Many companies, especially startups and growing businesses, don’t have all the technical expertise they need in-house. Instead, they rely on software development agencies, engineering firms, contract research organizations, testing labs, prototype manufacturers, design firms, or independent consultants to perform some, or in some cases all, of their R&D.
Most founders and business owners already know that hiring a foreign contractor generally means that those costs won’t qualify for SR&ED investment tax credits.
The trap is assuming that hiring a Canadian contractor automatically makes the work eligible.
If some or all of the SR&ED work is ultimately performed outside Canada, that portion of the contract may not qualify, even if your agreement is with a Canadian company and every invoice comes from a Canadian address.
Understanding where the work is actually performed can make the difference between a fully supportable SR&ED claim and an unexpected adjustment during a CRA review.
Rule #1: Contract SR&ED must be performed in Canada
For a contract expenditure to qualify for SR&ED, the related SR&ED work must be carried out in Canada.
If an entire contract is for work performed outside Canada, none of the contract amount can be claimed for SR&ED.
This commonly arises when companies hire:
- Software developers located outside Canada
- Overseas engineering consultants
- Foreign testing labs
- Contract research organizations outside Canada
- Scientists, engineers or technical specialists working remotely from another country
Rule #2: A Canadian invoice does not automatically make the work eligible
This is where companies get caught.
Imagine you hire a Canadian contractor to support your R&D. You assume the work will be carried out entirely by its Canadian team.
However, the contractor may:
- Assign part of the work to employees located outside Canada
- Subcontract specialized work to an overseas firm
- Complete the project using a combination of Canadian and foreign personnel
The fact that your agreement and invoices are with a Canadian company does not automatically make the entire contract eligible for SR&ED.
If the work is performed partly in Canada and partly outside Canada, only the portion relating to the SR&ED carried out in Canada may qualify.
Rule #3: Mixed contracts must be reasonably allocated
A single contract may include SR&ED work performed partly in Canada and partly outside Canada.
The good news is that this does not automatically disqualify the entire contract.
Instead, the claimant must reasonably allocate the contract amount between SR&ED carried out in Canada and outside Canada.
CRA does not prescribe a single allocation method, but it should be reasonable and supportable. Depending on the circumstances, this could be based on:
- Fair market value of Canadian and foreign work
- Hours spent by Canadian and foreign personnel
- Project phases or deliverables completed in each country
- Technical work records
The important part is that you can demonstrate to CRA how the allocation was determined.
What CRA may examine
During a SR&ED review, CRA may look at:
- The contract
- Statements from the claimant
- Information about the contractors work
- Supporting project documentation
- Where the SR&ED activities were actually carried out
CRA may request information to determine whether your allocation between the Canadian and foreign work is reasonable.
Once that allocation has been established, CRA generally will not look through the contract to determine the contractor’s underlying cost structure when determining your allowable SR&ED contract expenditure.
Questions to ask before signing a contract
If you intend to claim SR&ED, consider asking your contractor these questions before work begins:
- Will all of the work be done in Canada?
- Will any portion of the work be subcontracted?
- Will any non-Canadian employees be working on the project?
- Can Canadian and foreign work be separately identified if needed?
- Can you provide documentation to support where the work was done if CRA requests it?
These questions are much easier to answer at the beginning of a project than during a SR&ED review 1, 2, 3+ years later.
Example
Startup A hires a Toronto software development company for $250,000 to develop an AI platform. Because the contractor is Canadian, Startup A assumes the entire contract will qualify for SR&ED.
During an SR&ED review, CRA asks where the development work was performed. The software development company explains that while project management, solution architecture and QA were completed by the Canadian team, some of the software development was carried out by developers located in Asia.
To support the claim, the contractor provides project schedules and labour allocations identifying which team members worked on each phase of the project and where they were located. Based on this documentation, Startup A is able to reasonably allocate the contract between the SR&ED work performed in Canada and the portion performed outside Canada.
As a result, approximately 60% of the contract is accepted as relating to SR&ED carried out in Canada, while the remaining 40%, representing the work performed outside Canada, is not eligible for SR&ED investment tax credits.
The Bottom Line
Outsourcing R&D is often the right business decision, whether you’re an early-stage startup, a scaling technology company or an established manufacturer tackling a complex technical challenge. But don’t assume that a Canadian invoice automatically means the entire expenditure qualifies for SR&ED.
Understanding who is performing the work, where it is being performed, and how contracts involving both Canadian and foreign work should be allocated can help protect your claim and avoid surprises during a CRA review.
A few questions at the start of a project can save a significant amount of time, and potentially preserve valuable SR&ED tax credits, when it comes time to file your claim.
