“Income Sprinkling” & SR&ED: Why the Two Are Not Comparable Means of Paying Less Tax
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Will small businesses substitute “income sprinkling” with filing a claim for the SR&ED tax credit to decrease their taxes payable?
In July 2017, the federal government announced plans to “close three loopholes which the government says have allowed high-earning business owners to avoid higher tax rates.”1 The changes were introduced to limit “‘income sprinkling,’ which allows a business owner to split his or her income among family members, whether they are involved in the business or not,” which lowers the taxes payable by the business.2
How Will this Change Affect SR&ED?
In light of the proposed changes to the small business tax credit rate,3 some consultancy firms are advising that professional medical organizations and small businesses should claim the SR&ED tax incentive instead.4 However, this may not be sound advice for medical and other business professionals.
On the medical side, it is true that some family doctors may qualify for the SR&ED credit and see significant tax savings. Most, however, likely do not. For family doctors who treat colds and cases of flu, there is probably no advantage to applying for the SR&ED tax credit.
Other types of small family businesses may also have trouble qualifying for the credit. Does a family grocery store conduct projects eligible for an SR&ED credit? Maybe, but our guess is probably not.
How is SR&ED Defined?
According to the Canada Revenue Agency (CRA), SR&ED consists of:
(a) basic research, namely, work undertaken for the advancement of scientific knowledge without a specific practical application in view,
(b) applied research, namely, work undertaken for the advancement of scientific knowledge with a specific practical application in view, or
(c) experimental development, namely, work undertaken for the purpose of achieving technological advancement for the purpose of creating new, or improving existing, materials, devices, products or processes, including incremental improvements thereto.5
A small family bakery is unlikely to have the means to do basic or applied research or experimental development. There may be instances of small bakeries pushing scientific or technological boundaries on the perfect way to make a key lime pie, and generating new knowledge as a result because nobody has made it that way before. However, those instances are probably rare.
There are some examples of work undertaken by medical practices and other small family businesses that would qualify for an SR&ED tax credit. However, the use of the credit should not be seen as a substitute for the “income sprinkling” loophole. In fact, the most successful businesses do not rely on taxation schemes at all: they are cash-positive with a loyal and regular client base.
SR&ED Does Not Guarantee Paying Less Tax
Businesses moving from “income sprinkling” to SR&ED may be setting themselves up for disappointment. There is no guarantee of successfully obtaining a tax credit through the SR&ED program. The CRA has also become more stringent in reviewing claims, with fewer businesses successfully claiming SR&ED in recent years.
The SR&ED tax credit was introduced to encourage businesses to innovate.6 It is first and foremost a tool to enable businesses to carry out innovative research and development (R&D). To successfully file for an SR&ED credit, a company must put effort and care into its claim to the CRA, and clearly illustrate how it has advanced scientific or technological knowledge. Although successful SR&ED claims do result in tax refunds, the SR&ED tax credit is not a program for businesses to avoid paying taxes.
Conclusion
In conclusion, small business owners should beware of anybody who suggests that the SR&ED program is a quick and easy method to avoid corporate income tax. When used properly, the SR&ED program yields a great benefit to those who have done the work to qualify for it. When misused, claimants – by virtue of the time and, possibly, money they spend on completing and filing their claim – will be left with nothing for their effort (or lack thereof).
Be careful of misinterpreting the SR&ED tax credit as a tax break. “Income sprinkling” and the SR&ED program are not comparable, and you think otherwise at your own risk.