In today's changing world, business is much more competitive. Diminishing trade barriers have forced Canadian businesses into global competition and rapid technological changes are forcing businesses to be constantly innovative, and leaders in their fields.

To maintain their competitive edge, Canadian businesses must devote significant resources to the scientific research and experimental development (R&D) of new products and processes. The Canadian government has recognized the benefits to the Canadian economy achieved by encouraging Canadian businesses to be more productive by investing resources into R&D and foreign businesses to perform their R&D in Canada. As a result, the Canadian tax benefits for R&D activities carried on in Canada are among the most generous R&D incentives in the world.

Surprisingly, not all businesses who are conducting qualifying R&D activities in Canada apply for these incentives. In fact, it is estimated that less than 15% of businesses that are eligible are applying for the benefits.

This bulletin explains both the federal and provincial R&D tax incentives available and how they could apply to your business. Ask yourself whether your business is performing R&D and how you could benefit. The savings will make it worth your while.

What is R&D?

Under the Canadian tax rules, R&D is defined as "a systematic investigation or search carried out in a field of science or technology by means of experiment or analysis." Most people interpret this to mean that R&D must be carried out in a laboratory by skilled scientists. This is simply not true.

In fact, R&D activities for small businesses are usually integrated with daily business activities. R&D can just as easily be carried out on the production floor of your business.

Generally, R&D occurs when a business' objective is technological advancement, development occurs in a systematic manner through the efforts of individuals who are skilled in the technologies involved and technological uncertainties are overcome. Three basic criteria must be met if an activity is to qualify as R&D under our tax rules. These criteria are:

• scientific or technological advancement;
• scientific or technological uncertainty; and
• scientific or technological content.

Scientific or Technological Advancement

The project in question must be working towards a scientific or technological advancement. The Canada Revenue Agency (CRA) states that this "is the discovery of knowledge that advances the understanding of scientific relations or technologies."

This test is not as onerous as it sounds. What it means is whether you are creating something new — for example, a new product or simply an improvement to an existing one. It is important, however, that you are working towards something that is truly new and not information that is common knowledge at the time.

Note that you do not have to be successful to qualify for R&D tax benefits. It is the attempt to achieve a scientific or technological advancement that is important in determining whether you are engaged in eligible R&D activities. Failure to achieve your objectives actually increases existing knowledge and is therefore R&D — you will have shown that your objectives cannot be met by the approach you used.

Scientific or Technological Uncertainty

There must be an element of scientific or technological uncertainty in your endeavour. Technological uncertainty must arise due to the fact that the solution to your problem is not obvious to people familiar with the available knowledge and technologies for your business. This means that, at the outset, you are unsure as to whether your goals can be achieved, or there is uncertainty as to the method by which you can attain your objectives. This uncertainty would be removed by performing R&D.

Scientific and Technical Content

Basically, this means that your research must be conducted in a scientific manner. The CRA states that your project "must be a systematic investigation or search going from hypothesis formulation, through testing of the hypothesis by experimentation or analysis, to the statement of logical conclusions."

While this sounds a bit intimidating, it really isn't. Basically, your R&D must be conducted in an orderly fashion and you must have documentation to support the work that you did. The CRA has placed great emphasis on a "repeatability criterion" — they expect that a knowledgeable person should be able to "repeat" the research that you did. Therefore, good documentation is critical to support your R&D claims. While a couple of cases have shown that it may be possible to convince a court that you did conduct R&D even though you didn't maintain good documentation (the R&D claims were allowed based on oral testimony of the taxpayers), a lack of documentation will almost certainly mean that the CRA will deny your R&D claims.

Remember that you do not have to be in a "high-tech" industry to be involved in R&D. Ask yourself the following questions to determine if you have any activities that may qualify for R&D benefits:

• Have you developed a new product, are in the process of developing one, or are adding improvements to an existing product?
• Are you improving the methods by which you produce an existing product? The development of an improved manufacturing technique or process, whether to improve product quality or just reduce production costs, could be R&D.
• Are you spending money on improvements with respect to the environmental impact of your manufacturing process? If you have developed techniques to cut pollution or reduce waste, these costs may qualify as R&D.

Contact your BDO advisor for assistance if you have questions as to whether a particular activity could qualify as R&D.

What are the R&D Tax Incentives?

Under Canadian tax law, there are three major benefits for qualifying R&D expenditures. These are:

• A full tax deduction in the year the expenditures are incurred, even if they are capital in nature;
• The ability to "pool" R&D expenditures, which enables you to carry over deductions to the extent that they are not needed currently; and
• Eligibility for attractive investment tax credits (ITCs), which can be refundable in cash if you don't need them to reduce current taxes payable.

The ITCs are particularly attractive for Canadian controlled private corporations (CCPCs) who carry on qualifying R&D activities.

In addition to the federal tax incentives, many of the provinces have their own R&D tax incentives. These are outlined later in this bulletin in the section entitled Summary of Provincial R&D Tax Incentives.

Current Tax Deduction

R&D expenditures can be classified in one of two categories: current and capital.

Current R&D Expenditures

A current expenditure is an amount that you would ordinarily consider to be currently deductible for tax purposes. Examples would include amounts spent directly on R&D activities such as wages paid to employees who are engaged in this work and materials. In addition, overhead to support R&D activities is also a current expense. Examples of overhead expenses include general and administrative costs such as office supplies, salaries of support staff and the costs related to maintaining the facilities in which the R&D activities are conducted.

Calculating overhead which qualifies as an R&D expenditure is often difficult. This is due to the fact that overhead must be "directly attributable" to R&D activities to qualify. This is generally interpreted to mean that the overhead must be incremental — in other words, the overhead expense would not have been incurred if there had been no R&D activity.

Calculating this incremental overhead has, over the years, proven to be difficult and has often been the source of disagreement between the CRA auditors and taxpayers, particularly for small businesses where R&D activities are often integrated with other activities. However, there is an alternative method to compute R&D overhead for purposes of calculating R&D ITCs, which generally eliminates this problem. This method, known as the "proxy method", is discussed in more detail under the heading "Investment Tax Credits".

Capital R&D Expenditures

A capital outlay is an amount paid for capital property such as machinery and equipment. Normally, these assets must be written off for tax purposes in accordance with the tax depreciation rules known as the capital cost allowance (CCA) system. For example, manufacturing assets are ordinarily written off at a CCA rate of 30% per year on a declining balance basis. Note that the cost of a building is generally not eligible for treatment as an R&D expenditure.

All qualifying R&D expenditures, including capital expenditures, can be deducted immediately for tax purposes. However, to qualify for full R&D tax incentives, depreciable capital assets must be acquired with the intent to use the property "all or substantially all" in R&D activities. The CRA interprets this to mean that they are used 90% of the time in that capacity.

Restricted R&D incentives are available for "shared-use" capital property — depreciable assets which are acquired to be used only part of the time for R&D purposes. This is discussed in more detail under the heading "Investment Tax Credits". Property qualifying as shared-use capital property is written off under the normal CCA rules, and therefore these expenditures are not currently deductible.

Pooling of R&D Expenditures

As mentioned above, R&D expenditures are accumulated separately or "pooled" for tax purposes. This pool of expenditures can then be written off immediately, or the deduction can be deferred indefinitely for tax purposes. This is extremely useful if you don't have sufficient taxable income to take advantage of the tax deductions now. By deferring the deduction for R&D expenditures to future years, you avoid creating tax losses which expire if not utilized within the loss carryforward period.

This pooling of expenditures gives you, the taxpayer, the maximum flexibility in claiming your R&D expenditures for tax purposes. You have the option of claiming all, none, or a portion of your R&D pool in the current taxation year, or in any taxation year in the future. In other words, you can save the tax deductions for when you will need them.

Investment Tax Credits (ITCs)

Perhaps the most important tax benefit of R&D expenditures is the availability of generous ITCs, which reduce your income tax liability dollar for dollar. And if your available credits exceed your income tax, you may qualify to claim your ITCs as cash refunds from the government.

ITCs are calculated as a percentage of the cost of your R&D expenditures. Note that any government or non-government assistance received for your R&D activities reduces the amount of expenditures on which you claim ITCs.

For most taxpayers, the ITC rate is 20%. However, if you carry on your R&D activities in a CCPC, you may qualify for an enhanced ITC rate of 35%. Any ITC you receive will reduce your R&D costs in the taxation year following the year in which the ITC is claimed and therefore will reduce the pool of R&D expenditures that you can deduct for tax purposes in the future.

A CCPC's eligibility for the enhanced 35% ITC rate will depend on its taxable income for the previous year, aggregated with the taxable incomes of any associated corporations. Companies are considered "associated" if they are under common ownership and control, according to specific rules in the Income Tax Act. Note that certain relieving rules were introduced for small businesses raising funds from common investors effective for taxation years ending after March 22, 2004. Where certain conditions are met and the CRA is satisfied that a group structure was not set up to gain access to multiple expenditure limits (ie. certain venture capitalists), corporations will not be considered associated and will not have to share the expenditure limit for purposes of determining their eligibility for the enhanced ITC rate.

If taxable income for your associated group of companies for the previous year is $300,000(1) or less, the first $2 million of R&D expenditures of the associated group will qualify for the 35% ITC rate. If the taxable income of your associated group for the previous year exceeded $300,000(1), your access to the 35% ITC rate will start to be restricted. This is done by reducing the $2 million expenditure limit by $10 for each dollar by which the prior year's taxable income exceeds $300,000. This effectively reduces the total annual amount of R&D expenditures eligible for the 35% ITC rate. This is best illustrated in Table A below. Note that with taxable income of $500,000, your corporation will become ineligible for the 35% ITC rate on any of your R&D expenditures. You will, however, still be eligible for the 20% rate.

Access to the enhanced ITC rate will also be restricted when taxable capital exceeds $10 million, as it is phased out for taxable capital between $10 million and $15 million on a straight line basis.

Table A

R&D Overhead — The Proxy Method

The proxy method is an alternative method to compute R&D overhead for purposes of calculating R&D ITCs, which is often beneficial to use. This will mean that you will not have to identify incremental overhead incurred for R&D purposes, which is usually difficult for small businesses.

Under the proxy method, the ITCs on R&D overhead are based on a "proxy amount". This amount includes salaries and wages of personnel directly engaged in R&D activities. If one of your employees is working on R&D projects 50% of the time, then 50% of their salary would be included in the proxy amount. Note that there are limits on the salaries of "specified employees" for this purpose (a "specified employee" is someone who owns 10% or more of the shares of the corporation or corporations within the associated group). This limitation is the lesser of 75% of the specified employee's salary and a prescribed ceiling which, for 2005 is $102,750 and for 2006 is $105,250.

If you choose this method, 65% of the proxy amount will be eligible for R&D ITCs. Note that the proxy method is only for purposes of determining R&D ITCs for overhead. If the proxy method is used, actual overhead costs will not be eligible for treatment as an R&D expenditure and are deducted as regular business expenses.

Using the proxy method will generally be beneficial to you if your incremental overhead (i.e. the extra overhead you incur because of your R&D activities) is low, or your R&D activities are labour intensive (since the proxy amount is based on direct R&D salaries and wages). Your BDO advisor can help you determine if using the proxy method will be beneficial for you.

Shared-Use Capital Property

As we have already stated, only capital property that is purchased to be used "all or substantially all" in R&D activities qualifies as an R&D expenditure. As capital assets usually have a life of several years, this test is extremely difficult to meet, particularly for small businesses that may use an asset partly for R&D purposes and partly for production.

Fortunately, our tax rules allow limited R&D ITCs on shared-use capital property. If property is used primarily (more than 50% of the time) for R&D activities, the asset will qualify for rduced R&D ITCs. The credit will be one-half of the regular R&D ITC and will be payable over two years.

Note that shared-use capital property is written off under the normal CCA rules and will not be eligible for pooling with other R&D costs. Capital property meeting the "all or substantially all" test, however, will still qualify as a capital R&D expenditure and will be eligible for full R&D ITCs.

Stock Option Benefits

In a recent court case (Alcatel Canada Inc.), the taxpayer was allowed to claim the value of stock option benefits of employees engaged in R&D as qualifying expenditures for R&D ITC purposes. Although there is no cash outlay or payment made by the corporation with respect to stock option benefits, the judge in this case held that there was a real economic benefit to the employees and a cost to the employer; therefore the benefits were considered an expenditure. The CRA accepted the decision in this case, but in doing so they outlined certain conditions to be met in order for the taxpayer to claim an ITC in respect of the value of stock option benefits.

The opportunity to claim stock option benefits for R&D ITC purposes was short-lived, however, as the government has introduced proposals to amend the Income Tax Act to ensure that the amount of an expenditure on which a tax credit or deduction may be claimed, is limited to the amount actually disbursed by the taxpayer. In other words, an expenditure will not be considered to have been made except to the extent of an actual outlay or expense incurred by the taxpayer. This proposed amendment is to apply to stock options granted and shares issued on or after November 17, 2005.

Getting Cash For Your R&D ITCs

If you don't have sufficient taxes payable to fully utilize your R&D ITCs, you may still benefit immediately. In certain circumstances, R&D ITCs can be refundable in cash from the government to help subsidize your R&D expenditures. This is a very attractive benefit as it can substantially reduce the costs of financing your R&D expenses.

Qualifying CCPCs are eligible for cash payments for all of their R&D ITCs on current expenses and 40% of their R&D ITCs on capital expenses, on the first $2 million of R&D expenditures. Reduced refunds are available for ITCs on expenditures over the expenditure limit. Other CCPCs also get attractive refunds on R&D expenditures which are eligible for the enhanced 35% rate, but get no refund of ITCs on expenses eligible for the 20% ITC rate. Individuals and unincorporated businesses can also get partial refunds of their R&D ITCs.

Since qualifying CCPCs get the most attractive refunds, it may be wise to ensure that your CCPC qualifies. A qualifying CCPC is one whose taxable income, together with associated corporations, does not exceed its federal small business limit in the preceding year. The federal small business limit was $250,000 in 2004 and increased to $300,000 effective January 1, 2005.

Table B summarizes the refund rates available to all businesses.

Table B

How Much Does R&D Cost You?

The generosity of the federal R&D incentives can be illustrated by looking at the after-tax cost of performing R&D. Let's assume that you own a CCPC and would qualify for the 35% enhanced R&D ITC rate. The after-tax cost of performing $10,000 of R&D as compared with incurring regular current and capital expenditures is shown in Table C below. As the numbers indicate, the after-tax cost of R&D is only about 53% of the actual expenditure. Regular current and capital expenditures have an after-tax cost of approximately 81% and 97% of the expenditures respectively.

The savings for businesses that do not qualify for the 35% enhanced rate, either because they are not CCPCs or their taxable income is too high, are even more pronounced. Even though R&D ITC rates will only be 20%, the after-tax cost of the expenditures is lower because these businesses pay income tax at higher tax rates (the expenditures would be deducted against income not eligible for the small business deduction available to CCPCs on their annual small business limit). The after-tax cost of performing $10,000 of R&D for these businesses, as compared with regular current and capital expenditures is also shown in Table C.

Note that this analysis does not take into account any provincial R&D incentives that may be available. Provincial incentives are outlined later in this bulletin.

Table C

How Do You Apply for R&D Incentives?

To claim the R&D tax incentives, the CRA's Schedule 32 to the Corporate Tax Return, Claim for Scientific Research and Experimental Development Expenditures Carried Out In Canada (also known as form T661), must be completed and filed with your corporation's tax return. The form requires a detailed explanation of your R&D projects and the costs you incurred which you are claiming as R&D expenditures. To calculate your R&D ITCs, you must also file Schedule 31, Investment Tax Credit.

To qualify for benefits, it's critical that these forms be filed within one year after the filing due date for the taxation year in which the R&D expenditures were incurred. For corporations, this is 18 months after the taxation year-end. This rule exists to ensure that claims are filed on a current basis. If you don't file all of the required information (including project descriptions) within this timeframe, you will lose your ability to claim R&D tax incentives on your R&D expenditures for that taxation year.

Note that the Minister of National Revenue has had the discretion to waive the 12-month filing deadline. However, an amendment to the income tax rules has been proposed such that exceptions to the filing deadline will no longer be allowed. This will apply to claims made for R&D treatment and ITCs on or after November 17, 2005.

Your BDO advisor can assist you in preparing your R&D application.

Will Your Claim be Audited by the CRA?

Yes, 100% of first time R&D claims are audited. The initial audit is usually the Science Audit, generally performed by the CRA based on the technical descriptions you have submitted. In most cases, you will be visited by a science advisor to verify or clarify the information in the reports. Also, a business auditor will contact you to set up an appointment to review the financial side of the claim. The length of the audit is generally determined by the size and complexity of your claim.

Your BDO advisor can help you deal with the CRA during the audit of your claim to ensure that you obtain the maximum benefits from the R&D program.

Other Matters

If you perform R&D, you should also be aware of the following items:

Contract Payments to Non-Arm's Length Parties – If you contract out R&D work to a non-arm's length party, only the performer of the work can claim R&D incentives on the work done. This rule ensures that R&D tax incentives are only claimed on actual R&D costs incurred and not on any profit margin earned on the contract payment. However, the party to which you contracted the work out can transfer the ITCs back to you, if a joint election is filed (Form T1146).

Contract Payments to Arm’s Length Suppliers – Effective for claims filed after September 30, 2005, taxpayers are required to include a statement of the work performed by contractors with their claim. This change has been made by the CRA to allow them to better understand the nature of payments made to contractors in order to determine if the costs are eligible depending on whether the traditional versus proxy method for making claims has been used.

R&D Activities Carried on Outside of Canada – Generally, R&D activities must be performed in Canada to qualify for the tax incentives. This makes sense as the purpose of the incentives is to ensure that R&D activities happen on Canadian soil. There has been significant case law in the area of expenditures incurred outside of Canada and your BDO advisor should be consulted in this area.

Canada has generally included the area within 12 nautical miles from the Canadian coastline. This definition was broadened in the 2005 federal budget for R&D purposes. Expenditures incurred in the exclusive economic zone of Canada (including the airspace above that zone or the seabed or subsoil below that zone) will be considered to be incurred in Canada, effective for expenditures incurred on or after February 23, 2005. The exclusive economic zone consists of the area that is up to 200 nautical miles from the low-water line along the coasts of Canada.

Recapture of ITCs on Sale of Property – ITCs on property which qualified for R&D incentives in any one of the preceding 10 years will be recaptured if the property, or property which incorporates it, is converted to commercial use or otherwise disposed of.

Planning to Maximize Your R&D Claim

Here are some tips to ensure that you get the maximum benefit from the R&D rules.

Properly Account for Your R&D Expenditures

It's very important to have both good documentation of your R&D project and good accounting records for your R&D expenditures. Pay particular attention to the following items:

• Make sure you identify all of your R&D activities. This is best done by persons who are familiar with the CRA's R&D rules. BDO has the experts who can help you.
• Set up your accounting system to capture all R&D expenditures separately. Watch in particular for staffing costs, and ensure that your system picks up the portion of salaries and wages for employees who work on R&D projects only part of the time.
• Ensure that your system identifies any incremental overhead that is attributable to your R&D activities and that this is recorded separately.

Consider Using the Proxy Method for Overhead

Using the proxy method can increase your R&D ITCs. Compare the ITCs calculated under this method with ITCs calculated on actual incremental overhead to determine which maximizes your R&D claim. Your BDO advisor can help you analyze which method is better for you.

Keep Taxable Income Below $300,000

If your R&D activities are carried out in a CCPC, you should ensure that the taxable income of your company, together with any associated companies, is kept below $300,000(2) each year. This is important to ensure that the maximum amount of R&D expenditures will qualify for the enhanced 35% R&D ITC rate, as opposed to 20% for other taxpayers. Also, ITCs on current R&D expenditures for qualifying CCPCs can be fully refundable.

Carry on Your R&D Activities in a Corporation

If you are an individual carrying on R&D activities, strongly consider incorporating in a CCPC to qualify for the higher ITC rates.

The tax incentive system for R&D activities in Canada is very generous. Don't miss the opportunity to apply for these benefits if you're involved in qualifying activities. Talk to your BDO advisor for more information on how you can benefit from the R&D tax incentives.

Summary of Provincial R&D Tax Incentives

ONTARIO

In addition to a 100% deduction of current and capital R&D expenditures in the year in which they are incurred, there are other incentives for:

• businesses carrying on R&D activities in Ontario;
• for investors in research companies; and
• for employees of research companies.

Incentives for Businesses

Deduction for Federal R&D Investment Tax Credit
For taxation years commencing after February 2000, Ontario permits a deduction from Ontario taxable income of the amount of federal ITCs claimed in the preceding taxation year. The Ontario deduction is limited to the part of the federal ITCs that can reasonably be considered to relate to Ontario R&D expenditures. This amount is grossed up by (i.e. divided by) the Ontario allocation factor for the year.

Ontario Innovation Tax Credit (OITC)
The OITC is a refundable tax credit calculated at 10% of the R&D expenditures incurred by CCPCs which qualify for the enhanced 35% federal R&D ITC rate. It is also available to certain larger CCPCs that are not eligible for the enhanced 35% ITC rate. 100% of current R&D expenses and 40% of R&D capital expenditures qualify for this refundable credit. This credit reduces eligible R&D expenses for federal purposes and therefore reduces the federal R&D ITCs.

Ontario Business-Research Institute Tax Credit
This 20% fully refundable tax credit is available for corporations that incur R&D expenditures in Ontario under approved contracts with eligible research institutes (e.g. universities, colleges, hospital research institutes and certain non-profit research organizations). The limit on annual expenditures which qualify for the credit is $20 million. This credit reduces eligible R&D expenses for federal purposes and therefore reduces the federal R&D ITCs.

Incentive for Investors

Extra Credit for Research Oriented Labour-Sponsored Investment Funds
Investments in research oriented labour-sponsored investment funds ("LSIF") carry a 20% Ontario tax credit to a maximum of $1,000 per year, which is an additional 5% to a maximum of $250 over the normal credit for LSIF investments. The federal government will grant its matching credit for these investments up to 15% to a maximum of $750 per year. Therefore, the combined federal and Ontario non-refundable tax credit is 35%.

A research oriented LSIF is a LSIF that has at least 50% of its capital available for investment invested in companies whose R&D expenses are at least 50% of their total expenses. Note that a fund is authorized for the extra credit on a year by year basis.

Note that the Ontario government has announced plans to phase-out the credit for LSIF investments by 2010.

Incentive for Employees

Research Employee Stock Option Credit
The existing stock option rules treat all employees of corporations as receiving employment income either on the exercise of stock options or on the sale of shares acquired with the options. If the stock option arrangements meet certain criteria, the employees are entitled to a deduction equal to 50% of the amount of the taxable employment benefit.

In 2001, Ontario enacted legislation to provide eligible employees of R&D companies with a non-refundable stock option credit. The Ontario Research Employee Stock Option Credit was designed to eliminate the Ontario income tax for an eligible employee employed by an eligible corporation on qualified stock option benefits up to $100,000 of such income per year.

In 2004, the Ontario government announced the elimination of this credit, however, there are transitional provisions to consider. Under these provisions, an eligible employee will be able to claim the credit on stock option benefits or capital gains (from the sale of shares acquired with stock options) reported or realized in respect of 2009 or earlier years, provided that the underlying options were granted before May 18, 2004 and after December 21, 2000.

How Much Does R&D in Ontario Cost You?

Table D below illustrates the after-tax cost of paying a $10,000 salary to an R&D employee by a CCPC in Ontario that qualifies for the federal 35% ITC rate and the Ontario 10% OITC rate. As the numbers indicate, the after-tax cost of the R&D salary is only about 23% of the actual expenditure. Regular salary has an after-tax cost of approximately 81% of the expenditure. For capital expenditures, the after-tax cost of the R&D equipment at the end of the first taxation year is about 60% of the expenditure compared to 97% of regular capital expenditures.

The after-tax cost of performing $10,000 of R&D for businesses that do not qualify for the 35% enhanced rate, either because they are not CCPCs or their taxable income is too high, as compared with regular current and capital expenditures is also shown in Table D.

Table D

QUÉBEC

Like the federal government, Québec allows a 100% tax deduction for current and capital R&D expenditures. Federal R&D ITCs are taxable and accounted for in the Québec R&D pool at the same time that they are accounted for at the federal level. However, the amount used as a basis for calculating the various Québec R&D tax credits is not affected by the federal ITC.

17.5%/37.5%(3) credit for R&D wages (QTC)
Québec offers a refundable tax credit for R&D equal to 17.5% of wages paid in Québec. Where the corporation is not controlled by non-residents of Canada, the rate is increased to 37.5% of the first $2 million of R&D wages in Québec. Where the assets of the corporation (and associated corporations) are greater than $25 million based on prior year financial statements, the enhanced credit is reduced from 37.5% to 17.5% on a straight-line basis, as assets increase from $25 million to $50 million.

The 17.5%/37.5% credits are available to corporations which contract to have R&D done on their behalf. Where unrelated subcontractors are used, Québec allows the above credit to apply to 50% of the consideration paid to the unrelated subcontractor attributable to R&D undertaken by the subcontractor's employees in Québec. Where the subcontractor is related, the amount of the credit is based on the portion of contract remuneration that is attributable to the subcontractor's Québec R&D, or would have been so attributable had there been employee salaries.

Québec R&D credits are not taxable for Québec purposes. However, they are taxable for federal purposes and reduce the amount on which the federal R&D ITC is calculated.

For fiscal years beginning after April 21, 2005, taxpayers will be required to carry on a business in Québec and have a permanent establishment in Québec in order to be eligible for this R&D credit.

Other Québec R&D incentive programs:

• A 35% refundable credit for 80% of R&D expenses pursuant to University, Public Research Centre or Research Consortium contracts.
• 35% refundable credit for R&D expenses pursuant to Pre-Competitive Research contracts.
• 35% refundable credit for dues and fees paid to an eligible Research Consortium.

How Much Does R&D in Québec Cost You?

Table E below illustrates the after-tax cost of paying a $10,000 salary to an R&D employee by a CCPC in Québec that qualifies for the federal 35% ITC rate and the 37.5% QTC rate. As the numbers indicate, the after-tax cost of the R&D salary is only about 11% of the actual expenditure. Regular salary has an after-tax cost of approximately 78% of the expenditure. For capital expenditures, the after-tax cost of the R&D equipment at the end of the first taxation year is about 51% of the expenditure compared to 97% of regular capital expenditures.

The after-tax cost of performing $10,000 of R&D for businesses that qualify for the federal 20% ITC rate and the 17.5% QTC rate, as compared with regular current and capital expenditures is also shown in Table E.

Table E

BRITISH COLUMBIA

British Columbia provides a non-refundable R&D credit of 10% on qualifying R&D expenditures incurred in the province by qualifying corporations after August 31, 1999 and before September 1, 2009. Unused non-refundable credits can be carried forward ten years and back three years if they can't be used in the current year. The credit generally reduces eligible R&D expenses for federal purposes, and therefore reduces the federal ITCs. It is not taxable provincially. Note that non-refundable credits may be renounced to maximize federal credits, if it is beneficial to do so.

The 10% credit is refundable for CCPCs if the expenditures are within the $2 million federal expenditure limit.

Effective April 1, 2000, B.C. matches the federal recapture provision where property on which the B.C. R&D credit has been claimed is disposed of, or converted to commercial use within 10 years of acquisition.

SASKATCHEWAN and MANITOBA

These provinces have non-refundable R&D tax credits available to corporations with a permanent establishment in the respective province and that incur R&D expenditures in that province.

The credit rate for Saskatchewan is 15%. In Manitoba, the credit rate was increased from 15% to 20%, effective for eligible expenditures made after March 8, 2005. In both provinces, the credit can be carried forward ten years and back three years if it can't be used in the current year.

The credit reduces eligible R&D expenses for federal purposes and therefore reduces the federal R&D ITCs. The credit can be renounced if, in your situation, it is better to maximize the federal credits and not claim the provincial credit.

NEW BRUNSWICK

New Brunswick provides a 15% refundable tax credit for eligible R&D expenditures incurred in respect of R&D carried on in New Brunswick after January 1, 2003 by corporations with a permanent establishment in New Brunswick. Also effective January 1, 2003, New Brunswick implemented similar rules to those provided federally with respect to the recapture provisions.

Prior to January 1, 2003, a non-refundable tax credit of 10% of eligible R&D expenditures was provided, which could be carried back three years and forward seven years.

NOVA SCOTIA and NEWFOUNDLAND & LABRADOR

Both provinces have a 15% fully refundable tax credit for corporations with a permanent establishment in the province that incur R&D expenditures in the province. The credit reduces eligible R&D expenses for federal purposes and therefore reduces the federal R&D ITCs. Note that the expenditures which qualify for the Nova Scotia credit are not reduced by government or non-government assistance received, which is unlike the federal ITCs. Nova Scotia also provides similar rules to those provided federally with respect to the recapture provisions.

YUKON

The Yukon provides a 15% fully refundable tax credit for eligible R&D expenditures incurred in respect of R&D carried on in the Yukon after June 30, 2000 by corporations with a permanent establishment in the Yukon. The credit is similarly available to individuals resident in the Yukon after 2000. An additional 5% credit is added for qualified R&D expenditures made to the Yukon College.

OTHER PROVINCES and TERRITORIES

There are no other special provincial or territorial tax incentives for R&D activities.

Notes:
(1) For taxation years that ended before 2003, the taxable income threshold that could not be exceeded was $200,000.
2) When applying the threshold you generally need to look back to the previous year. The $300,000 threshold generally applies where the previous taxation year ends in 2003 or subsequent taxation years. Where the previous taxation year ended in 2002 or earlier, the threshold was $200,000.
(3) The refundable tax credit rate of 37.5% for R&D was increased from 35%, generally effective for R&D expenditures incurred after April 21, 2005, regarding R&D work carried out after that day.