What is the Allocation Method and When is it Appropriate in SR&ED?
Updated to Reflect New Policies (2022)
*** Some of the policies referenced were updated 2021-08-13. This article has been updated and is accurate as of 2022. ***
The allocation method for capturing Scientific Research and Experimental Development (SR&ED) expenses can describe any number of methods used to track eligible expenditures when applying to the SR&ED program. Generally speaking, the Canada Revenue Agency (CRA) will view any method as “reasonable” as long there are controls and evidence in place to test how reasonable the amount claimed is.
Example Allocation Method
The allocation method can be thought of as the “best guess” approach; the final amount claimed for SR&ED is based on a variety of tracking systems and documentation (i.e. time sheets, progress reports). The information is then used to generate percentages (rather than an absolute amount) of time spent on SR&ED work by various individuals and within various departments.
The same allocation method, however, will not work for every company as best practices differ depending on a company’s R&D environment. Companies must use documentation practices and allocation methods that reflect their project’s needs. We’ve highlighted some key excerpts from the example allocation method outlined in the CRA’s SR&ED Salary or Wages Policy: 1
Example of an allocation method
The methods a company uses to allocate labour expenditures to SR&ED work must be tailored to the way it collects and manages financial information.[…]
The [example] company is is a venture-backed start-up company developing a Web-based supply chain management software program that is fully customizable by the customer. The company is developing a new architecture that will serve as the base for a family of products. The development of the initial architecture meets all the requirements to be considered SR&ED.
During the one-month ramping period, the [system] architect began to write periodic summaries that were to be produced monthly. The summaries allocated the work as SR&ED undertaken for the given period. The report identified both the SR&ED effort and the non-SR&ED work during the period in question.
By the sixth month, the R&D group found it necessary to use project scheduling and resource allocation tools to manage the experimental development process. These tools permitted the team to identify the resources associated with the specific work. Also in the sixth month, the finance group implemented a time-sheet system. The system was intended to address the overall needs of the company. The time sheet data would enable the finance group to track total hours worked along with employee vacation, holiday and sick leave. The data would provide the information necessary to allocate expenditures to cost centres including experimental development (in other words, the system would be used to allocate researchers’ time to projects). In addition, the system would provide the data necessary to bill customers for consulting services after the product was released.
The approach
In this particular year, there was no single system that the controller could rely on to quickly get the costing associated with the SR&ED projects. It was apparent that a variety of allocation methods and control systems would have to be used to calculate the labour expenditures associated with the projects.
The controller set up a spreadsheet listing all of the employees along with the salary or wages data received from the payroll service. The controller then proceeded to take a look at each employee to allocate the salary or wages to SR&ED and non-SR&ED work. She also considered what information would be available to serve as a control should a review occur along with information on how to set up a better system in the future. The controller planned to file a claim using the proxy method to calculate the SR&ED tax incentives.
Product engineering
The system architect also pointed out that some of the product engineering team participated in the project. An analysis of the project scheduling and resource allocation tools used by the R&D team showed that in the last seven months each of the product engineers spent about two months helping with the architecture. The product engineering team was employed for only seven months of the year, so the controller planned to allocate 29% (2 / 7 months) of their time to SR&ED projects.2
For more information on the “proxy method” please see our SR&ED: Proxy vs. Traditional, and Which One to Choose article.
Lessons to be Learned
After reading through the example allocation method strategy above (we recommend reading the text in full in the CRA’s SR&ED Salary or Wages Policy),3 there are a few lessons that can be extrapolated:
1. Tailor your allocation method
Claimants must cater to the specific needs of their company. In the example above, the controller utilized different and appropriate allocation methods (time sheets, project planning documents, etc.) for each department/employee, rather than trying to apply the same methods across the board.
2. Strive for improved documentation practices
If you see a flaw in your allocation method, either fix it immediately (if it won’t undo or compromise the pre-existing documentation) or make a note to alter your method for the next claim period. There is no sense in continuing to use a flawed or inefficient method.
3. Educate your controller
Ensure that your controller (i.e. the individual who monitors overspending, authorizes purchases, determines cost allocation methods, etc.) has access to the SR&ED Salary or Wages Policy.4 This will help the controller determine the correct tracking method to use for your company’s R&D environment.
Policies to Know
The SR&ED Salary or Wages Policy features valuable information about the SR&ED program and we encourage claimants and potential claimants to read it from start to finish.5
Your allocation method article is very interesting, I enjoyed reading it. With that amount of tracking going on, the filer could easily move to a very accurate, push button reporting environment for ITC claims. This would be accomplished by building an ITC datamart which pulls all the necessary personnel, project, and timesheet data from the different sources. We did that at Cognos, pre-IBM days. The “C” suite execs were able to use the accurate ITC estimates, immediately at the end of the FY, for tax rate calculations. CRA was consulted, when we started building the system, which increased their confidence in what we were doing. Win win.
I completely agree. Push button reporting is the ideal situation, as it does provide better insight to the C-suite execs and helps the CRA feel confident in the reporting. Definitely a win win!