An Alternative for Extending Refundability of SR&ED Tax Credits (2007)

April 26, 2013 SRED

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In 2007, the Information Technology Association of Canada (ITAC) wrote a discussion paper concerning the refundability of tax credits.¹ The organization argued that Scientific Research and Experimental Development (SR&ED) credits are useful in limited cases, and examined the feasibility of extending the credits in some way to include more categories.

There are four categories of taxpayers that benefit from SR&ED, the report said:

Small- and medium-sized Canadian-controlled private corporations (CCPCs), who receive 35% fully refundable tax credits on the first $2 million of annual SR&ED performed;
Canadian corporations who pay enough taxes to “make use of the credits”, which includes “very profitable companies doing a high level of R&D in proportion to sales, and moderately profitable companies with lower levels of R&D spending”;
Taxpaying Canadian subsidiaries of multinationals “for whom the tax credit does not simply result in higher domestic tax payable by the parent company”; and,
Canadian firms that expect to turn a profit in the future, whether realistically or not.

The authors said there was a large gap in benefits for other companies looking to use the credit:²

For other taxpayers the tax credits are at best a windfall at some future date when they can make use of them (but too late to have impacted budgeting decisions on R&D spending when the credits were generated) and at worst a compliance exercise with no payback.

The authors add that the SR&ED credits “benefit companies with relatively lower levels of R&D spending as a percentage of sales disproportionately to those with high levels of R&D spending because the latter are less likely to able to use all of the credits they generate.”

Minding the Gap in SR&ED

When it comes to companies that specialize in technologies, the authors state that there is a prominent disconnect between being a small corporation and generating enough profits to effectively use tax credits. The report includes several common factors that relate to a small company’s failure to expand, such as:

Receiving United States venture money, only to lose Canadian corporation status for accepting it;
Having any class of shares of its stock listed on a designated stock exchange;
Investing profits in growth rather than simply reaping the profits;
Enduring the cycles of boom and bust that technology is known for; and,
The need for constant innovation in a market that has short lifespans for its products.

‘All or Nothing’

“The problem is that the structure of the SR&ED tax credit rules is an ‘all or nothing’ structure,” the authors wrote. ³

Either one can use credits (through refundability for small CCPCs or against taxes payable for profitable companies) or one cannot. This means that for companies outside of the four categories listed above, Canada has no federal tax incentives for SR&ED.

The authors acknowledged that adding full refundability for all SR&ED information technology companies would increase the government’s SR&ED tax burden, however, the authors also suggested partial benefits could be a solution to temper that tax burden. In the report, the authors add that no extensive legislative changes are required to achieve these measures.

One simple design would be extending the 40% refundability of credits currently available to individuals and CCPCs in excess of their expenditure limit to all taxpayers […] This would, in effect, provide an 8% cash credit with the balance of 12% available against future tax payable.

An alternative design could be allowing companies to choose between a refundable wage credit (similar to that in effect in Quebec today) or a non-refundable SR&ED credit as it now exists. The choice could be made in each taxation year. The taxpayer would be choosing between immediate cash of a lower amount or a higher credit that might be useful in the future.

Looking at How Other Countries Incentivize Innovation

The Information Technology Association of Canada (ITAC) additionally contracted JPW Innovation Associates (JPWIA) “to determine if the practice of offering optional discounted credits occurs in other jurisdictions.”

“Several countries have ‘discount’ mechanisms in place […] Australia, Austria and United Kingdom,” JPWIA wrote.

A common feature of these countries [sic] programs is that they all employ enhanced allowances from taxable income, not direct tax credits. Yet another country – Norway – offers a tax offset from withholding taxes and social security contributions for firms unable to fully utilize earned tax credits.

As a summary of JPW Innovation Associate’s report, here is what each nation offers:

Australia
The nation allows all small companies (regardless of national origins) to receive a refundable tax credit “net of any other tax owing before it is refunded.” According to JPWIA, “the maximum tax offset is equivalent to tax savings from R&D tax concession – in such case [sic] the tax offset is 7.5 per cent.” At the time the report was published, there were no quantifiable results yet available on the program’s effectiveness.
Austria
All firms, regardless of size or nationality, can claim an “alternative refundable tax credit” totaling 8% in lieu of drawing an enhanced allowance. The tax credit provides more benefit to companies because the allowance works out to about 6.25% after taking into account the corporate tax rate of 25%. However, when the article was published, there was no firm result yet on how well the R&D allowance and alternative tax credits were performing.
United Kingdom
Firms below a certain size can receive a 150% allowance for current R&D spending. Additionally, unprofitable companies can “sacrifice” R&D losses in return for receiving a tax credit payment that adds up to no more than 24% of the cost of the R&D. About 90% of small and medium enterprise support comes from this procedure. When the report was written, there was an evaluation taking place of the R&D tax allowance.
Norway
Small Norwegian companies receive 20% back from qualifying R&D spending, and larger ones 18%. Companies that can’t take full advantage of the credit may choose to offset it against social security contributions or withheld tax from employee salaries. Results from an ongoing evaluation were expected shortly after the report’s release, although the authors noted this is a popular option for companies.