SR&ED Contract Expenditures Outside of Canada
It is common for SR&ED projects to involve work contracted to professionals outside the claimant’s company and 80% of these SR&ED contract expenditures may be claimed on the related SR&ED tax claim forms to increase the claimant’s final SR&ED refund. It is also possible that all or a portion of the SR&ED will be carried on outside of Canada. This article delves into contract expenditures for SR&ED incurred outside of Canada, and how the CRA requires claimants to address such expenditures.
Contract Expenditures for SR&ED
Contract expenditures may be claimed as an SR&ED expenditure and used to increase a claimant’s total SR&ED refund. This is stated in the CRA’s Assistance and Contract Payments Policy:
Where a Canadian claimant contracts to have SR&ED carried out on its behalf by another party, the amount payable under the contract may be a qualified SR&ED expenditure for investment tax credit (ITC) purposes.1
Up to 80% of an arms-length contract payment may be claimed as a qualified SR&ED expenditure:
Only 80% of the expenditure related to SR&ED contracts is allowable as a qualified SR&ED expenditure for the purpose of calculating the investment tax credit (ITC).2
The SR&ED tax forms will automatically remove 20% from contract expanditures, so be sure to enter the full value of the eligible SR&ED-related contract expenditures on your SR&ED tax forms.
Contract Expenditures Outside Canada
Unlike the rules surrounding employee salaries or wages, if a contract is entered into and the contractors, or subcontractors, complete work outside Canada then that work will not be an allowable SR&ED expenditure. The Contract Expenditures for SR&ED Performed on Behalf of a Claimant Policy states:
A claimant may enter into a contract with an arm’s length party where all or a portion of the SR&ED will be carried on outside Canada.
Where an entire contract relates to SR&ED work carried on outside Canada, no portion of the contract amount is allowed as an SR&ED expenditure. Such expenditures cannot be included on Form T661, Scientific Research and Experimental Development (SR&ED) Expenditures Claim. The payer will be able to deduct the SR&ED contract (see section 5.0) amount as an expenditure for SR&ED work performed outside Canada under subsection 37(2) of the Income Tax Act when calculating their net income or loss for income tax purposes, but no ITC will be earned for such expenditures.
Where SR&ED work is carried on partially in Canada and partially outside Canada under the same contract, the claimant must allocate the contract amount between the SR&ED carried on in Canada and the SR&ED carried on outside Canada.
The method used to allocate the contract amount between the SR&ED carried on in Canada and the SR&ED carried on outside Canada must be reasonable and may, for example, be based on the fair market value of the SR&ED work carried on in Canada and the SR&ED work carried on outside Canada. Discussions with the claimant, an examination of the contract, and a review of the performer’s work and related costs, if available, may also be used to allocate a reasonable portion of the contract amount to SR&ED carried on in Canada and SR&ED carried on outside Canada. The claimant must be able to show the CRA how the costs were allocated between SR&ED carried on in Canada and SR&ED carried on outside Canada.3
If a contractor, or subcontractor hired by the contractor, performs SR&ED work outside Canada it will not be considered a qualified SR&ED expenditure, however, if the work is only partially performed outside of Canada then the expenses should be allocated to determine what percentage of work, and the related expenditures, were completed within Canada so that they may be claimed and utilized to increase the claimant’s total SR&ED refund.
Don’t miss out on any tax credits you may be eligible for.
The Look-through Rule
When a contractor’s work is completed partially outside of Canada and the related expenses must be allocated as above, it is necessary to follow the look-through rule. This mechanism is defined within the Income Tax Act:
Look-through rule
(14) For the purposes of subparagraphs (1)(a)(i.01) to (iii), the amount of a particular expenditure made by a taxpayer shall be reduced by the amount of any related expenditure of the person or partnership to whom the particular expenditure is made that is not an expenditure of a current nature of the person or partnership.4
The look-through rule states that all expenditures not of a current nature must be removed from the taxpayer’s SR&ED claim. This rule is referenced in the Contract Expenditures for SR&ED Performed on Behalf of a Claimant Policy as well:
… the claimant’s SR&ED contract expenditure must be reduced by the amount of any related expenditure of the person or partnership (the performer) that is not an expenditure of a current nature (for example, capital property) – the look-through rule.
When a claimant is required to reduce an expenditure because of the look-through rule, the performer is required to inform the claimant in writing of the amount of the reduction. This information is to be provided without delay if requested by the claimant and in any other case no later than 90 days after the end of the calendar year in which the expenditure was made.5
If a contractor has been required to abide by the look-through rule and remove all expenditures, not of a current nature, such as expenditures made outside of Canada, then they are required to inform the claimant (payer) of the amount of reduction. Typically, when a contract is for SR&ED only, the CRA will not use the look-through mechanism to identify the type of expenditures the performer incurred, however, they are able to utilize the look-through rule in the case of any uncertainty. They may utilize it to determine that:
- the contracted SR&ED was performed in Canada;
- the services were rendered in the claimant’s tax year;
- the performer awards a contract to a subcontractor to do some of the work under the contract;
- the SR&ED contract expenditure is reduced by the amount of any related expenditure of the person or partnership (the performer) that is not an expenditure of a current nature, see section 4.0.6
Conclusion
If a contract for SR&ED is entered into and the contractors, or subcontractors, complete work outside of Canada then that work will not be defined as being of a current nature and is therefore not an allowable SR&ED expenditure. All expenditures not of a current nature must be removed by using a rational SR&ED allocation method. The contractor or subcontractor is also required to abide by the look-through rule and must provide a written declaration of any costs they incurred outside of Canada no later than 90 days after the end of the calendar year in which the expenditure was made. We recommend you track all SR&ED-related expenditures as your SR&ED project progresses, this contemporaneous documentation will prevent any confusion when it is time to prepare your SR&ED tax forms and will help you if your claim is pulled for an audit.