A non-refundable credit is a terrible thing to waste

The government of Canada offers great research incentives through its Scientific Research & Experimental Development (SR&ED) program. For Canadian-controlled private corporations (CCPCs) these incentives are commonly refundable; however, for non-residents that control Canadian corporations eligible for SR&ED, these credits are generally non-refundable.

Non-refundable credits decrease tax liability; however, what happens when the tax liability is insufficient to offset the credits, or there is no tax liability? Simply put, the non-refundable credits could languish, and while they can be carried forward, certain planning opportunities may be implemented to use these credits in a more tax-efficient manner.

Overview of the SR&ED incentives

SR&ED tax incentives come in two forms:

1. Income tax deduction – Federal and provincial legislation provides for deductions to net income. Eligible SR&ED expenditures are recorded in a “pool” for tax purposes and may be deducted in the year they are incurred or carried forward indefinitely.
2. Investment tax credits (ITCs) – SR&ED ITCs are available federally and in many of the Canadian provinces. These credits may be applied against income taxes payable in the current year, carried back for three years, or carried forward for generally 20 years.

While CCPCs benefit the most from SR&ED credits, foreign-controlled Canadian subsidiaries are still eligible for a federal non-refundable credit at the 15 per cent basic rate. The Canadian provinces generally follow the same expenditure rules, with exceptions. Notably, Quebec has some substantially different rules that can be advantageous.

What is the challenge, and how can it be overcome?

The SR&ED program provides more than $3 billion in tax incentives to over 16,000 claimants annually, making it the single largest federal program that supports business research & development (R&D) in Canada. The program is administered by the Canada Revenue Agency.

Challenges arise if the Canadian subsidiary of a non-resident-controlled corporation does not have taxes payable or does not expect to be taxable in the future. In this case, the non-refundable ITCs will accumulate, and the company will not be able to take advantage of them.

Assuming the below facts, the Canadian corporation may be able to utilize the non-refundable ITCs through transfer pricing policies. Generally, a Canadian corporation engaged in the development of an intangible or in R&D activities operates on a cost-plus basis. Multinational corporations may consider reviewing and updating their transfer pricing policies to use their non-refundable credits.

1. Corporation A, a U.S. resident corporation and parent of a Canadian entity (Canco), sets up a captive R&D centre in Canada to develop a new mining technology.
2. Corporation A retains legal ownership of the IP  developed by Canco. Canco reserves the right to exploit the IP in Canada.
3. Canco develops the intangible at a cost of $1 million and recharges its cost of performing the R&D functions to Corporation A at a mark-up.
4. Of these costs, about $600,000 are eligible for SR&ED ITCs.
5. In situation 1, Canco earns a mark-up of 5 per cent.
6. In situation 2, Canco earns a mark-up of 12 per cent.

In the above example, if the Canadian corporation applies a mark-up of 12 per cent on its costs, it would be able to use more of its ITCs, which, where justifiable, may be considered the right approach by the tax authorities. However, the above approach is not enough to use the SR&ED non-refundable credits or may use them too slowly. Other approaches may also be used that allow a Canadian subsidiary of a foreign corporation to undertake some non-routine functions and participate in the profits, thus increasing the Canadian subsidiary’s income and, therefore, using more ITCs.

Consider a potential tax audit when implementing changes sot the transfer pricing policies.

The above planning is effective but requires professionals from multiple tax disciplines in multiple countries to review the tax implications and the possibility of a tax audit. Increasing the Canadian corporation’s mark-up may result in a tax audit from the tax authority of the other country, e.g., the U.S. tax authority in the above example. Therefore, a detailed analysis of the functions, risks, and assets of the corporations should be undertaken and transfer pricing benchmarking analysis and documentation should be prepared before implementing any tax planning measure.