What are the ‘red flags’ in the SR&ED program for attracting audits?

Mar 14, 2017
Business tax Credits & incentives

The Canada Revenue Agency (CRA) seeks to encourage claims under the Scientific Research & Experimental Development (SR&ED) program, but wants to be sure that the program’s resources go to companies conducting work that genuinely qualifies.

Many entrepreneurs are concerned that their claims will be audited, soaking up precious time of the company’s senior executives, with a possible result that the claim is denied. This can cause a hole in the company’s expected cash flow for the coming year.

Some of the ‘red flags’ that cause claims to be audited, challenged or denied are:

Salaries versus dividends

Many entrepreneurial companies focus on developing products and services, and turning their vision into reality. They may not care much about what they think of as ‘details’ — such as the form of compensation paid to the founders and management team. Sometimes, they find it easier to pay out the company’s surplus value in the form of dividends rather than taking the trouble to make it a formal salary.

This means, unfortunately, that the compensation given to these senior people, who may be central to the success of the company’s projects, cannot be factored into the SR&ED claim. This is because the appropriate portion of an employee’s salary can be counted towards SR&ED, but dividends or other forms of compensation (including stock options) cannot.

The CRA may flag any claim that seeks to include non-salary compensation. This means it is strongly encouraged where SR&ED work is being conducted to have those directly engaged employees paid through a formal salary, rather than dividends or other withdrawals.

Contractors versus internal labour

Some companies outsource significant amount of their research & development work to outside contractors – sometimes because they do not have the required skills in-house, and sometimes because they do not want to invest in hiring employees for what might be a short-term situation.

However, CRA tends to see a high percentage of time going to contractors as a ‘red flag’ – in some cases, their view is that the SR&ED benefits should go to the organization to which the work is being subcontracted. So, from an SR&ED point of view, it is better to have as much as possible of the claims for staff time go to actual employees of the company.

Other red flags – new filings, non-compliance, unsubstantiated claims

A few other ‘red flags’ that may attract a SR&ED audit, are:

  • New filings – because the CRA has found that it takes companies a year or more to develop skills to create a problem-free SR&ED claim, filings from new claimants tend to attract more scrutiny
  • Companies new to Canada – CRA wants to be sure that the program’s enhanced benefits go strictly to Canadian-Controlled Private Corporations (CCPCs) within the CRA’s definition of that term. So, auditors tend to look closely at claims made by companies extending operations into Canada and making SR&ED claims as CCPCs.
  • Development work claimed is vastly different than the nature of the business
  • Description of experimental development work is not compliant with the program
  • Unsubstantiated claims with little or no supporting documentation
  • Large claims for material expenditures, with minimal internal staff time

In understanding these ‘red flags’, businesses will be able to mitigate the risks of being audited and having their claims denied.

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