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Canadian Association of Petroleum Producers' Submission in Response to Joint Finance Canada – Canada Revenue Agency Consultation Improving the Scientific Research and Experimental Development Tax Incentives:
November 29, 2007
Nancy Horsman and Peter C. Armstrong
Joint Finance Canada - Canada Revenue Agency SR&ED Consultations
140 O'Connor Street
Ottawa, ON K1A 0G5
Dear Ms. Horsman and Mr. Armstrong:
Re: Scientific Research and Experimental Development Consultation Process
The Canadian Association of Petroleum Producers (CAPP) represents 150 companies that explore for, develop and produce natural gas, natural gas liquids, crude oil, oil sands, and elemental sulphur throughout Canada. CAPP member companies produce more than 95 per cent of Canada's natural gas and crude oil. CAPP also has 130 associate members that provide a wide range of services that support the upstream crude oil and natural gas industry. Together, these members and associate members are an important part of a $100-billion-a-year national industry that affects the livelihoods of more than half a million Canadians.
The federal Scientific Research and Experimental Development (SR&ED) consultation process provides an opportunity for taxpayers, claimants and industry associations to recommend how best to improve the SR&ED tax incentive program. As such, this letter outlines CAPP's comments and recommendations for helping to improve this important program.
The business environment for oil and gas companies in Canada has become more challenging recently because of policy initiatives at both the federal and provincial levels. The Alberta provincial royalty review and subsequent new royalty framework, previous Alberta restrictions on various royalty programs and the royalty tax credit, federal initiatives to tax income trusts and phase out the accelerated capital cost allowance for oil sands only, various climate change initiatives – all these have been announced within the last twelve-to-eighteen months. They have a negative effect on encouraging business investment and development, reducing or offsetting the positive effects of continued reductions in federal corporate income tax rates. As such, the value of business-encouraging programs like the federal SR&ED tax credit becomes increasingly important.
A large percentage of CAPP member companies already claim the SR&ED tax incentives. With some improvements to the program, such as those suggested in this letter, more companies will be encouraged to integrate the program into their business strategies and to ultimately perform more innovation and advancements for the petroleum industry.
CAPP has identified two main themes and associated points for improving the SR&ED federal tax credit program. These are:
1. Improve the administration of the program
a. Re-establish the joint government-and-industry collaboration and thus re-establish the incentive culture
b. Provide an effective and timely redress procedure
c. Clarify documentation requirements
2. Restructure parts of the legislation
a. Allow SR&ED submissions after the 18-month rule - subject to a penalty
b. Institute partial refundability for non-taxable entities
c. Restructure the contract payment rules
d. Expand the territorial limit to be consistent with the tax laws
e. Rewrite the exclusions in the ITA 248(1) such that there are no redundancies.
Our recommendations and comments are grouped into these main themes, which are described in detail in the attachment. The discussion relates to key questions posed by the Department of Finance and the CRA, to which they are seeking input from this consultation process. Please consider the points highlighted below in your efforts to improve the program.
We feel it is essential that the Canada Revenue Agency (CRA) and the Department of Finance make these recommended administrative improvements so that any legislative improvements have the greatest success of being achieved. Furthermore, it is our opinion that the implementation of the independent directorate did not fully accomplish one its main objectives, which was to shift the administration from a traditional audit mentality to that required of an incentive program like SR&ED. Our members have experienced that in the past 5-6 years, the culture seems to have reverted back to the audit mentality – that is, one focused on ensuring compliance rather than encouraging participation and, ultimately, research and development.
CAPP appreciates the opportunity to provide these recommendations on the SR&ED program. We respect the Department of Finance and the CRA's actions to seek the public's thoughts and comments. We believe it is a crucial step towards bettering the program. We would be pleased to meet with you to discuss further our recommendations and we look forward to the findings and results of this process.
Manager Fiscal Policy
Key Comments and Recommendations to Improve the Federal Scientific Research and Experimental Development Tax Credit Program
1. Improve the Administration of the Program
Many CAPP members still face issues in having their claims processed and assessed in an effective and efficient manner. This results in an increased cost of compliance and thus an increased effective cost of performing R&D in Canada. The general sentiment is that many aspects of the current administration are fairly inflexible, which is a characteristic that is not conducive to an incentive program for fostering more innovation in Canada.
1a. Re-establish the joint government-and-industry collaboration and thus re-establish the incentive culture
A growing number of members relay their negative experience with (primarily) technical reviews. They feel the reviews are becoming more confrontational, a style that characterized the management of the program in the oil and gas sector in the mid 1990s. Cooperative work between the petroleum sector and the CRA was able to re-establish credibility in the program, returning a sense of client focus and encouragement being an equal priority to compliance. Research and technology advisors (RTAs) benefited from the contact with industry, enabling an even-handed and consistent application of the guidelines across companies. The emphasis was more on "what was done" rather than "what was said". Unfortunately, this no longer seems to be the case.
We also note that newer RTAs often possess strong credentials in research environments, although sometimes in narrow fields. However, they seem to have little experience in the experimental development area of industrial research and development. The perception is that these less experienced RTAs may not have received sufficient training in the true breadth of eligibility criteria. For example, field pilots are different from commercial scale operations, but the distinction may be lost on an RTA that has a pure research perspective.
Since this program is for the greater benefit of encouraging research and development throughout the community, it is reasonable to expect the community to be involved in the process. Over the years, there has been an on and off again spirit of collaboration between the CRA, practitioners and industry including:
- The SR&ED Partnership Committee
- The SR&ED Advisory Committee
- Industry participation in the development of guidance
- Three joint conferences
- Local CRA and practitioner committees
This collaboration was beneficial to both parties and assisted in the program working smoothly. Currently, the CRA has disbanded almost all of these committees and there is little or no dialogue between industry, practitioners and the CRA. We recommend that the government reopen dialogue with industry and practitioners and find an effective forum to do so.
In addition, increasing the responsibilities of the NTSS positions, re-instating the headquarters scientific leadership and implementing a training program involving industry resources will demonstrate the government's commitment to transparency and collaborative efforts to improve the program.
Implementing these recommendations would also assist in demonstrating a recommitment to experimental development. By having industry and the CRA work together such that the CRA sees and understands the front line challenges faced by industry, this will help them understand where and to what magnitude experimental development is occurring in various industry sectors.
1b. Provide an Effective and Timely Redress Procedure
The first stage of a redress process is rebutting the RTA's technical report itself. Our experience has shown that the technical reports virtually never state how the opinion of the RTA is supported by fact, legislation or policy and rather are of the tone of 'I do not feel it is SR&ED'. The integrity of the program is lost if no due justification for disallowment of the claim is provided in the RTA report and thus no adequate basis for rebuttal by the claimant is possible. The SR&ED program has evolved to be one of an 'opinion' of the RTA rather than a position based on fact, policy or legislation.
Following the disagreement with the RTA report by the claimant, there is currently no proper, unbiased technical redress process. Therefore there is a need for a redress process to replace or supplement the normal appeals process, one that emphasizes neutrality and efficiency. Local reviews by appeals staff of science issues are too easily influenced by the original science reviewers and policy makers. Headquarters personnel in Ottawa are seen as not having the necessary experience to provide authoritative or objective second opinions with the technical aspects of oil and gas claims. Fundamental issues have been raised during the CRA's reviews for which there have been no adequate resolutions. These issues include concerns about the qualifications of science reviewers, interpretations, consistency, and practices. In the case of simple procedural issues, a quick and simple way to have a neutral party resolve the problem consistently and fairly is often not available.
When a claimant feels the reviewer does not understand the technological challenges specific to the industry or to the project then the chances of progressing towards disagreements and a redress stage are increased. Furthermore, the program loses its integrity when a claimant proceeds with rebuttals and seeks a neutral reviewer, only to have the claim return to the original office or reviewer.
1c. Clarify the documentation requirements and guidelines for the use of claimant testimony as support for the SR&ED
Historically, the CRA has held the position that evidence for SR&ED should only be that which is produced naturally in the course of carrying on day-to-day business. However, CAPP members have frequently experienced the CRA straying from this position. The type of information requested through the CRA's request for "contemporaneous" documentation is unrealistic in a normal business environment. Furthermore, when our members augment their normal documentation with claimant testimony, this does not seem to be fully considered by the CRA. In other words, the CRA states that only 'normal' business documentation is required for SR&ED, but the technical staff of the CRA require the strict types of documentation only produced in a lab-type environment.
This is an especially important issue in experimental development activities carried out by oil and gas companies since they are usually occurring in a business environment rather than in a 'lab-type' setting. As a result, many of the contemporaneous documents contain business-related information as well as technological and scientific information. Furthermore, industry often embarks on field SR&ED without much formal written documentation. During the late 1990s the tacit partnership between the CRA (then Revenue Canada) and industry recognized this reality. Interpretation bulletins and papers were developed by government-industry working groups to help facilitate the consistent application of the guidelines across the broad spectrum of industry sectors. We believe that returning to this partnership method may be one way both industry and the CRA can gain a common understanding of what types of documentation are commonly produced in oil and gas company's normal environment (and thus those that support SR&ED) and how and when claimant testimony can support the submission
2. Restructure Parts of the Legislation
2a. Allow SR&ED submissions after the 18-month rule - subject to a penalty
The Income Tax Act contains numerous deadlines and many include provisions for late filing, some with and some without penalties.
The SR&ED program's 'all-or-nothing' 18-month filing deadline, in conjunction with the Minister's inability to waive the deadline (via recently proposed legislation) demonstrates an inflexibility of the SR&ED program and is overly punitive and counterproductive to the nature of an incentive program intended to encourage research and development. This proposed legislation should either be repealed or it should be modified to allow late filing with a penalty.
2b. Institute partial refundability, even for non-taxable companies, and allow the ITC's to offset other taxes (e.g. payroll taxes)
For years, many stakeholders have called for making the SR&ED credits universally accessible to all business entities. This would encourage participation by small companies in the oil and gas sector where they are not taxable in the early stages of corporate growth.
We recommend that the federal government allow companies in a financial loss position to access tax credits refundable in cash, subject to certain limits.
This change would also allow companies with foreign parents located in a country with a foreign tax credit regime, such as the United States, to benefit from the program while still retaining the intellectual property rights, knowledge and the benefits of the innovation in Canada.
We also recommend that the federal government allow applicability of the tax credits to other taxes in addition to income taxes – for example, payroll taxes.
- Allow Canadian corporations to apply their ITCs against payroll taxes such as the employer's portion of the Employment Insurance premiums. From a corporate income tax perspective, as the SR&ED tax credits are taxable in the year following the year that they are utilized, there will be an increase in overall corporate tax revenue which will partially offset the reduction in Employment Insurance premiums.
- Again, this proposal would make the Canadian regime more attractive to foreign investors with a foreign tax credit regime. Overall, this recommendation would result in a meaningful cost reduction to research and development performers that otherwise could not access the benefits of the SR&ED program.
2c. Restructure the contract payment rules
The current contract payment guidance is complex, particularly when determining which party in the contract agreement is entitled to claim SR&ED.
Despite the CRA's guidance, the treatment of contract payments remains a confusing area for many SR&ED performers. We understand the system is in place to ensure two parties do not make claims on the same expenditures. However, determining entitlement to the claim is not straightforward. This is especially the case in the oil and gas industry which has complex contract arrangements. For instance, when oilfield service companies and energy producing companies work closely on projects, each contributing their resources (e.g. the well for the energy producer and the equipment for the oilfield service company) it is not always apparent which should claim the SR&ED.
In many cases, taxpayers must analyze the terms of the contract read as a whole and review the facts surrounding the particular situation for each contract payment to determine whether the contract should be included or excluded from its claim. Also, taxpayers that receive contract payments must make a determination whether the payment is for SR&ED or for something else. This can be very onerous to taxpayers, their advisers and to the CRA when reviewing claims.
We recommend a restructure of the rules to include an election in which the non-related contracting parties could designate formally which of the parties has the right to claim the SR&ED associated with that contract.
The result of this legislative change would not only specify clearly which party to the SR&ED contract is entitled to claim the investment tax credits but would also achieve the CRA's goal of preventing two parties from claiming investment tax credits on the same SR&ED expenditure.
2d. Expand the territorial limit to be consistent with Canadian tax law
The term "in Canada" is not specifically defined in the Income Tax Act ("ITA"); however, it appears that the ITA currently refers to more than one meaning of "in Canada".
For SR&ED purposes, subsection 37(1.3) describes the economic zone of Canadawith reference to the Oceans Act, as to embrace all area within what is known as the 200 nautical mile limit. However, for non-SR&ED income tax purposes, section 255, subsection 127(9) and regulation 4609 expand the meaning of 'in Canada' to include the areas far outside the 200 nautical mile limit. In other words, the SR&ED meaning of 'in Canada' is more restrictive than other definitions in the ITA and this creates a scenario in which an activity can be classified as 'in Canada' for paying income tax, but not 'in Canada' for obtaining SR&ED tax credits.
We believe this to be prejudicial against offshore oil and gas projects that occur beyond the current 200 nautical mile limit but are being taxed in Canada. This will be a deterrent for future projects that are planning to take place further offshore from Canada not only in the Atlantic, but Arctic and Pacific oceans as well.
Therefore, we recommend that the territorial limits for performing SR&ED fall under the same territorial limits applicable to all entities liable to pay tax in Canada, for business carried on in Canada. This could be remedied by having section 255 of the ITA apply for SR&ED purposes (thus removing the restrictive mileage provision currently found in subsection 37(1.3) of the ITA).
2e. Rewrite the exclusions in subsection 248(1) of the ITA such that there are no redundancies, specifically with the exclusion 'h'
The only sectors that are specifically mentioned in the exclusions of paragraphs 248(1) (e) to (k) of the ITA are the social sciences and the oil and gas and mining sectors. We fully understand the rationale to exclude research in the social sciences or the humanities. However, the Department of Finance has clarified that exclusion 'h' was not added to exclude all activities in the oil and gas industry involving drilling, prospecting, etc. but rather, it was added for two reasons:
1. to prevent 'double dipping' between SR&ED and other oil and gas deducting provisions in the ITA such as CDE and CEE as per section 66, and
2. to ensure routine (non-SR&ED) activities were not claimed as SR&ED.
Since the ITA forbids the double deduction of any expenditure, the first reason given is moot. Furthermore, since the ITA already defines what is qualifying SR&ED under subsection 248(1), our members feel there is no need to define what is not SR&ED under the exclusion of paragraph 248(1) (h). In other words, since we have experienced that this redundancy has added significant administrative ambiguity to the SR&ED program for our sector, we recommend that it be removed from the exclusions in subsection 248(1) of the ITA.