WHEN SHOULD CLAIMANTS CREATE TECHNICAL DOCUMENTATION?
(and when should they assemble it?)
Preparing for an “SR&ED” (Scientific Research and Experimental Development) tax audit should really begin well before your company receives notification that your claim is under review. In fact your company should begin assembling supporting documentation at the same time that you decide to perform eligible SR&ED.
As we’ll see later on from the audit letter itself (see Section 3 on page 2 of the letter), there is an expectation that the documentation was developed at the time the work was being performed. It has been our experience that claimants like to assemble that information only after they receive notification of audit. Presumably they do this in the hopes that they won’t be audited. There are 3 serious problems with this approach:
The chances of being subject to an audit have increased significantly in recent years. It is our belief that claims prepared on a contingent (i.e. success-based) basis receive special attention from CRA. Regardless of the engagement terms, the doubling of SR&ED audit staff means that an SR&ED audit is far more likely.
- Documentation assembled after the fact may not have existed before the audit letter was issued – and therefore can’t be construed as ‘contemporaneous documentation‘. If this is apparent to the auditor, the CRA might elect to deny your claim in its entirety for lack of ‘acceptable’ documentation.
- The CRA generally provides 30 days of lead time to assemble supporting documentation. However they don’t communicate by email, but by letter or fax. This effectively reduces the available time to respond by a week or so – and as you’ll see, the amount of documentary evidence requested is considerable – particularly if it wasn’t identified before the claim was filed.
DO CONTINGENT FEES INCREASE AUDIT RISK?
Commencing in January of 2014, claimants are required to disclose the nature of any billing arrangement with a third party claim preparer. While the CRA denies that this section is used to screen files for audit, the CRA would hardly disclose how they in fact do screen files for audit – since this is really their ‘secret sauce’.
Certainly it is our experience that files prepared on a contingent basis are far more likely to be audited than those done on an hourly basis.
WHAT KIND OF DOCUMENTATION DOES THE CRA EXPECT?
The CRA expects claimants to develop ‘contemporaneous’ documentation detailing plans to overcome technological uncertainties and achieve the desired advancement.
Note that the suggested format presupposes sophisticated activity-based costing – from small businesses that are often challenged maintaining rudimentary books and records on a timely basis.
MAPPING SR&ED TO PRODUCT DEVELOPMENT – WHAT IS THE CHALLENGE?
The Income Tax Act requires that SR&ED activities be “related to a business of the taxpayer”.
In fact 95% or more of SR&ED claims relate to the experimental development of new and improved products or processes – which clearly relate to a business. However even the most sophisticated claimants have difficulty distinguishing between the new features of the product or process and the technological advancement required to deliver these ‘new features’.
The engineers who develop those new products don’t explicitly hypothesize about how to overcome technological uncertainties. Instead they focus on development plans for the new features or products. Determining what work is eligible usually involves inferring from the development plan, what technological uncertainties existed and what their ‘hypothesis’ was – often many months after the work was done.
All of which makes it difficult for them to provide contemporaneous documentation of their SR&ED activities – since contemporaneous documentation exists for the entire product development process – and not the more narrowly-focused SR&ED activities.
EXAMPLE OF AN AUDIT LETTER