Claiming Contractor Costs in SR&ED: The Rules and Pitfalls
Using external contractors for R&D is common in software, but the SR&ED rules surrounding them are complex. Learn how to maximize your eligible contractor expenditures.
Many software startups rely heavily on external contractors, freelancers, and development agencies to build their products. While consulting fees are generally eligible for SR&ED, there are crucial restrictions that often catch founders off guard.
The 80% Rule for Canadian Contractors
The most important rule regarding SR&ED contractors is the 80% limitation. If you hire a Canadian contractor to perform SR&ED on your behalf, you can only claim 80% of the invoiced amount in your eligible expenditure pool.
Why? The CRA assumes that the remaining 20% represents the contractor's profit margin and non-SR&ED overhead, which are explicitly ineligible for the credit.
The "Performed in Canada" Requirement
SR&ED is designed to stimulate the Canadian economy. Therefore, the CRA strictly requires that the SR&ED work be performed in Canada.
If you hire a Canadian contracting firm, but they outsource the database architecture to developers in Eastern Europe or South America, that portion of the invoice is ineligible. You must obtain documentation from your contracting firm confirming that all claimed activities occurred within Canadian borders.
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T4A Reporting Requirements
When you claim contractor expenditures for SR&ED, you must demonstrate to the CRA who performed the work. This requires filing T4A slips for your Canadian contractors and providing their Business Numbers (BN) or Social Insurance Numbers (SIN) on the T661 form.
Failing to provide this information can result in the entire contractor portion of your claim being denied.
Arm's Length vs. Non-Arm's Length Contractors
The CRA treats "arm's length" (independent, third-party) contractors differently than "non-arm's length" (related or affiliated) contractors.
If you hire a development agency owned by your sibling or a holding company you also control, they are considered non-arm's length. In these cases, you cannot claim the invoiced amount. Instead, you can only claim the actual underlying eligible costs incurred by the related contractor (e.g., their employee salaries or direct materials).
Key Takeaways
- Ensure your contracts explicitly state that the work must be performed in Canada.
- Always collect the Business Numbers or SINs of your contractors before filing.
- Remember that only 80% of arm's length Canadian contractor fees are eligible.
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