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CATA Submission in Response to Joint Finance Canada – Canada Revenue Agency Consultation Improving the Scientific Research and Experimental Development Tax Incentives:
Recommendations for Maximizing Canada's Investment in R&D
Finance-CRA Consultations on Improving Canada's SR&ED Tax Incentives and Better Leveraging the Results
CATA – Background
- 1998, CATA issued a submission to the Minister of National Revenue titled The Federal System of Scientific Research and Experimental Development Tax Incentives: Renewing the Partnership Through Consensus, Consistency and Predictability calling for renewal of the SR&ED program. In response, on November 5, 1998, the Minister of National Revenue announced an Action Plan to improve the SR&ED program.
- 2006, CATA conducted online consultations and round table discussions on the SR&ED incentives. Primary focus: legislation. Many administrative issues were raised as well. CATA issued report dated November 14, 2006.
- November 2006, CATA submitted formal observations and recommendations to the Minister of Finance on legislative opportunities for improving the tax incentives and leveraging the results.
- 2007, CATA examined the CRA's report on the results of their claimant satisfaction survey conducted in 2005. CATA issued analysis of the CRA's report in October 2007.
- 2007, CATA conducted online consultations on the administrative aspects of the tax incentives. CATA issued report in October 2007.
Fall 2007, CATA met with company Managers and Practitioners from across Canada to understand the results and to obtain ideas and agreement on what is needed.
CATA – Today's Challenge: Tax incentives are the preferred form of incentives but they must be truly world class for Canada to be an Innovation Nation
- Canada spends 3+ billion dollars a year on incentives yet we are not leveraging the results effectively.
- The results, IP (intellectual property), of our successes are not effectively retained and capitalized in growing our economy.
- Knowledge based investments and jobs in IT and Manufacturing are moving offshore.
- The current system of tax incentives highly distorts the way investors and owners look at where to put their earnings:
- current structure of the Refundable investment tax credits (ITCs) discourages Canadian investors, discourages the reinvestment of earnings in emerging firms, discourages offshore venture investment;
- current Non-refundable ITCs are often ineffective in promoting reinvestment of corporate earnings in Canada, in encouraging corporations to invest in Canada and in capitalizing on Canadian inventiveness;
- current CRA administrative practices and interpretive challenges have once again become major impediments to the success of the incentives as motivators; and
- current CRA administrative practices discourage the commercialization of technologies by applying an artificial research based model for engineering developments involving Experimental Development rather than a real world model reflecting how industrial engineers work.
The Cost of Distortions
Comment: given the legislative and administrative distortions, Canada's tax incentives cannot be world class for the majority of potential investors.
- The majority of Canadian companies without access to the credits on a current basis will not use the tax credits in planning their R&D investment even when their existence depends on innovating.
- Companies with Foreign Tax Credit regimes have difficulties accessing the benefits.
- Non-refundable tax credits benefit after-tax calculation of earnings and therefore, lose influence on investment decisions.
- Offshore venture funding is discouraged.
- Non-refundable credits are a disincentive to the reinvestment of earnings in innovation.
- Problematic administrative practices lead to companies treating the tax credits only as a windfall and often booking the credits at only 50% of face value.
Emerging Administrative Themes
CATA's re-analysis of the CRA's 2005 Claimant Satisfaction Survey indicated that:
- the SR&ED program was working for some claimants, but
- for some claimants, particularly larger claimants (> $50 million in annual revenue), the program was not working efficiently or effectively;
- as early as 2005, the CRA's own survey showed that higher revenue claimants were significantly less satisfied with the administration of the program than were smaller claimants (< $50 million annual revenue). For example,
- only 51% of larger claimants were satisfied with the overall administration of the program compared with 73% of smaller claimants;
- 34% of larger claimants had concerns with their most recent claims compared with 16% of smaller claimants;
- only 64% of larger claimants were satisfied that the CRA processed their claims consistently from year-to-year, i.e., predictably, compared with 81% of smaller claimants.
Emerging Administrative Themes
CATA 2007 Consultations
- Ad hoc policy development. Some CRA reviewers are reported to be often confused about and inconsistent in understanding and applying national policy. Some reviewers deny the validity of national policies and/or they re-interpret national policies.
- Lack of transparency. It also appears that the CRA may be shifting national policy but not communicating it to the community, e. g., documentation standards, treatment of SR&ED associated with commercial activities, treatment of contracts, etc.
- Effective, objective, timely processes for the resolution of concerns/disputes during reviews and appeals are lacking. The redress available through regional offices and the appeals process is seen to lack objectivity/expertise and to be captured by local office interests and relationships.
- Some CRA reviewers are increasing standards for the documentation required to support claims using artificial research oriented models of how Experimental Development is conducted.
- Some CRA reviewers are not cognizant of the areas they are reviewing, the challenges faced in getting technologies to actually work in the real world and how science/engineering is developed outside of the research oriented environment.
- Effective oversight of the both science and financial reviewers is not being achieved with current administrative practices associated with the highly regionalized reporting structures within the CRA.
Result: lack of consistency, transparency, predictability, timeliness, cost-effectiveness and a level playing field for companies
- Contract payment policy is being incorrectly applied or ignored.
- Project structuring – some reviewers are breaking up a project into multiple micro bits ("nuggeting") instead of viewing it as a single integrated project when critical uncertainties are associated with the interaction of the whole at the project level.
- Recognizing Experimental Development and the Software Guide – some reviewers are not accepting these documents as policy, as well as many sector specific guidance documents, etc.
- Commensurate science/engineering work is being carved out from SR&ED activities.
- Documentation requirements are creating high ad hoc artificial barriers to claims effectively eliminating claims for Experimental Development in real world engineering environments, e.g., some reviewers are requiring new research level standards for documentation to support claims and not respecting CRA policy and guidance on what is reasonable.
- Allocation of expenditures based on business records is not being allowed.
CATA – Observations from Consultations (November 2007)
- Some of the CRA's managers seem to have shifted their goals from achieving entitlement through a process of education and reviews to a focus on compliance/dollar recovery through a focus on audit.
- Extremely antagonistic relationships are once again being established which are impacting on the professionalism of the CRA staff.
- The overheads associated with developing claims and supporting them are once again becoming excessive.
- Some CRA reviewers seem to lack the experience and skills to apply technical and financial policies in the context of the larger claims. Is a separate, centralized, dedicated group of senior reviewers needed to handle the more complex workload associated with larger claimants?
- Consistent policy direction and oversight over the reviewers seems to be hindered by the lack of policy direction, experience and program knowledge amongst regional managers. The result is the development of regional and individual reviewer ad hoc micro-economic policy instead of a level playing field.
- There is concern that consideration is being given to eliminating some of the more effective existing services, including:
- PCPR (Pre-claim Project Review);
- Account Executive;
- Process Review and related Memorandums of Understanding (MOUs).
- Such changes are unacceptable to most participants.
- In general, claimants do not think the program is broken but raise critical concerns about the administration of the program.
CRA is not seen to have demonstrated that it can maintain a timely, cost-effective, consistent and predictable delivery of the tax incentives over an extended period. Historically, the private sector has had to get involved repeatedly and politically to get the program on track in order to achieve the Administrative Policy Objectives for the incentives.
For the participants, the status quo is not acceptable and fundamental organizational changes are seen to be required which assure that the long term focus of the administrators is on effectively delivering and communicating entitlements to Canadian businesses.
When consultations and surveys are indicating that 30% to 50% of claimants are having difficulties with the program, action is required.
- Finance needs to clarify the areas of the legislation that are unclear, and/or conflict with business realities.
- Immediate changes to the system of management oversight are required to ensure that effective opportunities exist to obtain corrective action for issues of due process and for technical issues. This is true for both reviews and appeals.
- Immediate remedial actions are needed to establish effective management and procedures to ensure that public policies and guidance are transparent, and that they are consistently and predictably applied in the reviews.
CATA Recommends the Government implement a 3 step action plan to achieve truly effective and world class incentives
Action Plan should address the development of:
1. legislative clarification for areas where policy clarifications by the CRA have repeatedly failed to provide transparent, stable policy application by reviewers;
2. a stable, and effective administrative structure that supports nationally consistent, transparent policy, effective operational oversight of reviews, effective and timely redress for both reviews and appeals, and a national consensus amongst the program's users on policy interpretation of the legislation;
3. enhancements to the incentives through new legislative provisions to remove legislation sourced distortions, i.e., provide universal access for all businesses seeking to innovate through R&D.
Without the first two, history argues that improved incentives will fail to provide the broad stimulus for innovative science/technology based improvements that Canada's businesses need.
1. Legislative clarification to better reflect current intent of the legislation:
- Clarify that the definition of SR&ED in paras. 248 (1) (a), (b), (c) and (d) defines what constitutes SR&ED activities and work, particularly when the SR&ED work is conducted as part of the commercial aspects of a business, i.e., clarify the inclusions by eliminating the exclusions, i.e., paras. (e) through (k) and by adding an exclusion for research in the social sciences and humanities to the preamble to ss. 248 (1). Experimental Production should be explicitly defined in conjunction with the treatment of the cost of materials transformed and consumed in the Regulations, not implicitly as is now the case.
- Clarify the legislation to permit, on an elective basis, non-related Canadian taxpayers to a contract to formally designate which of the parties has the right to claim the SR&ED associated with that contract.
- Clarify the definition of SR&ED cost so that it is clear that SR&ED costs are costs that can reasonably be allocated to the SR&ED work on the basis of books and records normally expected to be maintained by a business. In principle this should be an administrative fix.
- Revise the proposal for section 220.2 of the Income Tax Act that will prevent the Minister from accepting claims after the 18-month deadline to allow their acceptance, subject to penalty.
- CATA does not endorse a solely labour based approach to refundability as an appropriate simplification because it does not provide support for all businesses and for the full spectrum of costs incurred in doing R&D.
2. That the administrative environment be changed so that
- the administrative/operational practices are once again focused on the management of the reviewers in a way that leads to timely, consistent, cost-effective delivery of the entitlements within the boundaries of the established public policy and guidance, not simply compliance.
- The conflict that CRA has in managing this program given its focus on compliance and audit needs to be addressed. It is clearly conflicting and confusing some of the reviewers. In this respect CATA recommends that the Government determine if there are environments more conducive to the successful, consistent and stable management of the program the impacts of the highly decentralized regionalized organizational structure inherent in CRA today on consistency are eliminated. In this respect, CATA recommends that consideration be given to the creation of a single, dedicated centralized group of financial and technical reviewers for the larger files. This has the added advantage of allowing the needed expertise to be drawn together and focused on this challenging but critical group of files.
- The Account Executives and Process Reviews could be managed out of this group for added synergy. Both of these are very successful in the eyes of those using them. The importance to the success of the program of their retention and continued refinement cannot be overstated.
- Effective, timely, objective and independent redress is available during the reviews and appeals that is achieved through the use of appropriate independent expertise in making assessments of issues.
In this respect, CATA recommends that consideration be given to the creation of a SR&ED Ombudsman who would be responsible for the resolution of concerns, for developing appropriate advisory processes to obtain private sector consensus on the interpretive policies, and for input on the operational effectiveness of the administration. Consideration should be given to having the Ombudsman report to a Minster with an economic portfolio.
3. Enhance the incentives by creating a simplified, 2-tiered 35% Enhanced Rate / 20% Normal Rate system of ITCs:
- eliminate the CCPC requirement for the ITC at the 35% Enhanced Rate;
- permit ITCs to be applied to government remittances besides income taxes, e.g., payroll taxes;
- expand the Expenditure Limit from $2 million to at least $10 million for the tax credits earned at the 35% Enhanced Rate;
- decrease the clawback of the ITC at the 35% Enhanced Rate after $400,000 of taxable income, i.e., increase the taxable income limit for the 35% enhanced credit from the current $400,000 to $600,000 for 2008 and subsequent taxation years. Therefore, taxpayers would be able to access fully refundable tax credits at the enhanced rate with taxable incomes up to $600,000 and proportionally reduced amounts with taxable incomes between $600,001 and $1,000,000;
- increase the grind of the Expenditure Limit for access to the 35% Enhanced Rate for every dollar in taxable income in excess of $ 600,000 to a ratio of $25 to $1. Therefore, taxpayers would be able to access the enhanced rate credits with taxable incomes of up to $600,000 as proposed above and proportionately reduced amounts with taxable incomes between $600,0001 and $1,000,000. In excess of this, only the 20% Normal Rate could be accessed by any firm.
- completely remove the Taxable Capital Restriction from the calculation of the Expenditure Limit for SR&ED purposes or at least increase significantly the threshold at which the restriction applies to the availability of the 35% enhanced rate; and
- provide refunds of unused credits earned at either the enhanced or normal rate to a per company limit of $12.5 million of ITCs in the first year, $25 million of ITCs in the second, $50 million of ITCs in the third & $100 million of ITCs in the fourth year. Phasing in this refundable provision over four years should minimize the impact on government expenditures and should permit the uptake of the less restrictive structure by new claimants to be effectively monitored.
Promote the Exploitation of Canadian Innovation by creating an integrated cadre of tax measures that complement the SR&ED Tax Credits and encourage the commercialization of the results of R&D, specifically
- CATA recommends the government look at the use of a combination of targeted tax measures including, accelerated Capital Cost Allowances (CCA Rates), Flow Through of Investment Tax Credits (ITCs) to passive investors and the creation of an Innovation Account or Innovation Reserves which companies can use to reinvest earnings in their firms.
The tax measures should promote commercialization through investment in emerging businesses and the investment of earnings by larger firms in the commercialization of technologies in Canada.
The incentives should promote investment in all sectors of the economy. CATA does not support an expansion of the definition of SR&ED to explicitly support commercialization, because of the resulting complexity.
CATA – Highlights
- The Government needs to find a way to re-establish its focus on developing private sector consensus on interpretive policy and to establish up-to-date knowledge of the current edges of R&D and current business practices, and to reflect this in their review processes.
- The Government needs to renew the administrative commitment to delivering entitlements to claimants by establishing a stable environment supportive of the program's full objectives, not just compliance, e.g., an environment dedicated to achieving the program's economic objectives by delivering entitlements.
- Finance needs to provide appropriate clarification and enhance the legislation, for example, making the refundable tax credits accessible to all performers of SR&ED.
- Universal accessibility to refundable credits is essential to ensure that the SR&ED tax incentives provide all Canadian business with the whole support they need to exploit their full creative, innovative and competitive potential.
- The Government needs to rise to these opportunities and make the SR&ED tax incentive program truly effective for all Canadian business and allow it to play an even greater role in fostering a more competitive and prosperous economy.
CATAAlliance - 2007 On-line Consultations on Administrative Aspects of the SR&ED Tax Incentive Program – 2007 Consultation Report, issued in October 2007
CATAAlliance - SR&ED Tax Incentive Program Canada Revenue Agency (CRA) 2005 Claimant Satisfaction Survey – Analysis of the CRA's Report on the Results of their Survey, issued in October 2007
CATAAlliance – Maximizing Canada's Investment in R&D, Opportunities for Improving Canada's SR&ED Tax Credits and Leveraging the Results, A Submission to The Honourable James M. Flaherty, P.C., M.P., Minister of Finance, November 2006. (This was previously provided to the Department of Finance Canada.)
CATAAlliance - Improving Canada's Scientific Research and Experimental Development (SR&ED) Tax Incentive Program – November 14, 2006
CATAAlliance - The Federal System of Scientific Research and Experimental Development Tax Incentives: Renewing the Partnership Through Consensus, Consistency and Predictability, Submission to The Honourable Herb Dhaliwal, Minister of National Revenue, May 1998
G. Bruce Doern, School of Public Administration, Carleton University - Institutional Aspects of R&D Tax Incentives: The SR&ED Tax Credit, Occasional Paper Number 6, April 1995
We thank both organizations for the effort that they are putting into these consultations and we compliment the Government for its commitment to improving these incentives.
Finally, we will be formalizing the recommendations we have discussed with you today in our formal submission to Ministers Flaherty and O'Connor.