SR&ED Salary or Wages Policy (Draft) CRA s SR&ED Policy Review Process KPMG Submission

Transcription

1 SR&ED Salary or Wages Policy (Draft) CRA s SR&ED Policy Review Process KPMG Submission 30 April 2011

2 Contents Introduction 1 Review of SR&ED Salary or Wages Policy (Draft) Paper 2 1. Is the language easy to understand? 2 2. Is the information well organized? 7 3. Are there any gaps or omissions in the information? 7 4. Is there any information that is not necessary? What are the best features of the document? Do you have any other comments or suggestions to improve the document? 14 Appendix 15 CRA Policy Document: SR&ED Salary or Wages Policy - Draft 15

3 Introduction As part of the CRA s SR&ED Policy Review Project, stakeholders were asked to comment on the CRA s SR&ED Salary or Wages Policy (Draft) Paper. KPMG Canada LLP s (KPMG) response to this draft policy paper outlines the firm s views and recommendations for this part of the SR&ED Policy Review Project. Our comments are not exhaustive we have highlighted selected areas of the draft paper that we believe may benefit the most from being revised. This document specifically addresses the SR&ED Salary or Wages Policy (Draft) Paper and is organized to address the six questions that the CRA has outlined in its process document, namely: 1. Is the language easy to understand? 2. Is the information well organized? 3. Are there any gaps or omissions in the information? 4. Is there any information that is not necessary? 5. What are the best features of the document? 6. Do you have any other comments or suggestions to improve the document? For ease of reference, the CRA s draft policy paper is reproduced in the appendix. We support the CRA s initiative and welcome the opportunity to participate in the consultations. Submitted on behalf of KPMG in Canada by: Carlo Ciaramitaro, CA Partner - Tax Canadian and Americas Practice Leader R&D Tax Incentives Practice T E [email protected] David Regan, CA Partner - Tax T E [email protected] Carl Deslongchamps, CA Partner - Tax T E [email protected] Ed Zacharuk, CA Partner - Tax Western Canada SR&ED Practice Leader T E [email protected] Gregory Brennan, CA Partner - Tax T E [email protected] David Durst, MBA, CMA Associate Partner - Tax T E [email protected] 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 1

4 Review of SR&ED Salary or Wages Policy (Draft) Paper 1. Is the language easy to understand? KPMG s overall impression of the document is that the language used is reasonably easy to understand and is a good source of information. We did, however, note that in several situations the language could be viewed as somewhat vague and thus taxpayers could misinterpret it. Our comments address the following sections of the document. Section 4.2 Meaning of bonuses Unenforceable "Bonus" refers to a payment that is not earned Enforceable "Bonus" also refers to an amount paid (premium) The paragraph and sentence structure in this section may lead to confusion. As such, KPMG suggests the following revision: Unenforceable Bonuses An unenforceable "Bonus" refers to a payment that is not earned Enforceable Bonuses An enforceable "Bonus" also refers to an amount paid (premium) Section Employees who are directly engaged In addition, employees are considered to be directly engaged in SR&ED when they are performing technical support work such as engineering, design, operations research, mathematical analysis, computer programming, (non-routine) data collection, testing or psychological research commensurate with the needs and directly in support of the basic or applied research or experimental development work. [emphasis added] This paragraph appears to be inconsistent with the current definition of Scientific research and experimental development found in subsection 248(1) of the Income Tax Act (Canada) ( ITA ). To make this paragraph more consistent with the definition in the ITA, we suggest removing the word non-routine, which we ve underlined above. 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 2

5 Section 7.2 Supporting documentation and other evidence Proxy Method A claimant should be able to show that the salary or wages are for SR&ED work performed by employees of the company on activities that are considered to be directly engaged in SR&ED. When applying the expenditure allocation in a claim under the proxy method, the information system used by a claimant must capture directly engaged time. Other labour costs are covered by the prescribed proxy amount. KPMG submits that this paragraph seems to establish an expectation of claimants information systems that seems to be contrary to CRA s previous positions that taxpayers can rely on documentation normally generated from systems presently used to run their operations and are not required to implement new systems solely for SR&ED purposes. Such information systems tend to track business costs rather than directly engaged employee time. As a result, many claimants normally generated information would need to be reviewed and filtered to arrive at SR&ED eligible expenditures. As such, KPMG suggests revising this paragraph along the following lines: A claimant should be able to show that the salary or wages are for SR&ED work performed by employees of the company on activities that are considered to be directly engaged in SR&ED. When applying the expenditure allocation in a claim under the proxy method, the information system, along with other systems and forms of contemporaneous documentation used by a claimant, may be used to illustrate directly engaged time. Other labour costs would be covered by the prescribed proxy amount. Section 8.1 Meaning of undertakes, supervises or supports The third paragraph of this section reads as follows: Supervision for purposes of the directly attributable rules does not include the performance of managerial functions that relate to general administration. However, supervision could include some non-technological functions, e.g. long-term strategic planning, contract administration, etc., that directly relate to the prosecution of SR&ED. These functions would generally be performed in carrying out the other related duties of a technological supervisor of SR&ED (see section 9.0 Administrative salary or wages under the traditional method). KPMG submits that the specific roles within an organization that are outlined in this paragraph may not apply to all situations and could be misinterpreted. KPMG suggests removing the last sentence because the description technological supervisor may not be appropriate or may not exist in certain corporations. Section 8.1 Meaning of undertakes, supervises or supports The last paragraph in this section reads as follows: 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 3

6 Support work does not include the performance of clerical duties involved in carrying out SR&ED. Note that this is consistent with the position taken in paragraph 32 of IT-145R (Consolidated), Canadian Manufacturing and Processing Profits Reduced Rate of Corporate Tax, concerning clerical staff. Salary or wages relating to clerical or administrative support staff, could be included as SR&ED overhead expenditures (see section 9.5 Clerical and administrative staff providing a service to SR&ED employees). KPMG submits that that last sentence could be reworded to clarify how to deal with these types of expenditures. The draft version above may confuse a reader who may not know the difference between the terms support work and support salaries. To help clarify, we suggest a revision to the last sentence such as the following: Salary and wages relating to clerical or administrative support staff should be included as SR&ED overhead expenditures when directly related to SR&ED work. Section 8.2 Supporting documentation and other evidence Traditional Method A sentence in the middle of the second paragraph of this section reads as follows: When applying the expenditure allocation in a claim under the traditional method, the information system used by a claimant must capture directly engaged time, as well as directly related and incremental time. KPMG submits that this paragraph seems to establish an expectation of claimants information systems that seems to be contrary to CRA s previous positions that taxpayers can rely on documentation normally generated from systems presently used to run their operations and are not required to implement new systems solely for SR&ED purposes. Such information systems tend to track business costs rather than directly engaged employee time. As a result, many claimants normally generated information would need to be reviewed and filtered to arrive at SR&ED eligible expenditures. As such, KPMG suggests revising this paragraph along the following lines: When applying the expenditure allocation in a claim under the traditional method, the information system, along with other systems and forms of contemporaneous documentation used by a claimant, must capture directly engaged time, as well as directly related and incremental time. Section 9.2 Application of the rules The portion of salary or wages for hands-on work performed by administrative staff is an expenditure directly attributable to SR&ED and could qualify as salary or wages of an employee who directly undertakes, supervises or supports the prosecution of SR&ED. However, work performed by administrative staff with no technological background generally does not qualify as hands-on work. In this case, an analysis of the duties performed is required to determine the direct linkage to SR&ED work. 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 4

7 KPMG submits that the last sentence could be expanded as follows to clarify how these expenditures qualify: In this case, an analysis of the duties performed is required to determine the direct linkage to SR&ED work and include the expenditures as an SR&ED overhead expense or other expenditures. Section 9.3 Examples of tasks directly related to the prosecution of SR&ED KPMG submits that the examples of tasks directly related to the prosecution of SR&ED in section 9.3 should include clerical and administrative tasks as per section 9.5. We suggest that the CRA could include in the list the examples provided in section 9.5 of clerical and administrative staff providing a service to SR&ED employees that is in support of SR&ED related activities. Section 9.3 Examples of tasks directly related to the prosecution of SR&ED Tasks/departments that are generally not directly related to SR&ED work: Bidding costs Purchasing (other than direct purchasing of material/sr&ed equipment) KPMG suggests expanding the purchasing exclusion to include those individuals responsible for the contracts with suppliers or R&D subcontractors. As such, we suggest revising the second bullet above as follows: Purchasing (other than direct purchasing of material/sr&ed equipment or subcontracts) Section 9.4 Incremental test Further, an expenditure for administrative salary or wages must also meet the incremental test (would not have been incurred had it not been for the prosecution of SR&ED) to be deductible as SR&ED expenditure. The claimant must demonstrate that the expenditure is incremental: if the SR&ED work were not carried out, would the expense still have been incurred? If yes, the expense would not meet the test and would therefore not be allowable as SR&ED expenditure. KPMG believes that the omission of the words or a portion thereof when referring to expenses in this paragraph could lead to confusion and inconsistency with other sections. As such, we suggest the CRA consider revising this paragraph by adding the underlined words: Further, an expenditure for administrative salary or wages must also meet the incremental test (would not have been incurred had it not been for the prosecution of SR&ED) to be deductible as SR&ED expenditure. The claimant must demonstrate that the expenditure, or a portion thereof, is incremental: if the SR&ED work were not carried out, would the expense, 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 5

8 or a portion thereof, still have been incurred? If yes, the expense would not meet the test and would therefore not be allowable as SR&ED expenditure. Section 13.3 Support for labour allocation The labour allocation must be supported by evidence that: the allocation method is appropriate in the company's environment the allocation method is consistent with the legislation and the administrative practices of the CRA the allocation system is functional throughout the year KPMG submits that the wording in this section seems to indicate that one singular allocation system must be in place throughout the year. This is often not the case for first-time claimants or for taxpayers who may implement systems that are suited for a particular department or group, which may differ from a system that might be required of another group that captures information that is relevant for their business. Systems may also not be used at all times in environments where SR&ED is not predominate. We suggest the CRA consider revising the third bullet in this list along the following lines: Where applicable, the allocation system is functional throughout the periods of SR&ED activities taking place Section 13.6 When is a labour allocation method reasonable? The second sentence of the second paragraph in this section reads as follows: The CRA will advise a claimant either orally or in writing if there is a need for additional supporting information relating to a claim for SR&ED labour expenditures. If in writing, the letter will explain that proper supporting information will have to be kept for claim periods starting after the date of the letter. KPMG submits that this statement implies that the CRA will not discuss its suggestions prior to issuing a letter. Ideally, KPMG believes that the onus should be on the CRA to explain and detail why current systems were insufficient to show how the SR&ED expenditures were segregated from other expenditures that may be tracked for business purposes but do not qualify. A system may not always provide detailed low level (activity level) tracking as exhibited in the case study in this paper. As such, KPMG suggests the CRA consider revising this paragraph along the following lines: The CRA will advise a claimant either orally or in writing if there is a need for additional supporting information relating to a claim for SR&ED labour expenditures. The CRA will also work with the claimant to come up with a system that provides the information required by the CRA to support an SR&ED claim but does not require the taxpayer to track more information than would be required for that business. If in writing, and if agreed upon in collaboration with the taxpayer, the letter will explain that proper supporting information will have to be kept for claim periods starting after the date of the letter. 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 6

9 2. Is the information well organized? Our overall impression of the document is that the information is well organized and useful. We did, however, note that the information on traditional and proxy method-related subjects could be better organized. Specifically, it is sometimes unclear which policy topic relates to which costing method. KPMG suggests having a separate section for each of the traditional and proxy methods. For example, section 7 could be placed under the Proxy Method heading and sections 8 and 9 could be placed under the Traditional Method heading. 3. Are there any gaps or omissions in the information? KPMG noted several places in the document where adding examples or data could help to state policy more clearly and make it easier for taxpayers to understand. Our comments address the following sections of the document. Section 2.3 Table outlining SR&ED salary or wages inclusions and exclusions Included in SR&ED salary or wages Salary or wages (section 2.0) KPMG believes that this table presents an opportunity to clearly outline the expenditures made for a benefit that would be taxable to the employee and generally included within the definition of salary or wages. As such, we suggest adding the following information: Included in SR&ED salary or wages Salary or wages (section 2.0) (including vacation pay, statutory holiday pay, sick leave pay, pay in lieu of termination notice, bonuses, tips and gratuities, honorariums, director s fees, management fees and commissions.) Section 3.0 Taxable benefits The second paragraph in this section states: As stated in the T4088, Guide to Form T661 Scientific Research and Experimental Development (SR&ED) Expenditures Claim, salary or wages could relate to gross wages reported on a T4 slip for the calendar year if the tax year ends at the calendar year-end. KPMG believes that this statement presents an opportunity to provide a practical example of how a taxpayer would analyse the information reported on a T4 supplementary slip in order to calculate SR&ED salary and wage expenditures. KPMG suggests the statement be revised to provide a numeric example which extracts amounts reported in box 14 of the T4 supplementary slip and then apply an appropriate 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 7

10 SR&ED allocation, based on a fact pattern or case study that details the allocation, in order to calculate SR&ED salary and wage expenditures. Section Amounts that are not salary or wages Example Facts Employee X (a non-specified employee) receives salary of $10,000 per month. He earns 1 month of vacation and 1 month of sick leave each year. KPMG believes that examples throughout the document are an excellent method to illustrate and apply the information within the relevant section. However, the examples could be more detailed to help clarify any ambiguity or what if scenarios. As such, KPMG suggests adding to the example above as follows: Example Facts Employee X (a non-specified employee) receives salary of $10,000 per month. He earns 1 month of vacation and 1 month of sick leave each year. Earned vacation and sick leave are inherently accrued while working, along with the expenditure being incurred by the company at that same time. Section Portion of an expenditure for salary or wages The directly engaged salary or wages or portion thereof is calculated on the time spent directly engaged in SR&ED relative to the total time worked. For example, if a salaried employee earning $100,000 per year spends all of their 1,800 regular hours directly engaged in SR&ED KPMG believes that ambiguity surrounding the calculation of employee s time spent directly engaged in SR&ED, and in particular what constitutes regular hours, may lead to varying interpretations and results. The CRA may want to consider providing an example that illustrates how regular hours are determined as there appears to be some inconsistency in applying these rules. KPMG suggests adding an example such as the following: The directly engaged salary or wages or portion thereof is calculated on the time spent directly engaged in SR&ED relative to the total time worked. For example, if a salaried employee earning $100,000 per year spends all of his or her 1,800 regular hours (which is net of statutory holidays and vacation, specifically 52 weeks 40 hours per week = 2,080 hours, less 80 hours statutory holidays, less 200 hours vacation = 1,800 regular hours) directly engaged in Section Example Reasonably be considered to relate to SR&ED An employee who is directly engaged in the prosecution of SR&ED 60% of the time receives a regular salary of $100,000 and a commission of $15,000 on the sale of a product. The amount for the commission is not an 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 8

11 expenditure on SR&ED as it not directly linked to the SR&ED work being performed. KPMG is concerned that ambiguity surrounding the details of how the prosecution of SR&ED 60% of the time is calculated could lead to varying interpretations and results. KPMG suggests adding an example such as the following: An employee who is directly engaged in the prosecution of SR&ED 60% of the time, for example a total of 1,080 hours out of 1,800 regular hours (which is net of statutory holidays and vacation, specifically 52 weeks 40 hours per week = 2,080 hours, less 80 hours statutory holidays, less 200 hours vacation = 1,800 regular hours) receives a regular salary of $100,000 and a commission of $15,000 on the sale of a product. The amount for the commission is not an expenditure on SR&ED as it not directly linked to the SR&ED work being performed. Section All or substantially all When the portion of the expenditure represents all or substantially all (90% or more) of the time spent by the employee on SR&ED work, all of the expenditure is deemed to be on SR&ED. KPMG is concerned that ambiguity surrounding the details of how 90% is calculated could lead to varying interpretations and results. KPMG suggests the following revision: When the portion of the expenditure represents all or substantially all, commonly referred to as 90% or more, of the time spent by the employee on SR&ED work, all of the expenditure is deemed to be on SR&ED. For example, a total of 1,620 hours out of 1,800 regular hours has been spent on SR&ED, where 1,800 regular hours are net of statutory holidays and vacation. Specifically calculated as follows, 52 weeks x 40 hours per week = 2,080 hours, less 80 hours statutory, less 200 hours vacation = 1,800 regular hours. Section 12.2 Employees of a related corporation Legislative Reference Income Tax Act Subsection 37(13) Non-arm's length contract Linked work This legislative reference appears to be missing a citation to subsection 37(1.1), as follows: Subsection 37(1.1) Business of related corporations Section 13.7 Example of an allocation method The example provided is a very practical approach to preparing an SR&ED filing using an allocation method. In order to enhance the example, KPMG suggests providing more details and calculating actual amounts as they would be reported on the T661. In particular, specific details regarding expenditures incurred, T4 amounts, percentages translated to hours, application of percentages to expenditures incurred, etc., would help clarify the example. 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 9

12 4. Is there any information that is not necessary? KPMG submits that several sections of the policy paper under the proxy method seem to define directly engaged in a more restrictive way than previous documents. These sections detail which hands-on work different roles can perform and also provide what could be interpreted as a restrictive list of tasks for each role (Paragraph 7.1). This approach seems to differ from the prior policy document AP96-06 which states, Whether an employee is directly engaged in SR&ED is a question of fact based on the duties performed and not on the job title. As such, the information in the policy paper seems less like a consolidation of previous papers and more like a policy change. If this consolidation is not meant to be a policy change, then it seems that the explanation of directly engaged in the policy paper could be misinterpreted by RTA and taxpayers. For example, many businesses may have managers/supervisors who, by the nature of their role and activity, have very few or no administrative tasks and therefore could be ASA directly engaged in SR&ED. As presented, the policy paper seems to imply that managers won t be able to do paragraph 248(1)(d) activities and could further be interpreted to indicate that taxpayers can not claim managers as directly supporting the SR&ED activities in this capacity. KPMG submits that the CRA may want to consider simply stating what directly engaged means and then perhaps give several examples that include situations where employees at various levels of an organization become directly engaged in SR&ED, including managers, employees and non-specialized employees. Our comments address the following sections of the document. Section 7.1 Meaning of directly engaged Generally, the CRA considers the time employees, including first-line supervisors and managers (see section 7.1.3), spend to perform the following tasks as time they are directly engaged in SR&ED: preparing equipment and materials for experiments, tests, and analyses (this does not include time spent maintaining equipment); experimenting, testing, and analyzing; collecting data for experimentation and analysis; and directing the course of the ongoing SR&ED work being claimed in the year. The CRA considers time spent performing the following tasks to be time during which employees are directly engaged in SR&ED (to the extent that the tasks are required as part of an SR&ED project): recording measurements, making calculations, and preparing charts and graphs; conducting statistical surveys and interviews; preparing computer programs; and working in engineering or design, operations research, mathematical analysis, computer programming, data collection, testing, or 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 10

13 psychological research that is commensurate with the needs and directly in support of eligible SR&ED work. The claimant should view its employees' tasks in terms of how they correlate to the primary reason for employment when determining whether the employee's salary or wages are directly engaged in SR&ED. [emphasis added] KPMG submits that the current structure in this section that provides distinct roles for supervisors/managers and employees and associated tasks for each role could be misinterpreted to mean that eligibility is determined by role, contrary to the rules in the ITA, which indicate that anything directly engaged is eligible. Specifically, KPMG recommends that last sentence underlined above be removed from the policy because it appears to conflict with AP96-06, which says, Whether an employee is directly engaged in SR&ED is a question of fact based on the duties performed and not on the job title. Further, KPMG suggests removing the first sentence of the second paragraph underlined above as well and combining the eight bullet points. Section Non-specialized employees who are directly engaged Tasks performed by non-specialized employees are generally not considered to be "directly engaged" in SR&ED. For example, any work related to equipment maintenance or repairs, materials-handling, and clerical and administrative support activities does not qualify under the proxy method (Refer to the Traditional and Proxy Methods Policy. This document is currently under development and a link will be provided once the project is complete.). KPMG recommends that the CRA consider removing this paragraph from the policy. We are concerned that taxpayers and RTAs could misinterpret this paragraph to mean that these tasks are always ineligible. This is not the case any task within an organization which can be shown to be directly engaged and commensurate is eligible under the ITA. Section Managers and supervisors who are directly engaged Managers and supervisors are also considered to be directly engaged in SR&ED when they are performing experimentation and analysis in the performance of basic research, applied research or experimental development and when they are carrying out technical activities in support of the research or development work. In addition, managers and supervisors who supervise the ongoing SR&ED work are also considered to be directly engaged in SR&ED when they are directing the course of the ongoing SR&ED work or when they are providing direct technical input into the SR&ED work. However, any time spent by a 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 11

14 manager or supervisor performing non-technological management activities or decision-making functions that do not directly influence the course of the SR&ED, even if it relates to the SR&ED, is not considered to be time the manager or supervisor is directly engaged in SR&ED. In most cases, work performed beyond the first-line level of supervision does not qualify as directly engaged in SR&ED. Where time is claimed for employees beyond the first-line level of supervision, the claimant will be asked to provide details of the duties the employees performed during the time they were directly engaged in SR&ED. The claimant will also have to demonstrate how these duties are "directly engaged," as described above. It is KPMG s suggestion that this section be revised to remove any implications that managers cannot perform specific types of directly engaged activities. We suggest this section be revised as follows to recognize that managers can perform directly engaged activities: Managers and supervisors are also considered to be directly engaged in SR&ED when they are performing SR&ED under subsections (a) through (d) of 248(1) of the ITA. In addition, managers and supervisors who supervise the ongoing SR&ED work are also considered to be directly engaged in SR&ED when they are directing the course of the ongoing SR&ED work or when they are providing direct technical input into the SR&ED work. However, any time spent by a manager or supervisor performing non-technological management activities or decision-making functions that do not directly influence the course of the SR&ED is not considered to be time the manager or supervisor is directly engaged in SR&ED. Where time is claimed for employees beyond the first-line level of supervision, the claimant will be asked to provide details of the duties the employees performed during the time they were directly engaged in SR&ED. The claimant will also have to demonstrate how these duties are "directly engaged," as described above. Section Meaning of solely in support The SR&ED work carried on outside Canada must be solely in support of SR&ED carried on in Canada by the claimant. Work carried on outside Canada that is basic research, applied research, experimental development or work described in paragraph (d) of the definition of SR&ED in subsection 248(1) of the ITA would qualify as "support work" provided the work is an integral part and is solely in support of the SR&ED work carried on in Canada by the claimant. The question whether an activity performed outside Canada is solely in support of the SR&ED work carried on in Canada is a question of fact to be determined on a case by case basis. 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 12

15 - Where an activity is in support of both an SR&ED project carried on in Canada and another SR&ED project carried on outside Canada, that activity would not be considered to be solely in support of the SR&ED work carried on in Canada. - Where an activity performed outside Canada supports work that involves SR&ED carried on in Canada and at the same time supports non SR&ED work (dual purpose activity) performed in Canada, that activity would not be considered to be solely in support of the SR&ED work carried on in Canada. KPMG submits that the policy paper s current explanation of solely in support may not allow for situations where technical staff cannot control what other spinoff R&D occurs in other countries stemming from test results. Therefore, we recommend that section be revised to exclude solely in support such that the portions of time spent outside of Canada become ineligible when they no longer support Canadian R&D as it is often feasible to differentiate between eligible and ineligible portions of a trip. As such, KPMG suggests that the first two paragraphs of section be revised as follows: The work claimed for SR&ED that was carried on outside Canada must be in support of SR&ED carried on in Canada by the claimant. Work carried on outside Canada that is basic research, applied research, experimental development or work described in paragraph (d) of the definition of SR&ED in subsection 248(1) of the ITA would qualify as "support work" provided the work is an integral part and is in support of the SR&ED work carried on in Canada by the claimant. The question whether an activity performed outside Canada is in support of the SR&ED work carried on in Canada is a question of fact to be determined on a case by case basis. KPMG also suggests that the last bullet paragraph of section be revised as follows because Canadian technical staff cannot control what other spinoff R&D occurs in other countries stemming from testing: Where an activity performed outside Canada supports work that involves SR&ED carried on in Canada and at the same time supports non SR&ED work (dual purpose trip) performed in Canada or elsewhere, that portion of the trip which was not considered to be in support of the SR&ED work carried on in Canada would be ineligible. 5. What are the best features of the document? KPMG believes that the legislative references within the document are well positioned and presented as footnotes which allows an interested reader to quickly refer to additional information should it be required to understand their specific case. 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 13

16 The hyperlinks in the policy paper to related sections are extremely beneficial, although the CRA may want to consider also distributing PDFs of these files with active HTML links. Access to PDFs would benefit users because these files tend to be easier to print and distribute than websites. 6. Do you have any other comments or suggestions to improve the document? The CRA may want to consider an overall objective of providing more practical examples throughout the paper. This approach will provide consistency in the document and help enhance the reader s understanding. Conclusion KPMG welcomes the opportunity to contribute to the consultation on this important issue for Canadian corporations. We look forward to answering any questions from the CRA about this submission and to providing further comments when new proposals are released. 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 14

17 Appendix: CRA Policy Document SR&ED Salary or Wages Policy Draft Table of Contents 1.0 Purposes 2.0 Definition of "salary or wages" o 2.1 Legislation o 2.2 Expenditures incurred Examples of expenditures not incurred o 2.3 Table outlining SR&ED salary or wages inclusions and exclusions 3.0 Taxable benefits o 3.1 Expenditure incurred vs. Value of taxable benefits Example: Automobile and motor vehicle benefits o 3.2 GST/HST or PST considerations o 3.3 Value of taxable benefits T4 slips 4.0 Bonuses, remuneration based on profits and other types of remuneration o 4.1 Meaning of "remuneration based on profits" o 4.2 Meaning of "bonuses" o 4.3 Inducement payments and non-competition payments to employees o 4.4 Expenditure on or in respect of SR&ED 5.0 Amounts that are not salary or wages o 5.1 Related benefits o 5.2 Expenditures for extended vacation or sick leave Example o 5.3 Stock option benefits Options granted or shares issued on or after November 17, Background Stock option benefits Treatment of stock option benefits o 5.4 Retiring allowances Accumulated vacation and sick leave credits upon retirement 6.0 Specified employees o 6.1 Bonuses or remuneration based on profits for specified employees Limitation regarding specified employees Rules for associated corporations 7.0 Salary or wages of employees directly engaged in SR&ED Proxy method o 7.1 Meaning of "directly engaged" Employees who are directly engaged Non-specialized employees who are directly engaged Managers and supervisors who are directly engaged o 7.2 Supporting documentation and other evidence Proxy method o 7.3 Calculating the amount of the expenditures Portion of an expenditure for salary or wages Only the portion of the salary or wages that can reasonably be considered to relate to SR&ED can be included Example Reasonably be considered to relate to SR&ED All or substantially all (ASA) Example All or substantially all 8.0 Undertakes, supervises, supports Traditional method o 8.1 Meaning of "undertakes, supervises or supports" 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 15

18 o 8.2 Supporting documentation and other evidence Traditional method o 8.3 Calculating the amount of the expenditures Portion of an expenditure for salary or wages Only the portion of the salary or wages that can reasonably be considered to relate to SR&ED can be included All or substantially all (ASA) o 8.4 Salary or wages under the traditional method and Form T Administrative salary or wages Traditional method o 9.1 "Directly attributable" tests "Directly related" and "incremental" salary or wages o 9.2 Application of the rules o 9.3 Examples of tasks directly related to the prosecution of SR&ED o 9.4 "Incremental test" o 9.5 Clerical and administrative staff providing a service to SR&ED employees 10.0 Salary or wages of employees carrying on SR&ED outside Canada o 10.1 Calculation of permissible salary or wages for SR&ED work carried on outside Canada Example o 10.2 Applying the rules Meaning of "solely in support" Salary or wages paid were not subject to income or profits tax from another country Determining amount B - Limit o 10.3 How to calculate permissible salary or wages for work carried on outside Canada for Form T Unpaid salary or wages o 11.1 Identification of unpaid salary or wages on Form T661 o 11.2 Evidence of payment Unpaid amounts vs. Reserve 12.0 Other issues related to salary or wages o 12.1 Employee vs. Self-employed o 12.2 Employees of a related corporation 13.0 Allocation of labour expenditures for SR&ED o 13.1 Cost allocation methods o 13.2 Research and development (R&D) environment o 13.3 Support for labour allocation High-level information Medium-level information Low-level information o 13.4 Sources of supporting information Development plans Supervisors' summaries Time sheets Naturally generated information o 13.5 R&D environment Distinct well-defined R&D projects Dedicated R&D environments Early stage or start-up business Shop floor SR&ED o 13.6 When is a labour allocation method reasonable? o 13.7 Example of an allocation method The approach Appendix A - References o A.1 Legislative references o A.2 Jurisprudence 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 16

19 o A.3 CRA publications 1.0 Purposes This draft policy document consolidates the content of Canada Revenue Agency's (CRA) publications that deal with salary or wages for scientific research and experimental development (SR&ED) claims. The purpose of this document is to clarify the position of the CRA regarding salary or wages when administering the SR&ED legislation under the federal Income Tax Act (ITA) and the Income Tax Regulations (Regulations). In particular, its purpose is: to explain what may be included in salary or wages for SR&ED purposes; to highlight the differences between directly undertaking, supervising or supporting salary or wages under the directly attributable rules when using the traditional method and directly engaged salary or wages when using the proxy method; and to clarify the CRA's position with respect to a number of issues that are common to both the traditional method and the proxy method. 2.0 Definition of "salary or wages" The expression "salary or wages" is defined in the Income Tax Act (ITA) (section 2.1) and means income from an office or employment. Salary or wages generally includes any expenditure made in respect of a benefit that would be taxable to the employee under section 6 of the ITA (section 3.0) as well as vacation pay, statutory holiday pay, sick leave pay, pay in lieu of termination notice, bonuses (section 4.0), tips and gratuities, honorariums, director's fees, management fees and commissions. These amounts must be paid to or incurred for the employees in the year (section 2.2). Salary or wages do not include amounts in respect of the employer's shares of the related benefits (section 5.1), amounts for extended vacation or sick leave (section 5.2), stock options benefits (section 5.3) and retiring allowances (section 5.4). There is also a general rule that applies to exclude unpaid salary or wages (section 11.0). The general rules described in the sections referred to above also apply for SR&ED purposes. However, there are specific rules that apply in order for salary or wages to be an allowable SR&ED expenditure. These rules are discussed in section 7.0 for a claimant using the proxy method (Please refer to the Traditional and Proxy Methods Policy. This document is currently under development and a link will be provided once the project is complete.) and in section 8.0 for claimants using the traditional method (Refer to the Traditional and Proxy Methods Policy. This document is currently under development and a link will be provided once the project is complete.). Other specific rules apply to salary or wages for SR&ED purposes. There are rules for: specified employees (section 6.0), administrative salary or wages under the traditional method (section 9.0) and for salary or wages of employees performing SR&ED outside Canada (section 10.0). 2.1 Legislation The definition of salary or wages in the Income Tax Act (ITA) is as follows: 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 17

20 "salary or wages", except in sections 5 and 63 and the definition "death benefit" in this subsection, means the income of a taxpayer from an office or employment as computed under subdivision a of Division B of Part I and includes all fees received for services not rendered in the course of the taxpayer's business but does not include superannuation or pension benefits or retiring allowances. Legislative Reference Income Tax Act Subsection 248(1) Definition of "salary or wages" 2.2 Expenditures incurred To be included in the pool of deductible expenditures for SR&ED carried on in Canada, an expenditure must be an expenditure "on or in respect of SR&ED". One of the requirements to meet this condition is that the expenditure must be incurred. Legislative Reference Income Tax Act Subsection 37(8) SR&ED expenditures Examples of expenditures not incurred In certain cases, expenditures are considered not to be incurred. Some examples are: employee remuneration that is not paid within180 days from the end of the tax year in which the expense was incurred (see section 11.0 unpaid salary or wages) the value of a taxable benefit (see section 3.1) stock option benefits (see section 5.3) Legislative Reference Income Tax Act Subsection 78(4) Unpaid remuneration and other amounts 2.3 Table outlining SR&ED salary or wages inclusions and exclusions Included in SR&ED salary or wages Salary or wages (section 2.0) If it is incurred on or in respect of SR&ED If electing the proxy method, salary or wages for employees directly engaged in SR&ED in Canada may be included (section 7.0) If using the traditional method, salary or wages for employees directly undertaking, supervising, or supporting SR&ED may be included (section 8.0) Administrative salary or wages for employees directly attributable may be included as SR&ED overhead expenditures provided the traditional method is used (section 9.0) Permissible salary or wages for SR&ED work performed outside Canada may be included (section 10.0) 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 18

21 Taxable benefits (section 3.0) - Cash benefit May be included in SR&ED salary or wages - Non-cash benefit (the value of the benefit) May be included in SR&ED salary or wages, if: - the value is a reasonable estimate of actual costs - the value of the benefit does not include any GST/HST or PST, unless no input tax credit was claimed - the actual costs to which the non-cash benefit relates are not claimed as a business expense Bonuses [Footnote 1] (section 4.2) Remuneration based on profits (section 4.1) Inducements, non-competition payments (section 4.3) For employees other than specified employees For employees other than specified employees Considered to be remuneration for services rendered during employment (exceptions may apply) Excluded from SR&ED Salary or Wages Related benefits (section 5.1) Extended vacation or sick leave (section 5.2) Stock option benefits (section 5.3) Retiring allowance (section 5.4) Could be considered as overhead under the traditional method Considered not directly undertaking, supporting or supervising; considered not directly engaged Considered not to be an expenditure for SR&ED Could be considered part of overhead under the traditional method [Footnote 1] The rules discussed are only for bonuses with respect to expenditures for salary or wages. Rules concerning bonuses affecting the prescribed proxy amount are discussed in the Policy on the prescribed proxy amount. 3.0 Taxable benefits Taxable benefits are benefits or allowances an employer provides to its employees that are taxable under the ITA. For example: automobile benefits; housing, board, and meals; gifts and awards; interest-free or low-interest loans; group term life insurance policies; or tuition fees. 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 19

22 As stated in the T4088, Guide to Form T661 Scientific Research and Experimental Development (SR&ED) Expenditures Claim, salary or wages could relate to gross wages reported on a T4 slip for the calendar year if the tax year ends at the calendar year-end. However, when using the T4 slips as a basis for determining the allowable salary or wages, certain adjustments may be required to be made as discussed in sections 3.1 to 3.3 below. Legislative Reference Income Tax Act Section 6 Taxable benefits 3.1 Expenditure incurred vs. Value of taxable benefits Where an employee receives a non-cash benefit, the employer must determine the value of the benefit and include that value in the employee's income. A list of all non-cash benefits is provided in Guide T4130, Employer's Guide Taxable Benefits. For the employer, however, the value of a benefit is not an expenditure incurred and, therefore, is not an allowable SR&ED expenditure. In certain cases, the actual costs incurred by the company may have no relation to the value of the benefits otherwise determined. In determining the allowable amount of a taxable benefit, only the actual costs incurred in respect of the taxable benefits should be included in the allowable salary or wages. This is consistent with the existing practice applicable to the automobile standby charge (see section 3.1.1). The value of a benefit to the claimant will be allowed as an SR&ED expenditure if all the following conditions are met: it represents a reasonable estimate of the actual cost incurred (the onus is on the claimant to demonstrate the reasonableness); the amount of the benefit claimed does not include any GST/HST or PST (unless no input tax credit refund was claimed) (see section 3.2); and the actual costs, including capital cost allowance (CCA), to which the value of the benefits relates are not claimed as business expenses under section 9 of the ITA Example: Automobile and motor vehicle benefits The benefit for an automobile provided by the employer for the year includes a standby charge for the year and an operating expense benefit for the year (minus any reimbursements by the employee). The value of the benefit, including the GST/HST or PST that applies, is included in box 14 of the T4 slip as "Employment income," and in the "Other information" area under code 34. Although automobile taxable benefits, including standby charges, may not involve an expenditure incurred in the year, in practice an amount in respect of such benefits can be included as salary or wages if the amount represents a reasonable estimate of the actual costs incurred and does not include any GST/HST or PST (unless no input tax credit refund was claimed) and the automobile expenses and CCA to which the standby charge relates are not included in calculating business income. 3.2 GST/HST or PST considerations Some taxable benefits (like non-cash benefits) included on the employee's T4 slip may include a GST/HST or PST component. The employer may claim an input tax credit for the GST/HST that applies on the taxable benefits (or a similar provincial credit for PST on taxable benefits). The amount of input tax credit claimed is deemed to be government assistance. 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 20

23 Therefore, no GST/HST or PST amount should be included in the allowable SR&ED salary or wages where an input tax credit (or a similar provincial credit) is claimed in respect of these amounts. Legislative Reference Income Tax Act Subsection 248(16) GST Input tax credit and rebate 3.3 Value of taxable benefits T4 slips Other taxable non-cash benefits are based on the value of the benefits (for example, value of parking). A list of all non-cash benefits are provided in Guide T4130, Employer's Guide Taxable Benefits and Allowances. Other than specific codes for certain non-cash benefits, it should be noted that code 40 could include the value of certain non-cash benefits as well as GST/HST or PST, depending of the type of benefits. Claimants also have to ensure that no amounts are claimed as salary or wages for the following benefits: Interest-free and low-interest loan (box 14 of the T4 slip and code 36 and 37 in the "Other information" of the T4) is not an expenditure incurred and does not qualify as SR&ED salary or wages. Security options benefits (box 14 of the T4 slip and code 38 in the "Other information" of the T4) are not allowable expenditures (see section 5.3). In certain situations, placement agency workers (box 14 of the T4 slip and code 81 in the "Other information" of the T4) are not employees of the claimant, yet the claimant pays the salary and has to prepare the T4 slip for the workers. In these situations, the salary or wages of the placement agency workers do not qualify as salary or wages expenditures for the claimant but could qualify as a contract expenditure for SR&ED performed on the claimant's behalf (Please refer to the Contract Expenditures for SR&ED Performed on Claimant's Behalf Policy. This document is currently under development and a link will be provided once the project is complete.). 4.0 Bonuses, remuneration based on profits and other types of remuneration Restrictions apply to bonuses and remuneration based on profits in respect of specified employees (see section 6.0). When calculating the prescribed proxy amount, all bonuses and remuneration based on profits (both to specified and non-specified employees) are excluded from the salary base of employees directly engaged in SR&ED in Canada. (Please refer to the Prescribed Proxy Amount Policy. This document is currently under development and a link will be provided once the project is complete.) "Bonus" and "remuneration based on profits" are not defined in the ITA or the Regulations. Therefore, the ordinary dictionary definitions of the terms apply. Legislative Reference Income Tax Act Subsection 37(9) Remuneration based on profits or bonus for specified employees Legislative Reference Income Tax Regulation Subsection 2900(9) Exclusions to salary base 4.1 Meaning of "remuneration based on profits" 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 21

24 "Remuneration based on profit" means any remuneration to an employee that is conditional on the profit of the business or that is a portion of the profit of the business. 4.2 Meaning of "bonuses" "Bonus" is an amount in addition to the employee's normal remuneration (additional remuneration). Unenforceable "Bonus" refers to a payment that is not earned and is a gift or gratuity. The amount would be considered to be a bonus if it was not paid pursuant to the employee's terms of employment and the employer was under no obligation to make the payment. For this purpose, the extent to which a bonus payment is based on an employee's performance is immaterial. Enforceable "Bonus" also refers to an amount paid (premium) to an employee in recognition of achieving certain performance objectives pursuant to the employee's terms of employment (or specific agreement). In that case, the employer was under no obligation to pay the bonus until the employee met the specific performance objectives. The liability will be recognized as a bonus only in the year the legal obligation arises. The number of times in the year that a bonus is paid does not, in itself, affect the meaning of the term "bonus". Where an employee performs duties that are considered to be directly engaged in SR&ED under the proxy method (see section 7.0) or are considered to be directly undertaking, supervising or supporting the prosecution of SR&ED under the traditional method (see section 8.0) and the only remuneration in the year in respect of performing those duties was bonuses or remuneration based on profits, the CRA will consider an amount thereof that is commensurate with the performance of those duties to be salary or wages directly attributable to SR&ED or directly engaged in SR&ED. The determination of what is commensurate is a question of fact and may require the utilization of industrial standards published by various technological or professional associations. The above position would apply in a situation where a company could not pay an employee (specified or other than specified) a salary throughout the year but, at year-end, was able to pay its employee a lump-sum amount. Under this position, the amount (or a portion) is considered to be salary or wages, both for the purposes of the pool of deductible SR&ED expenditure and the prescribed proxy amount calculation, and not a bonus/remuneration based on profit on Form T661, provided that all necessary payroll procedures have been followed and applied. Legislative References Income Tax Act Clause 37(8)(a)(ii)(A) SR&ED Expenditures in Canada under the traditional method Clause 37(8)(a)(ii)(B) SR&ED Expenditures in Canada under the proxy method Subsection 37(9) Remuneration based on profits or a bonus for specified employees Legislative Reference Income Tax Regulation Subsection 2900(9) Exclusions to salary base 4.3 Inducement payments and non-competition payments to employees 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 22

25 An amount received under an agreement made immediately before, during or immediately after the period that the payee was employed by the payer is deemed to be remuneration for services rendered during the period of employment. This deeming rule does not apply, however, if the amount cannot reasonably be regarded as having been received under the contract of employment or for entering into a contract of employment or for a covenant with respect to what the payee is or is not to do before or after his employment terminates. To be considered remuneration for services rendered during the period of employment, any amount payable under a written or oral agreement, as described above, must have the nature and quality of salary, wages, commissions, etc. Inducement payments to prospective employees (often referred to as a "signing bonus") or non-competition payments to employees who terminate their employment, such as described above, are treated as regular salary or wages for services rendered during the period of employment. These types of payments do not meet the definition of "bonus" (see meaning of bonus in section 4.2). Further, under the Regulations, an amount described in section 6 of the ITA such as an inducement payment that is deemed to be remuneration for services rendered during the period of employment is excluded from the salary base for the purpose of calculating the prescribed proxy amount (PPA). For more details on the salary base, see section 3.0 of the Prescribed Proxy Amount Policy (this document is currently under development and a link will be provided once the project is complete). Legislative References Income Tax Act Section 5 Income or Loss from office or employment Subsection 6(3) Payments by employer to employee Legislative Reference Income Tax Regulation Subsection 2900(9)(a) Exclusions to salary base 4.4 Expenditure on or in respect of SR&ED To be deductible for SR&ED purposes, bonuses, remuneration based on profits and other remuneration as discussed in section 4.3 above must be an expenditure on or in respect of SR&ED. This would be the case only if the amount can reasonably be considered to be in respect of the prosecution of SR&ED under the traditional method (see section 8.0) or to relate to such prosecution under the proxy method (see section 7.0). For more details see section Only the portion of the salary or wages that can reasonably be considered to relate to SR&ED can be included. Legislative References Income Tax Act Subsection 37(1) Pool of deductible SR&ED expenditures Subsection 37(8) SR&ED expenditures 5.0 Amounts that are not salary or wages 5.1 Related benefits A claimant may be able to treat related benefits as Overhead on line 360 of Form T661 under the traditional method. For more details, see section 4.3 of the SR&ED Overhead 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 23

26 Expenditures Policy (this document is currently under development and a link will be provided once the project is complete). Related benefits include the employer's share of payments to the Canada Pension Plan (CPP) or the Quebec Pension Plan (QPP), Employment Insurance (EI), the Worker's Compensation Board (WCB), or the Commission de la santé et de la sécurité du travail du Québec (CSST), an approved employee pension plan, or employee medical, dental, or optical insurance plans, and premiums to a superannuation plan. The following expenditures can also be considered related benefits, provided such expenditures do not constitute a taxable benefit, since taxable benefits are elements of an employee's salary or wages (see section 3.0): supplementary sick benefits; and an employer's contributions in relation to an employee savings plan where, for instance, for every $3 dollars that an employee uses to purchase shares in the parent company the employer undertakes to pay $1 dollar, up to a given maximum. The employer's contributions to the Quebec and Ontario health insurance plans are not "related benefits," since it is not necessary to be an employee to benefit from these plans. Consequently, under the traditional method such contributions are general business expenses that can only be SR&ED expenditures if they are directly related and incremental to the prosecution of SR&ED in Canada. For more details, see the SR&ED Overhead Expenditures Policy (this document is currently under development and a link will be provided once the project is complete). Legislative Reference Income Tax Act Subclause 37(8)(a)(ii)(A)(II) SR&ED expenditures in Canada under the traditional method directly attributable Legislative Reference Income Tax Regulation Paragraph 2900(2)(c) Other expenditures directly related and incremental to the prosecution of SR&ED traditional method 5.2 Expenditures for extended vacation or sick leave Salary or wages relating to extended vacation or sick leave are not considered to be directly undertaking, supervising or supporting SR&ED or directly engaged in SR&ED since the employee would not be performing any duties during the leave period. Extended leave is considered to be leave in excess of the normal annual leave earned Example Facts Employee X (a non-specified employee) receives salary of $10,000 per month. He earns 1 month of vacation and 1 month of sick leave each year. Year 1 He was directly engaged in SR&ED for 6 months. The other 6 months, he performed duties that were totally unrelated to SR&ED. He did not take vacation or sick leave in Year April 2011 SR&ED Salary or Wages Policy (Draft) Paper 24

27 Year 1 Directly Engaged Salary calculation: Salary Expense 12 x $10,000 $120,000 Accrued Vacation Expense (considered reasonable) 10,000 Total $130,000 Year 1 Directly Engaged Portion: 6/12 x $130,000 = $65,000 Year 2 He was directly engaged in SR&ED for 8 months. The other 2 months, he performed duties that were totally unrelated to SR&ED. He took 2 months of accrued vacation in Year 2. He did not take any sick leave in Year 2. Year 2 Directly Engaged Salary calculation: Salary Expense 10 x $10,000 $100,000 Vacation Expense 10,000 Total $110,000 Year 2 Directly Engaged Portion: 8/10 x $110,000 = $88,000 Year 3 He was directly engaged in SR&ED for 2 months. The other 4 months, he performed duties that were totally unrelated to SR&ED. He took 6 months of sick leave in Year 3. He did not take any vacation in Year 3. Year 3 Directly Engaged Salary calculation: Salary Expense 6 x $10,000 $60,000 Sick Leave Expense 60,000 Accrued Vacation Expense (considered reasonable) 5,000 Total $125,000 Year 3 Directly Engaged Portion: 2/6 x $75,000* = $25,000 *Salary Expense $60,000 (6 x $10,000) + Sick Leave Expense Attributable to normal annual leave $10,000 (1 month) + Accrued Vacation Expense $5, Stock option benefits Options granted or shares issued on or after November 17, Background Stock option benefits In a decision rendered on February 24, 2005, by the Tax Court of Canada - Alcatel Canada Inc. v. Her Majesty the Queen, [2005] T.C.C 149, 2005 DTC 387, [2005] 2 CTC 2001, a corporate claimant was allowed to claim an SR&ED investment tax credit for the amount by which the fair market value of shares issued by the corporation exceeded the exercise price payable to the corporation for its shares under an employee stock option plan. 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 25

28 Proposed legislation announced on November 17, 2005, clarifies that such an excess will not be recognized as an expenditure for income tax purposes. The CRA administers the proposed legislation as if it were law Treatment of stock option benefits For income tax purposes, no expenditure will be considered to have been made by a taxpayer on shares issued on the exercise of options, except to the extent of an actual outlay or expense incurred by the taxpayer. In essence, the value of an option granted and the increase between the option price and the exercised share price are not an expenditure for SR&ED. This proposed legislation (administered as if it were law) applies to options granted or shares issued on or after the amendment date (November 17, 2005). In determining the expenditure resulting from the claimant having granted or issued an option on or after November 17, 2005, the value of an option granted by a claimant is not considered to be an expenditure for income tax purposes. Legislative Reference Income Tax Act Subsection 143.3(2) Options Limitation The proposed legislation provides for two (2) reductions from the related expenditure as described below. The first reduction applies on the issuance of a share (other than on the exercise of an option). Generally, the corporation is to reduce the related expenditure by the amount, if any, by which (i) the fair market value of the share exceeds (ii) that portion of the amount of the consideration that the issuing corporation has received for issuing the share that is added to, and not deducted because of a provision of the ITA from, the paid-up capital of the class of shares that includes the share. Legislative Reference Income Tax Act Paragraph 143.3(3)(a) Limitation concerning issuance of a share The second reduction applies if the issuance of the share is a consequence of the exercise of an option. Generally, the corporation is to reduce the related expenditure by the amount, if any, by which (i) the fair market value of the share exceeds (ii) that portion of the amount paid, pursuant to the terms of the option, by the holder to the issuing corporation for issuing the share, that is added to, and not deducted because of a provision of the ITA from, the paid-up capital of the class of shares that includes the share. 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 26

29 Legislative Reference Income Tax Act Paragraph 143.3(3)(b) Limitation concerning exercise of an option However, under the proposed legislation, the reductions do not apply to reduce an expenditure if the expenditure itself does not include an amount determined to be excesses as described in these subsections. Legislative Reference Income Tax Act Subsection 143.3(5) Clarification 5.4 Retiring allowances A retiring allowance is included in the income of the recipient. However, a retiring allowance is not considered to be salary or wages by definition. As a result, a retiring allowance cannot be allowed as salary or wages under either the traditional or the proxy method. A claimant may be able to treat a retiring allowance as Overhead on line 360 of Form T661 under the traditional method. For more details, see the SR&ED Overhead Expenditures Policy (this document is currently under development and a link will be provided once the project is complete). Legislative References Income Tax Act Subparagraph 56(1)(a)(ii) Retiring allowance Subsection 248(1) Definition of "salary or wages" Accumulated vacation and sick leave credits upon retirement Payments in respect of yearly accumulated vacation leave and sick leave are considered to be income from an office or employment and are taxable as salary or wages in the year in which the payment is received. However, the Supreme Court of Canada in Harel v. The Deputy Minister of Revenue of the Province of Quebec (77 DTC 5438, [1977] CTC 441) has confirmed that an amount received upon or after retirement in respect of unused sick leave credits qualifies as a retiring allowance. See also the SR&ED Overhead Expenditures Policy (this document is currently under development and a link will be provided once the project is complete). Legislative Reference Income Tax Act Subsection 5(1) Income or Loss from office or employment 6.0 Specified employees A specified employee is an employee who does not deal at arm's length with the employer or who is a specified shareholder of the employer. A specified shareholder is a person who owns, directly or indirectly, at any time during the year, 10% or more of the issued shares of any class of the capital stock of the employer or of any corporation related to the employer. A specified employee could also be someone related to a specified shareholder; e.g. a sister, a brother, a spouse, etc. For the purpose of determining the 10% threshold, shares owned by a person with whom the employee does not deal at arm's length are included. Refer to interpretation bulletin IT- 419R2, Meaning of Arm's length. 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 27

30 Legislative References Income Tax Act Subsection 248(1) Definition of "salary or wages" Section 251 Rules concerning relationships between entities 6.1 Bonuses or remuneration based on profits for specified employees An expenditure on or in respect of SR&ED carried on in Canada does not include a bonus or remuneration based on profits, in respect of a person who is a "specified employee" of the payer. Thus, for example, if a corporation pays or accrues a bonus to an employee who is its sole shareholder and therefore a specified employee, the bonus is not an expenditure on or in respect of SR&ED. However, a bonus paid or payable by the same corporation to an employee who is not a specified employee of the corporation could be an expenditure on or in respect of SR&ED. Legislative Reference Income Tax Act Subsection 37(9) Remuneration based on profits or a bonus for specified employees Limitation regarding specified employees In addition, the amount that a claimant can claim as an expenditure on SR&ED for salary or wages of a specified employee is subject to a limit (salary cap). The salary or wages is limited to five times the Year's Maximum Pensionable Earnings (YMPE) as determined under section 18 of the Canada Pension Plan and prorated for the number of days on which the claimant is a specified employee during the year. To obtain the YMPE for each year, use the following link: Legislative References Income Tax Act Clause 37(8)(a)(ii)(A) SR&ED Expenditures in Canada under the traditional method Clause 37(8)(a)(ii)(B) SR&ED Expenditures in Canada under the proxy method Subsection 37(9.1) Limitation re specified employees Rules for associated corporations No expenditures may be claimed for the salary or wages of a specified employee of two or more associated corporations unless the associated corporations files an agreement with the CRA using Form T1174, Agreement Between Associated Corporations to Allocate Salary or Wages of Specified Employees for Scientific Research and Experimental Development (SR&ED). It should be noted that individuals related to a particular corporation, certain partnerships and certain limited partnerships are deemed to be corporations associated with the particular corporation. The amount which may be claimed as SR&ED expenditures in respect of salary or wages incurred for a specified employee is the amount allocated among associated corporations. The amount may not exceed five times the year's maximum pensionable earnings (YMPE) for the calendar year in which the tax year ends. Each associated corporation should file with its tax return, a completed copy of the form, and a certified copy of the resolution of the directors authorizing the agreement, or a Directors' 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 28

31 resolution delegating authority to an authorized officer of each corporation signed by the designated authorized officers of each corporation. The Directors' resolution will be in effect for all subsequent years until it is rescinded. Where two corporations are owned exclusively by one shareholder, such a transfer signed by authorized officers of each corporation will be accepted provided that a signed confirmation by the shareholder is filed with Form T1174 and states that he or she is the only shareholder of both corporations and has authorized the transfer of the qualified expenditures from one corporation to the other corporation. A Directors' resolution will not be required. Note: Each associated corporation should file Form T1174 no later than the corporations' respective reporting deadline for the particular tax years. Otherwise the amount for the salary or wages of a specified employee is deemed not to be an expenditure on SR&ED. Legislative References Income Tax Act Subsection 37(9.1) Limitation re specified employees Subsection 37(9.2) Associated corporations Subsection 37(9.3) Agreement among associated corporations Subsection 37(9.4) Filing Subsection 37(9.5) Deemed corporation 7.0 Salary or wages of employees directly engaged in SR&ED Proxy method Under the proxy method (Please refer to the Traditional and Proxy Methods Policy. This document is currently under development and a link will be provided once the project is complete.), an expenditure on, or in respect of, SR&ED includes the portion of an expenditure made in respect of an expense for salary or wages of an employee who is directly engaged in SR&ED in Canada. Only the portion that can reasonably be considered to relate to such work having regard to the time spent by the employee on such SR&ED can be included. When that portion represents all or substantially all (90% or more) of the time spent by the employee on such work, all of the expenditure is deemed to be on, or in respect of SR&ED. However, there are restrictions concerning bonuses and remuneration based on profits of specified employees as well as a salary cap for specified employees (see section 6.1.1). Legislative Reference Income Tax Act Subclause 37(8)(a)(ii)(B)(IV) SR&ED expenditures in Canada under the proxy method - directly engaged salary or wages 7.1 Meaning of "directly engaged" Directly engaged in SR&ED whether an employee is directly engaged in SR&ED is based on the tasks that are performed and not on the job title of the employee. Directly engaged refers to "hands-on" work (see below), which would be included in paragraphs (a) to (d) of the definition of SR&ED in paragraph 248(1) of the ITA. Generally, the CRA considers the time employees, including first-line supervisors and managers (see section 7.1.3), spend to perform the following tasks as time they are directly engaged in SR&ED: 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 29

32 preparing equipment and materials for experiments, tests, and analyses (this does not include time spent maintaining equipment); experimenting, testing, and analyzing; collecting data for experimentation and analysis; and directing the course of the ongoing SR&ED work being claimed in the year. The CRA considers time spent performing the following tasks to be time during which employees are directly engaged in SR&ED (to the extent that the tasks are required as part of an SR&ED project): recording measurements, making calculations, and preparing charts and graphs; conducting statistical surveys and interviews; preparing computer programs; and working in engineering or design, operations research, mathematical analysis, computer programming, data collection, testing, or psychological research that is commensurate with the needs and directly in support of eligible SR&ED work. The claimant should view its employees' tasks in terms of how they correlate to the primary reason for employment when determining whether the employee's salary or wages are directly engaged in SR&ED. Table 3 in the T4088, Guide to Form T661 Scientific Research and Experimental Development (SR&ED) Expenditure Claim, provides assistance to claimants to determine how to handle the salary or wages for various tasks and duties. The determination of whether an employee is directly engaged in the prosecution of SR&ED, however, is a question of fact Employees who are directly engaged Generally, employees conducting experimentation and analysis in the performance of basic research, applied research, or experimental development are considered to be directly engaged in SR&ED. In addition, employees are considered to be directly engaged in SR&ED when they are performing technical support work such as engineering, design, operations research, mathematical analysis, computer programming, (non-routine) data collection, testing or psychological research commensurate with the needs and directly in support of the basic or applied research or experimental development work. The CRA does not consider employees providing a service to SR&ED staff to be directly engaged in SR&ED. This includes clerks, secretaries, and receptionists engaged in accounting, payroll, finance, legal support, purchasing, sales, human resources, shipping, inventory control, maintenance, word processing, and other such activities. See, however, section 9.5 Clerical and administrative staff providing a service to SR&ED employees, for the treatment under the traditional method Non-specialized employees who are directly engaged "Directly engaged" work could include hands-on work performed by both specialized and non-specialized employees. Whether the work of a non-specialized employee can be considered work "directly engaged in SR&ED" is a question of fact. This would be the case only if the following conditions are met: 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 30

33 The work performed by the non-specialized employee must be directly in support and be an integral part of the basic or applied research or experimental development work. The word "direct" means proceeding from one point to another without deviation or interruption; straight; "directly" would mean in a direct manner, without an intervening step or intermediary. This means that only the time spent by a non-specialized employee who is involved in an SR&ED project, in a direct manner and without an intervening step or intermediary, could qualify as directly engaged in SR&ED work. Further, an activity is considered to be directly in support of SR&ED when it is reasonable to believe that the activity is required to carry out the SR&ED. That is, it has been shown to be an integral part of the systematic investigation of a problem, and is required in the search for a theoretical or practical solution. and The non-specialized employee's work must be supervised by staff with scientific or technological qualifications. Tasks performed by non-specialized employees are generally not considered to be "directly engaged" in SR&ED. For example, any work related to equipment maintenance or repairs, materials-handling, and clerical and administrative support activities does not qualify under the proxy method (Refer to the Traditional and Proxy Methods Policy. This document is currently under development and a link will be provided once the project is complete.). However, examples of tasks performed by a non-specialized employee who could qualify as directly engaged in SR&ED include: operating a machine for the purposes of an experiment that requires the use of this machine; feeding raw materials into a machine for the purposes of an experiment; performing work such as welding, machining, mechanics, electrical work and plumbing where that work is required and is an integral part of an SR&ED project (for example, construction and testing of a prototype); and performing other tasks that are directly in support and are an integral part of an SR&ED project Managers and supervisors who are directly engaged Managers and supervisors are also considered to be directly engaged in SR&ED when they are performing experimentation and analysis in the performance of basic research, applied research or experimental development and when they are carrying out technical activities in support of the research or development work. In addition, managers and supervisors who supervise the ongoing SR&ED work are also considered to be directly engaged in SR&ED when they are directing the course of the ongoing SR&ED work or when they are providing direct technical input into the SR&ED work. However, any time spent by a manager or supervisor performing non-technological management activities or decision-making functions that do not directly influence the course of the SR&ED, even if it relates to the SR&ED, is not considered to be time the manager or supervisor is directly engaged in SR&ED. 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 31

34 In most cases, work performed beyond the first-line level of supervision does not qualify as directly engaged in SR&ED. Where time is claimed for employees beyond the first-line level of supervision, the claimant will be asked to provide details of the duties the employees performed during the time they were directly engaged in SR&ED. The claimant will also have to demonstrate how these duties are "directly engaged," as described above. 7.2 Supporting documentation and other evidence Proxy method A claimant should be able to show that the salary or wages are for SR&ED work performed by employees of the company on activities that are considered to be directly engaged in SR&ED. When applying the expenditure allocation in a claim under the proxy method, the information system used by a claimant must capture directly engaged time. Other labour costs are covered by the prescribed proxy amount. Claimants should maintain information supporting the reasonableness of the allocation of directly engaged salary or wages, including: a description of the allocation method used; the rationale for the selection of the allocation method, considering the claimant's business environment; and the internal controls that are available to test the allocations. See section 13.0, Allocation of labour expenditures for SR&ED. See also Appendix 2, Documentation and other evidence to support your SR&ED claim, in the T4088, Guide to Form T661 Scientific Research and Experimental Development (SR&ED) Expenditures Claim. The following steps should be taken during a review of a claim, where it is unclear whether or not the duties being claimed are directly engaged in SR&ED: The claimant would be asked to explain how the duties in question relate to the SR&ED activities being claimed; and The CRA will work with the claimant in establishing the reasonableness of the salary or wages claimed. 7.3 Calculating the amount of the expenditures Under the proxy method, the portion of an expenditure made in respect of an expense incurred in the year for the salary or wages of an employee who is directly engaged in SR&ED in Canada can only be deductible for SR&ED purpose if it can reasonably be considered to relate to such work having regard to the time spent by the employee thereon. For this purpose where that portion is all or substantially all of the expenditure, that portion shall be deemed to be the amount of the expenditures. Legislative Reference Income Tax Act Subclause 37(8)(a)(ii)(B)(IV) SR&ED expenditures in Canada under the proxy method - directly engaged salary or wages Portion of an expenditure for salary or wages The directly engaged salary or wages or portion thereof is calculated on the time spent directly engaged in SR&ED relative to the total time worked. For example, if a salaried employee earning $100,000 per year spends all of their 1,800 regular hours directly engaged in SR&ED and works an additional 600 hours of unpaid overtime performing general 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 32

35 administrative duties, the directly engaged salary or wages are $75,000 (in other words 1,800/2,400 x $100,000) Only the portion of the salary or wages that can reasonably be considered to relate to SR&ED can be included The fact that an amount is included in the calculation of salary or wages of an employee directly engaged in SR&ED does not necessarily mean that it represents salary or wages for SR&ED purposes. Where the proxy method is used, the legislation clearly indicates that only that portion of salary or wages that is reasonably related to work that is directly engaged in SR&ED can be allowed as an expenditure for SR&ED purposes. The word "relate" means to show a logical or causal connection between; to have relationship or connection (between two things). Accordingly, there must be a reasonable connection between the amount of salary or wages and the prosecution of SR&ED. It should be noted that, in the case of employees who spend all or substantially all (ASA) of their time to the prosecution of SRED, all of their time is considered to be related to the prosecution of SR&ED. In order to determine if there is a reasonable link between an amount of salary or wages and the SR&ED work being performed, the underlying reasons for paying the salary or wages would have to be determined and demonstrate how it is related to the SR&ED. Bonus or remuneration based on profits paid or payable to an employee who is not a specified employee of a corporation has the capacity to be related to the prosecution of SR&ED, and therefore could be an expenditure on or in respect of SR&ED. For example, where a corporation is taking advantage of marginal tax rates by reducing the corporation's taxable income to or below the small business deduction limit through the payment of bonuses or remuneration based on profits from income derived from normal business operations, the bonus or remuneration based on profit could be considered to have a reasonable link to the prosecution of SR&ED. There would be no reasonable link between the expenditure and the prosecution of SR&ED where, for example, an employee (where the ASA rules do not apply, see section below) receives: salary, including a bonus, when the income that was used to pay the amount was not earned from the ongoing, normal activities of the business. This would include an amount paid to an employee that was earned from a capital transaction such as the sale of the business, the sale of shares or the sale of an asset, salary earned from a non-eligible activity (for example, a finder's fee), or a bonus for the achievement of specific sales targets. Such amounts do not have the capacity of being allocated to SR&ED (cannot be SR&ED expenditures). In other words, the allocation of salary or wages to SR&ED is made after such amounts are excluded from total remuneration. Legislative Reference Income Tax Act Subclause 37(8)(a)(ii)(B)(IV) SR&ED expenditures in Canada under the proxy method - directly engaged salary or wages Example Reasonably be considered to relate to SR&ED 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 33

36 An employee who is directly engaged in the prosecution of SR&ED 60% of the time receives a regular salary of $100,000 and a commission of $15,000 on the sale of a product. The amount for the commission is not an expenditure on SR&ED as it not directly linked to the SR&ED work being performed. The amount of the commission does not have the capacity of being allocated to SR&ED (cannot be SR&ED expenditures). Therefore, only $60,000 could be allocated to SR&ED ($100,000 x 60%) All or substantially all (ASA) When the portion of the expenditure represents all or substantially all (90% or more) of the time spent by the employee on SR&ED work, all of the expenditure is deemed to be on SR&ED. However, there are restrictions concerning bonuses and remuneration based on profits of specified employees, as well as a salary cap for specified employees (see section 6.1.1). For example, subject to the "specified employee" rules, the wages of an employee hired for SR&ED purposes are considered all or substantially all attributable to the prosecution of SR&ED if 90% or more of this employee's time is spent on the prosecution of SR&ED. The basis for applying the ASA rule is the tax year; it is not based on a specific period during the tax year. The ITA refers the portion of an expenditure made in respect of an expense incurred in the year for the salary or wages. Legislative Reference Income Tax Act Subclause 37(8)(a)(ii)(B)(IV) SR&ED expenditures in Canada under the proxy method - directly engaged salary or wages Example All or substantially all An employee worked 90% of the time directly engaged in SR&ED for the first 6 months of the tax year and worked in non-sr&ed activities in the remaining 6 months. The employee' salary for the tax year was $100,000. The directly engaged salary or wages (or portion) is calculated on the time spent directly engaged in SR&ED relative to the total time worked in the year: in this case the allowable salary would be $45,000 (90% x ½ = 45% of $100,000). It would be incorrect to claim 100% of the employee's salary for the first 6 months. 8.0 Undertakes, supervises, supports Traditional method Expenditures for salary or wages that are either all or substantially all attributable (ASA) to the prosecution of SR&ED or directly attributable to the prosecution of SR&ED can be claimed under the traditional method (Please refer to the Traditional and Proxy Methods Policy. This document is currently under development and a link will be provided once the project is complete.). However, there are restrictions concerning bonuses and remuneration based on profits of specified employees as well as a salary cap for specified employees (see section 6.1.1). An expenditure directly attributable to the prosecution of SR&ED includes the portion of the amount incurred for salary or wages of an employee who directly undertakes, supervises or supports the prosecution of SR&ED that can reasonably be considered to be in respect of such prosecution. 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 34

37 Legislative References Income Tax Act Subclause 37(8)(a)(ii)(A)(I) SR&ED expenditures in Canada under the traditional method ASA Subclause 37(8)(a)(ii)(A)(II) SR&ED expenditures in Canada under the traditional method directly attributable Legislative Reference Income Tax Regulation Paragraph 2900(2)(b) Employee remuneration traditional method 8.1 Meaning of "undertakes, supervises or supports" "Undertakes" means performing experimentation, analysis and other related activities in the performance of basic research, applied research, experimental development or technical support activities (work described in paragraphs (a) to (d) of the definition of SR&ED in paragraph 248(1) of the ITA. "Supervises" refers to the day-to-day management of work described in paragraphs (a) to (d) of the definition of SR&ED by an employee, not merely the supervision of employees who undertake or support SR&ED work. It is expected that the performance of such work would require a significant technological background based on the employee's academic or work experience, or both. Supervision for purposes of the directly attributable rules does not include the performance of managerial functions that relate to general administration. However, supervision could include some non-technological functions, e.g. long-term strategic planning, contract administration, etc., that directly relate to the prosecution of SR&ED. These functions would generally be performed in carrying out the other related duties of a technological supervisor of SR&ED (see section 9.0 Administrative salary or wages under the traditional method). The word "supports" describes the performance of any of the work described in paragraph (d) of the definition of SR&ED and other technical work that relates to the prosecution of SR&ED. The other technical support could include work performed by non-specialized employees (see section 7.1.2). Support work does not include the performance of clerical duties involved in carrying out SR&ED. Note that this is consistent with the position taken in paragraph 32 of IT-145R (Consolidated), Canadian Manufacturing and Processing Profits Reduced Rate of Corporate Tax, concerning clerical staff. Salary or wages relating to clerical or administrative support staff, could be included as SR&ED overhead expenditures (see section 9.5 Clerical and administrative staff providing a service to SR&ED employees). Legislative Reference Income Tax Act Subsection 248(1) Definition of "SR&ED" Legislative References Income Tax Regulation Paragraph 2900(2)(b) Employee remuneration -traditional method Paragraph 2900(2)(c) Other expenditures directly related and incremental to the prosecution of SR&ED traditional method 8.2 Supporting documentation and other evidence Traditional method The claimant must develop an appropriate allocation method for labour that is in part directly attributable to SR&ED and in part attributable to non-sr&ed activities. 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 35

38 Under the traditional method, SR&ED "directly attributable" salary or wages expenditures include both salary or wages of an employee who directly undertakes, supervises or support the prosecution of SR&ED and salary or wages that is directly related to the prosecution of SR&ED and that would not have been incurred had it not been for such prosecution, (directly related and incremental salary or wages). When applying the expenditure allocation in a claim under the traditional method, the information system used by a claimant must capture directly engaged time, as well as directly related and incremental time. See section 7.2 for comments regarding documentation requirements for the "directly engaged" salary or wages. Actual expenditures that are directly related and incremental to the prosecution of SR&ED should be included in the claim (see section 9.0). The labour allocation method should provide support for the SR&ED portion of these costs to be included in the claim. See section 13.0 Allocation of labour expenditures for SR&ED. See also Appendix 2, Documentation and other evidence to support your SR&ED claim, in the T4088, Guide to Form T661 Scientific Research and Experimental Development (SR&ED) Expenditures Claim. The following steps should be taken during a review of a claim where it is unclear whether or not the duties being claimed are for an employee who directly undertakes, supervises or supports the prosecution of SR&ED: The claimant would be asked to explain how the duties in question relate to the SR&ED activities being claimed; and The CRA will work with the claimant in establishing the reasonableness of the salary or wages claimed. 8.3 Calculating the amount of the expenditures Under the traditional method, expenditures directly attributable to the prosecution of SR&ED include the portion of salary or wages incurred for an employee who directly undertakes, supervises or supports the prosecution of SR&ED to the extent the amount incurred can reasonably be considered to relate to such prosecution. Also, where all or substantially all of the expenditure is attributable to the prosecution of SR&ED in Canada, the portion is the amount of the expenditure. Legislative References Income Tax Act Subclause 37(8)(a)(ii)(A)(I) SR&ED expenditures in Canada under the traditional method ASA Subclause 37(8)(a)(ii)(A)(II) SR&ED expenditures in Canada under the traditional method directly attributable Legislative Reference Income Tax Regulation Paragraph 2900(2)(b) Employee remuneration traditional method Portion of an expenditure for salary or wages The portion of salary or wages amount referred to in the Regulations is generally calculated on the time spent directly undertaking, supervising, and supporting the prosecution of SR&ED compared to the total time worked. Legislative Reference Income Tax Regulation Paragraph 2900(2)(b) Employee remuneration traditional method 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 36

39 8.3.2 Only the portion of the salary or wages that can reasonably be considered to relate to SR&ED can be included Where the traditional method is used, the legislation clearly indicates that only an expenditure that can reasonably be considered to relate to the prosecution of SR&ED can be allowed as an expenditure for SR&ED purposes. There must be a reasonable link between the amount of salary or wages and the SR&ED work being performed for an amount to be an allowable SR&ED expenditure. See section for more details All or substantially all (ASA) Where all or substantially all (ASA) (90% or more) of an employee's time is spent on SR&ED activities, the employee is deemed to have spent all of the time on SR&ED. The employee's total salary or wages are treated as SR&ED expenditures (subject to the salary cap for specified employees, see section 6.1.1). Where this rule is applied, there should be some form of evidence to support the use of the ASA test for each employee. The ASA rule only applies where an expenditure of a current nature is used 90% or more for the prosecution of SR&ED work. Therefore, in the case of salary or wages, the ASA rule can only apply to the salary or wages of an employee who directly undertakes, supervises or supports the prosecution of SR&ED as described in section 8.1. The ASA rule does not apply to other employees such as clerical and administrative staff providing a service to SR&ED employees. See section for more details on the ASA rule. Legislative Reference Income Tax Act Subclause 37(8)(a)(ii)(A)(I) SR&ED expenditures in Canada under the traditional method ASA 8.4 Salary or wages under the traditional method and Form T661 Salary or wages incurred for an employee who directly undertakes, supervises or supports the prosecution of SR&ED are directly attributable to SR&ED. For the purposes of Form T661, these expenditures are treated as being directly engaged salary or wages. However, under the traditional method, the portion of other salary or wages of employees who directly undertake, supervise, or support the performance of SR&ED but who are not directly engaged in SR&ED can also be claimed as other expenditures on line 360 of Form T661(see section 9.0). Refer to Table 5 in the T4088, Guide to Form T661 Scientific Research and Experimental Development (SR&ED) Expenditures Claim, for example of such tasks. Additionally, expenditures that are directly related and incremental to the prosecution of SR&ED are directly attributable to SR&ED (see section 9.5). Salary or wages incurred for clerical and administrative personnel providing a service to SR&ED employees could be considered to be directly related and incremental to SR&ED depending on the facts of the case. These types of expenditures are also reported on line 360 of Form T661 as overhead and cannot be claimed when using the proxy method. 9.0 Administrative salary or wages Traditional method This section explains the rules and clarifies which administrative salary or wages are "directly related" to the prosecution of SR&ED under the traditional method of calculating investment tax credits. The comments below apply to all claimants, including dedicated SR&ED performers. 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 37

40 9.1 "Directly attributable" tests "Directly related" and "incremental" salary or wages To be allowable as an expenditure "directly attributable" to the prosecution of SR&ED, an expenditure, or portion of an expenditure, for administrative salary or wages must satisfy two tests: 1. It must be "directly related" to the prosecution of SR&ED in Canada and 2. the expenditure would not have been incurred had such prosecution not occurred (incremental). The dictionary definitions of the words "direct," "directly," "relate," and "related," respectively, are: 1. "Direct" means proceeding from one point to another without deviation or interruption; straight. 2. "Directly" means in a direct manner; without an intervening step or intermediary. 3. "Relate" means to show a logical or causal connection between; to have relationship or connection (between two things). 4. "Related" (past tense of "relate") takes the meaning expressed in item 3 above. By virtue of the words "directly related", all the time spent by administrative staff would not be "directly related" to the prosecution of SR&ED, unlike the time spent by staff hired to perform their duties specifically in such prosecution. However, the words "portion" and "directly related" in the Regulations indicate that some duties of the administrative staff would meet the tests, the determination of which would be based on a finding of fact. The work performed by particular employee(s) or department(s) must connect with (in other words "relate to"), and be done without an intervening step or intermediary (in other words "directly") between the employee/department and, the SR&ED work, or the SR&ED staff, or the machinery/equipment used by staff to perform SR&ED. Expenditures for administrative salary or wages that do not meet the above tests are not expenditures on SR&ED under the ITA. Legislative Reference Income Tax Regulation Paragraph 2900(2)(c) Other expenditures directly related and incremental to the prosecution of SR&ED traditional method 9.2 Application of the rules The portion of salary or wages for hands-on work performed by administrative staff is an expenditure directly attributable to SR&ED and could qualify as salary or wages of an employee who directly undertakes, supervises or supports the prosecution of SR&ED. However, work performed by administrative staff with no technological background generally does not qualify as hands-on work. In this case, an analysis of the duties performed is required to determine the direct linkage to SR&ED work. 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 38

41 There must be a direct linkage of expenditures for administrative salary or wages to specific SR&ED work, staff or machinery/equipment. To make this determination in respect of a particular employee, it is necessary to examine the duties performed by the employee. For example, where a vice president (VP) of a company is required to hire a Personnel Manager who, in turn, is required to hire SR&ED staff, there would be no immediate contact between the VP and the SR&ED or SR&ED staff. In this situation, no portion of the VP's time could be said to meet the "directly related" test, although there may be an indirect relationship. On the other hand, any time spent by the Personnel Manager in hiring SR&ED staff could be considered to meet the "directly related" test. Expenditures for tasks that are attributable entirely to non-sr&ed work would not qualify. For example, non-sr&ed work includes the functions of planning (non technological), direction, control, co-ordination, systems, or other functions at a managerial level. Legislative References Income Tax Regulation Paragraph 2900(2)(b) Employee remuneration - traditional method Paragraph 2900(2)(c) Other expenditures directly related and incremental to the prosecution of SR&ED traditional method 9.3 Examples of tasks directly related to the prosecution of SR&ED Following are examples of tasks performed by administrative staff, or work performed in certain departments of a corporation that are directly related to SR&ED work, as well as examples of tasks that are generally not directly related to SR&ED work. Tasks/departments that are directly related to SR&ED work: Financing of SR&ED ("directly related" if the funds are used to perform SR&ED); Evaluating, recruiting and hiring of SR&ED personnel (note that this is the only Human Resources activity that is directly related); Technical implementation and control of scientific projects; defining future SR&ED direction; supervision of SR&ED group and SR&ED project selection/evaluation. Such tasks are usually performed by a VP of Technology; Evaluating the technological feasibility of a product and the potential SR&ED efforts and costs involved (for projects carried out); Technological planning for on-going SR&ED projects (assignment of technological personnel, job priority, development of technological strategies, assessment of quality of materials used); and Work performed by clerical staff for tasks directly related to payroll, purchasing and accounting. Tasks/departments that are generally not directly related to SR&ED work Bidding costs Purchasing (other than direct purchasing of material/sr&ed equipment) Taxation and Legal services Sales, marketing and advertising Employee relations Development of benefits program for SR&ED personnel Corporate secretary and reporting to shareholders Initiating and closing of licensing agreements 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 39

42 Feasibility studies (non-technological) leading to potential SR&ED collaborations and assessing the commercial feasibility of a given technology Commercialization of existing intellectual property Review and approval of SR&ED budgets and cost control Patent application (including the technological contribution) 9.4 "Incremental test" Further, an expenditure for administrative salary or wages must also meet the incremental test (would not have been incurred had it not been for the prosecution of SR&ED) to be deductible as SR&ED expenditure. The claimant must demonstrate that the expenditure is incremental: if the SR&ED work were not carried out, would the expense still have been incurred? If yes, the expense would not meet the test and would therefore not be allowable as SR&ED expenditure. Legislative Reference Income Tax Regulation Paragraph 2900(2)(c) Other expenditures directly related and incremental to the prosecution of SR&ED traditional method 9.5 Clerical and administrative staff providing a service to SR&ED employees A portion of the salary or wages for clerical and administrative staff providing a service to SR&ED employees (e.g. in personnel, accounting, maintenance or repairs, and purchasing) may also qualify for SR&ED purposes if the functions performed are non-technological and aid the ongoing SR&ED claimed in the year, and the salary or wages of the clerical and administrative staff providing the service are directly related and incremental to the prosecution of SR&ED. Since clerical and other staff providing the service to SR&ED employees is not involved in the prosecution of SR&ED work, the ASA rule (see section 8.3.3) does not apply to these employees. Legislative Reference Income Tax Act Subclause 37(8)(a)(ii)(A)(I) SR&ED expenditures in Canada under the traditional method ASA Legislative Reference Income Tax Regulation Paragraph 2900(2)(c) Other expenditures directly related and incremental to the prosecution of SR&ED traditional method 10.0 Salary or wages of employees carrying on SR&ED outside Canada Claimants can earn SR&ED investment tax credits (ITC) on permissible salary or wages for SR&ED work carried on outside Canada after February 25, The SR&ED work carried on outside Canada must be directly undertaken by the employees of the claimant, and must form part of the SR&ED carried on in Canada by the claimant. Permissible salary or wages incurred by a claimant in a tax year is limited to 10% of the total of salary or wages for the SR&ED carried on in Canada. The permissible salary or wages for the work carried on outside Canada is deemed to be an expenditure made in Canada by the claimant. Accordingly, such expenditures are excluded from the application of the rules for SR&ED carried on outside Canada. 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 40

43 10.1 Calculation of permissible salary or wages for SR&ED work carried on outside Canada In order to determine the amount that can be claimed as the permissible salary or wages for SR&ED carried on outside Canada, claimants will first have to calculate the two amounts A and B below. The lower of Amount A or B can be claimed as the permissible salary or wages for SR&ED carried on outside Canada. Amount A Total of salary or wages for SR&ED work carried on outside Canada The salary or wages that can be claimed for SR&ED work carried on outside Canada must meet the following criteria: the costs were incurred after February 25, 2008; the SR&ED work was directly undertaken by an employee of the claimant and not performed by a contractor; the employee who performed the SR&ED work was a resident of Canada at the time the expense was incurred; the work was related to a business of the claimant; the SR&ED work carried on by the employee outside Canada was an integral part and solely in support of the SR&ED work carried on in Canada (see section ); and the salary or wages paid were not subject to income or profits tax from another country (see section ). Amount B 10% of the total of SR&ED salary or wages for SR&ED carried on in Canada This limit is calculated as 10% of the total salary or wages claimed for SR&ED carried on in Canada (see section ). Note: Although the legislation refers to an expense incurred in the year for salary or wages paid to an employee in respect of SR&ED, it is the practice of the CRA to use the amount on line 306 of Form T661 (expenditure incurred) for the purposes of determining the 10% limit. For the tax year that includes February 26, 2008, the 10% limit is prorated based on the number of days after February 25, 2008, that are in that tax year over the total number of days that are in that tax year. The formula is: (Number of days in the tax year after February 25, 2008) / (Total number of days in the tax year) Legislative Reference Income Tax Act Subsection 37(1.5) Salary or wages outside Canada Limit determined Example Company A's tax year end is September 30, Company A claimed one SR&ED project carried out in Canada during the tax year. Company A has five employees (other than specified employees) performing SR&ED and each are paid $9,000 per month. All employees are working 100% of their time on the SR&ED project and they all reside in Canada. Company A's SR&ED salaries for 2008 tax year are $540,000 ($9,000 x 12 x 5 = $540,000). 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 41

44 Employee 1 performed SR&ED work outside Canada in November 2007 (30 days) Employee 2 performed SR&ED work outside Canada in March 2008 (31 days). The permissible salary for work carried on outside Canada is the lesser of A or B: Amount A Calculated $9,000 Eligible salary for Employee 2 only as Employee 1 performed SR&ED work before February 25, Amount B Calculated $31,092 (total salary or wages for SR&ED performed in Canada) x (10%) x (proration for the number of days in the tax year after February 25, 2008 / total number of days in the tax year) ($540,000 - $18,000) x (10%) x (218/366) Based on the above calculation, the amount that can be claimed as salary or wages for work carried on outside Canada on line 307 of Form T661 is $9, Applying the rules Meaning of "solely in support" The SR&ED work carried on outside Canada must be solely in support of SR&ED carried on in Canada by the claimant. Work carried on outside Canada that is basic research, applied research, experimental development or work described in paragraph (d) of the definition of SR&ED in subsection 248(1) of the ITA would qualify as "support work" provided the work is an integral part and is solely in support of the SR&ED work carried on in Canada by the claimant. The question whether an activity performed outside Canada is solely in support of the SR&ED work carried on in Canada is a question of fact to be determined on a case by case basis. Where an activity is in support of both an SR&ED project carried on in Canada and another SR&ED project carried on outside Canada, that activity would not be considered to be solely in support of the SR&ED work carried on in Canada. Where an activity performed outside Canada supports work that involves SR&ED carried on in Canada and at the same time supports non SR&ED work (dual purpose activity) performed in Canada, that activity would not be considered to be solely in support of the SR&ED work carried on in Canada Salary or wages paid were not subject to income or profits tax from another country Salary or wages paid to an employee for SR&ED work carried on outside Canada can be included as permissible salary or wages only if the claimant reasonably believes that the salary or wages is not subject to an income or profits tax imposed, because of the employee's presence or activity in a country other than Canada, by the government of that particular country. 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 42

45 This rule takes into account only those taxes that are applied because of an employee's presence or activities in a foreign country and not, for example, a tax that applies to a country's citizens regardless of where they live or work. To determine whether the salary or wages paid to an employee for work performed outside Canada is subject to an income or profits tax imposed by a foreign government, the claimant should consider the tax treaty between Canada and the foreign country in which the SR&ED work in support of the SR&ED in Canada is performed. Usually salary or wages paid to an employee for SR&ED work carried on outside Canada can be included as permissible salary or wages if the employee sojourns only a short period of time in the foreign country. As stated in 25 of interpretation bulletin IT 270-R3, Foreign tax credit: The location of the source of an individual's office or employment is considered to be the place where he or she normally performs the related duties. If those duties require the individual to spend a significant part of the time in a country other than Canada, the individual may be subject to tax in that foreign country on a portion of the remuneration. However, it is a question of fact whether salary or wages paid to an employee is not subject to an income or profits tax imposed by a foreign jurisdiction. The onus is on the claimant to make this determination. If this condition is not satisfied for example, if the claimant knows or has reason to believe that the amount is being taxed in the foreign country where its employees are carrying out the SR&ED salary or wages paid to the employee would not be included in the amount of the permissible salary or wages (see section 10.1) Determining amount B - Limit Amount B is calculated as 10% of the total salary or wages claimed for SR&ED carried on in Canada. The 10% limit is calculated on the total allowable salary or wages for SR&ED in Canada and not only on the salary or wages relating to the project(s) carried on in Canada that the work outside Canada solely supports. For example, if the claimant carries out two SR&ED projects in Canada and testing outside Canada is required for one of the projects, the total salary or wages expenditures for SR&ED in Canada is taken into account for the calculation of the 10 % limit. Under the traditional method, Amount B can include the portion of other salary or wages of employees who directly undertake, supervise, or support the SR&ED that can be claimed as other expenditures on line 360 of Form T661 (salary or wages of employees not directly engaged in the prosecution of SR&ED). See Table 5 in the T4088, Guide to Form T661 Scientific Research and Experimental Development (SR&ED) Expenditures Claim, for examples of such tasks. Other salary or wages that are considered overhead expenditures, such as the salary or wages of clerical support staff claimed on line 360 of Form T661, are not included in the total salary or wages for the purpose of calculating the 10% limit. Legislative Reference Income Tax Regulation Paragraph 2900(2)(b) Employee remuneration traditional method 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 43

46 10.3 How to calculate permissible salary or wages for work carried on outside Canada for Form T661 The calculation of permissible salary or wages for SR&ED work carried on outside Canada (see section 10.1) is determined with respect to the total amount of salary or wages for the SR&ED inside Canada. The calculation does not distinguish between specified employees and employees other than specified employees. However, the way Form T661, Scientific Research and Experimental Development (SR&ED) Expenditures Claim, is structured, the total amount of permissible salary or wages for SR&ED outside Canada should be allocated between employees other than specified employees (line 307) and specified employees (line 309). The total of lines 307 and 309 cannot exceed 10% of the total amount of salary or wages for the SR&ED inside Canada (line 306 of Form T661). Thus, when an amount is claimed on line 307 of Form T661 (for other than specified employees) the amount that may be claimed on line 309 (for specified employees) cannot exceed: [10% of the amount on line 306 of Form T661 less the amount claimed on line 307]. Legislative References Income Tax Act Subsection 37(1.4) Salary or wages for SR&ED outside Canada Subsection 37(1.5) Salary or wages for SR&ED outside Canada Limit determined Subsection 37(2) Research outside Canada Subsection 37(9) Remuneration based on profits or a bonus for specified employees 11.0 Unpaid salary or wages Accrued salary or wages are used to calculate the portion that is directly attributable to or directly engaged in SR&ED. If the remuneration remains unpaid 180 days after the end of the year in which the expense was incurred, the expense is deemed not to have been incurred in the year but rather in the year in which the amount is paid. Where the proxy method is being used, prior unpaid amounts that are deemed to be incurred in the year actually paid are excluded from the directly engaged salary base for the purpose of calculating the prescribed proxy amount. This eliminates the possibility of the prescribed proxy amount approximating SR&ED "overheads" using salary or wages relating to another year. In applying these rules, the CRA considers a payment made on the 180th day to have been made within the time limit. These rules apply to both arm's length and non-arm's length transactions. However, they do not apply to: a reasonable vacation or holiday pay, or a deferred amount payable under a salary deferral arrangement as defined in subsection 248(1) of the ITA that, if received, would be included in the recipient's income. Legislative Reference Income Tax Act Subsection 78(4) Unpaid remuneration and other amounts Legislative Reference Income Tax Regulation Subsection 2900(9) Exclusions to salary base 11.1 Identification of unpaid salary or wages on Form T April 2011 SR&ED Salary or Wages Policy (Draft) Paper 44

47 A claimant must identify, on line 315 of Form T661, Scientific Research and Experimental Development (SR&ED) Expenditures Claim, for a particular tax year, an expense in respect of unpaid salary or wages or other remuneration that was not paid within 180 days of the tax year end, in order for the expense to be deductible under subsection 37(1) of the ITA in the year in which it will actually be paid. In the year the expenditure is paid, it has to be reported on line 310 of Form T661. Legislative Reference Income Tax Act Subsection 37(11) Filing requirement 11.2 Evidence of payment Whether accrued and unpaid remuneration is actually paid within the 180-day period involves a finding of fact that can only be established after examining all the evidence that would support such a conclusion. The best evidence of payment is that the related payroll withholdings were remitted on time. Source deductions must generally be remitted within 15 days after the month in which the amount was withheld. However, this is not the only acceptable evidence of such payment. Other evidence that would corroborate the payment of the wages would include: the issuance of a T4 slip to the employee the reporting of the income by the employee the actual payment of the amount (by cheque, cash, or journal entry crediting the employee's account with the payer) the directors' resolutions other audit evidence which would include the overall condition of the employer's books and records, the historical practice with respect to accruing salary or wages, and the credibility of the payer and employee. An ordinary promissory note is generally regarded as a promise to pay a debt at a later date, and not as payment of the debt on the date on which the note was issued. However, an amount may be paid by a promissory note if an agreement between the parties clearly indicates that the note was accepted as absolute payment Unpaid amounts vs. Reserve No deduction is allowed for an amount as, or on account of, a reserve, a sinking fund, or a contingent liability unless it is expressly permitted by the ITA. In order for an expense that remains unpaid at the end of a tax year to be deductible for tax purposes, it must constitute a genuine liability for the claimant. If such an unpaid amount does not constitute a genuine liability, no deduction is allowed and the rules for unpaid salary, wages or other remuneration do not apply. For a genuine liability to exist there must be an enforceable claim by the creditor with a reasonable expectation that the debt will in fact be paid by the debtor. More details on unpaid amounts can be found in interpretation bulletin IT-109R2, Unpaid Amounts. Legislative Reference Income Tax Act Paragraph 18(1)(e) Reserves 12.0 Other issues related to salary or wages 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 45

48 12.1 Employee vs. Self-employed The criteria used by the CRA to determine whether an individual is an employee or selfemployed have been established by the courts. The question to be determined is whether the contract between the parties is a contract of service, which is evidence of an employer/employee relationship, or a contract for services, which indicates a client and independent contractor relationship. Generally, a contract of service exists if the person for whom the services are performed has the right to control the amount, the nature and the management of the work to be done, as well as the manner of completing the work. A contract for services exists when a person is engaged to achieve a defined objective and is given all the freedom required to attain the desired result. The contract, which sets out the rights and obligations of both parties, provides important information in determining the type of relationship that exists. However, even more important than the contract is the actual circumstances surrounding the performance of services and whether such findings of facts agree with what is stated in the contract. Thus, the determination of whether there is an employer/employee relationship requires a review of the facts of each case. There is no single conclusive test that can be universally applied to determine whether a person is an employee or is self-employed. The CRA makes every effort to ensure that taxpayers are fully aware of its administrative practices and interpretations. In this regard, the criteria the CRA uses to determine whether an individual is an employee or is self-employed have been published in pamphlet RC4110, Employee or Self-Employed?, which is available on the CRA's Web site. In addition, taxpayers wishing to resolve employee/self-employed issues may seek the assistance of the CPP/EI Rulings Division at their local tax services office Employees of a related corporation Confusion may occur with respect to who is in fact performing SR&ED when two or more companies that do not deal at arm's length with each other use each other's resources (employees) to perform SR&ED. A non-arm's length situation exists (see Glossary in the T4088, Guide to Form T661 Scientific Research and Experimental Development (SR&ED) Expenditures Claim) where two parties that deal with each other are related to each other, one party exerts control over the other, or one party has beneficial (financial) interests in the other. For salary or wages expenditures to be included in the claimant's SR&ED claim, it must be incurred in respect of its own employees to perform SR&ED. Salary or wages of an employee of a related company that performed SR&ED on the claimant's behalf cannot be claimed by the claimant. In such a situation, a non-arm's length contract situation would exist between the claimant and the other related company. It is the practice of the CRA to consider work performed by the employees of the related corporation as being SR&ED if the following conditions are met: the work is performed by the related corporation (or partnership) at a time when it does not deal at arm's length with the claimant, and the work would be SR&ED if it were performed by the claimant. 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 46

49 When these conditions are met, the amount paid by the claimant to the other non-arm's length company to perform SR&ED on behalf of the claimant can be treated as a non-arm's length SR&ED contract (Refer to the Contract Expenditures for SR&ED Performed on Claimant's Behalf Policy. This document is currently under development and a link will be provided once the project is complete). The related corporation would have to file a Form T661, Scientific Research and Experimental Development (SR&ED) Expenditures Claim, and the use of the Form T1146, Agreement to Transfer Qualified Expenditures Incurred in Respect of SR&ED Contracts Between Persons Not Dealing at Arm's Length, could be considered for the transfer of the qualified expenditures. For more details on the transfer of qualified expenditures, please refer to the Qualified SR&ED Expenditures Policy (this document is currently under development and a link will be provided once the project is complete). Legislative Reference Income Tax Act Subsection 37(13) Non-arm's length contract Linked work 13.0 Allocation of labour expenditures for SR&ED Many SR&ED claimants have information systems that capture information about SR&ED work and related costs as a project progresses. These systems can be electronic or paper based and may include a variety of methods of capturing information about the SR&ED labour for the purposes of calculating SR&ED salary or wages. Where formal systems have not been implemented, claimants can determine SR&ED salary or wages using appropriate labour allocation methodologies. This section is intended to provide guidance on the elements of such methodologies and to provide an illustration of a sample application. This section may be used by claimants for preparing the labour expenditure portion of their SR&ED claims. This section does not address technical documentation for SR&ED work. For the technical documentation topic, see the document called Guide to Supporting Technical Aspects of a Scientific Research and Experimental Development (SR&ED) Claim. The allocation methods outlined here are for illustrative purposes only. Other approaches may be acceptable, as long as they are reasonable within the context of a claimant's research and development environment, are documented, and are effectively and consistently applied. The suggested approaches can be used with either the proxy or the traditional method Cost allocation methods An SR&ED cost allocation method is a systematic approach to determining which expenditures, or portion of expenditures, relate to SR&ED work. A claimant must be able to show that the cost allocation method used is based on a systematic approach, and provide a reasonable level of accuracy in calculating the SR&ED expenditures. Documentation should be kept to identify the key elements of the cost allocation method, including the controls that were used in preparing the claim. The level of detail and sophistication of books and records will depend on many factors, such as the size of the claimant's organization, the claimant's knowledge of SR&ED policies and practices, and the size of the claim. A small business may have less sophisticated financial control systems than a large company, due to the nature of its business or because of cost constraints. A first-time claimant may have an informal system of calculating SR&ED labour expenditures, while an experienced claimant may have a more sophisticated system. Where a large organization may rely on a combination of the methods discussed in this chapter, some small businesses may have to rely on informal, naturally generated information to 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 47

50 support their allocation of labour costs to SR&ED projects. In all cases, documentation of the labour effort and the related financial information is required to support the reasonableness of the expenditures included in a claim Research and development (R&D) environment All cost allocation methods use information and documentation that comes from the claimants' information systems. The CRA recognizes that the R&D environment will influence the way information is gathered and summarized. The nature and sources of available information will be a key consideration in developing an appropriate labour allocation method. For illustrative purposes, the following four R&D environments are used to show appropriate labour allocation methods. The four environments discussed in detail in section 13.5 are as follows: distinct well-defined R&D projects dedicated R&D environments early stage or start-up business shop floor R&D The methods used to allocate labour expenditures to SR&ED in these four environments can be applied to other real-life R&D environments Support for labour allocation The labour allocation must be supported by evidence that: the allocation method is appropriate in the company's environment the allocation method is consistent with the legislation and the administrative practices of the CRA the allocation system is functional throughout the year There are generally three levels at which information can be summarized: high medium low Each level offers a different view of the SR&ED project. All the levels may provide a reasonable allocation of labour expenditures to an SR&ED project provided they are part of an information system that includes controls that can be tested to evaluate the materiality and accuracy of the results. In some cases, it will be necessary for the CRA to review information at more than one level to properly evaluate whether the allocation method is reasonable or not High-level information (corporate or strategic concept level) The documentation of a company'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 companies (especially large companies) 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 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 48

51 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 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 company. 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 company'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 companies, 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 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 Sources of supporting information The following is a list of potential sources of supporting information that could be used by claimants to support an allocation of labour expenditures to an SR&ED project. The objective is to provide key facts including: the names of the employees performing the SR&ED work confirmation of employment (hire and termination dates) verification that the individual is an employee and not a contractor identification of specified employee In addition, appropriate allocation methodologies can be used to determine the number of hours an employee spent working in SR&ED. When appropriate and effective controls are in place, each of the sources identified below may provide the information required. In some cases, more than one source of supporting information may be required to evaluate whether the labour allocation is reasonable or not Development plans 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 49

52 The resource-planning element of a project schedule plan may identify the resources associated with specific work to be undertaken in the claim period. Where the work relates to the technological or scientific objectives of the SR&ED project and the plan can be compared to actual results or other controls, one may be able to rely on these planning records to allocate labour to an SR&ED project Supervisors' summaries Project managers or technical supervisors often prepare periodic weekly, monthly or quarterly summaries. The summaries document the amount of SR&ED undertaken by the R&D teams for a given period. A person who has direct involvement in managing the work of SR&ED personnel should prepare such summaries. It is expected that the summaries would identify the significant SR&ED and any non-sr&ed work undertaken during the period in question. To be effective, the summaries should be updated regularly Time sheets Individual time sheets that allocate time to SR&ED and non-sr&ed work are a good source of supporting information. Time sheets can be used to show the reasonableness of an SR&ED labour claim. Time sheet codes may be based on business projects that do not align to SR&ED projects. In such cases, other evidence may be required to support the SR&ED labour allocation Naturally generated information Claimants may rely on other information that is naturally generated while performing the SR&ED work. This includes: contracts planning documents project specifications project objectives and milestones descriptions of problems to be solved resource allocation records and budgets written correspondence with customers and suppliers minutes of meetings supervisor summaries project, laboratory, or personal notebooks progress and final project reports organizational charts An allocation of labour based on naturally generated information must give the CRA a reasonable level of assurance that there is minimal risk of material error in the labour expenditure being allocated to an SR&ED project. The claimant should be able to show support for the claim in the documents and other information. However, if the relevance of the evidence is not clear, the CRA reviewer would consult with the claimant to understand the connection between the allocation method used and the documents being presented R&D environment The business environment in which SR&ED is carried out will influence the nature and sources of evidence that are available to support the labour allocation methodology. The four 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 50

53 R&D environments identified in section 13.2 are described below, along with sample labour allocation methods that might be appropriate in each environment Distinct well-defined R&D projects This environment is found in situations where the claimant's organization assigns personnel and resources to specific R&D projects. Projects have a defined start date, targeted finish date, and are based on well-defined technological objectives. Where the core project is SR&ED and support work is necessary to resolve the technological challenges, the work effort can be allocated completely to the project. Controls to identify and segregate non- SR&ED work, such as negative time reporting, provides an indication that the labour allocation is reasonable. Supporting information in this setting may include a development plan that can be used to verify job functions. Where labour resources are used in many projects and in both SR&ED and non-sr&ed, labour allocations can be made based on such things as: resource allocation or utilization summaries project cost control systems supervisor summaries Gantt charts time lines Dedicated R&D environments In principal, these are environments where a defined group of personnel are focused exclusively on R&D for new products or processes, usually to the exclusion of all other business activities of the company. A dedicated research department may be found in any industry, but is more likely to be found in a large multidisciplinary company. It should be noted that a dedicated R&D department might be involved in SR&ED and non-sr&ed work. Personnel in other areas of the company may also do SR&ED work. The claimant should be able to identify the SR&ED performed by the dedicated research department. The claimant should also be able to distinguish allowable SR&ED labour expenditures from the total expenditures of the dedicated research department. Additionally, the claimant should be able to provide documentation with appropriate controls supporting the allocation of SR&ED labour expenditures. A negative time reporting system that captures non-eligible labour expenditures can be quite effective in these settings. Supporting information in these environments can include such things as: supervisor summaries resource allocation or utilization summaries Gantt charts time lines time sheets Early stage or start-up business Early stage or start-up companies do R&D to develop new products or processes. In some situations, personnel may be focused on one SR&ED project. If so, the simplest approach may be to identify employees working on non-eligible work and subtract that portion of labour expenditures from the total labour expenditures. In this type of environment, a claimant should be able to identify the employees performing SR&ED within the business operations. The claimant should be able to distinguish allowable SR&ED labour expenditures from the 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 51

54 total operating costs of the business. Additionally, the claimant should be able to give information supporting the allocation of personnel to an SR&ED project. Documentation in this setting can include such things as: job descriptions development plans Gantt charts supervisor summaries time sheets Shop floor SR&ED Shop floor SR&ED commonly occurs in a variety of industry sectors. This type of SR&ED involves creating new, or improving existing, materials, devices, products, or processes in the field or at a commercial facility. Shop floor SR&ED can involve a variety of employees from different parts of an organization. An SR&ED project of this nature could involve shop floor supervisors, engineers, machine operators, mechanics, and welders. Individuals may report their time using time sheets, a time clock system, or other methods. Because of the variety of employees involved in shop floor SR&ED, it is advantageous to claimants to develop a process to collect information at the start of a project, otherwise difficulties may be encountered in supporting the time an employee spends performing SR&ED work When is a labour allocation method reasonable? The use of an allocation method in determining SR&ED labour expenditures will generally be acceptable to the CRA, as long as there is supporting information to establish the reasonableness of the method. Allocations should be supportable through effective controls and information that can be used to test the reasonableness of the amount claimed. The CRA is available to help claimants identify the type of supporting information and control systems needed to support a claim for SR&ED labour expenditures. The CRA will advise a claimant either orally or in writing if there is a need for additional supporting information relating to a claim for SR&ED labour expenditures. If in writing, the letter will explain that proper supporting information will have to be kept for claim periods starting after the date of the letter. The letter will also explain the types of information that will be expected by the CRA to support estimates after that period. Finally, the letter will inform the claimant that the CRA may visit the site of the business to confirm that proper documentation is being kept. If a claimant receives a request in writing but does not adequately support the SR&ED labour expenditures being claimed in a following year, these expenditures may not be treated as SR&ED expenditures Example of an allocation method The following example refers to a small start-up operation, which has developed simple allocation approaches to determine its SR&ED labour costs. The approaches used in this example are not the only acceptable methods for allocating labour expenditures to an SR&ED project. The methods a company uses to allocate labour expenditures to SR&ED work must be tailored to the way it collects and manages financial information. Other methods may be more appropriate in other industry sectors, but the concepts described in this example will be similar. Aco is a venture-backed start-up company developing a Web-based supply chain management software program that is fully customizable by the customer. The company is 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 52

55 developing a new architecture that will serve as the base for a family of products. The development of the initial architecture meets all the requirements to be considered SR&ED. During the first two months after incorporation, the four founders worked together on the architecture from the home of one of the founders. During this period, each of the developers worked on source code that was annotated and accompanied by a complete revision history. Although a great deal of progress was made, in the third month it was apparent that the seed funding would not take the company far enough. Over the next two months, one of the founders focused on approaching investors to raise more financing instead of working on the development. By the end of the fifth month, the company had raised $10 million dollars and they were ready to start ramping-up the company. Over the next month, 30 employees were to be hired. The first was a system architect who became responsible for the overall development of the architecture. Three of the founders stayed heavily involved in the development. The fourth founder continued to develop the business and participated only in the technical strategy design meetings for the ongoing development. Of the 30 employees added, 3 worked in finance and administration, 5 in sales and marketing, 3 in customer care, 1 in developing technical and user documentation, 4 in quality control, 10 in the research group, and 4 in product engineering. The system architect knew about the SR&ED Program. During the one-month ramping period, the architect began to write periodic summaries that were to be produced monthly. The summaries allocated the work as SR&ED undertaken for the given period. The report identified both the SR&ED effort and the non-sr&ed work during the period in question. By the sixth month, the research and development group found it necessary to use project scheduling and resource allocation tools to manage the development process. These tools permitted the team to identify the resources associated with the specific work. Also in the sixth month, the finance group implemented a time-sheet system. The system was intended to address the overall needs of the company. The time sheet data would enable the finance group to track total hours worked along with employee vacation, holiday and sick leave. The data would provide the information necessary to allocate expenditures to cost centres including development (in other words, the system would be used to allocate researchers' time to projects). In addition, the system would provide the data necessary to bill customers for consulting services after the product was released. By the eighth month, the company had signed contracts with a number of customers and the customer care group and product-engineering group were busy installing and improving an early release of the software. The company was not large enough to do a complete evaluation in-house. The company needed to install the software with a customer in order to evaluate it. The product was still clearly in development, because end-user technical requirements were being developed and analyzed by both the customer care team and product-engineering team to be included in future more advanced versions of the technology. At the end of the year the finance group was responsible for calculating the expenditures incurred in the year on eligible projects. The following is a summary of the resources by department: Personnel Number 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 53

56 Founders 4 Research and development 10 Product-engineering 4 Customer care 3 Quality control 4 Documentation 1 Finance and administration 3 Sales and marketing 5 Total 34 The standard work week for the corporation is 37.5 hours. Each employee is given three weeks of vacation. The total working hours in a year are hours (37.5x49) The approach Before preparing the claim, the controller familiarized herself with the Guidance to Sources of SR&ED Evidence for Software Claimscontained in the joint industry-cra document, Software/IT Guidance, available on the CRA Web site. In this particular year, there was no single system that the controller could rely on to quickly get the costing associated with the SR&ED projects. It was apparent that a variety of allocation methods and control systems would have to be used to calculate the labour expenditures associated with the projects. The controller had access to records of the wages paid to the employees for the year from the payroll service. The controller set up a spreadsheet listing all of the employees along with the wage data received from the payroll service. The controller then proceeded to take a look at each employee to allocate the wages to SR&ED and non-sr&ed work. She also considered what information would be available to serve as a control should a review occur along with information on how to set up a better system in the future. The controller planned to file a claim using the proxy method to calculate the SR&ED tax incentives. The founders The controller determined that three of the founders worked on the architecture throughout the year. The controller explained to these individuals that for salary or wages related to ongoing SR&ED projects claimed in the year, a number of things were considered as directly engaged. These things included: experimentation and analysis technical support activities direct supervision of employees performing experimentation and analysis technological documentation for internal use technological planning and analysis 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 54

57 The controller asked if any of the three founders did other tasks that consumed more than 10% of their effort in the year. The founders reviewed their calendars, diaries, and notebooks, and concluded that they had not performed non-sr&ed work that consumed more than 10% of their effort in the year. The controller considered these to provide a reasonable control that could serve to cross check for their conclusions during a CRA review. She concluded that these three founders were all or substantially all directly engaged in SR&ED, and therefore 100% of the effort of three of the founders should be included in the SR&ED claim. A similar approach was used with the fourth founder. After reviewing the founder's diary, the controller noted that the founder had spent two months, 17% (2/12) of the time, working alongside the other founders on the architecture or doing SR&ED. After the first two months, the work switched to non-sr&ed business activities such as securing financing. The founder stated that he participated in all the technical strategy meetings providing technical direction and estimated that his total involvement in SR&ED was about 50% of his time. The controller recognized that this was an estimate and may not be acceptable to the CRA. As a result, the controller tried to identify another approach to quantify the labour allocation. She noted that the technical strategy meetings occurred on Tuesday of every second week and that they typically lasted for three hours. That meant the fourth founder spent 60 hours in the last 10 months (3 x 2 x 10) involved in SR&ED or about two weeks effort. The controller confirmed the reasonableness of this approach with the founder. This was much lower than the 50% level, but did increase the level to 21% (2.5/12). Even though there were no time records for these meetings, the controller thought that the methodology was reasonable and claimed on this basis. As a final step, the controller noted that each of the founders retained enough ownership interest to be specified shareholders and that this fact would need to be considered in any calculation. Research and development The R&D group operated in a dedicated environment and only spent their time performing SR&ED work. The controller planned to cost 100% of the wages of each R&D team member to the project, but first planned to discuss her approach with the system architect to make sure the team members were not performing other activities. The system architect reviewed his monthly summaries and agreed with the approach in general, with two exceptions. In one case, a team member took sick leave for two months and was not available for the project. The controller planned to reduce the percentage to account for the sick leave. In the second case a team member was loaned to the customer care group for three months. Again, the controller planned to reduce the percentage for that team member to account for the non-sr&ed work. Subject to those adjustments, the software architect agreed that the R&D team was directly engaged in the project, and that 100% of the wages should be allocated to the project. Product engineering The system architect also pointed out that some of the product engineering team participated in the project. An analysis of the project scheduling and resource allocation tools used by the R&D team showed that in the last seven months each of the product engineers spent about two months helping with the architecture. The product engineering team was employed for only seven months of the year, so the controller planned to allocate 29% (2/7) of their time to SR&ED projects. 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 55

58 Customer care It was recognized that the customer care group was developing and collecting the technical requirements that were being incorporated into the architecture. There was plenty of evidence to show that the technical requirements were being developed, collected, and presented to the R&D team. There was no indication of the percentage of time a customer-care agent spent collecting the requirements. To determine that percentage, the controller sat with a customer-care agent and reviewed the work performed by the agent in the last month. It was determined that the agent spent 20% of her time collecting and documenting technical requirements. Based on this analysis, the controller allocated 20% of the time of each customer-care agent to the project as directly engaged salary or wages. Quality control The quality control group performed testing and quality control functions on all codes that were written by the company, whether it came from the R&D team or the product engineering team. The controller decided to allocate to SR&ED and non-sr&ed the work of the quality control team based on the same ratio of SR&ED to non-sr&ed work performed by the R&D and product engineering teams. Documentation The technical writer working in the documentation group spent all of his time writing documentation for external users that was incorporated into user manuals. The controller did not include this person's work in the claim. Other groups The salary or wages of the finance, marketing, and sales people were clearly not directly engaged and were not included in the claim. As a final measure, the time-sheet tracking system was reviewed to identify any extended vacation, flex days, or sick leave time that should be allocated to non-eligible activities. Appendix A - References A.1 Legislative references Income Tax Act Section 5 Subsection 5(1) Section 6 Subsection 6(3) Section 7 Description Income or loss from office or employment Income from office or employment Taxable benefits Payments by employer to employee Stock option benefits 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 56

59 Paragraph 18(1)(e) Subsection 37(1) Subsection 37(1.4) Subsection 37(1.5) Subsection 37(2) Subsection 37(8) Clause 37(8)(a)(ii)(A) Subclause 37(8)(a)(ii)(A)(I) Subclause 37(8)(a)(ii)(A)(II) Clause 37(8)(a)(ii)(B) Subclause 37(8)(a)(ii)(B)(IV) Subsection 37(9) Subsection 37 (9.1) Subsection 37(9.2) Subsection 37(9.3) Subsection 37(9.4) Subsection 37(9.5) Subsection 37(11) Subsection 37(13) Subparagraph 56(1)(a)(ii) Subsection 78(4) Subsection 143.3(2) Paragraph 143.3(3)(a) Paragraph 143.3(3)(b) Reserves Pool of deductible SR&ED expenditures Salary or wages for SR&ED outside Canada Salary or wages outside Canada Limit determined Research outside Canada SR&ED expenditures SR&ED expenditures in Canada under the traditional method SR&ED expenditures in Canada under the traditional method ASA SR&ED expenditures in Canada under the traditional method directly attributable SR&ED expenditures in Canada under the proxy method SR&ED expenditures in Canada under the proxy method - directly engaged salary or wages Remuneration based on profits or bonus for specified employees Limitation re specified employees Associated corporations Agreement among associated corporations Filing Deemed corporation Filing requirement Non-arm's length contract Linked work Retiring allowance Unpaid remuneration and other amounts Options limitation Limitation concerning issuance of a share Limitation concerning exercise of an option 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 57

60 Subsection 143.3(5) Subsection 248(1) Subsection 248(1) Subsection 248(16) Section 251 Clarification Definition of "salary or wages" Definition of "specified employee" GST Input tax credit and rebate Rules concerning relationships between entities Income Tax Regulations Paragraph 2900(2)(b) Paragraph 2900(2)(c) Paragraph 2900(9)(a) Subsection 2900(9) Description Employee remuneration traditional method Other expenditures directly related and incremental to the prosecution of SR&ED traditional method Exclusions to salary base Exclusions to salary base A.2 Jurisprudence 77 DTC 5438 (S.C.C.) (1977) CTC 441 Harel v. DMR (Que.) A.3 CRA publications Type Application policy Application policy Form Form Form Title SR&ED , Expenditures incurred for administrative salary or wages "directly related" test SR&ED 96-06, Directly Undertaking, Supervising or Supporting v "Directly Engaged" SR&ED Salary and Wages T661, Scientific Research and Experimental Development (SR&ED) Expenditures Claim T1146, Agreement to Transfer Qualified Expenditures Incurred in Respect of SR&ED Contracts Between Persons Not Dealing at Arm's Length T1174, Agreement Between Associated Corporations to Allocate Salary or Wages of Specified Employees for Scientific Research and 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 58

61 Experimental Development (SR&ED) Guidance Document Guidance Document Guide Guide Guide Guide Interpretation Bulletin Interpretation Bulletin Allocation of labour expenditures for SR&ED Software/IT Sector GuidanceT4088, Guide to Form T661 Scientific Research and Experimental Development Expenditures (SR&ED) Claim RC4110, Employee or self employed? RC4120, Employer's Guide Filing the T4 Slip and Summary T4130, Employer's Guide Taxable Benefits and Allowances Guide to Supporting Technical Aspects of a Scientific Research and Experimental Development (SR&ED) Claim IT-109R2, Unpaid amounts IT-151 R5 (Consolidated), Scientific Research and Experimental Development Expenditures Interpretation Bulletin IT 270-R3, Foreign tax credit Interpretation Bulletin IT-419R2, Meaning of Arm's Length 30 April 2011 SR&ED Salary or Wages Policy (Draft) Paper 59

62 KPMG LLP, a Canadian limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. Printed in Canada. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International. The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.