Alarm Bells Sounding Over Rumoured SR&ED Changes

First published on March 2, 2012 on Digital Puck: Connecting the Canadian technology community.

by John Ruffolo

The Canadian Federal government announced it is releasing the next Federal Budget on March 29, 2012. There are rumours the Budget could include changes to one of the most successful and globally-recognized Innovation programs that Canada has to offer – the SR&ED tax credit. As you know, in many ways, the SR&ED program is the foundation of a future based on innovation and a strong, knowledge-based economy.

My concern largely rests on comments made by the Federal government about recommendations made in the recently-released Review Panel of Federal Support to Research and Development, otherwise known as the Jenkins Report.

The Jenkins Report has some very good suggestions on how the government could be far more efficient in delivering and administering its various innovation-related programs. I fully support those initiatives.

The following recommendation, however, is one that generates great concern:

“Reduce the amount of SR&ED tax credit assistance by introducing incentives that encourage the growth and profitability of small and medium-sized enterprises (SMEs) while decreasing the refundable portion of the credit over time. Redeploy the savings to fund new and/or enhanced support for innovation by SMEs, as proposed in the Panel’s other recommendations.”

It’s uncertain whether the Federal government will act on this recommendation.

Although it is still only a rumour at this point, the notion of altering the SR&ED program is setting off alarm bells right across the country.

Let me give you 5 reasons why I think such a recommendation is a very bad idea.

#1 The SR&ED tax credit supports, rather than detracts, from Canadian productivity

One of the arguments for altering the SR&ED tax credit is that the more we invest in it, the more our overall productivity decreases. This is a fallacious argument. I do believe we have serious issues in productivity in Canada. However our productivity problems are most closely linked to sectors requiring significant capital investment, including manufacturing, processing, distribution and retail.

Our technology companies in Canada are trying to sell their technology solutions to such companies in Canada, but most end up being far more successful selling their innovation to customers outside of Canada. Much was written about all the spending manufacturers were going to make for new innovative machinery when our dollar hit parity with the US dollar. It didn’t happen.

#2 The SR&ED tax credit is the funding lifeblood for building strong Canadian tech companies

We are all well aware that the financing ecosystem for technology companies in Canada is broken. Between 2000 and 2010, venture capital invested in Canada decreased over 80 per cent from approximately $5.9 billion to $1.1 billion, with the number of companies receiving venture capital decreasing over 64 per cent from 1,007 to only 357 during that same period. How does the technology industry survive such a devastating blow? It is the SR&ED tax credit program, and in particular, the refundable SR&ED tax credit for early stage Canadian controlled private corporations. It is their lifeblood. It is practically the only source of financing for most of these companies in Canada. The entrepreneurs use these funds to hire more people, largely engineers, to build their products so that one day, they become medium sized businesses and hopefully global businesses. Taking the refundable tax credit away from companies when they are most vulnerable makes no sense; in fact, if you take it away at this stage, I can assure you that there won’t be many medium sized companies to give the re-deployed dollars to. Furthermore, once a company has customers and is generating material revenues, their alternatives in obtaining funding open up considerably.

#3 The SR&ED tax credit program is a small business jobs program

The Finance Minister has commented that the March 29 Budget “…is a jobs and growth budget”. So, what do our early stage entrepreneurs do with the proceeds of the SR&ED tax credit you ask? Well, aside from some computers and some fancy software, the money is spent on jobs! Jobs focused on innovation – software engineers, product development engineers, etc. Jobs that pay well and have a disproportionate impact to the wealth of our nation. These jobs mean that the brilliant graduates who leave our great schools stay here in Canada and become our future leaders of tomorrow. These entrepreneurs and employees are completely mobile and they will follow the money (i.e. jobs) wherever they might be if we don’t have them available in this country. By curtailing the SR&ED program, are we adding one more reason for our talented technology entrepreneurs to seek greener pastures?

#4 Do we believe that the government is more efficient than the private sector in allocating scarce resources?

This is really an argument about tax policy. If you are an economist, ideally there should be no distortions (either incentives or penalties) in the marketplace that might impact the allocation of scarce resources in a private market economy. In reality, there are a huge number of distortions that already exist in our tax code which aim to incent things that you want and disincent things you don’t want.

Let me give you an example. Why is Canada the global leader in mining and resource finance in the world? The answer – flow-through shares. The flow-through share program is largely a made in Canada invention and it has been wildly successful. It forms the foundation of the early stage junior mining industry (much like the role the SR&ED program plays in the technology industry). Do you think there is a hint of discussion of killing this program? Not a chance. I view the flow-through share program as a government supported program in which the private sector determines where to allocate the capital. The government provides a 45% rebate back to the investor (in the form of tax deductions at the highest marginal tax rate); that’s even higher than the 35% refundable SR&ED tax credit. The company raising the capital then takes the money and invests it in prescribed activities within a prescribed time frame.

The SR&ED program is very similar. The company decides what to do with the capital as long as it does so in a prescribed manner within a prescribed time frame; the difference is that the company receives the tax benefit to redeploy back into the company and create more jobs. The suggestion that the government should decrease the refundable credit and redeploy such funds to later stage companies (who have more options as noted above) at the direction of the government is a fundamental policy change. Rather than making these decisions, I believe the valuable role government can play is to provide the financial tools and the environment necessary to permit the winners and losers to emerge on their own merits in the private sector.

#5 The perceived abuses of the SR&ED tax credit system have been over-hyped

There has been a lot of talk around rampant fraud and abuse being associated with the SR&ED tax credit program. The problem is there are no facts to back this up. Whenever I ask for the facts, no one seems to have answers about how this conclusion was reached, other than some anecdotal stories.

One of the key points raised to suggest people may be manipulating the system is the use of advisory firms to help prepare SR&ED claims. I disagree with this wholeheartedly. Advisory firms are primarily used because the process is so complex. If it was simplified, along with the entire tax code, more people and companies would be able to file their SR&ED claims (and their income tax returns) on their own.

Also, the market for the assistance of such claims is dominated by a few very large reputable firms. Do you really think a large firm will risk its reputation with CRA for a few extra dollars? Not a chance. Furthermore, many of the engagements entered into with such firms backstop the defense of the claim all the way up to a challenge in court, all at the expense of the firm. Therefore, they are neither financially nor reputationally incented to prepare egregious or aggressive claims.

Now, perhaps there have been some organizations which don’t really care about their reputation with CRA and take their chances in the hope of receiving contingent fees today and playing the audit roulette tomorrow. But, if that is the real problem, then target that problem and shut it down. For example, the practice of contingency fees could be eliminated. Or, perhaps the government introduces a joint penalty of perjury attestation for both the advisor and CEO of the company supporting that the claim is in their view supportable. If there is not sufficient reasonable support to make the claim, a gross misstatement penalty could be assessed in similar fashion to the transfer pricing misstatement penalty provisions that exist in the tax code today.

Of course, there may occasionally be egregious (and possibly even fraudulent) SR&ED tax credit claims and we need to stop this. But to suggest it is a significant and widespread problem is irresponsible.

We all face challenges in a time of high deficits and constrained spending. Building a 21st century Innovation strategy need not be expensive. It isn’t about billion dollar bailouts or trying to create an industry where none exists today. We have one of the greatest Innovation programs in the world; it is envied and many countries have tried to copy it. We should look at ideas to deliver it more efficiently and eliminate any abuse, but let’s not throw out the baby with the bath water!

We live in the greatest country in the world. We have been blessed with what this country has provided us. It is now time to think about our long term future from an industrial strategy perspective. We need to allow our children and our children’s children to enjoy the same or better quality of life that we have enjoyed. We can make Canada the envy of the world. We can make Canada the Innovation Nation!

John Ruffolo

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