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Canadian Vehicle Manufacturers' Association Submission in Response to Joint Finance Canada – Canada Revenue Agency Consultation Improving the Scientific Research and Experimental Development Tax Incentives:
Response to the Joint Finance Canada - Canada Revenue Agency Consultation:
Improving the Scientific Research and Experimental Development Tax Incentives
30 November 2007
Canadian Vehicle Manufacturers' Association
170 Attwell Drive
The Canadian Vehicle Manufacturers' Association (CVMA) is the national association representing Canada's leading manufacturers of light and heavy duty vehicles. Our membership includes Chrysler Canada Inc., Ford Motor Company of Canada, Limited, General Motors of Canada Limited and International Truck & Engine Corporation Canada. Through their sales, manufacturing, research and development (R&D) and head office activities, our members directly employ over 100,000 Canadians and support an additional 50,000 retirees. In total, Canada's automotive industry, led by vehicle manufacturers, employs over 570,000 Canadians from coast to coast in every province and city.
In 2006, CVMA member companies produced over 70% of the 2.55 million light duty vehicles built in Canada and accounted for 54% of all light duty vehicles sold. Our members purchase over 80% of all automotive parts produced in Canada for vehicle production across North America. CVMA member companies currently produce 17 different light duty vehicles in Canada.
Despite significant restructuring within the automotive sector, these companies, in partnership with the federal and provincial governments, have contributed roughly 80% of the over $10 billion in new automotive (parts and assembly) investment announced in Canada since 2002. These investments in Canada have gone into advanced flexible manufacturing, leading edge environmental technologies, and new R&D activities.
With respect to the questions raised in Finance Canada/Canada Revenue Agency consultation paper, the CVMA is pleased to offer the following comments and recommendations:
1. How do the SR&ED tax incentives affect the performance of R and D in Canada and how can they contribute to increasing private sector investment in R&D?
As presently structured, the Scientific Research and Experimental Development (SR&ED) program has been successful in attracting some automotive industry research and engineering development activities in Canada. The program has, to some limited extent, helped retain automotive-related knowledge and talent in Canada. However, the automotive industry has long argued that the SR&ED eligibility criteria are biased in favour of organizations and activities focused on fundamental research and development versus the more important activities related to product commercialization and productivity improvement initiatives.
Presently, large Canadian companies use non-refundable SR&ED Investment Tax Credits (ITC) to lower their effective corporate income tax rates. While this program is effective for Canadian companies and offers an attractive starting point for foreign investors contemplating expanding R&D activities in Canada, an opportunity exists to tailor the present program to ensure Canada becomes a more attractive jurisdiction for investment in R&D, product commercialization and manufacturing productivity improvement activities.
To help enhance the program's ability to accelerate Canadian businesses' ability to compete globally, the CVMA strongly believes that the SR&ED tax rules should to be revised to include scientific and research initiatives in areas including product commercialization and productivity improvement. Canada's domestic automotive industry faces intense global competition which, in turn, drives Canadian vehicle manufacturers and their suppliers to work at the commercialization of new products and parts while also working to enhance equally important productivity and manufacturing process improvements. Such a strategy is imperative if Canadian vehicle manufacturers are to become cost competitive relative to jurisdictions including the United States, Asia and Europe.
Although B-index comparisons of R&D tax incentives and the marginal effective tax rate (METR) across OECD countries may place Canada in a favourable light, SR&ED tax incentives are not driving substantive private R&D investment. The CVMA recommends that the SR&ED program be modified to include support for a broader commercialization agenda which provides equivalent support to Canadian engineering development activities or that a new government program is created to encourage and accelerate these critical activities. The SR&ED program should not continue to group these important prosperity building activities and initiatives into what the program currently defines as "routine engineering." Program eligibility needs to be more inclusive of engineering development – and not strictly limited to "experimental development". As a significant amount of engineering development effort within the automotive sector relates to plant floor manufacturing process-based improvements, the CVMA strongly feels that the federal government should recognize process-based improvements – including the integration of systems and/or components – as eligible SR&ED activities.
As other global jurisdictions enhance R&D tax credits and establish funding for private sector technology development activities as a means to attract high value-added investment and engineering activities, it is important that Canada moves quickly to retain its domestic knowledge and talent. In a highly competitive global environment, research jobs are increasingly being globalized. The unprecedented appreciation of the Canadian dollar relative to the U.S. dollar underscores the urgency of the challenge. The government must make every effort to ensure that Canada has an enhanced and effective 'toolbox' of incentives to maintain and ideally grow its domestic-based advanced engineering and R&D investments.
Many Canadian government programs support R&D activities but almost every program requires external collaboration with third parties including, for example, university-based researchers. While collaborations are particularly useful in the development of early stage technology and concept development, much of the subsequent R&D effort is performed within individual companies. As R&D work progresses towards a specific commercial application, the effort naturally becomes less suited to open collaboration owing to the competitive risks and the potential disclosure of intellectual property. Therefore, if Canada is to realize its objective to increase the Canadian development and commercialization of advanced technologies, the creation of support programs targeted at private company based research and development activities or the amendment of existing programs in this direction is essential.
To that end, the CVMA believes that the continuation of an updated SR&ED program is necessary, but that it alone will not be sufficient to sustain existing or attract additional private sector investment in both research and development activities in this new era of global automotive competition.
2. Are there features of the SR&ED tax incentives that impede the growth of small and medium-sized innovative Canadian companies and how?
The CVMA recommends that the SR&ED tax credits be made refundable to all firms, irrespective of size
. This would assist all firms, who may not be in a tax payable situation, to build the tax credit into their R&D investment decision process, thereby improving cash flow. This idea was previously proposed by Canadian Advanced Technology Alliance (CATA) and the Canadian Manufacturing Coalition (CMC).
The focus of many innovative Canadian SMEs, including automotive parts makers, is squarely based on plant floor manufacturing process improvements. Continuous improvement and the creation of new efficiencies in their manufacturing processes are especially vital to an SME's immediate and longer-term regional and global competitiveness. However, SR&ED definitions have tended to incorrectly class these activities as "routine engineering" that do not qualify for support. The federal government's 2007 report Mobilizing Science and Technology highlighted that productivity improvements at Canadian firms lag other leading economic jurisdictions. Yet, the current SR&ED program's definitions do not support these activities of small to midsized auto parts companies attempting to address this very issue. Therefore, the CVMA believes that the SR&ED criteria should be revised to accept manufacturing process improvement activities or the government should create a separate funding program to address this pressing need in Canada.
3. How could more private sector R&D be leveraged?
i) As expressed earlier, the SR&ED program's current eligibility criteria should be broadened to include product and manufacturing process engineering development.
ii) The applicability of the 35% credit which is currently only available to Canadian Controlled Private Corporations (CCPCs) should be made more broadly available. This broadening could be achieved by adding a new qualifier for the higher rate based on industrial sector. (This is the case in India where companies engaged in scientific R&D are entitled to a 100% deduction of profits for 10 years. The auto industry, in turn, is entitled to a 150% deduction for expenditures on in-house R&D facilities.)
iii) The definition of eligible costs should be extended to include costs for patenting, prototyping, product testing and other pre-commercialization activities, as recommended by the Canadian Manufacturing Coalition.
iv) The CVMA recommends that there is an allowance to recognize engineering work performed outside Canada by Canadians as eligible for the SR&ED credit, so long as it supports further SR&ED work in Canada.
v) We are aware of a number of instances where the value of the SR&ED Credits is ignored by a foreign parent company in making decisions relating to R&D investments in Canada. In circumstances where a foreign investor owns a Canadian company performing SR&ED activities, they are generally able to recover the Canadian corporate income tax, payable by the Canadian company, in the form of a foreign tax credit against tax otherwise payable on the distributed earnings of the Canadian company. This claim is generally allowable to the extent that the Canadian income tax payable does not exceed the foreign investor's local income tax payable. As the corporate income tax rate in Canada continues to decline, the Canadian income tax paid will generally be fully refundable to the foreign investor or parent company. Since the ITC reduces the Canadian corporate income taxes payable this, in turn, reduces the foreign tax credits that are available to the foreign investor /parent, thereby increasing the company's local income tax liability. Consequently, the ITC provides no net benefit to the foreign investor in determining total income taxes payable for all jurisdictions. In other words, what the Canadian entity gained, the foreign parent company lost, resulting in a net wash.
There are options available to modify the SR&ED program, to make it more attractive to foreign investors. One idea would be to apply the incentive to amounts payable under a different government levy, such as the employer portion of Employment Insurance (EI) premiums. This would result in an increase to Canadian corporate income taxes payable and an equal and offsetting decrease to the pre-tax levy. Internal transfers made between programs could ensure that funding of the pre-tax levy was not impacted. Since the Canadian corporate income tax payable is not reduced under this proposal, the amount of foreign tax credit available to the foreign investor remains intact. When combined with a reduction in a pre-tax levy, such as the employer portion of EI premiums, the SR&ED credit may result in a more meaningful cost reduction for the foreign investor.
vi) With respect to best supporting Canadian R&D collaboration, we suggest that the program should focus on two specific options:
a. Transferable tax credits in collaborations allowing a firm to transfer credits for their portion of the collaboration to the other collaborating party; and,
b. Offer a higher tax credit rate if the work is involved with technology/knowledge transfer or commercialization with a Canadian supplier to encourage more involvement with the broader supply chain.
vii) As stated earlier, although the CVMA believes that the continuation of an updated SR&ED program is necessary, it alone will not be sufficient to sustain existing or guarantee additional private sector research and development activities in this new era of global automotive competition. However, in addition to the suggested revisions to make the SR&ED program more effective, the creation of support programs targeted at private company based research and development activities is essential.
Although Canada has significant support programs for collaborative research such as NSERC, there are virtually no support programs for private-based applied research, pre-commercialization and commercialization development activities available to the automotive industry. Given that other global jurisdictions provide significant supports in this area, this helps to explain why Canada continues to lag in the commercialization of new technologies in spite of the fact that Canada is a leader in early stage collaborative research activities. Without government program support for private "company based" research and technology development, which is necessary to commercialize scientific concepts, these activities and associated economic benefits will likely continue to be performed outside of Canada; changes must be made to reverse that reality.
4. Given the improvements already implemented or under study, how could administration of the SR&ED tax incentives be further improved and their complexity reduced?
The CVMA re-emphasizes that the definition of SR&ED must be broadened to specifically include product and process engineering development activities, recognizing that the engineering design methodology is analogous to the scientific method in creating new knowledge, products and associated manufacturing processes.
The Canada Revenue Agency's assessment and processing of the same client's SR&ED claims in subsequent years is often inconsistent. Individual science advisors should be able to make and sustain consistent interpretations of the eligibility of the technical work based on a client's prior audits or with the input of other science advisors from other clients. We suggest that once a precedent is established, no future justification for a project's eligibility should be required.
With regard to the program complexity, we believe that CRA should accept large projects with several inter-related minor elements not identified separately under an 'umbrella format'. One example is that of "Manufacturing Capability" within vehicle manufacturing. The launch of a new vehicle and associated new technologies into the production environment should be deemed an eligible SR&ED activity. The client should not be required to detail all the related minor elements separately.
CRA should consider offering companies the opportunity to apply for self-certification status. This could include the ability for CRA to review a firm's business processes, SR&ED documentation, financial records, and appropriate management oversight/guidance. No new technical documentation would be required except for the normal business records from the financial sections of the claim. Once self-certification status is granted by CRA, the company would be required to provide financial input to the income tax return to support the SR&ED claim. Moreover, no new technical documentation would be required save for any normal business records related to the financial components of the specified claim. Random spot audits could be undertaken as a more efficient form of quality control – as opposed to the current practice of 100% or near-100% audit of all documentation and associated financial claims.
CRA's public seminars and coaching companies on specific details of the SR&ED program is commendable as they are quite useful. Constructively, CVMA suggests that in addition to CRA's normal outreach efforts, CRA should leverage industry associations in its efforts to reach out to individual companies. CRA may also consider undertaking regular meetings with clients' technical staffs as part of a deliberate relationship-building program.
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