Can You Claim Work Done by Contractors in a SR&ED Claim?

In modern product development, engineering, and manufacturing, companies rarely build
everything using a single, 100% full-time internal team. Outsourcing technical milestones to
specialized agencies, freelancers, and external contractors is standard practice.

If your Canadian business pays third-party contractors to solve technical challenges, you can
absolutely claim their costs under the Scientific Research and Experimental Development
(SR&ED) program. However, the Canada Revenue Agency (CRA) views external contractors
through a entirely different lens than standard internal employees.

1. The 80% Rule for Arm’s-Length Contractors

When you hire an independent, third-party contractor—meaning an outsourced company or
individual with whom you share no ownership, control, or family ties—they are classified as an
arm’s-length contractor.

The CRA applies an automatic 20% haircut to these expenditures. You can only input 80% of
the contract value into your qualified SR&ED calculation pool.

Why the reduction? The CRA assumes that 20% of a third-party contractor’s invoice is
allocated toward their own administrative fees, profit margins, and overhead, rather than pure,
direct R&D labor.

The Math: If you pay an independent Canadian agency $100,000 to code an
experimental data-processing engine, your eligible SR&ED expenditure is capped at
$80,000. At the standard small business refundable credit rate of 35%, your cash-back
return on that contract will be $28,000 (federally), before stacking additional provincial
tax credits.
To protect your cash-back return and navigate an audit successfully, you must master the strict
rules governing contractor claims.

2. The Strict Geographic Border Rule

The CRA is explicitly clear on geography: The physical R&D work must be performed
within Canada’s borders. It is incredibly common for Canadian companies to hire a prominent
agency based in Toronto or Vancouver, only for that agency to quietly farm out the actual coding
or testing to developers in Eastern Europe, India, or South America.
If the CRA reviews your claim and discovers the work was executed overseas, the entire
contractor expense will be disqualified, regardless of whether the invoices were paid to a

registered Canadian corporation. When hiring contractors for R&D, your service agreements
should explicitly mandate that all personnel assigned to the project must execute their duties
from within Canada.

3. The “On Behalf Of” Test: Who Gets to Claim?

When two separate companies collaborate on a technical breakthrough, they cannot both claim
the same dollar spent. The CRA determines eligibility by establishing who the work was
performed “on behalf of.” To prove you are the rightful owner of the tax credit, your contractor
agreements must pass two critical tests:

• The Financial Risk Test: Who loses money if the project fails completely? If you pay
  the contractor a fixed fee or an hourly rate regardless of whether their prototype
  successfully works, you assume the financial risk, making you the eligible claimant. If
  the contractor only gets paid upon delivering a flawlessly functioning commercial
  product, they bear the financial risk and may hold the right to claim the work.
• The Intellectual Property (IP) Test: Your service contracts should clearly outline that
  your company retains the ownership rights to any intellectual property, patents, or custom
  code bases generated during the engagement.

4. Arm’s-Length vs. Non-Arm’s-Length Contractors

If you contract work out to a related entity—such as a subsidiary, a sister company, or an
individual contractor who also happens to be a significant corporate shareholder—you are
dealing with a non-arm’s-length (NAL) contractor.

For NAL relationships, the standard 80% contract rule is thrown out. Instead, you are bound by
the CRA Look-Through Rule:

[Your Company (Payer)] ─ (Hires Related Entity) ─> [NAL Contractor (Performer)]
(CRA looks through the contract to find)
[Actual, Raw R&D Costs]
(Salaries, Materials, etc.)

You cannot claim the mark-up or invoice value billed by a related company. You are only
permitted to claim the actual, raw cost of the R&D incurred by that contractor (such as the base
salaries of the employees they used and the raw materials they consumed), without any added
corporate profit margins or overhead additions.

Best Practices for Documenting Contractor Work

Contractor claims face much higher audit scrutiny than standard internal employee T4 claims. If
your claim is selected for a technical review, a folder full of vague monthly invoices reading
“For Software Development Services – $15,000” will be instantly rejected.

To safeguard your funding, ensure you actively collect:

1. SOWs with Technical Boundaries: Ensure Statement of Work (SOW) documents
   outline the specific technological uncertainties the contractor is hired to solve, rather than
   just a list of commercial product features.
2. Itemized Invoicing: Ask your contractors to separate eligible experimental testing and
   architecture design tasks from ineligible tasks (like UI/UX styling, bugs, or content
   creation) directly on their invoices.
3. Timesheets and Logs: Ensure your contractors can back up their billed hours with clear
   project logs, Git commit histories, or sprint tracking summaries showcasing their
   systematic testing loops.