Richard Hoy is president of the tax advisory firm Catax Canada.
Businesses of all kinds can claim research and development tax incentives, but it’s not just what you did that matters — who you did it with matters, too.
One of the biggest hurdles that accountants need to be aware of is the impact that partnerships can have on claims.
Businesses that are legally structured as partnerships are not excluded from the right to claim investment tax credits (ITCs) for SR&ED. However, partnerships that participate in the SR&ED program may find the process much more complex than normal corporations. Major differences in the treatment of partnership entities may result in reduced benefits. It is essential to take this into account before making a claim for SR&ED expenditures and credits.
Being aware of this can empower accountants to help their clients ensure that they receive the maximum benefit possible. Corporate clients may even take a different approach to how they enter into partnerships once they realize the importance of different partnership structures.
Partnerships and SR&ED
At first glance, the rules surrounding partnerships are not easy to understand. This is because the Income Tax Act does not define a partnership, it simply describes the tax consequences if a partnership exists.
The important thing for accountants is that for tax purposes, a partnership does not have a separate existence from its partners. Therefore, a partnership does not file a tax return and the income is not taxed at the partnership level.
Since a partnership is not a taxpayer, it cannot earn ITCs either. Therefore, all ITCs are calculated at the partnership level, but then allocated to some or all of the partners, who may be individuals, corporations or trusts.
The main difference for partnerships is that SR&ED is less generous and capped at 15% of eligible expenditures, even if the partner is a Canadian-controlled private corporation or a qualifying corporation. Basically, this reduced ITC rate of 15% is also only partially refundable; where a partnership has no tax payable in the year, only 40% of the total ITC of 15% can be refunded.
The main task facing the members of a partnership is to determine what their share of the ITC is. It must be “reasonable” and generally reflect their share of the partnership’s income or loss, as agreed by the members.
Eligibility rules also govern “partners” who are entitled to receive a share of any ITC, as part of a partnership with multiple members. “Specified members” are not eligible. These are partners who, in a given tax year or financial year, fail one of these three tests:
- been a “limited partner” at all times
- has not been substantially involved in the activities of the partnership on an ongoing basis throughout the year (funding alone is not sufficient)
- not have carried on a business similar to that of the partnership
A “limited partnership” has at least one general partner and one or more limited partners, who generally invest or contribute assets to the partnership, but do not participate in the management of the partnership’s business. A “general partnership” is made up of two or more general partners, and is often simply called a general partnership.
To be considered actively engaged in the activities of a partnership, a member would normally be expected to devote time, labor and attention to the activities of the partnership to an extent that has a significant impact on its proper functioning. . A partner who does not participate in the management of the business at all would certainly not be considered actively engaged.
Where there is a specified member, any ITC that would have been allocated to that member is shared among the other partners, but not necessarily on the same terms. The partners can decide what is reasonable in the circumstances and take into account the investments made by different partners, as well as the debts of the partnership and the individual members.
What might this look like in practice?
Example: A partnership with three members, who are individuals, claims SR&ED expenditures and ITCs. They include an active general partner, a specified member who is not a limited partner (a passive general partner) and a specified member, which is a limited partner (and by definition a specified member).
Each partner contributes $30,000 to the partnership, and the partnership borrows $20,000 from the bank, creating $110,000 of available funds. The partnership agreement stipulates that the members share the profits (and losses) in proportion to their capital contributions (one third each). The partnership spends $30,000 in qualified SR&ED expenditures, creating ITCs of $4,500 ($30,000 x 15%). According to their partnership agreement, each partner would be allocated one-third of the $4,500 ITC. However, the Act precludes allocating ITCs to specified members, of which it has two.
The allocation would be $1,500 ITC for the Active General Partner and $0 for the two Specified Members, leaving $3,000 ITC unallocated. In this example, there is only one unspecified member of the partnership, so that active general partner would receive all available partnership ITCs.
Firms owned by partnerships that perform SR&ED should review their status and involvement annually in light of these rules. The need to do so will be particularly acute for members who, even though they invest a great deal of time and money in a partnership, find that they still cannot claim SR&ED ITCs because they are classified as “determined members”.
Richard Hoy is chairman of the specialist tax consultancy Catax Canada. You can reach him at [email protected].