SR & ED Audit : what do you say ?

The audit by the CRA is certainly THE crucial moment in the claiming process for SR & ED tax credits. We cannot avoid an audit, but we can certainly minimize it’s negative impacts. In earlier articles in this series, we established the need to understand the audit issues, we discussed who will be present and how to prepare them for what. In this article, we discuss what main argument we have to build,  what do we show in order to convince the CRA.

Explain what ?

It is essential to present the project as a systematic experimental process and to justify the efforts claimed as reasonable for achieving this process.

1- Explain the systematic experimental process

The key phrase is experimental process, experimental process and experimental process. Repeat after me … experimental process

The ideal presentation of the project is to explain how our development process was experimental and systematic. The language must be technological (or scientific), but not commercial (talking about the needs or expectations of customers).

• Objectives: each project must be presented as if one views only the technological or scientific side. Still we have to give a context to the project, so we start with the business objectives (very quickly because it is not eligible) but we soon jump into the technological objectives.
• Status at the beginning: We explain where we were technologically at the beginning of the year (if this project is a continuation of last year) or of the project.
• Advancement and uncertainty: the advancement or progress is the result sought by the SR & ED, while uncertainty is the motivation for initiating the SR & ED. Therefore, an attempt to achieve progress is an attempt to resolve uncertainty. It is often easier to define uncertainty from the standard practice based on existing technology and from the basis of expertise available in the company and on the market. Uncertainty becomes exceeding this standard practice.
• Uncertainties and process: We explain the technological issues (uncertainties) from the objectives. We identify an initial hypothesis to solve each of these issues. According to the CRA, an hypothesis is an idea, based on the facts known at the beginning, which serves as a basis for a comprehensive study to prove or disprove this idea. We then explain the process, the work carried out, the experiments and trials, the errors and conclusions drawn from these results. If the uncertainty is not resolved, we then issue a new hypothesis and so on until the uncertainty resolution. The technological advancement will be achieved (or not) as a result of the resolution of the uncertainty.
• Status at the end: We explain where we stand at year end (if this project continues the following year).

We have described an ideal systematic process. It is not always possible to describe such a perfect process. But we must stick to this structure as much as possible if we want to convince the CRA auditor that we have managed a SR & ED process.

2- Demonstrate reasonable costs

Here, the demonstration aims at highlighting the distinction between the activities of this SR & ED experimental process from the regular R & D developments required for our customers and our technologies. We must show traces of distinctive choices. This results in a few key issues, including:

• Were claimed employee hours identified and linked to activities necessary in the experimental process to resolve the uncertainties?
• Did you show the distinction between the total costs and the SR&ED costs ?
• Are the managers hours claimed directly related to the experimental development activities?
• Does all the staff claimed fit into a technical role?
• How do you explain the resources or projects claimed as SR & ED at 100%? (This means that these resources have performed experimental development activities only from January 1 to December 31)
• Do your contracts for your subcontractors specify that :
  • they make SR & ED activities on your behalf, and
  • you retain all rights to this technology?
• Are your customer’s contracts labelled for the delivery of a good or service rather than providing research hours?

This is only an overview of issues for which the CRA financial examiner will want answers. Your guideline should be to demonstrate that the expenses claimed are reasonable.

Build a preliminary presentation of the project

This presentation will answer the 5 eligibility questions for each project. This preliminary statement will be presented to your employees at the first preparatory meeting. They will be rework and adapt it to their language, to their presentation style.

In the next article we discuss what happens at the audit meeting.

What do you think ? Have you lived audits where you had no idea what to say? How have you prepared (or not)? What were the results? What lessons have you learned? Why ?