What is the SR&ED credits accounting treatment in Canada? The accounting treatment of SR&ED tax credits is complex. Let’s answer the obvious question first. Are SRED credits taxable? Yes, they are. SRED credits are considered to be income to the firm that earns them, therefore they are indeed taxable. However, the tax treatment of SRED credits is favourable vs the tax treatment of regular income.
Let’s start with the default tax advantage for SRED tax credits. Federal SRED tax credits, called ITCs, are not taxable in the year that they are earned. ITCs are taxed in the year following the year they are awarded. This happens by default when you file for SR&ED tax credits. This tax deferral is advantageous. Get SRED credits now, pay the tax later (next year). It’s like a mini-RSP effect.
Let’s take a simple example. A December 31 Year End Canadian Controlled Private Corporation files a SRED application for its 2020 tax year in conjunction with its regular T2 filing in June 2021. The firm applies for $50K of ITC SRED credits. The company is not a first-time claimant for SRED. The SRED filing is accepted as filed, without a detailed review, in July 2021. The assessment in July will contain zero incremental tax for the award of the $50K in tax credits. The firm receives a direct deposit in July 21 from the federal government of $50K. If the company’s regular T2 filing attracted tax of $30K then the SRED credits would be used automatically to reduce the federal tax owing to zero, in which case the direct deposit would be $20K. A payroll tax balance or an HST balance would likewise be cleared to zero before paying out the SRED credits as a direct deposit or cheque to the company. But the important point here is that no taxes were paid in 2020 for the $50K in ITC SRED credits. For the 2021 tax year, the CCPC files its T2 with no SRED in June of 2022. The assessment that the company receives in July 2022 will reflect tax owing on the 2020 SRED award. If the company is based in Ontario, and its 2021 net income (increased by $50K to reflect the 2020 SRED award) is below the small business limit, the firm will pay 9% federal tax and 3.2% ON tax on the SRED award for a total of $6,100 in tax. The firm received a net benefit after tax of $43.9K for the SR&ED award. The important point for this example is that the firm had the use of the $6,100 interest-free for a year from July 2021 to July 2022 versus how an ordinary $50K in income would have been taxed all in 2020. As a default, the SR&ED credits accounting treatment Canada is tax-friendly vs ordinary income.
Now let’s make this example more realistic. Unfortunately, it’s more complex too. The CCPC in Ontario also receives provincial SRED credits. We’ll use ON in our example but all the provincial SRED credits are taxed in the same way. You can follow along with the G6 online SRED calculator here: https://www.g6consulting.ca/sred-calculator/. In addition to the awarded 35% ITC federal credits totalling $50K, the ON CCPC will receive an 8% Ontario Innovation Tax Credit, OITC, and a 3.5% Ontario Research and Development Tax Credit, ORDTC. These credits will total $12,873 and $5,181 respectively to this firm for total SRED credits of $68,054 in our example. Believe it or not, part of the provincial tax credits are tax-deferred for a year, just like the federal ITCs, and part of the provincial credits are taxed like ordinary income, ie., in the year they are received.
Only one amount of the provincial SRED credits is tax deferred by a year. This is the proxy amount of the provincial SRED credits awarded. Recall that proxy is the amount awarded to a company for overhead incurred to carry out SRED activities for the year. Proxy is an imputed amount, it is deemed to be 55% of the qualifying payroll expenditures incurred by the firm. Provincial credits awarded for the payroll expenditures themselves, and for materials and subcontract expenditures, are all taxed in the year the credits are awarded. Let’s re-visit our example. Say that all the expenditures for the firm’s 2020 SRED claim consisted of payroll amounts. This would equate to $103, 814 of salary expenditures. Using our G6 online calculator, the provincial SRED credits awarded total $18,054. The non-proxy amount is $18,054/1.55 or $11,648. The tax deferred proxy amount of provincial credits is $6,407 ($18,054 – $11,648).
If the company’s SRED expenditures had been all materials or all subcontracts for 2020, you can see that there will be no proxy awarded, thus there is no tax deferral for any of the provincial credits earned.
Let’s finish our ON CCPC example for tax deferral. The firm receives $68,054 in total SRED credits in July 2021. The tax for 2021 on this SRED is zero for the $50K ITC credits, 12.2% on the SRED payroll expenditure credits of $11,648 and zero on the provincial proxy credits of $6,407. So the firm pays taxes on the SRED credits in 2021 of only $1,305. The remaining taxes of $6,317 aren’t paid until 2022 ($68,054 x 0.112 – $1,305)
Note that provincial tax credits in ON can’t be calculated directly from total SRED expenditures. This is because the OITC credits are considered to be government assistance when calculating ORDTC and they claw back part of the ORDTC amount awarded. Therefore, the OITC is 8% of total expenditures but the ORDTC is not 3.5% of total SRED expenditures. ORDTC is in fact calculated as 3.5% of the result of total expenditures – OITC. In our example .035 x ($103,814 + $57,098 proxy – $12,873 OITC) equals $5,181. This grinding mechanism is discussed in detail here: https://www.g6consulting.ca/deductions-from-sred/.
SR&ED credits accounting treatment Canada is handled on the T2 Schedule 1. In 2020, the total SRED expenditures are added to net income on L118 of the Schedule 1. Then the total SRED expenditures less the non-proxy amount of the provincial SRED expenditures are deducted from net income on Line 411 of Schedule 1. The difference between these two amounts, that is all the provincial sred credits except the proxy amount are added to net income in 2020. In 2021 the proxy amount of the the provincial SRED credits are added to Schedule 1 Line 605. The ITCs awarded in 2020 are added to Schedule 1 Line 231. For our example, in 2021 the Line 300 net income will be increased by $56,407, made up of $50,000 in ITCs from 2020 and $6,407 of proxy provincial SRED credits from 2020. This increase in net income results in taxes of $6,317 on the SRED credits in 2021 ($56,407 x 0.112). This matches the taxes calculated earlier in our example.
Some SRED tax credits are non-refundable. For example, ITCs awarded to a public or foreign-owned company are 15% non-refundable. Non-refundable tax credits must be applied against a tax balance to convert them into cash. Non-refundable credits must be applied against a like balance. So, for example a non-refundable Ontario ORDTC amount must be applied against an Ontario corporate tax amount. Likewise, a non-refundable federal ITC credit must be applied against a federal corporate tax balance. It can’t be used provincially or applied against payroll or HST balances. Non-refundable taxes are not as liquid as refundable credits therefore they are less valuable.
An advantage of SRED non-recoverable credits is that they can be carried backwards 3 years to turn them into cash. This is good flexibility. Some tax credits can be carried back only a year or two. Additionally, tax credits can be carried forward for 20 years before they expire. This is also good flexibility. Many Canadian tax credits expire after 10 years.
Non-refundable SRED credits can be waived. Because SRED credits grind down other SRED credits, this can be useful flexibility. If a firm has no available tax balances and they expect to pay no taxes for several years, non-refundable can be of no foreseeable use. By waiving these credits, the amount of refundable credits received as cash will increase. Using our ON CCPC example again, if the firm decides to waive their ORDTC credits, the ITC credits received in 2020 will increase from $50,000 to $51.814. Total credits received drops, but for this firm, the ability to receive extra immediately useful cash is more valuable to them.
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