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An inter-company agreement can keep non-arm’s length SR&ED eligible.
Keeping SR&ED Eligible for Non-Arm’s Length Agreements
Joe’s company was going well. They had carefully tracked their R&D expenditures throughout the year. Joe opted to pay himself as a contractor, to reduce his costs – but at the end of the year, they realized this rendered his costs ineligible. This resulted in a 25% reduction from the return Joe expected from SR&ED. As a startup, this directly impacted the resources he could pull together in order to properly support his product platform. In fact, Joe was relying on the costs recovered with their SR&ED claim to support the loan they had taken out, and now their company is focused on managing debt instead of building the company. In short, a single financial error changed the entire trajectory of the business.
What Joe did is a common error in startups and even some larger firms. Expenses accrued from non-arm’s length agreements, i.e. transactions involving a party that is controlled by another entity, opposed to acting on its on behalf, will not get reimbursed by the government, regardless of what work was done.
What’s “Arm’s Length”? And What Defines “Non-Arm’s Length”?
According to the CRA, “Arm’s Length” refers to:1
A situation where two parties that deal with each other are not related to each other and no control exists between them. It is a question of fact whether two parties not related to each other are dealing with each other at arm’s length.
“Non-Arm’s Length”, according to the CRA, refers to:2
A situation where two related parties that deal with each other and one party exerts control over the other. In other words, the parties are not dealing at arm’s length.
The Contract Expenditures for SR&ED Performed on Behalf of a Claimant Policy also provides some information on arm’s length and non-arm’s length contracts for SR&ED.3
Knowing the rules regarding non-arm’s length agreements can be a critical component of setting up the financial side of a SR&ED claim. While salaries comprise the majority of all SR&ED expenditures in Canada, understanding how to set up and claim subcontractors and third-party payments is just as important to know for any company, whether for current or future work.
While arm’s length SR&ED contracts are typically standard and translate to eligible expenditures, non-arm’s length agreements introduce special rules, whereby “the claimant’s expenditures in respect of the SR&ED contract are allowable SR&ED expenditures, but do not qualify for SR&ED investment tax credit (ITC) purposes.” 4
Establishing Contracts for SR&ED
In drafting any contract, it must be established that the risk incurred from SR&ED activities, and the intellectual property accrued from the work, is solely owned by the primary claimant. It must be clear that the contractor is performing SR&ED work on behalf of the company.
It is important to consult a legal professional to ensure the contractual terms are set up to properly accommodate the SR&ED-eligible work related to the contracts in question. More detailed (and important!) information about this may be found here.
Transferring SR&ED Between Non-Arm’s Length Persons
Finally, there is one obscure method by which non-arm’s length contracts can earn you a refund. According to the CRA, this only applies to inter-company arrangements with respect to performing and claiming SR&ED. If the T1146 form is filled out by both parties, then it is possible to claim their costs.5 The caveat here is that both parties must still fill out their own SR&ED application independently, and the work that is described must meet all eligibility requirements independently of one another. The end result though is that one company ends up receiving the combined tax credits for all associated costs. This can be beneficial in certain situations.
Understanding the regulations around any indirect employment arrangement for SR&ED such as non-arm’s length agreements can greatly assist the claimant in keeping costs eligible. Pay due diligence to these aspects of business and ensure that all SR&ED expenses are legally eligible.
Do you have experience with non-arm’s length agreements for SR&ED?
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- Government of Canada. (July 15, 2015.) SR&ED Glossary. (Accessed: September 5, 2017.) Retrieved from: https://www.canada.ca/en/revenue-agency/services/scientific-research-experimental-development-tax-incentive-program/glossary.html#rmslngth. ↩
- Government of Canada. (July 15, 2015.) SR&ED Glossary. (Accessed: September 5, 2017.) Retrieved from: https://www.canada.ca/en/revenue-agency/services/scientific-research-experimental-development-tax-incentive-program/glossary.html#nl. ↩
- Government of Canada. (December 18, 2014.) Contract Expenditures for SR&ED Performed on Behalf of a Claimant Policy. (Accessed: September 5, 2017.) Retrieved from: https://www.canada.ca/en/revenue-agency/services/scientific-research-experimental-development-tax-incentive-program/contract-expenditures-performed-on-behalf-a-claimant-policy.html#s6_0. ↩
- Government of Canada. (December 18, 2014.) Contract Expenditures for SR&ED Performed on Behalf of a Claimant Policy. (Accessed: September 5, 2017.) Retrieved from: https://www.canada.ca/en/revenue-agency/services/scientific-research-experimental-development-tax-incentive-program/contract-expenditures-performed-on-behalf-a-claimant-policy.html#s7_0. ↩
- Government of Canada. (October 21, 2016.) T1146 Agreement to Transfer Qualified Expenditures Incurred in Respect of SR&ED Contracts Between Persons Not Dealing at Arm’s Length. (Accessed: September 5, 2017.) Retrieved from: https://www.canada.ca/en/revenue-agency/services/forms-publications/forms/t1146-agreement-transfer-qualified-expenditures-incurred-respect-contracts-between-persons-dealing-arms-length.html. ↩