Success-Based Fees in SR&ED: The Debate

April 27, 2012 Elizabeth Lance

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Success-Based Fees in SR&ED: The Debate — Are success-based fees in SR&ED draining money from innovators?

A number of articles outlining the abuse of SR&ED in the media, considerable attention has been focused on how consultants are being compensated.

In response to the public outcry, the government has listened. We believe there are two simple solutions to this debate: one will cost taxpayers millions, while the second will cost the consultants thousands but ultimately benefit the end recipient.

Success-Based Fees in SR&ED: The Debate

At the 15th annual SR&ED Practitioner Event Burlington (Jan 11, 2012), the CRA introduced several new senior management personnel who presented an interesting list of the top five concerns for both the CRA and for Tax Practitioners (an excellent summary can be found in this discussion post from the R&D Tax Credit Forum). One of the key statements made in the opening remarks reiterated the belief that consultant fees were diverting too much of the tax credit funding away from its intended purpose. At that event, there were also hints that a ban on success fee billing could be in the works.

It wasn’t until late March, with the release of the 2012 Federal Budget, that it was confirmed that a full investigation would be launched in this area:

Contingency Fees: The Government announces a study of contingency fees charged by tax preparers. Small and medium-sized businesses sometimes rely on tax preparers charging on a contingency-fee basis to prepare their SR&ED claims. These fees may be as high as 30 per cent of SR&ED benefits, or even more. The Government is concerned that high contingency fees charged by tax preparers are diminishing the benefits of the SR&ED tax incentive program to Canadian businesses and the economy. In the coming year, the Government will conduct a study, including consultations with taxpayers, to better understand why firms choose to hire consultants on a contingency fee basis and determine whether action is required. (2012 Canadian Budget, Page 71)

In the interest of saving the taxpayers a few million dollars to conduct such a sweeping study, here is a summary of the arguments made, both for and against success based contingency fees in SR&ED by the following groups: businesses, consultants, the CRA, and leading professionals. No need to hire one of the Big 4 – after all, they’re using a contingency model as well.

Fee Structures in Related Industries

The current market is saturated with SR&ED consultants who use contingency or success-based fees structure. But what, exactly, is a contingency fee structure? The field of SR&ED consulting is closely related to two main industries: accounting and legal. For the purposes of this article, we will outline the most common fee structures used in each area.

Hourly Fee. A billing structure in which an hourly rate is charged for services rendered.
Flat fee, also referred to as a flat rate or a linear rate, refers to a billing structure that charges a single fixed fee for a service, regardless of usage.
A contingent fee (US), conditional fee (England and Wales) or contingency fee (Canada) is any fee for services provided where the fee is payable only if there is a favourable result. It is also referred to as no win-no fee. The usual form of this agreement is that the Company will take a Client on the understanding that if lost, no payment is made; however, if the case is won, the Company will be entitled to a percentage of the amount recovered.

In the accounting profession, the first two models are the most prevalent when doing accounting work. In the legal profession, all three models are used regularly, depending on client needs and the area of law. The most prevalent in SR&ED, however, is contingency fees. But why?

The Success of Success-based Fees in SR&ED

It doesn’t take a rocket scientist to figure out why most people prefer a contingency model when dealing with the CRA regarding SR&ED. Simply put:

Consultant only gets paid if client gets paid. / “It’s a percentage of something I wouldn’t have otherwise had.”
Consultants are (theoretically) motivated to do a better job, since their pay hinges on their ability to maximize the claim. / “They share the risk with us.”
Clients don’t have to pay until the refund arrives. / “I can’t afford to use another model right now… even if I have to pay more in the long run.”
Clients aren’t familiar with the program. / “It sounds too good to be true, I’ll believe it when the cheque is in my bank account.”

Many clients see success-based contingency fees in SR&ED as the best fee structure, particularly those that have little or no previous experience with SR&ED.

The client organizations know that if they are paying a percentage of the refund to the consultants based on the total refund, they will likely pay significantly more than if they were to use an hourly model. So why are taxpayers agreeing to pay fees that sometimes run into the tens of thousands (or even hundreds of thousands)?

Should SR&ED Consultants Exist?

Underlying the question of how much to pay SR&ED consultants, is whether to pay them at all. Why do groups engage an external consultant to prepare a 1400 word document? Arguments include the following:

The SR&ED program is unpredictable. / “I’d rather have a professional handle my file.”
It’s too complicated (over 70 policy documents, dozens of Tax Court of Canada rulings, unclear process). / “I wouldn’t know where to start!”
Lack of time. / “I have enough to do running the business.”
Questions about eligibility. / “The consultant says I’m eligible, but I’m not sure how to position the claim to the CRA–they don’t see it.”
Poor experiences with the CRA SR&ED program. / “I’d rather not deal with them alone.”

Whether the CRA would like to admit it or not, they are an intimidating organization. What can be seen simply as “administering a program” can help an innovative company succeed–or fail–depending on the funding that is approved. With the stakes often quite high (hundreds of thousands of dollars), most companies would prefer to have someone experienced on their side of the table to help guide them through the process.

Option 1: Ban Contingency Fees

“In the world nothing can be said to be certain except death and taxes.” – Ben Franklin

There are several arguments put forwards by the CRA as to why contingency models should be eradicated. The most frequently cited reason is that this model diverts benefits from taxpayers to consultants, thereby “reducing the impact of SR&ED”. Admittedly, the ease with which new claimants can be sold on the contingency model has led to some abuse of the program, particularly by unqualified individuals, as mentioned in a 2011 Globe and Mail article about R&D in Canada. There have even been articles by SR&ED consultants on why they hate other SR&ED consultants.

Let’s be honest; consultants often act like a buffer between clients and the CRA. While this can be a help, it can also be a hindrance.

What would happen if contingency fees were banned? In this case, there is a precedent. In the US, the IRS issued an amendment to Circular 230 Section 10.27. that put severe restrictions on Contingent Fees. The result? A lawsuit from a major firm that had previously been able to use contingent fees.

Ryan LLC on April 12 filed suit in the U.S. District Court for the District of Columbia seeking a declaratory judgment that the IRS has overstepped its authority to regulate practitioners by prohibiting the use of contingent fee arrangements in filing refund claims as well as a permanent injunction against enforcing that provision of Circular 230.

Ryan, a global tax services firm, alleges that the contingent fee restrictions imposed on practitioners in 2007 amendments to Circular 230 are unconstitutional because the prohibition interferes with its ability to represent taxpayers who can afford to pay only on a contingent fee basis, and exceed the scope of regulation authorized in the statute. Ryan said it lost a substantial portion of its practice because of the Circular 230 restrictions. In the complaint, Ryan argues that the Circular 230 restriction on contingent fees for refund claims abridges a First Amendment right of individuals to “petition the Government for a redress of grievances.”

Just to state the obvious, this lawsuit is going to cost the taxpayers hundreds of thousands of dollars to defend.

With this lawsuit, it is no longer the issue of a few companies that have chosen to pay using contingent fees that have the “effect of the tax credit diluted”–every single taxpayer is now contributing to the court costs defending this amendment.

Eliminating contingency fees is a big-brother approach to the issue, which would reduce the number of options available to taxpayers who may not otherwise have assistance (if required) due to tight budgets. What’s more, this move may well exceed the purview of the CRA. Instead, why not take a page from the related industry of law?

Option 2: Adoption/Adaption of the Solicitors Act

The Solicitors Act – Ontario Regulation 194/04 – Contingency Agreements deals explicitly with how a contingency agreement should be structured. It addresses one of the major issues that we have encountered in our years of practice –knowledge that other fee structures even exist. Key points include:

The Solicitors Act obligates the inclusion of a statement that indicates the following (s. 2.3):

i. that the client and the solicitor have discussed options for retaining the solicitor other than by way of a contingency fee agreement, including retaining the solicitor by way of an hourly-rate retainer,

ii. that the client has been advised that hourly rates may vary among solicitors and that the client can speak with other solicitors to compare rates,

iii. that the client has chosen to retain the solicitor by way of a contingency fee agreement, and

iv. that the client understands that all usual protections and controls on retainers between a solicitor and client, as defined by the Law Society of Upper Canada and the common law, apply to the contingency fee agreement.

Additionally, there is the key item that covers early termination:

A statement that outlines when and how the client or the solicitor may terminate the contingency fee agreement, the consequences of the termination for each of them and the manner in which the solicitor’s fee is to be determined in the event that the agreement is terminated (s. 2.9.).

Other provisions include a simple example that shows how the fees will be calculated (S2.5-2.5), that the solicitor shall not recover more in fees than the client recovers as damages or receives by way of settlement (s.3.1), and that a solicitor shall not include in a contingency fee agreement a provision that,

(a) requires the solicitor’s consent before a claim may be abandoned, discontinued or settled at the instructions of the client;

(b) prevents the client from terminating the contingency fee agreement with the solicitor or changing solicitors; or

(c) permits the solicitor to split their fee with any other person, except as provided by the Rules of Professional Conduct (S4.1).

To see what it looks like in action, be sure to review this Sample Agreement Using the Solicitors Act.

Why would this be a useful tool to have SR&ED practitioners voluntarily adopt? Many clients are not aware that there are other payment structures available to them. This tool allows the client to make an informed decision and keeps the CRA out of legally questionable space. After all, once the refund is received, isn’t it at the discretion of the client how the funds are disbursed?

Summary

There are different opinions on success-Based Fees in SR&ED. Focusing on external matters detracts from internal improvement. The millions that will be spent on yet another SR&ED study are better served to continue to improve the program as per the recommendations in the Jenkins report.

The most important point that we have to keep our eyes on is this:

If there is no need for consultants, this whole debate around fee structures becomes irrelevant.