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The Canadian Chamber of Commerce's Submission in Response to Joint Finance Canada Canada Revenue Agency Consultation Improving the Scientific Research and Experimental Development Tax Incentives:

November 2007

The Canadian Chamber of Commerce

Introduction

The Canadian Chamber of Commerce welcomes the review (see Box 1) of the SR&ED tax incentive program. For our members, the program has been effective in encouraging investment in research and development (R&D) and in boosting profitability and cash flow.

Our members believe the program can be improved to maximize its impact. Over 30 countries offer incentives to encourage R&D and Canada must keep ahead of the competition. It is also imperative to enhance the overall competitiveness of Canada's tax system. Generous SR&ED tax credits encourage the creation of ideas but high marginal effective tax rates on production capital (i.e. the new products and processes that result from R&D) discourage it.[1]

Stimulating business spending on R&D will ensure that Canada remains at the forefront of scientific capability, enhancing our ability to shape and improve our nation's future. Over time, it can lead to higher productivity growth, economic growth and living standards.[2]

Canada's SR&ED Tax Incentive Program

Small Canadian-controlled private corporations (CCPCs) are eligible for an enhanced 35 percent refundable SR&ED tax credit on up to $2 million of qualified SR&ED expenditures carried out in Canada, and 20 percent on any excess amount. Unused Investment Tax Credits (ITCs) can be carried back three years or forward 20 years.

In 2004, almost $3.4 billion in assistance was provided to over 19,600 corporations via the SR&ED ITC. Small CCPCs accounted for about 80 percent of corporate SR&ED performers but only 23 percent of allowable SR&ED expenditures. Almost 50 percent of ITCs were earned by the manufacturing sector.

Eight Canadian provinces and Yukon offer additional R&D tax incentives that essentially piggy-back on the federal government's SR&ED program. This reflects increased competition among regions for knowledge-based investment.

SR&ED ITCs Generate Positive Net Economic Benefits

Finance Canada estimates for every dollar of assistance provided via the SR&ED ITC, there is a net economic gain of 11 cents.[3] Thus, with about $3.4 billion in assistance provided each year, the annual net economic gain is about $370 million.

Box 1

Improving the SR&ED Tax Incentive Program:
Questions for Consultation

1. How do SR&ED tax incentives affect R&D performance? How do multinationals decide on the location of R&D activities and how do SR&ED tax incentives play into that decision?

2. Do SR&ED tax incentives impede the growth of small- and medium-sized innovative Canadian companies?

3. How can the structure of SR&ED tax incentives be improved to encourage more private-sector R&D?

4. How can program administration and complexity be reduced?

1. SR&ED Tax Incentives Affect R&D Performance

"Studies seem to suggest that a 10 percent decline in after-tax user costs of R&D generates an increase in R&D expenditures of about 1 percent in the short run and 10 percent in the long run."[4]

Canada's SR&ED tax incentive program is one of the most generous in the world, yet business enterprise expenditure on R&D as a share of GDP is the second lowest among G7 nations and well below the OECD average (see Figure 1). Business performs 52 percent of R&D in Canada compared to 68 percent in the OECD (see Figure 2).

A number of factors explain the relatively weak investment in R&D by the private sector (see Box 2). Our business tax system plays a role as generous SR&ED tax credits encourage the creation of ideas but high marginal effective tax rates on production capital (i.e. new products and processes) – the fruits of R&D – discourage R&D.[5]

Sweden provides few direct subsidies for R&D yet business enterprise R&D expenditure as a share of GDP is almost three times that of Canada (2.93 percent and 1.07 percent, respectively). Sweden's marginal effective tax rate on production capital (which includes the statutory tax rate, capital taxes, sales taxes on capital inputs as well as deductions and credits associated with purchasing capital goods) averages 17.8 percent compared to 30.9 percent in Canada (2007).

"Canadian governments need to consider the effect not only of direct tax subsidies on R&D but also of the overall production tax regime in Canada".[6] The Canadian Chamber believes the best way to maximize the potential and efficacy of the SR&ED tax incentive program is to lower overall taxes on production capital by reducing federal and provincial statutory corporate income tax rates, phasing out provincial capital taxes, harmonizing provincial retail sales taxes with the GST, and ensuring that Capital Cost Allowance (CCA) rates line up with the true economic life of the relevant asset. Reducing the federal general corporate income tax rate to 15 percent by 2012, as stated in the 2007 Economic Statement, is a step in the right direction.

Figure 1

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Figure 2

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Box 2

Mobilizing Science and Technology to Canada's Advantage (S&T Strategy)

There are structural reasons for Canada's relatively weak private-sector investment in R&D. The more commonly cited factors are:

  • Industrial composition. Canada has research-intensive industries but they account for a smaller share of Canada's economy than in the U.S.
  • Smaller businesses. Canada has a larger number of smaller firms which often have difficulty financing and managing R&D.
  • Regulatory and marketplace framework policies. Policies pertaining to business taxation, intellectual property and regulation may not be conducive to private-sector investment in R&D.
  • Access to funding and venture capital. Venture capital in Canada tends to be invested in a large number of smaller firms at early stages of development rather than on building global leaders.

Source: Government of Canada. May 2007.

SR&ED Tax Incentives Can Play a Role in MNCs' R&D Location Decisions

Multinational enterprises tend to perform the majority of their R&D at home. Of the US$179.9 billion in R&D expenditures by U.S. MNCs in 2004, $152.4 billion (84.7 percent) was by U.S. parents and $27.5 billion (15.3 percent) by their foreign affiliates, of which, $2.7 billion was by affiliates in Canada.[7] The large R&D share of U.S. parents reflects the relative abundance of U.S. scientific and technical resources, efforts to limit the diffusion of strategic technologies in order to preserve competitive position, scale economies in R&D, and the ability to share R&D-generated information with operating units in other countries at low or zero marginal cost.

MNCs generally exhibit two patterns of behaviour that influence R&D location.[8]

  • State dependence: Prior decisions by other firms in the same industry to locate R&D in a specific location (province/state/country) cause an otherwise identical firm to locate its own R&D in the same place due to significant agglomeration economies in some industries. There are benefits and/or cost reductions resulting from the clustering of activities.
  • Heterogeneity: MNCs have different preferences over R&D locations for exogenous reasons. They may require access to research universities, a highly qualified labour force, critical production inputs, and/or first class infrastructure. They also consider trade, fiscal, regulatory, education, healthcare, immigration and labour market policies.

If the state dependent case is stronger, governments interested in attracting R&D should focus on luring initial entrants into a particular area, and R&D tax breaks and subsidies would be an effective motivating factor. If MNCs' R&D location choices are explained by heterogeneous country-specific characteristics, R&D tax breaks and subsidies may be less effective than investment in infrastructure and education, for example.

For U.S. multinational, R&D-intensive manufacturing industries (pharmaceuticals, electronic components, motor vehicles & equipment, industrial chemicals, and medical instruments), R&D location choices of other same-industry MNCs (state dependence) influence where they locate only in the electronics and industrial chemicals industries. Firm heterogeneity and country heterogeneity appear to be more important predictors of MNCs R&D location choice than agglomeration economies stemming from the prior R&D location choices of other firms. Luring initial entrants with policies like tax breaks may be less effective.[9]

A report (September 2007) prepared for the Association of the British pharmaceutical industry stated that "once a sufficient degree of quality is obtained, cost factors are likely to dominate the decision as to where to locate manufacturing. Rates of taxation are likely to be the single most important factor in this decision, particularly where the technology required for successful manufacturing is available in a wide variety of locations". R&D tax credits were perceived to be of some value to the UK research-based pharmaceutical industry, but this was limited for two key reasons. First, they generally involve relatively small sums in the context of a major pharmaceutical company's research budget. Second, the process of claiming them can be bureaucratic and the outcome uncertain. The study concluded that countries can use R&D tax credit to help attract R&D, "however, such schemes might possibly add to, but no way substitute for, the provision of an underlying high quality environment".[10]

"Empirical research shows that international investment incentives play only a limited role in determining the international pattern of foreign direct investment. Factors like market characteristics, relative production costs and resource availability explain most of the cross-country variation in foreign direct investment inflows. Nevertheless, it is clear that international investment incentives might play a role for MNC decisions on the margin. For instance, if a firm has two more or less similar location alternatives for its investment, incentives can tilt the investment decision."[11]

2. SR&ED Tax Incentives May Impede Growth of Small-and Medium-sized Business

In an Industry Canada survey conducted as input to the November 2002 National Summit on Innovation and Learning, small- and medium-sized business owners sent a strong message that overly narrow eligibility criteria and complex application procedures discourage them from taking advantage of government policies and programs that support R&D, commercialization and the adoption of new technology. As a result, the enormous potential for innovation among Canada's SMEs is underexploited and SMEs are not maximizing productivity and growth.

The OECD in its 2006 Economic Survey of Canada stated that "generous tax credits for business R&D should be re-examined". The preferential treatment afforded to small CCPCs "reinforces other policies that may discourage firms from growing, which is unfortunate because larger firms are more likely to undertake both R&D and innovation. An alternative approach of more closely targeting tax credits on R&D undertaken by new firms rather than small firms per se and on incremental R&D could be explored. But such tax credits need to be carefully designed in order to bring forth new innovation while minimizing deadweight costs".

3. Canada's SR&ED Program can be Improved to Encourage More Private Sector R&D

The SR&ED ITC system is only marginally effective for corporations that do not qualify for refundable ITCs such as publicly-controlled corporations; non-resident controlled corporations; a combination of the above; and certain CCPCs due to restrictions on taxable income and taxable capital for the prior year, or by virtue of certain association rules. When ITCs are not fully refundable, they do not provide the critical assistance that firms need to weather a sustained downturn. Instead, they are only available to these companies if they have taxes owing.

"The problem is that the structure of the SR&ED tax credit rules is an all or nothing structure. Either one can use credits (through refundability for small CCPCs or against taxes payable for profitable companies) or one cannot."[12] The Canadian Chamber of Commerce recommends that the federal government make all SR&ED ITCs fully refundable.

Canada would also be benefit from restructuring the SR&ED tax incentive program to attract foreign investment in SR&ED activities. For profitable Canadian subsidiaries of multinationals, SR&ED tax credits provide no direct incentive to maintain or expand R&D in Canada. ITCs reduce corporate income taxes payable in Canada making foreign MNCs less eligible to receive tax credits in their home country, increasing their income tax liability there. The SR&ED tax incentive program can be made more attractive to foreign investors by allowing corporations in Canada to offset the ITC against a pre-tax levy, such as employer Employment Insurance premiums. This would result in an increase in Canadian corporate income tax payable and an equal offsetting decrease in the pre-tax levy. Because Canadian corporate income tax payable is not reduced, the amount of foreign tax credit available to the foreign investor would not change.

The government should also consider expanding the ITC for collaborative R&D. Firms are likely to under invest in collaborative research (whether in partnership with a university, national laboratory, or industry consortium) because it tends to be more basic and exploratory. Moreover, research results are shared and firms cannot capture the full benefits.[13] Countries like Norway, Spain, the UK, Denmark, Hungary and Japan provide firms tax incentives/deductions for collaborative R&D.

4. Efforts Must Continue to Reduce Compliance and Administration Costs

The Canadian Chamber of Commerce commends the CRA for the work it is doing to improve the SR&ED administration process. Progress has been made with respect to claim outcome; consistency; program services; claimant interaction with staff; and program effectiveness. However, there is more work to be done.

In 2004, compliance costs represented 7.9 percent of the total value of SR&ED credits claimed and administration costs 1.7 percent. Compliance and administration costs amount to roughly 10 cents per dollar of tax subsidy.[14]

As tax rates come down across the world, the efficiency of tax administration and costs of compliance become more important to tax competitiveness. The Canadian Chamber of Commerce urges the federal government to simplify income tax rules; reduce the turnaround time for reviewing and processing claims; clarify and simplify forms and publications; and review administrative procedures in other countries and adopt best practices.

Conclusion

As a recent C.D. Howe Institute Commentary stated "the federal and provincial governments' preoccupation with tax credits targeted at research and development, and relative inattention to the competitiveness of the overall tax regime, is misguided. In effect, the Canadian approach has been to give with one hand, by providing generous tax credits targeted at R&D, and to take with the other, by imposing high taxes on the fruits of innovative activity and entrepreneurship".[15]

The best way to maximize the potential and efficacy of the SR&ED tax incentive program is to reduce the tax rate on production capital. Both the federal government and the provinces and territories have a role to play in this regard. Personal income tax rates should also be reduced to attract and retain highly skilled and productive workers (including scientific and technical employees) and to spur investment, risk taking and entrepreneurship (see Box 3 for specific recommendations).

Improvements to Canada's SR&ED tax incentive program are also necessary to improve its effectiveness and maximize its impact. The Canadian Chamber of Commerce makes a number of recommendations in this regard (see Box 3).

Box 3

Summary of Recommendations

RE: Overall Tax Policy

The Canadian Chamber recommends that the federal government:

  • Reduce, as planned, the general corporate income tax rate to 15 percent by 2012.
  • Adjust any Capital Cost Allowance rates that do not line up with the true economic life of the relevant asset.
  • Work with the provinces (British Columbia, Saskatchewan, Manitoba, Ontario and Prince Edward Island) to harmonize retail sales taxes tax with the GST.
  • Continue to encourage the provinces to speed up the phase out of capital taxes. Alberta is the only province to have eliminated all capital taxes.
  • Reduce personal income tax rates across all income tax brackets. Start by reducing the 22 percent rate (on taxable income between $37,178 and $74,357) to 21 percent in 2008.
  • Raise the threshold at which the top marginal personal income tax rate applies to $150,000 in 2008 and $200,000 as fiscal conditions permit.

Re: SR&ED Tax incentive Program

The Canadian Chamber recommends that the federal government:

  • Expand refundability of the SR&ED Tax Credit to all R&D performers.
  • Offset SR&ED tax credits against a pre-tax levy, like employer EI premiums.
  • Consider expanding the ITC for collaborative R&D, i.e. industry-industry, industry-university, and industry-government efforts. Continue to build linkages and relationships between the public and private sectors by fostering collaboration among university, college and government researchers.
  • Implement a focused and sustained effort to encourage SMEs to enter the SR&ED tax incentive program. Continue to clarify and simplify forms and publications to facilitate access for small business and reduce compliance costs.
  • Continue to simplify overall SR&ED program administration; strengthen the consistency and predictability of CRA's administration process; and reduce the turnaround time for reviewing and processing claims. Review administrative procedures relating to the SR&ED program in other countries and adopt best practices.
  • Continue to increase awareness of the SR&ED program both at home and abroad.

Notes

1. Mckenzie, Kenneth J. €œGiving with One Hand, Taking Away with the Other: Canada's Tax System and Research and Development.€ C.D. Howe Commentary No. 240. October 2006. [Return]

2. Nicholson, Peter J. €œThe Growth Story: Canada's Long-run Economic Performance and Prospects.€ International Productivity Monitor No. 7. Fall 2004. [Return]

3. Parsons, Mark and Nicholas Phillips. €œAn Evaluation of the Federal Tax Credit for Scientific Research and Experimental Development.€ Department of Finance Working Paper 2007-08. September 2007. [Return]

4. Mckenzie, Kenneth J. €œGiving with One Hand, Taking Away with the Other: Canada's Tax System and Research and Development.€ C.D. Howe Commentary No. 240. October 2006. See also Hall and van Reenen (1999) and Bloom, Griffith and van Reenen (2002). [Return]

5. Mckenzie, Kenneth J. €œGiving with One Hand, Taking Away with the Other: Canada's Tax System and Research and Development.€ C.D. Howe Commentary No. 240. October 2006. [Return]

6. Ibid. [Return]

7. Yorgason, Daniel R. €œResearch and Development Activities of U.S. Multinational Companies: Preliminary Results from the 2005 Benchmark Survey.€ Survey of Current Business, 22-39. March 2007. [Return]

8. Feinberg, Susan, E. €œThe International R&D Location Choices of US Multinationals.€ Academy of Management Best Papers Proceedings, IM: D1-D6. Robert H. Smith School of Business. University of Maryland. 2000. [Return]

9. Ibid. [Return]

10. NERA Economic Consulting. Key Factors in Attracting Internationally Mobile Investments by the Research-Based Pharmaceutical Industry. September 21, 2007. [Return]

11. Blomström, Magnus. €œThe Economics of International Investment Incentives.€ International Investment Perspectives. OECD. September 2002. [Return]

12. Information Technology Association of Canada (ITAC). An Alternative for Extending Refundability of SR&ED Tax Credits. January 2007. [Return]

13. Atkinson, Robert D. Expanding the R&E Tax Credit to Drive Innovation, Competitiveness and Prosperity. Springer Science+Business Media, LLC 2007. July 24, 2007. [Return]

14. Parsons, Mark and Nicholas Phillips. €œAn Evaluation of the Federal Tax Credit for Scientific Research and Experimental Development.€ Department of Finance Working Paper 2007-08. September 2007. [Return]

15. Mckenzie, Kenneth J. €œGiving with One Hand, Taking Away with the Other: Canada's Tax System and Research and Development.€ C.D. Howe Commentary No. 240. October 2006. [Return]