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Innovation Canada: A Call to Action

6. Program Mix and Design

This chapter addresses the second question in the government's charge to the Panel: "Is the current mix and design of tax incentives and direct support for business research and development (R&D) and business-focussed R&D appropriate?"

In its forthcoming report on business innovation policies, the Organisation for Economic Co-operation and Development (OECD) emphasizes the importance of striking the right balance in the mix of programs to support business innovation. It notes, for example, the requirement to have a set of instruments that is sufficiently differentiated to meet the needs of complex innovations systems while at the same time avoiding the inefficiencies of operating too many schemes at too small a scale — an issue that was addressed in the previous chapter.

The mix between direct and indirect measures is another important consideration, notably because each form of support offers certain advantages and disadvantages (Box 6.1). In its State of the Nation reports, the Science Technology and Innovation Council (STIC 2009, 2010) notes that, as a percentage of gross domestic product (GDP), government support for business R&D in Canada is among the most generous in the world, but underscores that, relative to comparator countries, Canada's support is heavily weighted toward tax incentives as opposed to direct support measures. Of particular note, as seen in Figure 6.1, the United States (US) spends significantly more on direct support measures relative to support through tax incentives. However, there is a trend among OECD countries to make greater use of R&D tax incentives (OECD forthcoming).

The Panel has concluded that the OECD data in Figure 6.1 to some extent overstate federal reliance on indirect support because (i) these data do not capture the full range of direct programs in Canada and (ii) the measurement of direct support varies across countries, making international comparisons problematic. Specifically, the Panel's mandate includes support not only for "direct government funding of business expenditure on research and development (BERD)," as depicted in Figure 6.1, but also for commercially relevant R&D performed by public and non-profit institutions — for example, support through programs that seek to help build links between academia and industry. The addition of these expenditures to the "direct" support mix would slightly increase Canada's ratio of direct to indirect support relative to the picture in Figure 6.1. There are also differences among countries in the calculation of certain items of direct government support that have the effect of increasing the reported direct expenditures of some countries relative to Canada — for example, their inclusion of loans to business and government procurement of R&D services as direct support measures. It should also be noted that the refundable Scientific Research and Experimental Development (SR&ED) tax credit is in effect a cash transfer to qualifying smaller companies to help fund their R&D activity, and thus has something in common with a "direct expenditure" program. On the other hand, the SR&ED credit, whether refundable or not, is quite unlike the direct spending programs reviewed by the Panel, since the latter have targeted criteria and are subject to assessment of the merit of the proposed business innovation project, while the SR&ED program has neither constraint.

Figure 6.1 Direct and Indirect Government Support of Business R&D, 2008 (except as noted) (percentage of GDP)a
Figure 6.1 Direct and Indirect Government Support of Business R&D, 2008 (except as noted) (percentage of GDP)

a The data illustrated in this figure do not include R&D tax incentives provided by sub-national governments — an important consideration, as in Canada provinces also provide tax support.

(Return to reference a)

Although one might debate the fine points of "direct versus indirect" spending ratios, it is abundantly clear from the program data presented in Chapter 3 that the federal government's mix of R&D support is very heavily weighted to tax incentives — the SR&ED program accounts for about 70 percent of the value of the support provided by the 60 programs reviewed by the Panel. International comparisons of tax incentive programs for R&D also demonstrate that the Canadian system is among the most generous in the world, particularly for small businesses (Figure 6.2). Comparisons including the sub-national level indicate, moreover, that the combination of federal and provincial tax credits in Canada provides much higher subsidy rates for R&D than are available, for example, in US states.

Box 6.1 Direct Support Versus Indirect Support

The OECD (2010a, p. 76) defines direct and indirect funding as follows: "Government direct R&D funding includes grants, loans and procurement. Government indirect R&D funding includes tax incentives such as R&D tax credits." In practical terms, the main distinction between direct and indirect support is that the latter is open ended and is available to all firms, whereas the former is limited in overall funding and is allocated by program administrators to specific projects, industries or regions. Direct support can therefore be targeted to specific areas, contrary to more neutral indirect measures.

It follows that the principal advantage of direct instruments lies in the ability to focus support on actors or activities considered more likely to achieve high social returns or to advance specific policy goals. Notwithstanding the benefits associated with this ability to strategically target resources, there are also some drawbacks to direct support measures. In particular, they generally involve more rigorous selection and evaluation processes, which can translate into higher administration costs for government and compliance costs for beneficiaries. Moreover, they can raise some concerns around the desirability of governments "picking winners" in the marketplace.

Conversely, indirect measures are advantageous for the opposite reason. Since they are non-discriminatory and widely available across firms, sectors, fields and activities, they more closely conform to market rationality. Indirect measures are also generally easier and cheaper to implement. The flip side, however, is that they are less amenable to being steered toward specific policy objectives.

The question therefore is whether Canada is relying too heavily on "indirect" tax expenditure in its overall mix of business innovation/R&D support. The great advantage of a tax-based approach is that, once basic eligibility criteria are met, it does not discriminate on the basis of sector, region or specific opportunity. Since the SR&ED program is based on the tax system, it operates "automatically." The tax incentive stimulates R&D generally, but leaves project selection decisions to individual firms. The government does not try to pick the winners — the companies do. The strength of the program is also potentially its weakness. The tax credit is a blunt instrument. Not every R&D project will generate the same rate of social return; not every R&D performer is equally in need of stimulus or equally likely to be successful; and governments will often be well justified in seeking to promote, through targeted support, certain domains of innovation and R&D for strategic purposes.

Changing the Mix: More Direct Support

The SR&ED program plays a fundamental role in lowering the costs of industrial R&D for firms, enhancing investment in R&D, and making Canada a more attractive place to locate R&D activity. However, a key implication of this heavy reliance on the program is that federal support for innovation may be overweighted toward subsidizing the cost of business R&D rather than other important aspects of innovation. In particular, the Panel believes the federal government needs to focus its innovation support more sharply on the strategic objective of growing innovative firms into larger enterprises — a key means of achieving the scale required to realize the Panel's vision of a Canadian business sector that stands shoulder-to-shoulder with the world's innovation leaders.

Figure 6.2 Tax Subsidy Rates on Investment in R&D for Selected Countries, 2009a
Country Large Firms (%) Small Firms (%) Combined Large/Small (%) Combined Ranking BERD Intensity Ranking in the OECD (2008)

a The data in this table include income tax deductions. They also include R&D tax incentives provided by sub-national governments. (Return to reference a)

b Not a member country of the OECD. (Return to reference b)

Source: Department of Finance (2009); and OECD (2011) for the rankings for BERD intensity (BERD as a percentage of GDP) in 2008.

France 38.6 47.6 40.2 1.0 14.0
Spain 34.1 36.9 34.5 2.0 24.0
Canada 26.9 46.0 30.2 3.0 18.0
India 29.3 31.7 29.7 4.0 b
Brazil 28.9 33.0 29.6 5.0 b
Ireland 26.2 26.1 26.2 6.0 19.0
United Kingdom 21.1 22.8 21.4 7.0 16.0
Japan 18.0 23.2 18.9 8.0 4.0
China 17.4 18.8 17.7 9.0 b
Norway 15.9 24.6 17.4 10.0 22.0
Australia 14.2 15.5 14.4 11.0 12.0
Korea 12.1 14.2 12.4 12.0 5.0
Netherlands 10.0 12.2 10.3 13.0 21.0
United States 9.1 10.0 9.2 14.0 7.0
Italy 4.9 17.5 7.0 15.0 25.0
Finland 3.1 3.4 3.1 16.0 2.0
Sweden 2.1 3.2 2.3 17.0 3.0
Germany 1.6 3.3 1.9 18.0 10.0
Switzerland 0.4 2.6 0.8 19.0 6.0
Russian Federation 0.2 0.6 0.3 20.0 b
Unweighted average 15.7 19.7 16.4    
Median 15.1 18.2 15.9    

For this reason, coupled with stakeholder calls for increased direct support, the Panel believes the government should rebalance the mix of direct and indirect funding by decreasing spending through the SR&ED program and directing the savings to complementary initiatives strategically focussed on serving the needs of innovative Canadian firms, especially small and medium-sized enterprises (SMEs), to help them grow and prosper. These complementary initiatives include those recommended in Chapter 5: (i) shored-up support for the Industrial Research Assistance Program (IRAP) to provide advice, mentoring and funding in support of R&D and commercialization projects by SMEs; (ii) a new commercialization vouchers pilot program to help SMEs connect with innovation partners; (iii) a new concierge system to improve client service; and (iv) increased access to a highly skilled and entrepreneurial workforce. They also include other measures discussed in the next chapter: (i) using procurement and related programming to foster demand for business innovation, particularly by SMEs; and (ii) improving federal support for risk capital at the start-up and later stages of growth to help small firms become larger ones, while retaining a significant presence in Canada as they grow. The end result of this rebalanced program mix would be a substantial increase in the range and sophistication of federal support for SMEs.

Overview of the SR&ED Program

The SR&ED tax incentive program is designed to encourage Canadian businesses of all sizes and in all sectors to conduct R&D in Canada that will lead to new, improved or technologically advanced products or processes (Box 6.2).

The SR&ED program generally provides a 20-percent tax credit to Canadian businesses, with an enhanced 35-percent federal tax credit available to qualified small businesses that are Canadian-controlled private corporations (CCPCs).1 The enhanced credit is fully refundable up to an expenditure limit, which is to say that the enhanced credit is payable regardless of the tax position of the company. The refundability feature for small companies means, for example, that many young companies that have little or no taxable income receive cash to help finance their R&D and potential growth.

The current expenditure limit to access the 35-percent credit with full refundability is $3 million, which at this limit can generate an annual tax credit of just over $1 million.2 The $3-million expenditure limit is gradually reduced to zero as prior-year taxable income rises from $500 000 to $800 000 or as prior-year capital assets rise from $10 million to $50 million. Spending above the expenditure limit qualifies for a 20-percent credit that is 40-percent refundable but, once taxable income exceeds $800 000 or capital assets exceed $50 million, CCPCs receive the standard non-refundable 20-percent SR&ED tax credit.

In 2007 — the most recent year for which such data are available — some 20 000 small businesses that were CCPCs received about $1.3 billion in SR&ED tax credits (Figure 6.3). (By way of contrast, 1082 SMEs received a total of $69.1 million in funding from IRAP in 2007.) About 3900 other firms earned roughly $2.0 billion in SR&ED tax credits in 2007. The average credit value for small businesses was about $65 000, compared with an average claim of approximately $700 000 for larger corporations. The number of qualified small businesses increased by more than 25 percent between 2004 and 2007, compared with a very modest growth for large businesses. Part of the growth in the number of small CCPCs in 2007 may have been due to an increase of the taxable income threshold that allows a company to qualify for the enhanced credit. Due to their higher credit rate and refundability, small CCPCs claimed about 40 percent of total credits while performing about 30 percent of qualifying R&D in 2007.

Box 6.2 Key Parameters of the SR&ED Tax Incentive Program

Nature and Purpose

The SR&ED program seeks to encourage Canadian businesses of all sizes and in all sectors to conduct R&D in Canada that will lead to new, improved or technologically advanced products or processes. The program offers two types of incentives:

  • Income tax deductions — All allowable SR&ED expenditures, including capital, may be deducted from taxable income in the year incurred at the taxpayer's discretion; unused deductions may be carried forward indefinitely. R&D spending is generally considered to be an investment — that is, the spending is undertaken in one period with the expectation of generating revenues in future periods — so allowing immediate deductibility of capital and current expenditures provides a significant benefit to firms.
  • Investment tax credits — Earned as a percentage of qualified SR&ED expenditures, investment tax credits can be used to reduce the amount of income taxes otherwise payable. They can be carried back up to three years and forward up to 20 years to reduce income taxes otherwise payable in those years. Credits earned in a year but not used are partially or fully refundable (that is, redeemed for cash) for smaller businesses.

Eligibility

  • Participants: corporations, proprietorships (individuals), partnerships and trusts
  • Costs: Salaries and wages, overhead expenses, materials, capital equipment expenses, contracts and payments to third parties such as post-secondary institutions
  • Projects: experimental development, basic and applied research, and support work (such as engineering design and operations research) carried out for the purpose of achieving technological advancement or advancing scientific knowledge.

Administration

Administration is the responsibility of the Canada Revenue Agency (CRA), while governing legislation (Income Tax Act) is the responsibility of the Department of Finance. Firms file a SR&ED claim for their eligible expenditures incurred. The CRA reviews the claim, and aims to process 90 percent of refundable claims within 120 days of receipt and 90 percent of non-refundable claims within 365 days of receipt. The CRA offers a preclaim advisory service to help businesses identify the eligibility of projects. It is available at no cost before claims are filed. As noted on the CRA website, the preclaim service is "neither an advanced income tax ruling nor a pre-approval of a SR&ED claim. A final determination on any SR&ED claim must be based on the actual work done and can only be made after the claim is filed."

The SR&ED program, unlike grant programs, is not subject to assessment of the quality of any particular business project. Businesses that do not qualify for a refundable credit nevertheless face "tax risk" in that they must have sufficient tax payable in order to fully benefit from the credit. This has the significant advantage of "targeting success" — that is, the (non-refundable) benefit is available only to companies that are sufficiently profitable — while making the credit less open ended than it initially appears. Although businesses can carry unused credits to future years, delayed use reduces the value of the benefit. With the almost 50-percent reduction in the federal statutory corporate tax rate since 2000, businesses now find it more difficult to fully utilize the SR&ED tax credit generated in a current year against federal tax otherwise payable, putting further downward pressure on the average expected effective tax credit rate. In contrast, the criterion for "targeting success" does not apply to the small CCPCs that receive a fully refundable tax credit.

Figure 6.3 Tax Expenditures, by Type of Corporation

a Includes CCPCs in expenditure limit phase-out range and small non-CCPCs. (Return to reference a)

Source: Department of Finance.

  Value of Credit ($ million) Number of Corporations (units)
2004 2005 2006 2007 2004 2005 2006 2007
Small CCPCs 1 043 1 119 1 128 1 298 15 482 16 917 17 712 19 806
Large firms 1 944 1 448 1 471 1 822 2 452 2 448 2 728 2 599
Othersa 137 170 208 136 1 259 1 510 1 920 1 310
Total 3 123 2 737 2 807 3 256 19 193 20 875 22 360 23 724

1 To have access to the 35-percent credit, the claimant needs to be incorporated as well. (Return to reference 1)

2 Only current expenditures are eligible for full refundability; capital expenditures, which account for about 4 percent of total costs, are eligible for a 40-percent refund. Access to full refundability is restricted to CCPCs with prior-year taxable income up to a maximum of $500 000, which is gradually reduced to zero as capital assets increase from $10 million to $50 million. (Return to reference 2)