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At Derrick Fung’s startup, the loyalty-and-rewards app Drop, is preparing to make claims under the SR&ED program.

J.P. MOCZULSKI/The Globe and Mail

Entrepreneur Derrick Fung knows what it's like to get a visit from the Canada Revenue Agency to have his company's claims reviewed under the Scientific Research and Experimental Development tax incentive program.

It was in 2012 with his last company, Tunezy, a website that provided unique music experiences such as backstage passes, which was sold to U.S. music promoter SFX Entertainment in 2013. Auditors came to Tunezy's Toronto office to interview its engineering team and learn more about the company's claims under SR&ED.

"It wasn't super-daunting. It was fair," says Mr. Fung. "But it's something you need to be ready for."

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SR&ED enables companies to earn investment tax credits on qualified expenditures either in the form of a cash refund, a reduction in taxes paid, or both. Companies can qualify if they have performed research and development to create a new product or process or improve an existing one.

CRA cracking down

The CRA has been more stringent with the program in recent years, which has led to a drop in the volume of claims and the number of filers. The CRA said it processed 24,300 claims, providing about $3.1-billion in investment tax credits in 2014-15, the latest figures available, down from 30,500 claims and about $3.5-billion in credits in 2010-11.

A CRA spokesperson noted that the 2012 federal budget made the SR&ED program "more cost-effective and less generous," and measures in the 2013 federal budget were made "to address non-compliance and protect the fiscal integrity of the SR&ED program." The 2013 changes also added more resources to review SR&ED claims, "where the risk of non-compliance is perceived to be high and eligibility unlikely," and more penalties for false statements or omissions.

"These budget announcements, along with the ongoing compliance activities conducted by the CRA, may have affected the intake of claims," the spokesperson said in an e-mail response to questions.

Ottawa said in its most recent budget that it's reviewing the program to "ensure its continued effectiveness and efficiency." There have been calls for the government to provide more direct subsidies to simplify the program.

Administrative headaches

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Many newer companies are unprepared for the administrative burden that comes with filing SR&ED claims, says Bryan Watson of Toronto-based Flow Ventures, a consulting firm that helps companies navigate the process.

Some startups don't realize until they are halfway through a project, or it is been completed, that some of their work qualifies, Mr. Watson says. The company then has to go back and try to document it.

Another problem arises when a company doesn't have the proper evidence to back up its claims, including detailed time sheets or something equivalent showing the number of hours spent.

"If you do the work, you're entitled to it … but it needs to be 100 per cent buttoned down," says Mr. Watson. "I don't know of many people who love time sheets, but companies really do have to make sure that they're documenting things properly. When they don't is when they get into trouble."

If the documentation isn't complete, the CRA can come back with a verdict of "unsubstantiated," Mr. Watson says​, even if they believe there was technological advancement or knowledge gained.​

"The best remedy for that is to have the best documentation possible."

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SR&ED 'not easy money'

Companies can appeal the results, but it can take months or even years — and a lot of resources. That's time and money that startups would probably rather spend building their businesses.

Also, tax refunds can be delayed. Some arrive in less than two weeks and others take up to six months or more, Mr. Watson says. If the CRA performs an audit, that will likely result in further delays.

"It's not easy money," says Markus Latzel, chief executive officer of the Toronto-based web content-management company Palomino Inc., which has applied for SR&ED credits for about half of the 15 years it has been in business.

Mr. Latzel says companies need to make sure they separate operating expenses, such as the cost of office space, from experimental work, such as software development. "The key is to track them separately right from the get-go so that later on it's easier to claim," he says.

At Mr. Fung's current startup, the loyalty-and-rewards app Drop, an accounting team is focused on preparing the proper financial and operating information required to make SR&ED claims.

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"It requires the engineering leads to spend time writing up pretty in-depth reports on why what we're building constitutes R&D," Mr. Fung says. "It's 100-per-cent worth it if you have a process in place."

Mr. Fung prefers to treat SR&ED as a bonus, instead of relying on the funds to run his business. "If we need an extra financial buffer to get us to the next round of financing or milestone, SR&ED is super helpful," Mr. Fung says.

At Palomino, SR&ED has been an incentive for the company to do more R&D to help it grow.

"Normally, as a small company, you might shy away from that because there is uncertainty. You might want to put more money into something that's more predictable," says Mr. Latzel. "SR&ED has helped us to make those decisions."

Karl Moore sits down with Cornell’s Chris Marquis to discuss how the economy and environment interact in China Special to Globe and Mail Update

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