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BDO Dunwoody LLP Submission in Response to Joint Finance Canada Canada Revenue Agency Consultation Improving the Scientific Research and Experimental Development Tax Incentives:

November 30, 2007

Attn: Nancy Horsman & Peter C. Armstrong
Joint Finance Canada – Canada Revenue Agency SR&ED Consultations
140 O'Connor Street
Ottawa, Ontario
K1A 0G5

Dear Ms. Horsman / Mr. Armstrong:

We are pleased to submit our comments on ways to improve the Scientific Research & Experimental Development ("SR&ED") program as requested in the October 5, 2007 Consultation Paper: Tax Incentives for Scientific Research & Experimental Development ("the Consultation Paper").

We trust you will find our comments helpful and we would be pleased to meet with you at a convenient time to elaborate on any of the issues discussed in the Consultation Paper or in this submission. We would appreciate further correspondence or questions directed to us in English. We also look forward to participating in the series of meetings that form part of the SR&ED program improvement process which are referred to in the Consultation Paper.

We hereby grant permission to post our submission on the Department of Finance website as part of the consultation process. The attached comments were prepared based on the collective contributions of the following individuals who are leaders in the firm's SR&ED practice. If you have any questions, please do not hesitate to contact any of them at your convenience.

David Spicer, LLB, CA
Senior Manager – Taxation Services – SR & ED, Vancouver Office
Telephone: 604-668-5421
Fax: 604-688-5132
E-Mail: dspicer@bdo.ca

Sandy Hale, CA
Tax Partner, Mississauga Office
Telephone: 905-270-7700, Fax: 905-270-9915 E-mail: shale@bdo.ca

Greg Skinner, BA
Senior Manager, Windsor Office
Telephone: 519-944-6900
Fax 519-944-6116
E-mail: gskinner@bdo.ca

Yours truly,
BDO Dunwoody LLP

John Wonfor, C.A., CFP, TEP
National Tax Partner
National Office

Comments on improving the Scientific Research & Experimental Development ("SR&ED") program as requested in the Department of Finance and the Canada Revenue Agency ("CRA") October 5, 2007 Consultation Paper: Tax Incentives for Scientific Research & Experimental Development

Submitted By BDO Dunwoody LLP

The October 5, 2007 Consultation Paper: Tax Incentives for Scientific Research & Experimental Development ("the Consultation Paper") provides a general overview of the SR&ED program, comparisons to other programs, and statistics on program usage. In the final section, four specific questions are identified as particular areas of focus in the consultation process. Following are comments with respect to each of these questions, and additional comments on other matters that we feel are important to the program. It is important to recognize that some comments may apply to more than one area of discussion.

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?

Specific areas of interest are the role that SR&ED incentives play in investment decisions of Canada's R&D performers, and how multinationals make R&D decisions.

  • A large number of other countries are now providing generous incentives and Canadian companies and multinationals can choose to perform R&D here or elsewhere. Canada needs to pay particular attention to the ability of companies to compare R&D tax incentives globally. Corporations will examine other factors in determining the location of their R&D activities such as intellectual property protection, currency fluctuations, R&D infrastructures, talent pools, labour costs and their ability to manage the R&D process remotely. Canadian R&D incentives must outweigh real or perceived costs to multinationals making a global decision to perform R&D in Canada versus elsewhere. Canada's incentives still stand out in that they are provided on all eligible R&D spending, rather than just spending above a base amount and this feature should be retained. We believe that eliminating the taxation of the SR&ED investment tax credits would be one effective way of enhancing the existing program.
  • If a multinational chooses to start an R&D operation in Canada, it may face many of the same challenges that a Canadian based start-up faces. Under the current regime, the Canadian founded entity may be provided with more generous credits and be allowed to access those credits in the form of cash refunds while it incurs losses related to significant R&D costs. If domestic transfer pricing and other rules provide adequate protection of the tax base, then the economic benefits of the R&D performed in Canada should be retained here whether the start-up is a Canadian-controlled private corporation ("CCPC") or not. Accordingly, the Government may want to consider revisiting the criteria on which the higher rate refundable credits are earned, and/or allowing the application of the non-refundable credits to other forms of taxes.
  • There are rules in the SR&ED legislation that disallow credits to be earned on R&D expenditures that are incurred outside Canada, even if incurred by a Canadian entity as part of a Canadian R&D project. If an entity has a type of project where certain types of activities cannot be carried on here, it may decide to carry on the entire project elsewhere. There are other R&D regimes that do allow for the inclusion of outside costs into claims and the Government may want to consider allowing such costs in specific types of situations. It is our understanding that over 30 countries have tax based regimes designed to attract investments in R&D. The fact that the Canadian regime restricts eligible expenditures to activities taking place within Canada limits opportunities for Canadian companies to pursue and participate in international R&D opportunities, and affects international investment in Canada. Clearly there must be an overall economic benefit to Canada from the investment of credits into these types of projects; however, we recommend that consideration be given to allowing eligibility on SR&ED activities that are undertaken outside of Canada provided that a Canadian Company incurred the costs.

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

Specific areas of interest are whether the current rules create barriers to the growth of these types of entities, and how companies manage the constraints.

  • As with other tax measures, certainty should be a key component of the regime. In order to provide a true incentive to business, there must be certainty in the way the program is administered throughout the country and within industries and various types of projects and claims. It is important to recognize that even perceived uncertainty can be enough to dissuade taxpayers from using the program or accurately planning their R&D investments and funding needs. Accordingly, the Government should continue existing efforts to provide clarification of the rules as they apply to various industries and legislative concepts. The inclusion of users and industry leaders in the preparation of some of these documents provides for more appropriate administration of the program. It is equally important that if a paper or stated policy is still available, that it be followed by taxpayers, and followed and perceived to be followed by those who administer the program. This not only applies to industry specific papers, but also to those documents that assist claimants with the definition of SR&ED, SR&ED project scope, eligible activities, and the determination of the size and scale of SR&ED expenditures that relate to a specific project. Enhancements to or formalization of pre-claim assistance procedures could also provide certainty to some claimants. The element of uncertainty increases the complexity of the program, which may act as an additional barrier to its effectiveness.
  • Real or perceived regional differences also affect the use and economic benefits related to the program. The SR&ED program is a National program administered by CRA from coast to coast. Management is organized regionally which may lend itself to inconsistencies in terms of how claims are reviewed. Some of these issues could be addressed using specific taxpayer requested reviews or ongoing mandated nationalized quality review processes similar to those used in many commercial settings. We also suggest that other methods be adopted by the CRA to improve communication between management groups and with SR&ED interest groups to facilitate improved mutual understanding which should contribute to improved claim quality. These would be in addition to nationalized training initiatives which have been used recently.
  • R&D costs can be very significant and often unpredictable. The burden of these types of costs and risks on small and medium sized businesses is sometimes prohibitive and the SR&ED incentives are therefore important to them. Many of the program's economic parameters (including the expenditure limit and some tests that affect the eligibility for high rate refundable credits) should be reviewed as they were set some time ago and have not been adjusted consistently with other tax measures and inflation. This may involve the increase or elimination of the capital tax tests, further increases to the taxable income limits, and an increase in the expenditure limit. We would recommend that consideration be given to increasing the expenditure limit to $4,000,000 and the maximum taxable income threshold to $1,000,000 from the existing level.
  • Additionally, we are concerned that where capital assets are to be claimed, that both intent and usage rules are applied in practice, and recommend that the focus be limited to the usage rule.
  • The SR&ED incentives do provide assistance to fund ongoing R&D activities, but in order to continue to fund R&D and grow their operations to take full economic advantage of the benefits associated with the R&D process, companies must access additional types of capital. To raise larger amounts of capital, many of these entities may look to investors outside Canada or to the public stock markets. If the capital investment is significant enough, then the company will no longer be eligible for the enhanced SR&ED incentives. The Government should carefully review the restrictions on the access to the enhanced incentives and determine if certain types of public companies or those with significant amounts of non-resident investors should be provided access to the enhanced credits, or be allowed to apply the credits to other forms of taxes .
  • Currently the CRA will not guarantee direction of ITC's to anyone other than the claimant. This is sometimes restrictive when potential investors are considering their security before they invest and fund ongoing or planned R&D. We recommend that consideration be given to developing and implementing protocols for ITC's to be directed to other parties as directed by the claimant.
  • Accessing capital in modern markets may involve the use of other types of entities including trusts, flow through entities and limited partnerships and it is important to ensure that legitimate structures are not denied access to incentives. The Government may wish to consider removing the restrictions that limit the refundability of these credits to non-CCPC's or, as noted above, allow their application to other forms of taxes
  • The SR&ED program is focused solely on the R&D activities and investment. The economic benefits of the investment in R&D are truly recognized by the commercialization of new technologies or knowledge. There are some other types of programs available for these purposes; however, it may be appropriate to consider extending some form of the investment tax credit incentives to the commercialization phase where the activities may not be SR&ED. The administration of this type of extension to the program may be made easier as the infrastructure to do so may already be in place at the CRA. Projects will have already been identified and screened for overall eligibility by an existing and knowledgeable team. Alternatively, another Department such as Industry Canada could be involved.

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

Specific areas of interest are whether the structure of the incentives could be improved to encourage more cost effective private-sector R&D and public-private R&D collaborations.

  • It is important to recognize that R&D is often not performed in isolation. Collaboration between related and unrelated entities is often a necessary part of the process to ensure that the correct resources and talent are brought to the project. Related to our above discussion of the need for certainty in the SR&ED program, and in response to this question, we recognize that the SR&ED program does allow an entity to claim expenditures where someone else performed the SR&ED on its behalf. The contract payment rules prevent abuse of this through artificial mark-ups or multiple claims for the same costs. In certain circumstances, where multiple arm's-length entities are involved, perhaps allowing them to file an election to determine who can claim costs could alleviate some uncertainty. Additionally, there are some general guidelines intended to clarify who can claim the costs; however, these can still result in some confusion with respect to the rules and their application to various types of activities included in the various parts of the definition of SR&ED itself and under alternative methods of claiming overheads. Further reinforcement of the interpretation, which to our understanding states: that provided it can be demonstrated that the contract work is attributable, commensurate with, in direct support and incremental to the SR&ED project, then the expenditure should be allowed as a contract payment regardless of whether the proxy election or traditional method have been selected for overhead; may be helpful at this time. At an overall level, it is important to revisit collaborative R&D in some detail and ensure that the rules and stated policies are adequate to cover many complex situations which may vary widely by industry or structure.
  • An entity that has successfully developed and commercialized new knowledge or technologies is often in a good position to evaluate and consider investments in other development efforts. To further encourage collaboration and investment within Canada an incentive, in the form of a credit or other measures, could be created to allow for this type of investment. This could encourage private investment and leverage as well as public-private collaboration. Currently the investment may be made in a way where the project belongs to the entity carrying on the work rather than the investor, which could prohibit the investor from benefiting in a more direct and meaningful way.

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?

Specific areas of interest include access, compliance burden, consistency, complexity and the provision of program information and services.

  • We have addressed the need for administrative consistency above as this is a key cornerstone of an effective program. We wish to add that there may be a need for an improved dispute resolution system that would involve an objective third party such as an ombudsman. Currently all mediation between the CRA and the taxpayer is handled by the CRA.
  • It is understood that evidentiary documentation is a requirement; however, current publications indicate that normal business documentation is all that should be necessary to support a claim (i.e. CRA states that it should not be necessary to develop and implement special or separate documentation for the sole purpose of satisfying SR&ED requirements). We recommend reinforcing the stated policies such that those who administer them recognize that business documentation requirements are broad based and that reasonable allocation methodologies should be acceptable in certain situations.
  • There may be some legislative restrictions on the ways that forms can be simplified; however, there are a large number of forms that may be involved in certain claims, especially where Provincial incentives are involved. Outreach related to the completion and filing of key forms such as the T661 and Schedule 31 is stronger than for other types of forms. Various election forms and the related anti-avoidance provisions may be inadvertently misunderstood or missed by claimants who are not intending to abuse the incentive program. A review of these forms (and elections), and the ability to include them in (or better cross reference them to) key existing forms may be appropriate at this time. Any opportunities to co-ordinate the delivery of the Federal program, forms and review processes with the Provincial incentives would greatly assist claimants with their claim preparation process.
  • The 18 month filing deadline is strictly enforced and claimants are encouraged to file well ahead of the deadline. For various reasons some claimants do have to file close to that deadline and it is important that they be provided with consistent evidence that their claim has been received prior to the deadline. Further consideration should be given to ensuring consistent long-term application of SR&ED specific claim date-stamping policies and procedures to provide this level of certainty.

General Comments

Many of those involved with SR&ED claims noted and appreciated the significant efforts made to improve the program starting with the Action Plan announced in 1998. Currently the Partnership or Steering Committee is no longer active and joint sub-committees have ceased to be active resulting in abandonment of commitments for publications such as interpretation papers that were sector specific which serve as useful reference documents for claimants. We ask that the Government consider re-activating some form of steering committee to facilitate improved communication and understanding between Industry and the CRA which in turn will positively affect the quality of SR&ED claim submissions. Additionally we encourage the CRA and SR&ED interest groups to communicate more frequently and openly to facilitate improved understanding, agreement and commitment to SR&ED claim requirement.

This type of joint effort, that involves claimants, advisors, and key industry representatives, results in better administration of the program and more acceptance of the program and policies by existing and potential claimants. Policy and legislative changes which do not involve this process have the potential to make the program adversarial and more difficult to comply with. If claims are filed within stated policies there should be no surprises during the review process. If there is a formal policy statement change to be made it should involve some notification and consultation and should not retroactively affect claims that have already been filed. The process of gathering input on ways to further improve the program as outlined in the Consultation Paper is a welcome next step in building on the SR&ED program's success.

We appreciate the opportunity to provide this input for consideration and would be happy to provide further clarification on any of the issues discussed above.