Innovation and SR&ED tax credits

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By Chris Bodnar

Over the past few years, Canada’s global innovation ranking has been called into question. The Conservative government, concerned with Canada’s poor results, has commissioned an expert panel to review Canada’s ranking and related innovation funding and support programs and to make recommendations for improvement.

According to the Conference Board, Canada ranks 14th in a list of 17 peer countries.

However, Canada’s funding of innovation ranks second among these countries. Canada’s pharmaceutical/biotech industry’s innovation performance mimics Canada’s overall ranking among the OECD countries.

If Canada is providing substantial funding, why don’t we rank higher on the innovation scale and what can we expect from government programs to fund Innovation?

The conference board defines innovation as “the ability to turn knowledge into new and improved goods and services.” In addition to this brief definition, I would add that the definition also includes the ability to export these new and improved goods and services. This is based on the fact that exports are one of the key criteria used to rank a country’s innovation performance.

So why doesn’t Canada rank higher? Some comments have been made that our resource industries, which comprise a large portion of our GDP, have preserved their existing commercial production methods and have not advanced new processes. Others suggest having too small a domestic market to reach critical growth along with the difficulty in establishing a viable business in foreign markets as possible causes. These are excuses.

The real questions are “What is needed to be done to improve innovation?”, and secondly, “What role does government funding play in this area?” When we look at countries that are successful, there seems to be both a consolidated vision and focus on innovation. The US does this in a number of industry areas, but countries like Switzerland have excelled in select areas of concentration, such as pharmaceuticals.

Vision comes from leadership. Focus is the single minded effort of an organization to achieve its vision.

Who, then, is responsible for setting the framework for innovation leadership and vision? In his recent State of the Union address, the U.S. President urged investment in various sectors to increase innovation.

The government can go a long way to establishing a vision and call to action.

Many other government leaders in other countries are delivering the same message.

To implement innovation requires resources, including funding. In Canada, the largest component of the $7 billion in annual funding for innovation is the Scientific Research and Experimental Development (SR&ED) program, which is now providing annual funding of approximately $4 billion.

Other funding comes from targeted government grants.

A 1997 study published by Finance Canada and Revenue Canada concluded that the federal SR&ED credit generates $1.38 in incremental R&D spending per dollar of foregone tax revenue. A further study in 2007 (Parsons and Phillips) concluded SR&ED tax credits generate a net economic benefit.

Apart from positive econometric studies, funding of this nature can be greatly accelerated with the right framework in place as well as vision and leadership.

There is currently a large push in the US to increase their R&D tax credit program. The Information Technology and Innovation Foundation have prepared a report on the significant limitations on the current U.S. R&D tax credit. In addition, draft legislation has been pending to increase the credit.

In the UK, Lord Richard Dyson submitted a report which is currently being considered by the Tory government. In the report he is urging the government to increase the tax relief for small and medium sized businesses developing new and improved products and processes.

France introduced a new R&D tax credit program in 2009 which provided for refundable credits for virtually all French companies of 30 per cent (and in some cases up to 50 per cent) of qualified expenditures.

By definition, SR&ED tax credits in Canada fund two main areas: basic and applied research and experimental development.

However, experimental development is where most claims are made under the SR&ED program. To make a claim under this category, a business needs to be creating or improving a new product or process.

Extrapolating the SR&ED tax credit program funding of roughly $4 billion for experimental development each year, Canadian companies are creating or improving products or processes at a total cost of approximately $17 billion.

There is one statistic that I believe is very important to keep in mind when discussing SR&ED tax credits in Canada: each year roughly 25,000 companies claim for SR&ED. Of the $4 billion given out each year, roughly 1,500 or 6 per cent of the companies making claims, receive roughly $3.2 billion or 80 per cent of the SR&ED funding. The remaining 23,500 companies receive $800 million of the SR&ED funding.

This statistic is comparable with the claims made in the US and other countries giving out R&D tax credit funding.

The other important point to keep in mind is that governments provide incentives in part to deal with economic inequities. Small companies have a difficult time obtaining bank loans to finance receivables let alone product or process development. Small companies have to finance innovation from profits whereas large companies have access to capital markets.

Thus, it is important to keep in mind that these two groups face different issues and receive substantially different levels of government funding.

In terms of why SR&ED is important and how it fosters innovation, the following comments are provided

1.     Tax credits are a fair and more objective manner of distributing funds to business as opposed to government grants. My experience is that grants tend to provide little certainty to business that funding with be received. Grants tend to be underfunded for the applications received with a small percentage of applicants actually receiving funding leaving the decision to the government to decide who should receive funding.

2.     The SR&ED tax credit program is doing exacting what it is intended; focusing companies on developing new products and processes.

3.     If the government wants a practical simple solution to trimming the SR&ED funding, eliminate the 18-month filing requirement and reduce it to six months. This time frame is when corporate tax returns need to be filed. Further, if a company does not see the value in filing early to receive funding or tax savings, then it either does not require funds or its business processes need improvement.

4.     Our firm’s experience is that Canadian companies, especially small and medium sized businesses, will opt to develop their own product or process as opposed to purchasing the technology, which is a more prevalent course of action in the U.S.

5.     There is very little statistical information provided by the conference board on how small business supports and contributes to innovation. Generally all statistical information is sampled from large business. It is also interesting to note the expert panel reviewing innovation and the SR&ED program have no small business representation on the panel.

6.     Virtually every country in the OECD, ( U.S., UK, France, Australia, Japan and Ireland) is moving, or recently has moved, to increase their R&D tax credit program. Apparently Germany is set to bring in a R&D tax credit program soon. R&D tax credits are the choice to assist innovation in OECD countries. Further, India and China have R&D tax credit programs.

7.     From working in other countries our firm has come to appreciate how competent Canadian firms are at developing new products and processes on time. I have heard this comment from engineers and other professionals who have worked in other countries like the US and UK. If we have a weakness I think marketing, selling and other commercialization issues need to be addressed.

8.     The comment we receive most from our clients is that SR&ED funding helps them undertake technically risky projects that they would not otherwise undertake, as well as being able to hire more skilled labour.