.

“Because we were very small, we were all-hands-on-deck,” he recalls in an interview. “Our time was disallowed in the SR&ED process. That was a surprise.”

Because SR&ED stipulates that only directly engaged employees and first-level management can be claimed, Hayward and his team could only claim for about half the people that worked on the projects. Aside from not having their work counted towards the program, Hayward found that the auditor he was working with wouldn’t accept the answers he provided.

“He didn’t believe he was ever talking to the right person,” Hayward says. “He didn’t want to talk to me, he wanted to talk to the people doing the work. And I’d say ‘But I am the people doing the work.’”

After the initial experience with SR&ED audits, Project X changed its approach to the program, dedicating resources to it and treating it much like its accounting department. It hired Toronto-based Grant Thornton LLP to manage its applications and help it work through audits.

“At the beginning it was very cumbersome, and it started to feel like we were spending more time building SR&ED credits than doing the work, but it’s really paid off for us,” Hayward says.

Project X has received between $80,000 and $300,000 back from the tax incentive scheme. This has allowed it to dedicate people to the process, and count on some of its R&D work done for clients to be reimbursed.

SR&ED audits denying work claimed more often in recent years
Hayward’s experience is emblematic of many entrepreneurs in the technology industry that have grappled with SR&ED. The program can yield returns, crediting 35 per cent of accepted R&D work conducted by smaller, Canadian-owned firms in a fully refundable way. That means that even if the firm doesn’t have taxable income, the government credits them for the work and sends money. But achieving such a refund is dependent on an entrepreneur’s ability to cut through red tape, with no clear assurances about what technical activities will be covered.

While the current federal Liberals made a change to the SR&ED tax credit program, removing the maximum income cap to receive a refundable benefit, it’s not clear how many firms this will actually help. While the intent is to allow firms that are scaling up to continue to receive incentives, a remaining taxable capital limit remains.

Aside from how tweaking the income limits will impact firms seeking SR&ED tax credits, the program became more likely to refuse claims made in the period of 2008 to 2017. IT World Canada collaborated with Toronto-based accounting firm Grant Thornton, which shared the results of an access to information request from the Canada Revenue Agency on SR&ED audits conducted between 2008 and 2017.

SR&ED infographic 2008 to 2017 by Mel Manasan data from Grant Thornton
Infographic by ITWC graphic designer Mel Manasan

While the number of audits to review SR&ED claims made have gone down overall, when audits are conducted they take longer to complete and are more likely to result in claims being denied. The burden of working to satisfy auditors, who provide different directions on how to document work, falls on the shoulders of the businesses applying to the program. As a result, SR&ED compliance becomes a burden that requires an additional line of business in itself, with some business owners wondering if the money received is even worth the extra upfront expense and work required to meet the burden of proof required by the CRA.

Additional data from the Canadian Advanced Technology Association (CATA) shows that aggregate “tax assistance” (i.e., tax credits) delivered by the CRA through the SR&ED program has gone down by $4.2 billion over the six years starting in 2009-2010 through 2014-2015. The $4.2 billion reduction does not include a significant amount of the legislated reduction in the SR&ED incentives announced in the 2012 Budget. This $500 million a year reduction came into full effect in TY 2016-2017.

While the number of applicants to the program increased by thousands between 2008 and 2012 (from 18,000 to 28,140), the amount of money provided through the program dropped by $400 million. By 2017, the number of applicants dropped back down to 21,000, and the amount of money provided through the tax credit hit its lowest point since 2005 at just $2.7 billion.

Under pressure for paperwork
In helping clients prepare SR&ED applications, Martha Oner, national leader of R&D and government incentives for Grant Thornton, says proper documentation is the major challenge faced by most claimants.

“What we have to show is not only that the work occurred but the extent of the work,” she says. “That’s really where a lot of companies fall down, and where the CRA tends to deny claims.”

Grant Thornton has clients gather documents, diagrams, schematics, financial records, and employment agreements to help demonstrate what roles and activities are contributed toward projects under the SR&ED program. Then Grant Thronton has the companies adopt a rigorous time-tracking approach, requiring not only that work-hours be assigned to specific jobs but that a description of the work completed during that time be included.

“That is the number-one compliance headache for our clients,” Oner says. “To go down to that level of minutia and say ‘OK, what did this person actively do for a quarter of an hour and how does that 15 minutes relate to the advancement of technology?’ is very, very challenging.”

At its broadest level, the SR&ED tax incentive is designed to reward R&D work that leads to innovation within companies. Firms must demonstrate that a new capability or process that was not available to it previously was the purpose of any work claimed.

In practice, applying for the tax incentive requires so much process and paperwork that many firms (like the firms interviewed for this story) hire an accounting firm to help them. Grant Thornton doesn’t charge up-front for its services, but takes a percentage of the refund issued by the CRA. Exactly how much that will be is uncertain.

The SR&ED ‘coin-flip’
Toronto-based startup Tweepsmap, which tracks trending topics in niche geographies and demographics, finds that the likelihood of getting its work approved for SR&ED is equivalent to the flip of a coin. Tweepsmaps CEO Samir Al-Battran says the SR&ED program does encourage him to pursue difficult problems, but if he doesn’t succeed in solving them, he can’t claim any work.

“Maybe 50 per cent of our research just fails. It doesn’t produce positive results or a positive outcome for us,” he says. “With SR&ED we go ahead and develop something, and at the end of the year we look and see which part of all that work we developed will count.”

What could help is a way to know ahead of time what will be considered SR&ED-eligible, Al-Battran says, so startups could make decisions about what research components to pursue. Since many startups are tight on budget, it’d be useful to predict what funds will come back through the SR&ED program.

Even after claims are accepted by the CRA, often just getting the refund paid out in a timely manner can be a challenge.

“We’ve had our filing sitting for two years before we got a refund,” he says. “It took a really long time.”

Tweepsmap follows the same filing process every time, Al-Battran says. It uses the same consultant, using the same tracking methods, but the outcomes seem different every year. It tracks each developer’s work-hours with Microsoft Excel spreadsheets. It also has a version control process, documenting each stage of a development project and outcome objectives.

Every tax season, Al-Battran says he spends a couple of weeks of his time focusing on pulling a SR&ED application together, calling on different engineers to also spend time putting together presentable documents.

“Going back at the end of the year, and having to go through all those documents and isolate which of our projects are SR&ED-eligible can be time-consuming,” he says. “There are multiple steps involved in a SR&ED filing.”

When asked if there was one thing it would change about the SR&ED process, Project X also points to the unpredictable nature of whether claims will be accepted or denied. Some of the self-taught lessons it has learned along the way about SR&ED could be part of an introductory training program that could point out a standard approach to tracking work done towards the SR&ED tax incentive. Guidance is needed to tell entrepreneurs what to track, how to track it, and how often to do do it. Project X tracks its SR&ED projects, and creates documentation using tools including Jira and WorkFlowy.

While the CRA has started to offer a First Time Claimant Advisory Service for SR&ED, both Project X and Tweepsmap said no advisor paid them such a visit when they first entered the program. Instead it was straight to the audit.

According to Oner, the first-time advisory service is typically about a half-day in length, involving two CRA staff – one focused on the financial side and one focused on the technical side. But the education provided in the session tends to be generic, and she questions if the CRA is really getting any value out of the effort.

“It’s been hard to identify the tangible benefits of the process,” she says. “The letters they provide are blanket generic statements; often times it’s not specific. Reviewers often just come out and provide the education session.’”

Benefit of recent changes unclear

For years, Russ Roberts has argued that despite its much-vaunted “innovation agenda,” Canada’s federal government has functionally reduced innovation spending by billions of dollars by reducing Scientific Research and Experimental Development (SR&ED) tax incentives – and now, he says, he has the numbers to prove it. (Government essentially cutting billions from innovation funding, CATA says by , IT World Canada).

Indeed, the SR&ED program has long been the focus of technology industry advocacy groups calling for improvements. In its pre-budget submission to the federal government made in 2018, the Information and Technology Association of Canada called for a number of adjustments focused on encouraging smaller firms to scale up to a larger size. That included improved SR&ED administration, reducing the burden of the program by being more flexible with timelines and accountability requirements. It also included a call for the higher threshold of taxable income to be raised. That change was made, removing the taxable income threshold that was previously capped at $800,000 per year.

How many more firms that will help apply for the credit isn’t clear. When asked, Tweepsmap CEO Al-Battran said it won’t affect him, and he doesn’t imagine it will be useful for many firms.

If you’re growing revenue but using that as income, instead of investing it back into the company, it’s not being spent on salaries, he says. “You could hire a lot of engineers with that extra income.”

At Project X, Hayward projects the change will benefit the firm in a couple of years. He says the firm has been growing a lot, but investing that money back into the company (meaning it wasn’t on the balance sheets as income). But in a couple of years time, the firm’s taxable income could pass the $800,000 mark.

Both firms interviewed for this story now say that despite the work it takes, and the problems they experience in filing for the SR&ED tax incentive, it has a positive impact on their business overall and is worth doing.

At Tweepsmap, Al-Battran says it makes the difference with hiring in Canada rather than off-shoring those software engineer positions. “Engineering is very expensive in Canada compared to an offshore development … SR&ED bridges the gap,” he says. “It gives us courage to tackle a more complicated problem.”

“At the beginning, it was very cumbersome and started to feel like we were spending more time building SR&ED credits than doing the work, but it has really paid off for us,” Hayward says.

Project X Labs is able to get money back and invest it in its people doing R&D work towards creating unique enterprise software, he says. As a small company, it helps the firm compete with larger players that have enough of their own capital to invest in R&D. Hayward even finds that employees involved in SR&ED projects are more engaged because they are working on innovative projects.

Had Hayward – and other SR&ED applicants – been equally confident knowing the steps necessary to achieve a successful application the first time around, the success they enjoy today would likely have come sooner.

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