Canada’s tax credit program for scientific research and experimental development (SRED) remains one of the world’s most generous tax incentives programs for R&D. The tax incentives are delivered through the Income Tax Act (ITA) and administered by the Canada Revenue Agency (CRA) through offices across Canada. In 2006, the federal government provided over $3 billion in R&D tax assistance to Canadian businesses.1 Unlike the corresponding U.S. program, Canada’s SRED program is legislated and therefore not subject to annual budgetary limitations.
There are two major components to the SRED program. First, the cost of R&D activities is fully deductible for Canadian tax purposes, regardless of whether the expenditures are current or capital, or when and where they are incurred. Second, and more important from a funding perspective, qualifying SRED expenditures are eligible to earn investment tax credits (ITC) calculated as a percentage of SRED expenditures.
Under the federal SRED program, ITCs earned at the rate of 20 per cent are non-refundable and may be used only to offset Canadian income taxes. Canadian-controlled private corporations earn fully refundable ITCs at the enhanced rate of 35 per cent. Should the ITC amount exceed Canadian taxes payable, the corporation receives a cheque from the government for the difference. SRED costs, up to the current expenditure limit of $3 million, are eligible for the enhanced refundable credits.
Most provinces have their own SRED tax credit program, complementary to the federal program. Federal SRED tax credits and the corresponding credits available in many provinces, combine to produce tax incentives that are very attractive.
While enhanced SRED tax credits are available only to Canadian-controlled private corporations, qualifying entities need not be controlled by Canadians nor closely held. By definition, a Canadian-controlled private corporation cannot be controlled by non-residents or public corporations, or a combination of both. Therefore, 50/50 ownership arrangements may meet this definition. In addition, venture capital organizations (which may themselves be widely held) are not generally public corporations and may qualify with 50 per cent equity held by Canadian residents. In structuring a Canadian R&D hub, it is important to examine whether the entity will qualify as a Canadian-controlled private corporation. Critical considerations include share ownership, options and other rights relating to shares, salient terms of a unanimous shareholders agreement, as well as factors that may be tantamount to control in fact of the corporation.
To qualify for SRED credits in Canada, the taxpayer must be carrying on business in Canada, incurring qualified expenditures, conducting R&D activities in Canada that are related to the business and filing timely SRED claims with the CRA. An R&DCo may be established in Canada for the express purpose of conducting R&D in Canada, and these activities may qualify for ITCs, including refundable ITCs at the enhanced rate, if the R&DCo is structured as a Canadian-controlled private corporation. An R&DCo may contract with a non-resident to perform R&D activities in Canada on behalf of the non-resident, and the non-resident may own the resulting technology. If the non-resident is non-arm’s length with R&DCo, or if the non-resident is not a taxable supplier for purposes of the SRED rules, then the amount paid by the non-resident to R&DCo for research services will not be deducted from R&DCo’s qualified SRED expenditures. Therefore, under appropriate circumstances, an R&DCo could enjoy the full funding benefit of refundable ITCs at enhanced rates, providing significant non-dilutive funding for future R&D activities.
Although the enhanced SRED program in Canada is available only to Canadian-controlled private corporations, there are strategies by which nonresidents can leverage the program in a way that is good for both Canadian science and for the technology ownership needs of the non-resident.