An open response to the SR&ED consultation call by a Canadian innovator
A unique opportunity to guide positive change to Canada's most important innovation support system
Context
On January 31, 2024, the government of Canada launched a consultation process to address a long-standing recommendation to overhaul the SR&ED credit program. The aim of the consultation is two-fold: to undertake cost-neutral restructuring of the way SR&ED credits are provided, and to address the deficit of patents and IP-related payments that has been the norm for decades. In the same call, they ask for feedback on implementation of a patent box regime to encourage Canadian IP to stay in Canada, to which I will respond in a separate article.
SR&ED is a refundable tax incentive that offsets the costs of R&D undertaken by Canadian firms. The calculation is complex, but once the dust settles it is possible to get about 54% of R&D salary costs and 27% of R&D contractor costs refunded if a project qualifies, up to $3M, with a reduced rate thereafter (there are a dozen corner cases that are not worth discussing here). About $4B is given out by the Canadian government every year under this program, completely dwarfing every other Canadian innovation support program.
While the program is well-intended and is obviously heavily used, it is poorly structured, with the result that more of the outlays go to large firms that certainly do not need the support, while only a small fraction is spent where it is needed. Reform has been badly needed for more than a decade to stem the tide of Canadian IP leaving the country, and calls for that reform have come from all over the public and private sectors.
The presentation of the consultation call is encouraging. The questions being asked are the right ones with respect to the issues that are faced by the SR&ED program generally, and while it comes a decade later than it probably should have, I am hopeful that it will lead to positive change. This outcome requires active participation by Canadian innovators and everyone involved in the innovation ecosystem generally.
This is an important issue and represents what is probably a once-in-a-lifetime opportunity to get this right. Whether or not you agree with the specific recommendations below, please share awareness of this consultation call as widely as you can.
Below, I’ve written an open letter to respond to the questions relating to SR&ED reform in the call. If you agree with my recommendations, feel free to reuse this content, minus the introductory paragraphs, to send your own response to the dedicated inbox.
An open response to “Cost-neutral ways to modernize and improve the SR&ED program”
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To whom it may concern,
I am a Canadian physicist and entrepreneur operating at the intersection of academic research and early-stage commercialization of innovative technologies. In the course of my career I’ve been involved in the innovation process as an inventor and researchers in an academic lab, responsible for generation of 27 patents filed globally; as founder of a nanotechnology company commercializing part of this portfolio; as a mentor and advisor to other scientists and engineers in the early stages of commercializing their inventions; and more recently as a policy critic attempting to use my experience to turn my experience interacting with the entire spectrum of the early-stage Canadian innovation support system into a productive input to innovation policy development. In the course of this, I have interacted with or used almost every early-stage innovation support program Canada has to offer, including SR&ED.
With proper design, the SR&ED program could be a significant incentive to developing Canadian IP, but is currently constructed in a way that severely reduces its potential impact, with more than 40% of the credit going to waste. I am happy to see that the SR&ED review is underway, and hopeful that the outcome will help address some of the problems that lead to Canada’s severe underperformance in innovation-based metrics among OECD countries. Below, I list four primary recommendations for overhaul of the SR&ED program, and in the answers to the questions listed in the call, I provide context and rationale for each one.
Specific Recommendations
Require that the parent company of any firm applying for SR&ED qualify as a Canadian Controlled Private Corporation (CCPC) in order for its subsidiary to be eligible for SR&ED. Canadian branch plants of multinationals should not be eligible. This ensures that IP developed using SR&ED funding is positioned to benefit Canada in the long term. This will also have the effect of focusing credits on SMEs where they are needed, as companies that will lose eligibly under this change are almost exclusively large multinational firms. It will also immediately make available almost $1B to support implementation of the required reforms and easily make the overhaul cost-neutral.
Move to a default approval model where all submissions by eligible firms are approved provided the base documentation is present, similar to the income tax model, with a subset spot-checked for compliance annually. This removes the need for technical due diligence by non-technical CRA staff, reduces administrative overhead, and removes subjectivity from the approval process. Greater certainty that SR&ED claims will proceed will motivate healthy risk-taking by innovative Canadian firms.
Simplify the SR&ED credit calculation to be a fixed percentage of the salary of employees conducting R&D, eliminate the direct method of SR&ED claims, and integrate SR&ED claims with the payroll tax submission system to reduce the management overhead for both applicant firms and administrators. Pay out credits monthly following the payroll tax submission to ensure that small companies are not limited by cashflow in their ability to conduct R&D. This also eliminates the need for dedicated SR&ED consultants and SR&ED-based lending, which currently takes anywhere from 15-30% of the value of the credit away from innovators.
Require that firms that have received SR&ED credits submit annual reports on the use of IP developed with the tax credit, including any downstream assignments, and that this requirement be inherited by any acquirer, assignee, or licensee of that IP, for a period of no less than 10 years. This provides a means for data collection on the long-term impact of SR&ED spending and a means to track the flow of patents and IP resulting from the credit. Make the aggregated, anonymized data public in an annual report and make evidence-based policy adjustments in response to findings.
A detailed rationale for each recommendation follows below the signature. Should you wish to contact me to follow up on any of the points made here, please do not hesitate to reach out in response to this message.
Sincerely,
Kyle Briggs
Detailed Rationale
How can the SR&ED program remain effective in supporting R&D investment by businesses of all types in Canada? How can the SR&ED program better support the growth and success of R&D-intensive Canadian businesses going forward?
Between publication and patenting in an academic setting and commercial relevance, new and innovative technologies must cross what innovators call “the valley of death”. In this period, a technology is no longer eligible for academic research grants, but has not yet been adequately de-risked for private capital. In most cases, this newly minted technologies have no immediate revenue generation, and are therefore unstable to sustain themselves without additional support. It has been shown in successful innovation hubs all over the world that realizing the long-term economic benefit of research requires very careful and focused policy design that predominantly targets this stage of development, getting technology across the valley of death before handing it off to private capital markets for scaling.
Among Canadian innovation support systems for early commercial development (NRC IRAP, CDAP, CanExport, etc.), almost all of them require minimum revenues and/or FTE counts to access support. Because new technologies, particularly those coming out of academic labs, are rarely revenue-generating in the early stages, these programs only begin support for innovation after a technology has crossed the valley of death on its own. More often than not, what happens instead is that the invention is simply taken elsewhere for development, resulting in a loss of a majority of Canadian IP before a company exists that could event attempt to develop it domestically.
As one of the only programs that does not have minimum eligibility requirements in principle, SR&ED has the potential to be the bridge by which newly minted technologies cross the valley of death. However, as currently constructed, it fails in this role. This boils down to four key issues in its administration.
First, the bar for eligibility is such that a large portion of the benefit is paid out indirectly to foreign firms. Under the current definition of Canadian Controlled Private Corporation, branch plants of multinational firms with presence in Canada can easily be made eligible, resulting in Canadian funding private sector development of IP that leaves Canada the moment it is developed. This is addressed by the first recommendation, which suggests that the parent company should be a CCPC to be eligible, rather than the Canadian subsidiary.
Second, using a post-project approval model means that SR&ED effectively has the same barrier to entry as innovation support systems that are gated by revenue minima. Companies must front a full year of required R&D expenditure without any guarantee of recovery, which is only possible if they have a secondary source of funding such as early revenues or VC investment. As previously noted, new and innovative technologies are often too early for either. Subjective approval based on review by a non-technical expert within CRA means that there is never a guarantee of reimbursement. This issue leads to risk-avoidant behavior from SMEs in particular in the most vulnerable point in their development, since a disallowed claim could easily be an existential threat. This is addressed by the second recommendation.
Third, the complexity of SR&ED-eligibility calculations and the need for short-term cashflow often requires that companies turn to SR&ED-backed lending and external experts to manage their claims, often paying high interest rates and contingency fees that together redirect up to 30% of SR&ED expenditures away from R&D. This is the rationale behind the third recommendation, which would enable a continuous, incremental payout of SR&ED benefits throughout the year to ensure continuity of cashflow. In the following questions, I elaborate on how this could be implemented practically.
Fourth and finally, while the opacity of the program makes it impossible to measure this externally, it is evident from the information available that a significant portion of SR&ED credits are claimed by a small number of large companies, many of which are not actually Canadian. Rather, multinational conglomerates with Canadian branches are able to claim this credit to develop IP in Canada which is then shipped out of the country for development or shelving elsewhere. This is taxpayer money subsidizing valuable research that will never see any return on investment for Canada, but without long-term tracking of the impact, concrete estimates are difficult to come by and evidence-based policy decisions are effectively impossible. This is the core rationale behind the fourth recommendation, which involves establishing long-term reporting on the use and value of IP developed using SR&ED credits as a contractual obligation following receipt of SR&ED credits.
What improvements to the definition of SR&ED, the program's eligibility criteria, and/or the program's overall architecture should be considered?
If the goal of SR&ED is to support development of Canadian IP for the long-term benefit of Canadians, recommendation 1 is critical: change the eligibility criteria to ensure that the credit only benefits firms that are fully Canadian controlled. According to data here, analysis by The Logic suggests that as much as 23% of SR&ED credits go Canadian subsidiaries or foreign firms, effectively subsidizing IP development which is immediately lost to Canada. This is a massively wasteful use of almost a billion dollars of taxpayer money annually that could be redirected to maintain cost-neutrality throughout implementation of the rest of these recommendations while actually increasing the impact SR&ED can have on small companies. The single largest cost-savings available to this review is to end eligibility for foreign multinational firms with Canadian subsidiaries.
Among eligible firms, it would greatly streamline the process to move to a default approval model. Default approval means that all of the administrative burden of vetting individual claims is removed, reducing delivery time, cost, and overheads to that which is required to conduct compliance spot-checks on a subset of claims, similar to the income tax system. It also means that firms can enact their R&D roadmap with confidence, knowing that they will not have the rug pulled out from under them when their project is deemed ineligible after incurring all the costs.
Program overheads could be further reduced by using the existing payroll tax collection infrastructure to administer SR&ED. Currently, companies remit payroll tax monthly, and SR&ED (at least the proxy method) is based on a percentage of eligible salary. It would be trivial to include as part of the payroll tax submission the total amount of SR&ED-eligible expenditures incurred in that month, for immediate credit. At the end of the year, when T4s are submitted, there can be a reconciliation where these numbers are automatically double checked for consistency, and any discrepancy can be easily corrected.
The only change needed to existing frameworks would be the addition of a SR&ED-eligible portion of salary alongside payroll tax, and an additional box on a T4 indicating the percentage of that salary which is SR&ED-eligible. Audits can be conducted as needed to ensure accurate reporting at the end of each fiscal year to address any discrepancies between T4 submissions and credits claimed leading to that point. This simplification would also eliminate the need for SR&ED consultants and SR&ED lending, which currently take anywhere from 15-30% of the total credit away from innovators.
Finally, there is a dire need for transparency in SR&ED. With savings identified above of up to a billion dollars combined with a reduction in administrative overheads, there is plenty of room to include more comprehensive data collection, aggregation, and reporting on the impact of the SR&ED credit. This recommendation in particular dovetails well with the patent box regime being contemplated in the same consultation call, on which I will submit a separate response.
How does the SR&ED program complement the existing suite of support programs for R&D in Canada? How could this complementarity be improved?
SR&ED is unique among Canadian innovation support systems in that it does not have minimum revenue requirements for eligibility. As previously discussed, this is a key feature since this gatekeeping by other programs, such as NRC IRAP, CanExport, and others, ensure that those innovation support systems are not usable by early stage firms. Together, the issues that are addressed by these recommendations act as a soft version of the same gatekeeping that is present in other innovation support programs, removing the main differentiator of SR&ED until they are addressed.
If the issue of annual remittance can be addressed, SR&ED has the potential to be the bridge by which innovative Canadian technologies arising from our highly efficient research pipeline cross the valley of death, but for the program to achieve this, it must first follow recommendations 2 and 3.
Are there more effective ways in which the overall level of assistance provided within the SR&ED program could be targeted? If so, what changes could be made to the SR&ED program to offset the costs of any proposed enhancements?
According to data here, The Logic suggests that as much as 23% of SR&ED credits go to foreign firms with Canadian subsidiaries. SR&ED consultants and tax filers often take 15-30% of the credit as contingency for their services, and SR&ED lenders routinely charge high interest rates. In aggregate, it is reasonable to estimate that approximately 40% of the payouts by SR&ED in the current framework are not being used to support activities that results in long-term innovation-based economic benefit to Canada. In addition, nearly $1.5B of the $4B paid out goes to large firms (>250 employees), with most of that going to just a handful of top recipients. SR&ED credits given to larger firms, with established cashflow and the ability to conduct R&D with or without SR&ED, diverts resources away from the early stages of building where innovation support is an existential necessity. Dealing with these problems is the focus of recommendations 1 and 4.
I do not anticipate that these recommendations will lead to significant additional costs for the program in the long run. In the worst case scenario, even if a small percentage of funds that would normally be paid out in credits are diverted to managing the resulting data, it will still represent an increase in SR&ED expenditures being targeted where they are actually needed over the status quo. The amount of waste present in the existing SR&ED program leaves a large amount of room for reallocation of resources while still increasing the overall impact on Canadian innovation.
How can the SR&ED program effectively ensure the retention of intellectual property (IP) within Canada, particularly to support innovative Canadian businesses to remain Canadian-owned and operated?
Basing SR&ED eligibility on the parent firm rather than the subsidiary is critical if IP developed with SR&ED credits is to be retained in Canada. Paying SR&ED credits out on a more regular schedule and removing subjectivity from the approval process will also go a long way toward motivating development of new technologies by Canadian firms.
The patent box regime contemplated by the same consultation call is also a step in the right direction, but hinges on SR&ED reform to be effective in the long run given the current rate of loss of Canadian-funded IP.
How can your suggested enhancements be funded by existing support available through the SR&ED program? What potential changes could best focus support to benefit Canada, including by creating economic opportunities for Canadians?
Savings in the proposed changes come from two places. First, ending SR&ED eligibility for Canadian subsidiaries of foreign firms will free almost $1B per year to support the proposed changes. Second, by using a default approval model support with spot checks instead of requiring vetting of every project submitted, and by using existing payroll tax collection infrastructure to administer the program, administrative overheads will be reduced compared to the existing system.
If all of these recommendations are adopted, I anticipate that cost-neutrality will not be difficult to achieve in the long run. These recommendations will also greatly increase the impact of the credit, ensuring that Canadian IP funded by SR&ED credits remains in Canadian control, and providing a clear path for evidence-based policy-making going forward. Removing the need for third party consultants and SR&ED-based debt financing will additionally ensure that a higher percentage of SR&ED payouts are directed where they are intended: to the innovators who are the basis of Canada’s economic future.