Overhead Cost in SR&ED: traditional method and proxy method

If your company is located in Canada and is trying to improve a product or process, then it may benefit from government funding. The federal government offers tax credits for your research cost through the Scientific Research and Experimental Development (SR&ED) programme, which is operated by the Canadian Revenue Agency (CRA).

The programme covers all R&D related expenses, including overhead cost and support staff.

An SR&ED consultant can help you to determine the kind of expenditures for SR&ED that can be written off, especially when it comes to managing your overhead expenses. These include expenditures incurred in the day-to-day running of the business outside of your experimental development work. It can include essential non-project costs, among them phone systems, office equipment, leases, light and power, and even some salaries unrelated to the SR&ED work itself.

The challenging choice ahead is that the CRA provides companies engaged in SR&ED with two options of claiming overhead costs: the traditional and the proxy method. The traditional method is the default method on the SR&ED claim forms but depending on your company and your project it may not result in the highest possible tax credit.

Once you have made your choice then you can’t change the method for that tax year, so for companies counting on SR&ED in Canada, choosing the right method is important!

Traditional Method for SR&ED Claims

The Traditional Method focuses on what you can plan and track, using date stamped record keeping processes that track all expenditures claimed as specific line items, each with their own justification. Detailed record keeping is paramount, as is an account of how your company chooses to allocate expenses between your SR&ED work and the other work that is completed external to this CRA programme.

The Traditional Method is calculated, therefore, using SR&ED work as a proportion of total work, and calculating your overhead expenses carefully. Some overhead expenses may not be written off as applying to SR&ED work, though. For example, if you have a production-oriented company where a line manager is usually considered to be overhead, but your SR&ED work does not involve production on that line, that job would not necessarily be included. The receptionist that provides administrative support to all team members could, however, be included.

This is the default method which will automatically apply if you do not select the Proxy Method on the T661.

It should be noted that following the traditional method requires arduous activity-based record-keeping. For any non-R&D cost, you should be prepared to prove that expenses are directly related to SR&ED. You must show that, had your SR&ED project not occurred, these expenses would not have been incurred.

SR&ED Proxy Method

The Proxy Method may be a simpler way to file a SR&ED claim. This approach calculates a percentage for overhead expenses using a previously-determined and prescribed proxy calculation of your SR&ED overhead. This equation is based on all human resource costs directly associated with an SR&ED project.

This easy-to-use approach limits the need for detailed record keeping. The salary base is an amount used to calculate the prescribed proxy amount (PPA). Usually, 55% of all SR&ED labour expenditures is used as the overhead calculation. Using the Proxy Method, a company would still be able to claim all the materials they need for their SR&ED work, but not a prorated amount of their overhead expenditures.

Overhead Cost and the SR&ED program: which method should be used?

What’s important in choosing one method over another is looking at your best-result financial outcome.There are two situations where the Traditional Method will likely result in a larger claim than the Proxy Method.

First, if a company engages contract workers for its SR&ED project, but uses internal support work secondments for SR&ED assistance. In this situation the Proxy Method can only be calculated based on funds paid to project employees alone, so overhead expenses may be inaccurate.

Second, larger companies that have a relatively high overhead may feel the need to accurately calculate that expense rather than rely on the Proxy Method.
Let’s look at an example of a company engaged in an SR&ED project and their expenses.

• Base salaries of project employees: $300,000
• SR&ED project expenses: $45,000
• Actual overhead costs: $150,000

Under the Traditional Method calculations, SR&ED costs that are deductible from their taxes would equal the simple total of these numbers: $495,000.Under the Proxy Method calculations, SR&ED costs that are deductible would equal the first two expenses, $345,000, plus 55% of $300,000, or $165,000. The total that could be expensed would then be $510,000.In this example, therefore, the Proxy Method would be the right choice for the company.It is critically important that if your company chooses the Traditional Method, your team is able and willing to make accurate record-keeping a priority. But, understanding the role of your human resource needs for SR&ED projects is a key part of planning ahead. The more employees you have dedicated to the project as a percentage of the project’s costs, the more valuable it may be to use the Proxy Method.