Updated to Reflect New Policies (2022)
*** Some of the policies referenced were updated 2021-08-13. This article has been updated and is accurate as of 2022. ***
The Scientific Research and Experimental Development (SR&ED) program has existed since 1986. There were several predecessor programs, but the primary legislation associated with this program (Section 248(1) of the Income Tax Act) has not changed significantly over the last 30 years. That said, the SR&ED program has quietly evolved into something very different since its original inception, and we are now wondering if the SR&ED program should be renamed to fit what the program has become?
Evidence of the program’s evolution can be found quite clearly in the T661 SR&ED expenditures claim form, which features some seemingly innocuous phrasing related to supporting documentation: “Check all that apply.” The form then lists the different possible types of supporting documentation for an SR&ED submission, including contracts, design of experiments, etc.1
What most people don’t realize, however, is that this information can either make or break your application.
The Impact of the “Five Questions”
In recent years, there has been a shift toward aligning SR&ED policy more closely with some of the relevant Tax Court of Canada rulings. More specifically, the focus has been to align with the most cited court case related to SR&ED – Northwest Hydraulic Consultants Ltd. v. The Queen. In this ruling from 1998 (a full 12 years after the inception of the program), Judge Bowman laid out what he believed were the five key questions that reviewers at the Canada Revenue Agency (CRA) should ask when considering the eligibility of work claimed under the SR&ED program.2
The five questions have become famous, albeit not for the right reasons. Those commenting on the impact of the Northwest case have focused on the debate regarding “standard practice,” the specific terminology used by Judge Bowman in the ruling, and so on. What no one could have anticipated was that his five questions would become the standard by which SR&ED projects were evaluated over 30 years later.
In particular, Bowman posed one question that drew minimal attention at the time of the ruling, but has since slowly eroded the program and shifted focus away from the original intent. (Assuming the original intent was to support basic research, applied research, and experimental development): Question #5: “Was supporting documentation kept?”.
SR&ED Policy Documents & Supporting SR&ED Documentation
By itself, this query about documentation seems reasonable. SR&ED applicants should aim to produce and keep documentation that demonstrates legal and policy requirements. The issue is as follows: the CRA doesn’t tell you what documents you should keep. They provide applicants with minimal guidelines, which are buried in financial policy, namely the SR&ED Salary or Wages policy.
The relatively vague instructions for documentation are as follows:
13.3.1 High-level information (corporate or strategic concept level)
The documentation of a business’s overall corporate and strategic objectives is referred to as high-level information. High-level information is generated by the conceptual high-level management processes and systems that businesses (especially large businesses) use for project management and cost control. For example, the strategic planning process, cost allocation and cost control systems, and project planning and project evaluation processes may all produce information that is relevant and useful in shaping and proving SR&ED claims. High-level information may provide context for the allocation method and may, in some circumstances, contain enough information to support a claim and no further review is needed. However, medium or low level information should be available to support high-level information.
13.3.2 Medium-level information (project level)
Information related to specific work efforts within a project or subproject is referred to as medium-level information. This includes management processes associated with specific work efforts or projects undertaken by the business.
This information supports the information generated by the high-level systems. Medium-level information is generated at the project level and generally relates to a business’s documentation of specific work efforts. Specific project plans that break projects into components or subprojects would be an example of medium-level information. These project plans could be revised as a result of the SR&ED process.
In some businesses, these work efforts are documented using financial reports (budget to actual), Gantt charts, time lines, resource allocation or utilization summaries, specific project cost control systems, and supervisor summaries for project team members. There should be a clear link between the SR&ED project objectives and the work undertaken by the members of the project team. Documents should identify all employees involved in an SR&ED project and should give enough information to identify SR&ED work that is included in the claim. A small sample of medium-level information should show the relevance of the high-level information and support the allocation methods that the claimant has used.
13.3.3 Low-level information (activity level)
Information related to individual tasks is referred to as low-level information. In some cases, information may be summarized at the lower level tasks undertaken to complete major work. Tasks can be documented with such things as resource allocation or utilization summaries, time sheets, and personal logs. An effective system of documenting tasks records hours worked on a project-by-project basis. There should be a clear link between the SR&ED project objectives and the tasks undertaken by the members of the team.3
There are a few more details in the T4088 (guide to form T661):
Indicate what evidence you have to support your SR&ED claim. Tick all items on the list that apply. If you have items or documents to support your claim that are not listed, tick the box at line 281 and use 15 words or less to describe them on line 282.
If you fail to tick a box when you initially file your claim, you can still provide the evidence to the CRA reviewer during the review of your claim even if the reporting deadline has passed.4
And also in Appendix 2 of the T4088 (emphasis added):
It is important to maintain supporting evidence (for example, information, records, and documentation) to substantiate that the scientific research and experimental development (SR&ED) work was performed and allowable expenditures have been incurred. The business environment in which SR&ED is carried out will influence the nature and sources of evidence that are available to support the SR&ED claim. If your SR&ED claim is selected for review, you will be asked during the review to support your claim by providing supporting documentation that were generated as the SR&ED was being carried out. Work for which you have no relevant supporting evidence will likely be disallowed.
The following sections are provided to help you identify the type of documents and other items the CRA reviewers generally consider as supporting evidence. However, the lack of detailed documentary information should not discourage you from making an SR&ED claim or be considered as an indication that SR&ED did not take place, particularly in the case of a first-time claimant. In such a case, the CRA should be consulted to help you identify other types of supporting evidence that could be used to support the SR&ED work and the related expenditures.
Supporting the SR&ED work claimed
Most often, supporting evidence is in the form of contemporaneous documents (for example, documents generated as the SR&ED was being carried out). Contemporaneous documentation that is dated, signed, and specific to the work performed are the best supporting evidence that you can provide. If you choose to substantiate the work performed using other evidence, you must ensure that the evidence clearly addresses the questions in Part 2 of Form T661.
Table 1 in this appendix provides a list of examples of documentation and other items that you could use as supporting evidence. Note that the table is only meant to be a tool to help you identify the type of supporting evidence you have to support your claim and to organize your documentation should your claim be selected for review. It is important to note that:
- the table is not a checklist to determine the eligibility of work as SR&ED. That is, the existence of supporting evidence as listed in the table does not by itself indicate the work is SR&ED. It is the content of that supporting evidence that will determine if the evidence is relevant;
- the table is not an exhaustive list—other forms of supporting evidence may be relevant; and
- it is not expected that all of the supporting evidence listed in the table would be generated for every SR&ED project. However, some form of relevant supporting evidence must be available to address the questions in Part 2 of Form T661.
Supporting the SR&ED expenditures claimed
You are required to keep complete and organized records that support the expenditures claimed. Requirements for records needed to support financial transactions are set out in Guide RC4409, Keeping Records. Typical financial records and documents that may be requested during the financial review include financial statements and records, ledgers, journals, and vouchers. Source documents such as receipts, contracts, and general correspondence may also be requested.
In addition to the above general financial records, SR&ED claimants must keep any related documents and information to support the specific expenditures claimed on Form T661. This includes but is not limited to:
- cost breakdowns per project for each line item in Part 3 of Section B of Form T661
- the cost allocation method used to allocate labour and overhead expenditures to SR&ED
- time sheets that support the salary or wages claimed by employees on SR&ED activities
- contracts and/or agreements related to the SR&ED claim logbooks or other documents that support the use of equipment for SR&ED
- documents to support third-party payments such as to whom and for what the payments were made
- supporting schedules such as the reconciliation of amounts on Form T661 to the financial statements
- schedules to support the SR&ED investment tax credit (ITC) recapture amount
- provincial/territorial income tax returns, if applicable
Maintaining appropriate supporting evidence will facilitate the review of your claim and help you to substantiate your claim. This is especially important in work environments where both SR&ED and commercial work are taking place. For example, using the project records you have, you should be able to explain and/or demonstrate:
- who did the work claimed and how much time employees spent on SR&ED work;
- how the work claimed was related to the scientific or technological advancement sought;
- how materials were used, the quantities consumed or transformed in SR&ED work, and how materials and products were ultimately disposed of;
- in the case of contracts and/or agreements relating to claimed work, what services or products were provided, who performed the work, where the work took place, as well as who acquired rights to any intellectual property resulting from that work; and
- how the project costs that are attributable to SR&ED work are segregated from those that are for non-SR&ED work, when the SR&ED is carried out in a commercial environment.5
A Lack of Specifics
Note that despite the length of the text with SR&ED policy, there is minimal guidance on what specific documentation should be created. There are also several vague sentences that dance around making definitive and helpful statements, such as “the business environment in which SR&ED is carried out will influence the nature and sources of evidence that are available to support the SR&ED claim.” This leaves room for a fair bit of interpretation — by SR&ED applicants and CRA reviewers alike.
The phrasing is also interesting. The act of producing and keeping documentation is often positioned as a suggestion, i.e. “It is important to maintain supporting evidence” rather than a requirement.
Court Cases & Supporting SR&ED Documentation
However, the fifth question from Judge Bowman’s landmark ruling (“Was supporting documentation kept?”) does not leave room for suggestion — a lack of supporting documentation is a definitive strike against the eligibility of an SR&ED submission.
This strict approach has been reinforced by the court system. At a recent Canadian SR&ED symposium, one of the panellists plainly stated that their firm uses the presence or absence of sufficient documentation as a screening question for SR&ED applicants. Without documentation, this particular legal firm does not advise proceeding an appeal. To support this cautious approach, there are multiple court cases that cite a lack of documentation as an issue when determining the eligibility.
Their position is reasonable, given the multiplicity of court cases that cite a lack of documentation as an issue when determining eligibility. These cases include (but are not limited to):
- ACSIS EHR (Electronic Health Record) Inc. v. The Queen (2016),
- Concept Danat Inc. v. The Queen (2019),
- Dock Edge + Inc. v. The Queen (2019),
- National R&D Inc. v. The Queen (2020),
- 6398316 Canada Inc. v. The Queen (2021)
The CRA’s Unclear Treatment of Different Types of Evidence and Documentation in SR&ED
The rulings in these cases point to a preference for written, contemporaneous documentation vs. oral assertions regarding the work performed. Whereas oral testimony provided in court is under oath, verbal details provided by an applicant in a CRA SR&ED review meeting are not. Even in court, there are questions of credibility. If we think of the CRA as gatekeepers to taxpayer funds, it makes sense that they wish to limit the risk that these funds may be misused.
However, this becomes complicated because, in Canada, the burden of proof lies with the SR&ED applicant. Applicants must prove that their work is eligible to an organization (the CRA) that requires documentation but fails to clearly and definitively explain exactly what documentation is required. Further, the CRA can flat-out deny an application if they do not approve of the documentation that has been provided. So, while an organization may have project planning documents, progress reports, and records of meeting minutes (Line 270 and 276 respectively in the T661), if the CRA reviewer believes this has not been structured as an “SR&ED project” and there are too many commercial elements, the documentation will be deemed “insufficient”.
This begs the question… does this approach make sense?
SR&ED Work Performed… or SR&ED Work Documented?
From an academic approach, the CRA is no longer requesting basic research, applied research, or experimental development – rather, they require that applicants provide clear documentation of SR&ED activities using a knowledge management system and/or process that the CRA itself has not disclosed.
Perhaps inadvertently, the CRA has shifted the program focus away from the work being performed to the work being documented, and the work being documented in an approved format that they will not disclose.
This issue frequently comes up during reviews. SR&ED applicants are caught off-guard by the depth and extensiveness of the documentation expected. As one group pointed out, “notes that were better than a court stenographer” were considered inadequate. What’s worse is that these groups often turn to large consulting or accounting firms to help them resolve the matter, which doesn’t often have a significant impact as the fundamental issue (documentation) has not been addressed.
(It could best be described as hiring the partner at an accounting firm to argue that your tax deductions are legitimate when no receipts are available for review. There’s no point.)
This is why, when I meet with highly-trained engineers and programmers, I first discuss the program requirements regarding technological advancements and documenting their knowledge base, and then ask them to consider the SR&ED program as a knowledge management program that requires that these details (technological advancement and knowledge base) are carefully captured. Often, this results in a quick reassessment of how their work is documented to ensure that they meet the program criteria.
Should the SR&ED Program be Renamed?
To be completely honest, I don’t care what the program is called.
But it’s time that the CRA stops pretending that the program is about science or technological innovation in Canada – it’s not. It’s about demonstrating documentation compliance in addition to meeting all policy requirements regarding the CRA’s conceptualization of basic research, applied research, and experimental development.
At least if it was called the “Canadian Science and Technology Knowledge Development and Management” program, there would be less confusion and fewer of our top innovators abandoning the program because of the complexity of applying to a program with unwritten rules.
One final thought… Many years ago, there was an outcry regarding the use of consultants to assist companies applying to the SR&ED program. I have said this several times and I will say it again: there will continue to be a need for consultants so long as there are issues such as the ones described above. If anyone at the CRA is reading this and is upset that consultants earn a living helping companies navigate the policy documents and rules, it may be advisable that less time is spent focusing on the symptoms (a prolific consulting industry) and more time fixing the problem (an unnecessarily complex tax credit).
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- Canada Revenue Agency. (2022, July 8). T661 SR&ED Expenditures Claim. Retrieved September 20, 2022, from https://www.canada.ca/content/dam/cra-arc/formspubs/pbg/t661/t661-20e.pdf ↩
- Northwest Hydraulic Consultants Ltd. v. The Queen, 97-531-IT-G. Retrieved April 2, 2016, from http://decision.tcc-cci.gc.ca/tcc-cci/decisions/en/item/24675/index.do ↩
- Canada Revenue Agency. (2014, December 18). Support for Labour Allocation. In SR&ED Salary or Wages Policy (Chapter 13.3). Retrieved April 4, 2016, from http://www.cra-arc.gc.ca/txcrdt/sred-rsde/clmng/slrywgs-eng.html#s13_3_1 ↩
- Canada Revenue Agency. (2020, December 14). How to complete Form T661 – Line-by-line explanations. In SR&ED expenditures claim guide to form T661 (Section C – Additional project information). Retrieved September 20, 2022, from https://www.canada.ca/en/revenue-agency/services/forms-publications/publications/t4088.html ↩
- Canada Revenue Agency. (2020, December 14). Documentation and other evidence to support your SR&ED claim. In SR&ED expenditures claim guide to form T661 (Appendix 2). Retrieved September 20, 2022, from https://www.canada.ca/en/revenue-agency/services/forms-publications/publications/t4088.html ↩