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Stonecracker Scientific Law Office Submission in Response to Joint Finance Canada – Canada Revenue Agency Consultation Improving the Scientific Research and Experimental Development Tax Incentives:

Joint Finance Canada – Canada Revenue Agency
SR&ED Consultations

30 November 2007

Stonecracker Scientific Law Office Response to
Improving the SR&ED Program Tax Incentives for
Scientific Research and Experimental Development
Consultation Paper October 2007 ("Consultation Paper")

As the first and only law firm in Canada whose practice is entirely focused on SR&ED-related matters, Stonecracker Scientific Law Office ("Stonecracker") as an SR&ED-program stakeholder would like to thank both the Department of Finance and Canada Revenue Agency for this opportunity to provide real-world feedback based on our experience filing over 100 claims on behalf of many different clients in many different industries. We are pleased to be able to share our experience in an effort to improve on what we believe is one of the best R&D incentive programs in the world.

Stonecracker is providing its policy-related input based on years of direct promotion-to and education-of, the SR&ED program to countless taxpayers around the country, and to many foreign companies looking to enter Canada as a breakthrough investment opportunity on the global stage. Stonecracker is also providing its administration-related input based on years of hands-on SR&ED claim analysis, preparation, and prosecution for its clients throughout Canada.

We turn now to the questions posed in the Consultation Paper.

a) How do the SR&ED tax incentives affect the performance of R&D in Canada, and how can they contribute to increasing private sector investment in R&D?

In terms of the role that SR&ED tax incentives play in the R&D investment decisions of R&D performers in Canada, Stonecracker's experience has shown that much depends on the size of the R&D performer and the experiences that an R&D performer has with the administration of the program.

Our experience has shown that the vast majority of SR&ED-program users choose to immediately reinvest their SR&ED credits, especially refundable ones, directly back into further R&D. SME R&D performers, especially, are highly excited by the receipt of, and often completely dependent upon, refundable SR&ED credits to facilitate the continuation of their R&D in Canada.

However, despite our clients' general satisfaction with the administration of the SR&ED program, the following statement is likely very representative of our clients' sentiments: "When the administration of the program is good, it's very good, when it's bad, it's extremely bad."

That is to say that we have spoken to many former SR&ED program users whose experiences with SR&ED administration have been so exacerbating that they have chosen to stop performing R&D in Canada altogether, despite such activities possibly costing much more in other jurisdictions. The result is that the extremely valuable technical knowledge base and intellectual property may leave the country likely never to return. Some of our clients in the past year have written to the Minister of National Revenue, describing in detail their difficulties with the administration of the program with sentiments that echo this problem.

Regarding multinational company R&D investment decision processes, in our direct efforts to attract multinationals to Canada, we have seen companies taking a very broad analysis of R&D credits. Most do, indeed, conduct "head-to-head" comparisons of competing R&D credit programs when choosing a jurisdiction in which to locate offices and perform R&D. That is, Stonecracker's experience has shown that large companies consider not only the pure policy-based dictates of after-tax impact of a given country's program; rather, multinationals also typically consider the quality of the everyday administration of a program including such key factors as the:

i. Cost and other potential difficulties of compliance with an R&D program, including but not limited to administration, record keeping, auditing, legal, personal and communication with the program administrators.

ii. Culture of government officers/auditors/reviewers/managers within an R&D program: which is to say, is there an perceived overall attitude of assistance and incentive or is there a perceived overall attitude of audit/compliance?

iii.Lack or presence of real-world, non-laboratory, non-academic, R&D experience of government officers/auditors/reviewers/managers within an R&D program especially including business management of commercial R&D programs. Lack of understanding that real-world, non-laboratory, non-academic R&D is the norm. Lack or presence of demand for lab-type, or academic-type, documentary evidence.

iv. Refundability of credits for foreign-owned, and publicly-traded companies.

Our direct experience with multinationals has shown us that multinational companies' perception of Canada's R&D program is generally favourable, but we have also received direct feedback that all four points stated above are perceived as acute problem areas in Canada specifically.

For example, we have heard multinationals' comments that their impression is that Canada's SR&ED administration may be laden with an attitude of audit and compliance, versus their general belief that the U.K.'s program exudes the opposite, a desirable attitude of incentive and assistance.

Similarly, we have heard multinationals' impressions that Canada's SR&ED technical reviewers often fail to fundamentally comprehend the difference between lab-type or academic-type R&D versus real-world industrial experimentation; and therefore fail to fundamentally comprehend the work activities that must be undertaken and expenditures that are necessary to conduct real-world R&D. This is in sharp contrast to what these companies have said to us about their experiences with R&D technical reviewers in both the U.K. and Australia.

In terms of refundability of credits for foreign-owned entities, our multinational clients have expressed a frustration with trying to persuade foreign headquarters to conduct R&D in Canada given the non-refundable nature of credits for such entities. Some multinationals have expressed to Stonecracker a desire to move much, if not all, of their multi-billion-dollar R&D portfolios to Canada, but are often only willing to do so only if SR&ED credits are refundable (of course used against Part 1 taxes payable first).

b) Are there features of the SR&ED tax incentives that impede the growth of small and medium (SME) sized innovative Canadian companies, and how?

One major legislative hurdle governing SR&ED is that which denies publicly-traded SME's the refundability of their credits. Stonecracker has directly observed that the exclusion of publicly-traded SME's from refundability of SR&ED credits has caused many companies to choose to simply ignore or avoid Canada altogether for R&D purposes. This has been particularly true of SME's who turn to public capital markets for more rapid commercialization, or to raise a level of capital for commercialization that is difficult or impossible to do privately in Canada.

These companies are usually publicly traded Canadian SME's. Their offices, people, technology, and intellectual property are usually still all in Canada. The directors are usually Canadian. Most typically, these SME's have chosen to use Canadian stock exchanges for their entry into public capital channels.

These SME's have strongly voiced the opinion to us that publicly-traded Canadian SME's still face all the problems of growth and commercialization that they encountered when they were privately-held Canadian SME's

. Yet the single act of choosing to become publicly traded has a dire consequence on their eligibility under the SR&ED program given that they may still be years away from profitability and can only obtain non-refundable credits at a reduced rate.

Stated differently: publicly-traded SME's are still SME's. Since one major objective of the SR&ED program is to encourage rapid commercialization of R&D by SME's, and thus encourage wealth/tax-base building through R&D-performing SME's, why does the SR&ED program currently "punish" an

SME who turns to public capital channels to accelerate their commercialization path? For many small companies this is their only way to survive. The punishment comes in the form of denying these SME's the refundability of their SR&ED credits, and also providing such non-refundable credits at a much lower rate. On one hand the government is encouraging small businesses to grow through the use of our public capital markets, but on this hand is punishing them for doing so – in a way that may permanently retard their R&D initiatives.

Indeed, another perspective to consider is that by denying publicly-traded SME's their refundable SR&ED credits at private-held SME rates, we as a nation are directly denying the Canadian public rapid access to the wealth building (and therefore, tax-base) opportunity that is our R&D performing SME's. For many reasons, most Canadians simply cannot, and do not, invest in privately held R&D-performing SME's yet many would invest in the same SME if it were publicly-listed, given the associated liquidity and reporting transparency features of public listing. Yet for many early-stage SME's, the refundable SR&ED credits are a critical success factor. So SME management is often faced with choosing between growing slowly through private investors only and then receiving their SR&ED refunds, or growing much more quickly through public means but sacrificing valuable SR&ED refunds which may be critical to succeeding in early stage R&D in the first place.

Often, this dilemma results in a perpetual cash shortage in SME's and a private investment strategy that sees valuable intellectual property sold to a foreign company simply because the foreign interest is first to the table. The greatest loser in this scenario is the Canadian public, when we force our SME managers to create a business culture where Canadian businesses seek to sell our Canadian-developed intellectual property to the fastest (not necessarily highest) cash bidder because of cash flow challenges.

Additionally, from an administrative perspective Stonecracker has seen that restrictions against non-arms-length contracts (a norm for small startups), onerous rules for transferring expenditures between several non-arms-length businesses (also a norm for startups) and the absolute limitation period of 18 months for SR&ED filing are all difficult on SME's given that a majority of SME's are completely unaware of the SR&ED program when they start and often run into a limitation period immediately upon learning about the program.

SME's have expressed great concerns over requests for the lab-type, academic-type, R&D reporting and project documentation

that with apparently increasing frequency is being sought by CRA in its technical reviews, even though such a standard of documentation is not a legislated requirement.

Also, SME's have expressed concerns with requests by CRA for time sheets and time cards, years after-the-fact despite the fact that these SME's did not even know about the SR&ED program's very existence, much less its desire for such detailed time tracking. Such requests are repeatedly being made despite not being a legislated requirement. These requests are ridiculous and seriously hamper companies looking to use a program supposedly designed to help them.

In essence, SME's simply do not typically function during startup days in the manner which increasingly appears to be desired by CRA. SME managers do not speak SR&ED language nor use SR&ED terms. Most SME's we encounter, until we educate them, are not even aware that the SR&ED program has been in existence for decades.

c) How could more private sector R&D be leveraged?

As described in detail above, Stonecracker believes that allowing the refundability of SR&ED credits in public and foreign entities could dramatically improve private-sector R&D levels; especially if publicly-traded SME's were given refundability at the same rates, and under similar circumstances as privately-held SME's.

Furthermore, we submit that pre-SR&ED marketing/feasibility/user analyses and post-SR&ED-related pre-commercialization activities should all be eligible for SR&ED. The rationale behind this statement is that one major intent of the SR&ED program is to encourage investment in commercializable R&D to result in wealth-generating intellectual-property and technology. Therefore, any efforts related to establishing or ensuring the commercial viability of SR&ED output ought to be eligible.

Additionally, our observation is that a great proportion of commercially-successful SR&ED does not necessarily happen in universities or public R&D facilities. Therefore, to further encourage public-private R&D commercialization, we submit that private companies should be able claim for SR&ED purposes any intellectual property acquisition costs related to publicly-funded R&D products. The rationale behind this suggestion is that the publicly-funded R&D (i.e, in universities and research institutes) has already been paid for by taxpayers. Taxpayers should not therefore be "double-billed" through the exclusion of the acquisition costs for SR&ED of this publicly-funded R&D, especially not in the hands of a private company seeking to create royalty streams for the public.


if private companies are not to be allowed to include for SR&ED purposes the acquisition costs of publicly-funded R&D products, then we suggest that refundable SR&ED credits be allowed for the (partly) publicly-funded not-for-profit/tax-exempt institutions who are performing the R&D to begin with. The amount of allowable expenditures ought to at least equal the actual personal income taxes paid by the employees or contractors of such institutions. The rationale behind this suggestion is that, despite being in a non-taxable position, as an entity, such institutions create a great deal of ultimately commercializable R&D, and do still pay taxes through the R&D-performing employees' personal income taxes; and indirectly create wealth, intellectual property, and critical technological knowledge base through the R&D performing staff or when the R&D product is commercialized.

d) Given the improvements already implemented or under study, how could administration of the SR&ED tax incentives be further improved and their complexity reduced?

A great proportion of comments by Stonecracker's clients regarding ways to improve the SR&ED administration stem from a very singular point: SME and large entities alike, Canadian and foreign companies alike, have all expressed great concern over their impressions that the SR&ED program administration has taken on an air of audit and compliance versus that of an assistance and incentive program to encourage R&D and business investment in Canada.

Related to this are taxpayers' concerns with:

i. Requests for lab-type, academic-type, project reporting and time-tracking documentation. And similarly, a frequently expressed perception by taxpayers that the technical reviewers lack overall depth and breadth of real-world experience in non-academic, non-lab, SME industrial research.

ii. Incidents where technical reviewers express financial opinions, and financial reviewers express technical opinions - clearly contrary to the scope of their participation and usually of a spurious or incorrect nature.

iii. Reviewers' unwillingness to accept verbal evidence, despite Federal Court of Appeal decisions explicitly stating the acceptability of such evidence. This speaks to far greater concern where reviewers may be failing to, or refusing to, follow very high level court decisions specifically on topic.

iv. An apparent lack of relevant legal training of financial and technical reviewers. As administrative actors, all reviewers are bound by the rule of law and as such are required to apply the right legal test at the right time, according to case law and legislation. However, this is not always the case.

v. The dominance of financial and audit backgrounds in the management staff of the SR&ED administration. That is, many taxpayers have noted that there is an imbalance of skill sets and backgrounds given the industrial and technical nature of the entire SR&ED program. The dominance of audit and compliance backgrounds may be a factor in taxpayer's perception that the entire SR&ED program has taken on an air of audit and compliance.

In response to the concerns above, we have provided the following suggestions for actionable items, which if all applied, we believe would provide greater certainty, consistency, and speed in the administration of SR&ED claims:

i. Training of reviewers to accept verbal evidence as relevant and valid evidence.

ii. Training of reviewers to accept broader classes of documentary evidence different from what a lab or academic setting would normally produce.

iii. Continuous communication of relevant legal briefs to reviewers to ensure they are applying the latest in legislation and caselaw on point, in particular legal tests for eligibility under the SR&ED program.

iv. Reinstatement of partnership committees for continued feedback directly from industry. Stakeholder input is the norm around the world for good reason.

v. Continuation of the 13-point SR&ED action plan from 1998, where great insights were made but not yet completed after considerable time.

vi. A 2-year limitation period for refundable claims as seen in the U.K., and no limitation on non-refundable claims. Alternatively, allowance of late filings but with penalties.

vii. Allowance of a PDF or similar-format attachment to allow e-filing of T2's with SR&ED forms, so that a T2 does not have to be taken down to manual processing merely because it needs a SR&ED project description. That is, the project description could simply be in PDF format and form part of the e-file data stream. This would have additional benefits of secured delivery, and non-repudiation of completeness of that delivery.

viii. Allowance of e-mail correspondence with SR&ED reviewers. This would not only ensure more rapid completion of responses, but also allow taxpayers and the Government of Canada to continue on improving ecological footprints by avoiding faxes, paper and delivery.

We hope you have found our input valuable and thought provoking. We thank you again for providing us this opportunity for input on improving what we consider one of the best R&D programs in the world.

With explicit permission to post:

Kevin K. Wong, Barrister and Solicitor
Stonecracker Scientific Law Office
2022 – 1 Street North West, Calgary, Alberta, T2M 2T4
Phone: 403-537-0731 E-mail: kwong@stonecracker.com