SR&ED Legislation Draft: A Small Step Forward

Updates to SR&ED are welcome and positive, but are still missing the structural elements that would make SR&ED more efficient

Last year the Trudeau government began a consultation process on reform to the Scientific Research and Experimental Development (SR&ED) tax credit program that incentivizes private sector investment in R&D through use of refundable tax credits. The program is among the largest such incentive in Canada, amounting to some $4B in credits annually over the past few years.

At the time, I responded to the consultation through an initial open letter, and then again in response to the government’s follow up that synthesized what they had taken away from feedback in the first round.

On August 15, the Carney government released draft legislation toward enacting some of the updates, with no substantive changes from the original plan. While the changes were mostly positive, they were mostly low-hanging fruit and did not engage in a substantive way with what seem to be fairly straightforward structural changes to the way the credit is delivered that could make SR&ED more efficient at delivering value per dollar. My view on this has not changed much.

In this article, I reiterate part of what I proposed last time as additional measures that could be considered to maximize the impact of SR&ED and reduce inefficiencies.

What Stayed the Same (Pretty Much Everything)

Everything proposed in December is still there, and as far as I can tell, there is nothing much new. The changes announced in December 2024 indicated that expenditure limits on which the enhanced 35 per cent rate could be earned from $3 million to $4.5 million, as well as increasing from $10 million and $50 million, to $15 million and $75 million, respectively, the taxable capital phase-out thresholds for determining the expenditure limit. These threshold updates are unchanged in the new draft legislature, and represent only an adjustment of the limit to account for inflation since these thresholds were previously set. There is still no measure to continuously update these thresholds to keep pace with inflation. The December announcement also included a provision for extending eligibility for the enhanced 35 per cent refundable tax credit to eligible Canadian public corporations, and allowance for capital expenditures to be claimed for deduction against income and investment tax credit components of the SR&ED program. These are still there, and you can read my thoughts on it in my previous article on the topic.

In other words: the Carney government is moving forward with SR&ED reform as originally planned by the Trudeau government. While I have no objections to any of it, the inefficiencies that exist within SR&ED can only be addressed through changes to how the program is accounted for and delivered. Updating the base numbers is welcome, if overdue, but leaves on the table opportunities to increase the impact of the funding without increasing the cost.

What Could Still be Done

Anyone who has gone through the rigmarole of claiming SR&ED will tell you that the process is deeply inefficient. Claims take months to review, and payment of the credit can be delayed significantly. Because of the complexity of the rules around qualifying expenditures, most companies hire dedicated consultants to prepare their claims, which are usually paid on contingency, taking anywhere from 10-18% of the credit as payment and reducing the capital that flows back to the innovative companies that are being supported.

These structural issues disproportionately impact small companies. While an established company can weather a denied claim, for a small company, especially a pre-revenue company focused on the R&D required to commercialize something truly novel, a denied claim could be an existential threat. The cash-flow problems arising from the timelines and lump-sum nature of SR&ED payments require that innovative companies do one of two things: either they take fewer risks and spend less on R&D in the early stages to ensure that a denied claim will not end them, or they turn to SR&ED lenders to offset cash-flow, paying high interest rates in exchange while increasing the potential damage of a denied claim. Between contingency-based SR&ED preparation fees and interest rates on SR&ED lending, these cottage industries siphon off a large percentage of the credit. If this could be addressed, and if SR&ED could be better aligned with cash-flow requirements, the impact of this credit as an enabler of intelligent risk-taking would be dramatically increased without increasing the cost to taxpayers at all.

The means by which this could be achieved are also not complicated in principle.

SR&ED claims work in most cases through what is called the “proxy method”: instead of accounting for and claiming specific R&D expenses, companies can simply estimate the total salary paid in service of R&D, add 55% overhead, and claim that total as eligible expenditures (the calculation is a bit different for contractor costs, but we will focus on salary). The obvious change to SR&ED delivery is baked into the proxy method: because SR&ED credit is directly proportional to R&D-related payroll, SR&ED should be integrated with the payroll tax system.

Payroll tax is paid monthly. By incorporating a simple calculation of the percentage of each payroll tax submission that is SR&ED-eligible, the SR&ED credit could be used to first reduce the amount of payroll tax paid each month and then credited on a rolling monthly basis. Companies could then be required to submit the usual annual report that provides an overview of the past year of expenses as a means to verify these payroll tax deductions, but because this would be a correction to payments already made, the cash-flow implications would, assuming no major errors, be minimal.

This change alone would completely eliminate the SR&ED lending industry.

The second structural change should be focused on reducing uncertainty and the chance of a denied claim. Instead of post-vetting of research expenditures, pre-vet them. The annual report mentioned above should include not just verification of the payroll tax deductions claimed in the past year, but also a research plan for the following one. CRA could then provide advance notice to companies of ineligible expenses, which would allow for proactive adjustment to correct for any issues before they arise. The work required by CRA remains effectively the same, since they are approving these research plans regardless, but moves from a reactive, post-approval model that risks unexpected denials to a proactive, pre-approval model that reduces instances of denied claims. Increased confidence in expense eligibility and predictable cash-flow in turn promotes intelligent risk-taking and R&D-based innovation by Canadian firms, eliminates entirely the need for SR&ED lending, and reduces the value-add of SR&ED consultants, ensuring that more of the tax credit is used for its intended purpose. Together, these are potentially cost-neutral reforms that increase the fraction of the SR&ED credit that ends up where it belongs: in the hands of innovative Canadian companies.

Next Steps

While an exact estimate is somewhat challenging given public data on the topic, it is reasonable to estimate (as discussed in my previous posts on the topic) that upwards of 20% of SR&ED spending is not ending up where it should: in the hands of innovative Canadian companies,. Parts of the credit are being diverted through SR&ED consultants that exist only to navigate the complexity of the related administration and lenders that exist only because SR&ED is paid out as an annual lump sum rather than a monthly payroll tax credit. Addressing these through relatively simple changes to the way the credit is paid out could greatly increase the overall impact without changing the cost of the program.

I stand by my original recommendations as well, especially those relating to ensuring the SR&ED does not go to supporting subsidiaries of foreign firms. I will not reproduce them in full here, simply suggesting that you take a moment to review my previous article on the topic.

I intend to submit suggestions along these lines in response to the feedback invitation in the hope that the current administration is a little more ambitious than the last.