Shredding tax credits? Why Canada’s biggest R&D program may be funding the wrong innovation

Another concern is that foreign subsidiaries can easily access the program.

The CRA told The Logic it does not keep track of which SR&ED recipients are foreign-owned. For privacy reasons, it does not make public which companies apply for or receive the credit.

However, using the most recent data from the Research Infosource ranking of companies based on R&D spending, The Logic estimates that roughly 23 per cent of the $1 billion in credits distributed in 2016—nearly a quarter-billion dollars—went to foreign firms with subsidiaries in Canada.

“The foreign entity is doing its R&D in Canada, getting SR&ED credits, and the profit from that is earned in a foreign country,” says Charles Plant, a senior fellow at the University of Toronto Impact Centre, whose research on Canada’s patent challenges shows that virtually all patents generated from foreign subsidiaries’ R&D in Canada benefits the economy of another country when commercialized. “If that’s one of the objectives of the program—that we become a branch plant R&D creator—then that’s great,” he says. “But I don’t think that should be economically an objective.”

Beyond concerns of foreign companies’ access to SR&ED, one of the program’s grave faults, critics say, is its propensity to keep companies alive that would otherwise fail, by allowing them to continue to pay engineers, despite not having enough revenue to make the business viable.

“I think we do have a lot of zombie companies that are enabled by it,” says Fung. His concern is twofold: “When a zombie company keeps itself alive, barely, it holds onto talent that might otherwise contribute to the ecosystem,” he says. Meanwhile, these firms tie up investment dollars. “If you have a small startup, it’s more likely to still be funded by angel investors who can’t write off their investment until the company dies,” Fung notes. “Once the company actually shutters, they get that partial return on their tax credit and then can go invest again. So accelerating that natural cycle of birth and death for startups will incentivize a more mobile talent pool.”

Perhaps most problematic, though, is that SR&ED is tying up tax credits in a stage of the innovation pipeline that least needs it. As companies spend more on R&D, the proportion of what they can claim through SR&ED declines, meaning they have to cover more R&D costs themselves. “There’s a real gap in the middle there, at the scale-up phase,” says Douglas. “Our major problem is not with the discovery R&D—particularly in the last few years where we’ve gone from middling to a very strong presence in that ecosystem for startups. But when it comes to scaling that, we’re dead last in the OECD.”

The SR&ED program has been modified a number of times since its inception, often with small, administrative tweaks. In 2011, however, the program came under intense scrutiny, in part over companies hiring third-party tax preparers that filed their claims and collected upwards of 30 per cent of the resulting credit.

In response, the Harper government launched a consultation on the use of contingency fees for the program, and appointed an expert panel—dubbed the “Jenkins panel” for its chair, OpenText CEO Tom Jenkins—to take stock of SR&ED’s value to Canada’s innovation economy.

Since then, the Department of Finance—which oversees policy around SR&ED—has introduced several changes to the program in an effort to quell the public outcry. The government has reduced the general credit rate for large claims from 20 per cent to 15 per cent; businesses hiring third-parties to do R&D can now only claim 80 per cent of that work, down from 100 per cent; and, companies can no longer claim capital expenses, like equipment used for R&D.

At the same time, the CRA has introduced tighter administrative practices to stymie unintended uses of the program. In 2015, nearly 60 per cent of all SR&ED claims were flagged for review. Of those, 27 per cent were subject to a site visit from the CRA for further review, and 60 per cent of the companies checked saw their SR&ED claims reduced. Those numbers were unheard of 10, or even five, years ago, says Plant, who, on top of studying the program, filed SR&ED claims on behalf of the dozen-odd companies he has started or worked for since the 1980s. “Back then, if I made a mistake [filing a claim], the people at Revenue Canada would call me up and help me,” he says.

Stricter oversight is a double-edged sword, says Douglas. On the one hand, it weeds out predatory tax filers and companies taking advantage of the program—problems he says were rampant before the recent changes.

On the other hand, he notes, the stricter administrative environment adds barriers for bootstrapped companies who have long relied on the program as an accessible and reliable cash injection at the end of the year. He now sees more scale-ups forgoing SR&ED, too—as their returns diminish with growth, the likelihood of having their claims rejected isn’t worth the trouble of applying.

Trying to solve Canada’s innovation challenges through the income tax act alone is misguided, Douglas says. One alternative to addressing the scale-up gap or “valley of death,” as it’s sometimes called, is to move towards more direct funding programs—a model recommended by the 2011 Jenkins panel, and which is becoming more popular among other OECD countries.

More than 30 years after introducing SR&ED, the federal government is still grappling with many of the same challenges around improving Canada’s productivity and competitive edge. In Budget 2017, following the government’s analysis the previous year of the dilemma, Finance Minister Bill Morneau announced a review of all business innovation programs. Notably, SR&ED would get its own review “to ensure its continued effectiveness and efficiency.”

Anna Arneson, a spokesperson for the department, told The Logic, “The Department of Finance has been listening to stakeholders and conducting an internal review of the SR&ED tax incentive program,” adding that notice of the review in 2017 “resulted in a relatively high number of interactions with taxpayers about the SR&ED program…. The considerations raised during these interactions are all taken into account in the Department’s ongoing evaluation of the program.”

Arneson did not say when the review would be complete and did not provide further details on its objectives.

By now, many stakeholders are tired of reviews that yield minor amendments to programs designed for past economies that looked vastly different from today’s. “I think you have to look at all the various government programs [for innovation] and restart,” says Plant. “Go back to a clean slate and say, ‘what do we want to achieve, how do we know we’ve achieved it, and what are the levers we want to use to achieve those things?’”

In Budget 2018, the government unveiled a plan to consolidate its suite of business innovation programs, cutting the number by up to two-thirds. The Department of Finance did not say how SR&ED might fit in to the government’s new model for for supporting innovation.