Costs & Financials

The $40,000 Mistake Most Founders Make With Contractors

Most Canadian tech founders who use contractors for R&D work are either leaving tens of thousands on the table — or claiming amounts CRA will claw back. The 80% rule sounds simple. In practice, it trips up almost everyone.

Daniel Croft · Founder Finance Contributor 2026-06-04 7 min read

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The call most founders don't expect

Jamie runs a Vancouver SaaS company. Twelve employees, about $900K in annual engineering payroll, and a healthy mix of full-time staff and contractors. She filed her first SR&ED claim last year — a solid $185,000 in qualifying expenditures — and felt good about it. Her CPA was experienced. The narratives were strong. The time allocation was well-documented.

Three months after filing, CRA came back with a question. Not about the narratives, not about the technical uncertainty descriptions. About two of the contractors.

One was her former CTO, now operating through a holding company. The other was a developer who worked almost exclusively for Jamie's company but had incorporated in 2022. CRA's question was precise: were these parties at arm's length from the corporation? And if not, would she like to recalculate the SR&ED contractor expenditures for those engagements?

The answer cost her $38,000 in claimed credits. Not because the work didn't qualify — it did. But because she'd claimed the full contractor amounts, and the rules say you can only claim 80% of contractor costs, and only for contractors who are genuinely dealing at arm's length with your company.

This story plays out constantly in SR&ED claims. The contractor provisions sound simple on paper. In practice, they're where well-prepared claims most often have errors — both in the direction of underclaiming (forgetting contractors entirely) and overclaiming (not understanding the arm's-length requirement).

The 80% rule — and why it exists

When you pay a contractor to do SR&ED work, you can't claim the full invoice amount. You can claim 80% of the payment. The other 20% is excluded, period.

The reason is structural: the contractor themselves may also be filing an SR&ED claim for the same work. CRA caps what a corporation can claim on contractor payments to prevent double-counting across the two claims. The 80% is a rough proxy for the cost of the work after stripping out the contractor's margin and overhead.

The math: you pay a contractor $100,000 for qualifying R&D work. Your SR&ED claim includes $80,000 for that engagement. At the 35% federal CCPC ITC rate, that's $28,000 in refundable credit — not $35,000. The 20% haircut is real.

This is the easy part. Most founders know the 80% rule exists, even if they occasionally forget to apply it. The harder part is the arm's-length requirement — and it has teeth.

Arm's length: the test nobody explains clearly

CRA only allows you to claim contractor SR&ED costs if the contractor is dealing with your company at arm's length. An arm's-length relationship means neither party is controlled by the other, and there's no non-commercial relationship influencing the terms of the engagement.

That sounds abstract, so here's the version that matters in practice.

A developer you found on Upwork, hired at market rate, who has multiple other clients: almost certainly arm's length. Their rate is market-driven, they don't depend on your company, and there's no hidden relationship.
Your co-founder's spouse who also happens to be a developer and billed you $80K last year: probably not arm's length. CRA assumes non-arm's-length when related parties are involved, and the burden of proof is on you to demonstrate otherwise.
Your former CTO who left to consult but only works for your company: depends. If they've incorporated and are genuinely managing their own business, billing at arm's-length rates, and have other clients, it can qualify. If they're effectively a de facto employee operating through a corporation, CRA may disagree.
A development agency with 50 clients that also happens to be partially owned by your largest investor: the ownership link creates a related-party question that needs CPA-level review before claiming.

The most expensive version of this mistake: claiming non-arm's-length contractors at 80% of cost, having CRA reclassify the relationship, and then discovering that non-arm's-length contractor payments don't qualify at all — not at 80%, not at any percentage. It's a complete disallowance, not a partial one.

What happens when you get it wrong

Back to Jamie in Vancouver. Her former CTO was billing through a holding company, working almost exclusively for her company, at a rate his company set based on his previous employment salary. CRA concluded he wasn't at arm's length — not because they assumed bad intent, but because the facts didn't demonstrate a market-driven, genuinely independent relationship.

The $95,000 she'd paid him for qualifying work got disallowed entirely. Not reduced to 80%. Disallowed. Her SR&ED claim dropped by $95,000, which meant her refundable ITC dropped by $33,250. She also had to pay back what had already been processed.

The developer who'd incorporated: different story. He had four other clients, billed at prevailing market rates for a React specialist in Vancouver, and had an engagement letter with clear scope and deliverables. CRA accepted the arm's-length relationship. His $40,000 contribution to the claim stayed in — at $32,000 after the 80% adjustment.

The lesson Jamie took from this

Before filing year two, Jamie did a contractor review with her CPA. For every contractor billing more than $20,000 in SR&ED-adjacent work, they assessed: Does this person have other clients? Are we their primary source of income? Is their rate market-rate for their skills? Did we negotiate the rate or just accept a number? For the grey-area cases — the ones where the relationship was ambiguous — they documented the arm's-length basis and kept that documentation in the file. 'Audit insurance,' her CPA called it. 'If CRA asks, you have the answer ready instead of reconstructing it.'

The underclaiming version of this mistake

There's a mirror-image error that's less dramatic but more common: forgetting contractors entirely.

Many founders assume SR&ED is only for employees. It isn't. Arm's-length contractors performing qualifying R&D work are claimable — at 80%. For a company that relies heavily on contract engineering talent, this is a material pool. A company spending $300,000 annually on qualifying contractor work can claim $240,000 in SR&ED expenditures from those engagements alone.

Don't forget these

Freelancers on Toptal or Upwork who contributed to qualifying technical projects. Development agencies engaged for specific R&D problems. Specialist consultants (ML engineers, data scientists, security researchers) engaged for defined technical investigations. Academic researchers engaged through university partnerships — these have specific rules but can qualify. All 80% eligible if at arm's length.

The practical implication: when you're reviewing your engineering cost base for SR&ED purposes, don't stop at payroll. Look at contractor invoices, professional services lines, and technical consulting engagements. For each one, ask: was this work qualifying? Was the contractor at arm's length? If yes to both, 80% of that cost belongs in your claim.

This guide is for general information only. SR&ED contractor rules are specific and depend on the facts of each engagement. Arm's-length determinations are fact-specific and should be reviewed by a qualified Canadian CPA before filing. All claims should have professional review.

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