Archived - Part 2
An International Comparison of Tax Assistance for Investment in Research and Development
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Spending on research and development (R&D) is widely acknowledged as providing benefits not only to the firm undertaking the activity but also to the economy at large in the form of lower prices, improved products and access to new production technologies.1 In recognition of these spillover effects, it is common practice for governments to provide assistance to firms undertaking investment in R&D. This paper provides estimates of tax assistance for R&D investment by large and small firms, as measured by marginal effective tax rates (METRs), for the 30 member countries of the Organisation for Economic Co-operation and Development (OECD) and for 6 key emerging and transition economies. In order to provide a clear indication of how tax incentives affect the overall cost of R&D, this paper also presents estimates of the subsidy rate, defined as the percentage decline in the cost of R&D arising from tax incentives. The subsidy rates are developed through a straightforward transformation of the METRs. International rankings of tax support for R&D based on subsidy rates are therefore not substantially different from those based on METRs.
All countries in the comparison group provide tax assistance for investment in R&D in the form of generous tax depreciation allowances, which in many cases exceed the amount invested, and a third of the countries provide investment tax credits (ITCs). Eight countries in the comparison group, including Canada, provide special assistance to small firms for investment in R&D, primarily through higher ITC rates. Taking into consideration both large and small firms, Canada has the third most generous R&D tax regime in the comparison group, after France and Spain.
As discussed below, a number of simplifying assumptions are required in order to obtain quantitative estimates of tax assistance, and the estimates should therefore be interpreted with caution. For example, common assumptions about how the R&D is financed, the ability to claim credits and deductions as they are earned and the rate of return on the investment are made in order to focus attention on differences in tax parameters affecting R&D. In addition, tax provisions affecting R&D are in some cases highly complex, making it difficult to summarize them in terms of credit and tax depreciation rates that can be quantified in an economic model.
Finally, it is worth noting that governments provide support for R&D through a variety of channels, such as grants and loans as well as procurement and patent policies, not just through the tax system. As a result, the comparison made in this paper does not provide a complete picture of relative overall levels of support for investment in R&D.
Methodology, Assumptions and Caveats
A marginal effective tax rate is a comprehensive indicator of the tax burden on new investment. It combines in a single measure the statutory tax rate that applies to corporate income, factors that affect the corporate tax base (e.g. capital cost allowances and interest deductibility), along with ITCs and profit-insensitive levies such as capital taxes and sales taxes on investment goods.2 A METR measures the part of the return on an investment required to pay corporate-level taxes, expressed as a percentage of the total return to investors. For example, if the gross-of-tax return to shareholders is 6% and if the corporate tax system reduces this return to 4%, the METR would be 33%.3
In addition to tax parameters, calculation of METRs requires assumptions about the financial structure of firms, the rate of return on debt and equity, and the rate of inflation, all of which are used to calculate the financial cost of capital. The estimates are also sensitive to the capital assets—scientific equipment, buildings and inventories—used by firms to undertake R&D and how quickly they depreciate. In order to focus on differences in tax systems, these "economic" assumptions are generally held constant for all countries and types of firms included in the international comparison.4 As a result, the estimates presented in this paper indicate how the Canadian METR and subsidy rate would change if the tax systems of other countries were applied in Canada. The economic assumptions and parameters underlying the calculation of the R&D METRs are provided in Annex 1.
A central premise underlying the calculation of R&D METRs is that all spending on R&D, including salaries and the cost of materials, is undertaken to create an asset that is expected to generate a stream of revenue over time in the same way that investment in tangible capital generates future income.5 With this as a benchmark, all spending on R&D is capitalized, and immediate deductibility of current expenditures, which is permitted in almost all countries in the comparison group, constitutes tax assistance and therefore puts downward pressure on METRs.
As in the case of METR models generally, two working assumptions are made to keep the methodology tractable:
1. The METRs are calculated for profitable firms that can claim credits and deductions as they are earned.
To the extent that firms do not have sufficient income to immediately use all credits and deductions, this assumption overstates the amount of tax assistance (i.e. reduces the METRs) since any delay in claiming credits and deductions makes them less valuable to firms. While it would be possible to calculate METRs to reflect typical profit profiles and to calculate a weighted average METR for profitable and non-profitable firms, this approach would shift attention from general tax parameters to loss offset provisions. This shift could affect international comparisons, likely to Canada's advantage given our generous carry-forward and carry-back provisions for losses and credits.6 In addition, startups, which are usually small-scale, are less likely to be able to make immediate use of credits and deductions than other firms. As a result, the methodology used could overstate the amount of tax support provided to small firms relative to large firms. Further, since tax assistance is refundable to some extent in four countries, including Canada, the overstatement will not be uniform across all countries.
2. Investments in R&D are assumed to earn the normal risk-adjusted rate of return.
Returns in excess of the normal rate are taxed at the statutory rate, so to the extent that investment in R&D earns economic rents, the METR methodology will understate the effective tax rate on R&D investment. Further, since statutory rates vary across countries, this assumption could affect the rankings of tax assistance for R&D: in the presence of rents, countries with relatively low statutory tax rates, such as Canada, would have a lower effective tax rate than countries with relatively high statutory tax rates.
An Overview of Tax Support for R&D
This paper includes all legislated corporate income tax measures provided by national and subnational governments that will be in force in 2012.7 All countries in the comparison group provide tax assistance for investment in R&D through highly favourable tax depreciation allowances and 12 countries offer ITCs as well. These measures, along with corporate income tax rates, are the key tax parameters used to calculate METRs. This section provides an overview of these measures; additional details are provided in Annex 2. A detailed description of Canada's tax incentives for investment in R&D is provided in Annex 3.
Tax Deductions for R&D Expenditures
All countries except Korea and Russia allow current expenditures to be deducted in the year they are incurred and 10 countries provide "super" depreciation on current expenses ranging from 200% to 128%. In Greece and Austria, firms qualify for additional depreciation on expenses that exceed the average level of spending in the preceding two and three years, respectively. In addition to providing super depreciation on current spending, Australia provides a depreciation allowance on incremental spending. The United Kingdom stands out in providing a higher rate of tax depreciation for small firms than for large firms. Immediate deductibility of current expenditures is more valuable to small firms since this spending represents a higher share of their spending on R&D.
Fourteen countries, including Canada, allow immediate deductibility of spending on scientific equipment, while Hungary, Singapore, China, Austria and Australia allow super depreciation ranging from 200% to 118% for these expenses. In most of the remaining countries, tax depreciation for equipment equals or exceeds economic depreciation. In contrast, tax depreciation allowances for buildings fall below economic depreciation in 21 countries. Ireland and India are unusual in permitting immediate deductibility of investment in buildings. India also allows double deductibility of interest expenses.
Investment Tax Credits
The amount of assistance provided to R&D investment by an ITC depends on the rate and the design features of the tax credit. All 128 countries offering credits impose eligibility restrictions that reduce the effective ITC rate below the statutory ITC rate. For example, all countries except Ireland exclude investment in buildings from the base for ITCs. In the Netherlands, only labour expenses are eligible for the credit, while in Hungary eligibility is restricted to investment in scientific equipment. Ireland is the only country that provides an ITC on all types of investment in R&D.
In addition, the amount of eligible spending may be capped or the ITC may apply only to spending above a threshold value, such as some past level of spending. Restrictions such as these determine how the ITC rate affects the marginal and the average cost of investing in R&D (Box 1). This is an important distinction, since changes in marginal cost, not average cost, affect the decision as to how much to invest. In what follows, the term "marginal effective ITC rate" refers to the ITC rate adjusted for eligibility limitations as well as for caps and thresholds that determine the impact on the marginal cost of investing in R&D.
The marginal effective ITC rates used in the METR calculation are shown in Table 1. The most generous marginal effective ITC rates are offered by Spain and Canada, while Ireland and France offer relatively generous credits as well. In 6 of the 12 countries, the ITCs are deducted from the base for tax depreciation allowances, which limits tax deductions to the amount of private spending undertaken.
Although only seven countries9 have higher statutory ITC rates for small than for large firms, the marginal effective ITC rates are higher for small firms in all countries except Ireland. In many cases, the difference reflects the exclusion of buildings from the ITC base: buildings are a smaller share of spending by small firms (see Annex 1), so for a given statutory ITC rate the effective ITC rate is slightly higher for small firms.10 Ireland is an exception since its ITC applies to all spending on R&D, including buildings. Canada's combined federal-provincial marginal effective ITC rate for small firms is the highest in both absolute terms and relative to the credit for large firms.
Calculating Marginal Effective Investment Tax Credit Rates
This box describes in general terms how the marginal effective ITC rates used in this paper were calculated, and compares them to average effective rates.
Three countries—Spain, the United States and Ireland—provide ITCs based on spending that exceeds a threshold level. These "incremental" credits are implemented with the intention of raising the marginal effective ITC rate above the average rate, in order to increase the impact on investment per dollar of forgone revenue. In Spain, however, the base is defined as a two-year rolling average of past spending, so investment in the current period raises the base in subsequent years, which substantially reduces the incentive effect of the ITC (see Eisner, Albert and Sullivan (1984) for a detailed explanation). As a result, the marginal effective ITC rate falls well below the statutory rate, and will only be above the average effective ITC rate if R&D spending is growing relatively slowly. This analysis also applies to the additional depreciation deductions provided by Australia, Austria and Greece, which are available to firms that increase spending relative to a past average.
In contrast, the base for the US regular incremental credit is determined by multiplying R&D intensity (the share of R&D spending in total spending) in the base year by a moving average of sales. In this case, the base is only slightly affected by increased investment in R&D, so the marginal effective ITC rate is approximately equal to the statutory rate (see Watson (1996) and Hall (2008) for additional details). But since non-incremental spending receives a zero credit, the marginal effective rate exceeds the average effective ITC rate. Ireland provides a credit for R&D investment in excess of the level in a base year, defined as the first year R&D investments were made or 2003, whichever occurs later. In this case, the marginal ITC rate is lower than the statutory ITC rate because investment by some firms will fall below the level in the base year, making them ineligible for the credit. But since spending below the threshold does not receive a credit, the marginal effective ITC rate will nevertheless be greater than the average effective ITC rate.
Seven countries in the comparison group have ITC rates that vary by size of firm. In the Netherlands the threshold is set low enough that small firms receive a variable ITC rate while in Norway a cap on the credit affects some small firms. In the remaining countries—Canada, France, Italy, Japan and the US—the thresholds are set such that the special rates apply to both small and medium-sized firms. Since the definition of medium-sized firms varies more than the definition of small firms, this paper combines medium-sized firms and large firms into a single group of larger firms. Larger firms in these countries may therefore receive different ITCs, depending on their size. For example, in France a firm spending €150 million on R&D gets a 30% ITC on the first €100 million and 5% on the remaining €50 million. As a result, firms face a marginal ITC rate of either 30% or 5%.
The marginal effective ITC rates for these seven countries are weighted averages of the two rates available to firms, with the weights being the share of R&D conducted by firms spending less than and more than the threshold. Since the marginal rate declines as spending increases, the average effective ITC rate will be higher than the weighted average marginal effective rate. The difference is small in Canada because the higher ITC rate applies to a relatively small number of medium-sized firms that are affected by the phase-out of the more generous small business credit.
|1 Ranked by the level of the combined large/small rate. See Box 1 for a discussion of marginal effective ITC rates.|
Special Corporate Income Tax Rates
Eleven countries in the comparison group have a special rate of corporate income tax (CIT) for small firms. But these preferential rates generally have such low taxable income and/or capital thresholds that they are applicable only to a limited number of small firms, as defined in this paper.11 As a result, a low CIT rate is used in the METR calculations only for Canada, Korea, Spain and the UK, which have higher thresholds for their special rates. These lower CIT rates have a counterintuitive effect on the METR: decreases in the CIT rate cause small increases in the METR. In the presence of generous tax depreciation allowances, the normally harmful effect of higher taxes on the return generated by investment in R&D is dominated by the increased value of deductions, causing the effective tax rate to decline slightly.12
As noted above, the METR methodology assumes that firms can fully use depreciation allowances and ITCs as they are earned, which overstates the amount of tax assistance. The international comparisons implicitly assume that the overstatement is the same for all countries. In four countries, however, tax assistance is refundable, so the overstatement will not be uniform. Norway provides a refundable ITC for both large and small firms, although the cap on eligible spending is relatively low. Tax assistance for R&D is partially refundable in three countries. In France, the ITC is refundable after three years of carry-forward, although growing small and medium-sized firms can benefit from immediate refundability.13 Canada's federal ITC on current spending by small firms is also refundable without restrictions up to the expenditure limit, while ITCs on eligible capital expenditures and current expenditures above the expenditure limit are refundable at a 40% rate.14 In the UK, two-thirds of the super tax depreciation allowance available to small and medium-sized firms is refundable, subject to an additional cap.
Marginal Effective Tax Rates for Large and Small Firms
An international comparison of METRs for large and small firms is shown in Chart 1, along with the combined rate.15 (For ease of presentation, the METRs have been indexed on the value of the most generous level of overall assistance. As a result, the most generous level of overall assistance has been assigned a value of -100, with the negative value indicating that the tax system is subsidizing investment in R&D.) Considering both large and small firms, Canada has the third most generous level of tax assistance for R&D in the comparison group of countries, behind France and Spain. India and Brazil, ranked fourth and fifth, provide levels of assistance that are similar to Canada. Four of the ten top-ranked countries offer generous ITCs. Brazil, the Czech Republic, Hungary, India, Turkey and the UK are in the top ten because of generous tax depreciation rates, the benefit of which is enhanced by relatively high CIT rates in Brazil and India.
The list of the ten most generous countries does not change when only large firms are considered. Canada's ranking does, however, fall to fifth since India and Brazil provide more generous support for large firms undertaking R&D than Canada.16 When considering only small firms, the list of top ten countries differs only in that Norway replaces the Czech Republic. Canada has the most generous tax assistance provisions for small firms.
The METRs for small firms generally indicate a greater level of tax assistance (that is, they become more negative) than for large firms. This outcome reflects higher ITC rates for small firms in some countries as well as the differences in the composition of spending, such as a smaller share for capital spending, discussed above.
Subsidy Rates on Investment in R&D
METRs measure the change in the required rate of return on an investment caused by corporate-level taxes. More precisely, for investment in R&D capital, the METR is the "wedge" between gross-of-tax and net-of-tax returns expressed as a percentage of the net-of-tax return to investors.17 The tax system subsidizes investment in R&D in almost all countries, so the tax wedge is generally negative and is typically large relative to the net return to investors. For example, Canada's METR for large firms is
-147%, which means that R&D tax subsidies amount to about 1.5 times the net-of-tax return to investors.
An alternative way to measure tax assistance is to calculate the subsidy rate, defined as the percentage reduction in the cost18 of R&D capital arising from tax incentives. Tax subsidy rates are developed through a straightforward transformation of the METRs, so international rankings of tax support for R&D are not substantially affected.19 The subsidy rates are a useful supplementary measure of tax assistance, primarily because they provide a more easily understood indication than METRs of how tax incentives affect the cost of R&D. For example, Canada's METR for large firms is equivalent to a 26.9% subsidy rate on the cost of R&D capital.
While such an extension is beyond the scope of this paper, subsidy rates have the further advantage that they can be augmented to include other forms of government assistance, such as grants, that also reduce the cost of R&D capital. A comprehensive measure of government assistance to R&D is of interest in itself and would facilitate empirical analysis of the contribution of government assistance to international variations in R&D intensity. Such an indicator would also make it easier to assess the contribution of individual elements of support to increases in R&D intensity.
Subsidy rates are shown in Table 2 for the 36 countries in the comparison group. The overall subsidy rates range from 40.2% of the cost of R&D in France to near zero in the Russian Federation and Switzerland.
|Country||Large Firms||Small Firms||Combined Large/Small||Combined Ranking|
Comparison With the B-Index
Chart 2 compares the overall subsidy rates calculated using the METR framework and the B-Index methodology, which is used by the OECD in its international comparisons of tax assistance for R&D.20 The B-Index methodology measures the after-tax cost of investing in R&D taking into consideration ITCs and depreciation allowances. The B-Index differs from the METR framework in three respects:
- The B-Index does not include financing costs in the cost of investing in R&D.
- The B-Index does not include taxes other than corporate income taxes (e.g. capital taxes and sales taxes on capital goods are excluded).
- The B-Index is calculated assuming that the benchmark tax system allows all expenditures on R&D to be expensed rather than requiring them to be capitalized and depreciated as in the METR framework.
Leaving out financing costs and all taxes other than corporate income taxes increases the level of tax assistance for R&D in the B-Index. In contrast, adopting immediate deductibility of all spending on R&D as the benchmark reduces the level of tax assistance portrayed by the B-Index. For example, expensing of wages constitutes tax assistance in the METR framework but not in the B-Index. As can be seen in Chart 2, the latter effect dominates, so the B-Index subsidy rate is systematically lower than its METR-based counterpart, by 3.6 percentage points on average, or about 30% of the average METR-based subsidy rate. Note that R&D assets such as scientific equipment and buildings cannot always be expensed as assumed in the B-Index, so that the B-Index subsidy rate is negative in countries that do not provide other incentives for R&D. By contrast, in the METR framework the impact of tax depreciation depends on whether it is more or less generous than the economic depreciation rate.
Chart 3 shows the international rankings of subsidy rates obtained using the METR and B-Index frameworks. Most of the changes in moving from the METR to B-Index framework occur for countries providing less than the median level of support to R&D, where the estimates for the B-Index are tightly grouped. Canada's ranking does not change when tax assistance for R&D is measured using the B-Index.
This paper has presented estimates of tax assistance for investment in R&D by large and small firms as measured by METRs and as measured by subsidy rates calculated using the METR and B-Index frameworks. All 36 countries included in this paper provide tax assistance for investment in R&D through generous tax depreciation allowances and 12 countries provide ITCs as well. This paper has transformed statutory ITC rates into relevant indicators of the incentive to invest in R&D by adjusting them for the impact of eligibility criteria as well as for the impact of caps and thresholds. The METRs calculated for all countries are negative, indicating that investment in R&D is supported by the tax system. Eight countries, including Canada, provide more favourable tax treatment to small firms than large firms undertaking R&D. Considering both small and large firms, Canada has the third most generous R&D tax regime in the comparison group of countries, behind France and Spain. The METR methodology assumes firms can take full advantage of R&D tax incentives without refundability; this downplays the amount of assistance available in Canada and three other countries that have refundability provisions.
Subsidy rates—the percentage reduction in the cost of R&D investment—are a useful supplementary measure of tax assistance, primarily because they provide a more easily understood measure of how tax incentives affect the cost of R&D. For example, overall subsidy rates calculated using the METR framework range from near zero to 40% of the cost of investing in R&D. Since these subsidy rates are developed from the same analytical framework as the METRs, international rankings are not substantially affected. The B-Index, which is the most commonly used indicator for making international comparisons, shows a substantially lower level of tax assistance for R&D largely because the methodology adopts a benchmark tax system in which R&D spending is expensed rather than capitalized as in the METR framework. Nevertheless, using the B-Index methodology does not have a large impact on the international rankings of tax assistance for R&D.
Tax assistance is only one of several ways governments provide support to investment in R&D. A number of other factors, such as the amount of patent protection provided as well as the quality of labour and public infrastructure, affect how much and in what location firms decide to invest in R&D. The tax assistance measures presented in this paper therefore provide a useful but incomplete comparison of the incentive to invest in R&D.
Annex 1—Economic Parameters
This annex presents the economic parameters used in the METR model. They comprise the return required by suppliers of financial capital, the financial cost of capital to firms, inflation, debt and equity shares in the financial structure of firms, economic depreciation rates and the weights used to aggregate the inputs used to create the R&D asset. Except for the cost of finance, the economic parameters used in the model refer to the Canadian situation. Only the tax parameters are country-specific. As a result, the estimates presented in this paper indicate what would happen to the METR and the user cost of R&D if the tax systems of other countries were applied in Canada.
|Share in Total Expenditures1|
|Large Firms||Small Firms||Depreciation Rate2|
|Large Firms||Small Firms|
|Nominal return to investors||5.30||5.15|
|Risk-free interest rate4||5.76||5.76|
|Risk-adjusted equity return5||4.99||4.24|
|Real return to investors||3.30||3.15|
|Nominal cost of finance to firms||4.66||4.52|
|Debt/(Debt plus equity)6||40.00||40.00|
1 Calculated from data supplied by the Canada
2 Sources: Statistics Canada for physical capital and Hall (2007) for current spending.
3 Weighted average rate for large firms. The rate for small firms is 14.9%.
4 Average return on 10-year government bonds in G7 countries.
5 Calculated assuming that net of personal tax returns on debt and equity are equal. Average personal income tax parameters in the G7 countries are used for large firms and country-specific tax parameters are used for small firms.
6 Ten-year average of the economy-wide debt ratio in Canada.
Annex 2—Summary of R&D Tax Provisions by Country in 2012
|Current Statutory||Current Marginal Effective||Capital Statutory||Capital Marginal Effective||Combined Marginal Effective|| Taxable3/
|Statutory Corporate Income Tax Rate|
|Group of Seven|
|Smaller Developed Economies|
| Note: All US$ figures have been adjusted for 2009 purchasing
1 Includes all firms with more than 50 employees, except in Canada, where small firms are defined as those eligible for the 35% credit only.
2 The base for the investment tax credit (ITC) excludes buildings except for Ireland.
3 An ITC is described as taxable if firms are required to reduce the base for tax deductions by the amount of the credit received.
4 Medium-sized firms benefit from special refundability provisions in Canada and France.
5 Firms are eligible for the 30% ITC on the first US$109.2 million of eligible expenditures and 5% on the expenditures exceeding that amount.
6 The higher ITC rate is available to firms with less than US$858,226 in assets or with less than 1,000 employees.
8 Firms may choose between the regular incremental credit, which has a statutory rate of 20%, and the Alternative Simplified Credit, which has a 14% statutory rate that applies to a different base. The regular incremental credit is capped at 10% for some firms.
9 Incremental ITC. The marginal ITC rate is calculated as the credit on the current year less the present value of forgone credits as a result of the increase in the expenditure base in future years.
10 The ITC is available on labour expenses only.
11 Labour expenses receive a 42% volume ITC and other current expenses qualify for a 25% volume ITC. All current expenses are eligible for a 42% incremental ITC. Scientific equipment expenses qualify for an 8% volume ITC.
|Current Spending||Scientific Equipment||Buildings||Combined|
|Group of Seven|
|Smaller Developed Economies|
| Note: All US$ figures have been adjusted for 2009 purchasing
7 Firms with less than 250 employees and less than US$61 million in assets can claim a 175% deduction on current expenditures.
|Current Statutory||Current Marginal Effective||Capital Statutory2||Capital Marginal Effective2||Combined Marginal Effective||Taxable3/ Refundable|
Note: All US$ figures have been adjusted for 2009 purchasing power parities.
1 Small firms are defined as firms having less than 50 employees for all countries except Canada, where small firms are defined as those eligible for the 35% credit only. Only those countries providing higher statutory ITC rates for small firms are included in the table.
2 The base for the ITCs excludes buildings.
3 An ITC is described as taxable if firms are required to reduce the base for tax deductions by the amount of the credit received.
4 See Annex 3 for a detailed description of tax incentives in Canada.
5 ITCs for small firms are refundable in all jurisdictions except Manitoba.
6 Immediate refundability is available for growing small firms.
7 No enhanced federal ITC for small firms. Arizona, Indiana, Minnesota, North Carolina, Pennsylvania and Rhode Island provide higher ITC rates for small businesses based on levels of expenditures or gross receipts.
8 Firms may claim a 42% ITC for the first US$124,438 in R&D salary and 14% for the excess.
9 Eligible expenditures for the ITC are capped at US$0.639 million, so the marginal ITC rate for some small firms is zero.
Annex 3—Description of R&D Tax Incentives in Canada
The Federal Scientific Research and Experimental Development (SR&ED) Tax Incentive Program21
The SR&ED tax incentives have two components:
- An income tax deduction allows immediate expensing of all allowable expenditures (including full expensing of capital in the year of purchase subject to certain rules). The full value of current and capital SR&ED expenditures is added to a pool of unused SR&ED deductions, which can be taken at the discretion of the taxpayer. Unused deductions can be carried forward indefinitely.
- An ITC is applied to income taxes otherwise payable. Unused credits can be carried forward 20 years and back 3 years to reduce taxes payable in those years, and are partially or fully refundable for smaller businesses.
A business can generally claim both the income tax deduction and the ITC on the same SR&ED expenditures, although there are some specific differences in the base of expenditures eligible for the two components of the program. The income tax deduction is net of both federal and provincial ITCs. The federal credit is applied to eligible spending net of provincial ITCs.
Activities eligible for the SR&ED tax incentives involve systematic investigation or search carried out in a field of science or technology by means of experiment or analysis. In general, three broad categories of activity are eligible: basic research, applied research and experimental development.22 Certain support activities are also eligible where they are commensurate with the needs, and directly in support, of basic research, applied research or experimental development, although there are also certain activities that are excluded from the definition of SR&ED.
When reviewing whether an activity falls within the scope of the SR&ED program, the Canada Revenue Agency uses the following three criteria, each of which must be satisfied, to determine whether the activity meets the definition of SR&ED:
1. Scientific or technological advancement—The work must generate information that advances the understanding of scientific relations or technologies.
2. Scientific or technological uncertainty—The possibility of achieving a given result or objective, or the way in which it could be achieved, must be unknown or indeterminable based on generally available scientific or technological knowledge or experience.
3. Scientific and technical content—There must be evidence that qualified personnel with relevant experience in science, technology or engineering have conducted a systematic investigation through experiment or analysis.
Most current and capital expenditures in respect of SR&ED in Canada performed by, or on behalf of, a taxpayer and related to a business of the taxpayer, including a possible extension of that business, may be eligible for the SR&ED tax incentives.
In general, current expenses that are eligible for the SR&ED tax incentives include:
- Salaries or wages of employees directly engaged in SR&ED.
- The cost of materials consumed or transformed in SR&ED.
- Lease costs relating to machinery and equipment used all or substantially all (90% or more) for SR&ED.
- Certain expenses associated with contracts to perform SR&ED directly on behalf of the taxpayer or payments to third parties where the taxpayer is entitled to exploit the results of the SR&ED.23
In addition, taxpayers can choose how to treat overhead and administrative expenses. Under the "traditional method," overhead and administrative expenses must be specifically identified and allocated in respect of SR&ED and may be eligible for both the SR&ED tax deduction and credits. Under the "proxy method," these costs are deductible as ordinary overhead and administrative expenses, and a notional amount that is eligible for the SR&ED tax credits is calculated.
In general, capital expenditures that are eligible for the SR&ED tax incentives consist of expenditures for machinery and equipment that is all or substantially all used or consumed in the performance of SR&ED in Canada.
Rates and Limits
There are two rates of ITCs for SR&ED performed in Canada:
- The general rate is 20%.
- An enhanced rate of 35% is provided to Canadian-controlled private corporations (CCPCs) on up to $3 million of qualified expenditures.
The $3-million expenditure limit is phased out if prior-year taxable income is between $500,000 and $800,000 or if prior-year taxable capital is between $15 million and $50 million.24 Tax credits earned at the enhanced rate are fully refundable for current expenditures and are 40% refundable for capital expenditures. Unused ITCs can be carried back up to 3 years and carried forward up to 20 years to be applied against taxes payable in those years.
The following table presents the ITC rates and refundability rates for different types of businesses.
|Business Type||ITC Rates||
CCPCs with prior-year taxable income of $500,000
or less and prior-year taxable capital employed
in Canada of $10 million or less
|Expenditures up to expenditure limit1||35||100||40|
|Expenditures over expenditure limit||20||40||40|
CCPCs with prior-year taxable income between
$500,000 and $800,000
|Expenditures up to expenditure limit2||35||100||40|
|Expenditures over expenditure limit||20||0||0|
CCPCs with prior-year taxable capital employed
in Canada between $10 million and $50 million
|Expenditures up to expenditure limit3||35||100||40|
|Expenditures over expenditure limit||20||0||0|
|All other corporations||20||0||0|
1 Expenditure limit is generally $3 million per annum.
2 Expenditure limit for CCPCs is phased out for prior-year taxable income between $500,000 and $800,000.
3 Expenditure limit for CCPCs is phased out for prior-year taxable capital employed in Canada between $10 million and $50 million.
Most provinces and territories offer additional ITCs to firms that perform scientific R&D within their borders. The only provinces and territories that do not provide ITCs are Prince Edward Island, the Northwest Territories and Nunavut. Provinces generally follow the federal definitions for allowable SR&ED activities and expenditures.
Provincial credits are summarized in Table A3.2. Only Ontario and Quebec have enhanced ITC rates for small R&D performers. The Quebec ITC is unique in that it applies to wages only. ITCs provided in all jurisdictions except Ontario, Manitoba and British Columbia are refundable for all firms. The ITCs in Ontario and British Columbia, however, are refundable for small firms.
Manitoba, Ontario, Quebec and Yukon provide ITCs to firms that undertake R&D in conjunction with eligible research institutions within their borders; however, these ITCs are not included in the estimates of tax assistance developed in this paper. These credits are:
- Quebec: A refundable 35% credit is applicable to 80% of payments to eligible research centres.
- Ontario: A refundable 20% credit is applicable to payments to eligible research centres, up to $20 million annually.
- Manitoba: A refundable 20% credit is applicable to research in new technologies and biotechnologies undertaken with eligible research centres.
- Yukon: R&D undertaken in conjunction with Yukon College benefits from a 20% refundable credit, rather than the 15% credit that applies to other R&D expenditures.
Quebec's 2008 budget introduced a new wage-based 30% refundable tax credit for e-business, available for salaries paid between March 14, 2008 and December 31, 2015. The credit applies to corporations that have a permanent establishment in Quebec, carry out 75% of their activities in the information technology sector and whose development activities involve at least six full-time employees, with a cap of $20,000 per employee. However, Quebec's Department of Finance projects the tax expenditure associated with this new credit will be less than 5% of that of the R&D wage tax credit. Furthermore, since firms cannot claim two tax credits on the same wages, it is assumed that claims will first be directed to the R&D credit when both are available to the firm. As a result, the new credit is not included in the estimates of tax assistance for R&D prepared for this paper.
|Statutory Rate||Refundable Credit||Carry-Back||Carry-Forward||Expenditure Limit||Phase-Out Criteria||Additional Notes|
|British Columbia||10%||Qualifying CCPCs only||3 years||10 years||Federal limit for refundable credit||Federal criteria for refundable credit||Expires August 31, 2014|
|Alberta||10%||All recipients||–||–||$4 million||–||–|
|Manitoba||20%||No||3 years||10 years||–||–||–|
|Innovation Tax Credit||10%||All recipients||–||–||$3 million to nil, based on provincial phase-out criteria||
and $50 million
|Structure similar to two-tiered federal credit Expenditures above Innovation Tax Credit limit are eligible for R&D Tax Credit|
|R&D Tax Credit||4.50%||No||3 years||20 years||–||–|
|Quebec||Ranges from 37.5% to 17.5%, based on provincial phase-out criterion||All recipients||–||–||$3 million for ITC rates above 17.5%||
Linear phase-out for assets between
$50 million and $75 million
Only applies to eligible R&D wagess
Non-CCPCs only eligible for 17.5% rate
|New Brunswick||15%||All recipients||–||–||–||–||–|
|Nova Scotia||15%||All recipients||–||–||–||–||–|
Corrado, Carol, Charles Hulten and Daniel Sichel (2005). "Measuring Capital and Technology: An Expanded Framework." Measuring Capital in the New Economy, Corrado, Carol, John Haltiwanger and Daniel Sichel, eds. National Bureau of Economic Research Studies in Income and Wealth, Vol. 65. Chicago: The University of Chicago Press.
Eisner, Robert, Steven H. Albert and Martin A. Sullivan (1984). "The New Incremental Tax Credit for R&D: Incentive or Disincentive?" National Tax Journal, 37 (2): 171–185.
Hall, Bronwyn (2008). "The United States Research and Experimental Credit: A Report for the Canadian Department of Finance." Manuscript, August 2008.
Hall, Bronwyn (2007). "Measuring the Returns to R&D: The Depreciation Problem." National Bureau of Economic Research Working Paper 13473.
Lester, John, André Patry and Donald Adéa (2007). "An International Comparison of Marginal Effective Tax Rates on Investment in R&D by Large Firms." Department of Finance Canada Working Paper 2007–07.
McFetridge, Donald and Jacek Warda (1983). "Canadian R&D Incentives: Their Adequacy and Impact." Canadian Tax Paper No. 70. Canadian Tax Foundation.
Watson, Harry S. (1996). "The 1990 R&D Tax Credit: A Uniform Tax on Inputs and a Subsidy for R&D." National Tax Journal, 49 (1): 93–103.
3 Calculated as (6-4)/6. The return to investors is net of all expenses including depreciation.
4 The most important exception is that the rates of return on debt and equity for large firms are determined using data from Group of Seven (G7) countries and for small firms using country-specific tax parameters (see Annex 1 for additional details).
5 There is strong theoretical support for capitalizing R&D expenditure. See, for example, Corrado, Hulten and Sichel (2005).
6 Canada allows losses and R&D tax credits that cannot be used in the current year to be carried back 3 years and carried forward 20 years.
7 There are, nevertheless, several special cases to consider. The ITC in the United States is included despite being a temporary measure since it has been renewed every year but one since its inception in 1981. In contrast, Portugal's ITC, which is also temporary and currently scheduled to expire in 2010, is not included because it has been extended twice but allowed to lapse once since it was first introduced in 1997. In its 2009 budget, Australia announced its intention to replace its "super" depreciation on current expenses and its depreciation allowance on incremental expenses with a more generous ITC, but will undertake a consultation process before passing legislation to implement changes, so this measure has not been included.
8 Excluding Austria, which provides a refundable tax credit for non-profitable firms only as an alternative to super depreciation.
9 These are: Canada, France, Italy, Japan, the Netherlands, Norway and the US, where six states provide higher ITCs for small firms. In addition, the UK has a higher super tax depreciation allowance for small firms.
10 Spain has an additional credit for labour expenses, which is more valuable for small firms given their larger share of labour expenses.
11 The OECD gathers data on R&D spending by firms classified by the number of employees. This paper defines small firms as those having less than 50 employees for all countries except Canada, where small firms are defined as those eligible for the 35% federal credit only (see Annex 3 for details on the federal scientific research and experimental development tax incentive program). Firms in the phase-out range of the 35% credit are defined as medium-sized firms but are grouped with large firms in this paper. Note that defining small firms in terms of eligibility for the 35% federal credit rather than in terms of employment has only a minor impact on the share of small firms in total R&D spending.
12 For example, the Canadian METR for small firms falls from -296.6 to -298.4 when the higher large firm CIT rate is used in the calculation.
13 In 2009, refundability is available to all firms, not just to growing small and medium-sized firms.
14 Some provincial ITCs are refundable for both large and small firms. See Annex 3.
15 The METRs for large and small firms were combined for all countries using the OECD average share of R&D spending undertaken by small firms as defined in footnote 11.
16 An international comparison prepared in 2007 showed that Canada had the third most generous level of tax assistance for large firms undertaking R&D. Since then, enriched tax assistance in France, along with a modelling change affecting India, have changed this ranking. See John Lester, André Patry and Donald Adéa, "An International Comparison of Marginal Effective Tax Rates on Investment in R&D by Large Firms," Department of Finance Canada Working Paper 2007-07.
17 As discussed earlier, the return measured gross of corporate-level taxes is used in the denominator of the METR for non-R&D investments. For R&D assets, however, substantial tax preferences mean that the gross-of-tax return can have a value close to or equal to zero, which would cause the METR to become extremely large or become undefined. Using the net return in the denominator avoids this problem.
18 The cost of investing in R&D is defined as the opportunity cost of the funds invested plus a provision for depreciation, which is usually described as the "user cost" of R&D capital. The subsidy rate is the change in the user cost arising from tax provisions (the tax wedge) divided by the user cost net of corporate-level taxes.
19 The rankings for large firms do not change, but the rankings for small firms do change slightly. In particular, France replaces Canada as the jurisdiction with the most generous tax assistance for small firms when the assistance is measured by the subsidy rate. The rankings for small firms change because country-specific tax parameters are used to calculate the net-of-tax return to investors, and variations in the net return have different impacts on subsidy rates and on the METRs. The net return to investors in large firms is assumed to be the same for all countries, so the rankings are not affected.
20 The B-Index was first presented in McFetridge and Warda (1983).
22 The definition of SR&ED for income tax purposes is largely consistent with the OECD definition of R&D, as presented in the Frascati Manual.
23 Generally, eligible third parties are approved non-profit or tax-exempt associations, universities, colleges, research institutes and similar organizations.
24 Special rules apply to associated corporations, which generally result in the application of taxable income, taxable capital and expenditure limits to group totals.