Is the SR&ED Tax Credit Is the SR&ED Tax Credit Appropriate Given Recent Appropriate Given Recent

Industrial R&D Trends?Industrial R&D Trends?

Ron FreedmanRon FreedmanPartnerPartner

The Impact GroupThe Impact Groupron@impactg.com

Telfer Presentation, 5 October 2010Telfer Presentation, 5 October 2010© The Impact Group 2010© The Impact Group 2010

Scientific Research & Experimental Scientific Research & Experimental Development Program (SRED)Development Program (SRED)

Canadian-controlled private corporation Canadian-controlled private corporation (REFUNDABLE)(REFUNDABLE)• Investment tax credit (ITC) of 35% up to the first $3 Investment tax credit (ITC) of 35% up to the first $3

million of qualified expenditures for SR&ED carried out in million of qualified expenditures for SR&ED carried out in Canada, and 20% on any excess amountCanada, and 20% on any excess amount

Other Canadian corporationsOther Canadian corporations(NOT REFUNDABLE, CREDIT AGAINST TAXES)(NOT REFUNDABLE, CREDIT AGAINST TAXES)• Proprietorships, partnerships, and trusts can earn an ITC Proprietorships, partnerships, and trusts can earn an ITC

of 20% of qualified expenditures for SR&ED carried out of 20% of qualified expenditures for SR&ED carried out in Canadain Canada

Covers expenditures such as wages, materials, Covers expenditures such as wages, materials, machinery, equipment, some overhead, and machinery, equipment, some overhead, and SR&ED contractsSR&ED contracts

What is Eligible?What is Eligible? Basic researchBasic research

• to advance scientific knowledge without a specific to advance scientific knowledge without a specific practical application in viewpractical application in view

Applied researchApplied research• to advance scientific knowledge with a specific practical to advance scientific knowledge with a specific practical

application in viewapplication in view Experimental developmentExperimental development

• to achieve technological advancement to create new to achieve technological advancement to create new materials, devices, products, or processes, or improve materials, devices, products, or processes, or improve existing onesexisting ones

Support workSupport work• in engineering, design, operations research, mathematical in engineering, design, operations research, mathematical

analysis, computer programming, data collection, testing, analysis, computer programming, data collection, testing, or psychological research, or psychological research, but only ifbut only if the work is the work is commensurate with, and directly supports, the eligible commensurate with, and directly supports, the eligible experimental development, or applied or basic researchexperimental development, or applied or basic research

What’s What’s NotNot Eligible? Eligible? Social science and humanities researchSocial science and humanities research Commercial production of a new or improved Commercial production of a new or improved

material, device, or product, or the commercial material, device, or product, or the commercial use of a new or improved processuse of a new or improved process

Style changesStyle changes Market research or sales promotionMarket research or sales promotion Quality control or routine testing of materials, Quality control or routine testing of materials,

devices, products, or processesdevices, products, or processes Routine data collectionRoutine data collection Prospecting, exploring, or drilling for or producing Prospecting, exploring, or drilling for or producing

minerals, petroleum, or natural gasminerals, petroleum, or natural gas Development based solely on design or routine Development based solely on design or routine

engineering practice. engineering practice.

The SR&ED Intellectual The SR&ED Intellectual FrameworkFramework

1970s thinking1970s thinking Built on large in-house industrial Built on large in-house industrial

laboratory modellaboratory model Principles codified in OECD Frascati Principles codified in OECD Frascati

ManualManual

Part 1 – Understanding Industrial Part 1 – Understanding Industrial R&D TrendsR&D Trends

Business InnovationBusiness InnovationCapacity =Capacity =

R&D Spending $R&D Spending $XX

# of R&D Performers# of R&D Performers

Proposition:Proposition:

Improving Capacity Means ImprovingImproving Capacity Means ImprovingSpending Spending ANDAND Performers Performers

Corporate R&D Spending:Corporate R&D Spending:Real R&D Spending DroppingReal R&D Spending Dropping

Source: StatCan Cat. No. 88-001-X

Corporate R&D Spending (2002 = 100, $ Million)

14,26615,882

7,567

14,587

8,830

14,244

$0

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

$14,000

$16,000

$18,000

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Current $ R&D Spending Constant $ R&D Spending

+65% -2.4%

Corporate R&D Performers:Corporate R&D Performers:Growth ContinuesGrowth Continues

Number of Corporate R&D Performers

11,132 10,7719,805 9,649 9,784 9,967

10,84912,087

13,363

15,728

17,95119,515 20,154

0

5,000

10,000

15,000

20,000

25,000

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Number of Performers

+108.9%< >

SRED Applicants Growing RapidlySRED Applicants Growing Rapidly

SR&ED Applications & Approvals, 1990-2004

9,330

11,442 11,459 10,999

13,725

17,739

3,663 4,450 4,959

10,7719,804 9,783 9,967

10,84912,087

13,363

15,729

15,628

12,34010,88211,05210,518

8,187

11,864 10,728

20,132

3,695

11,132

9,648

17,222

0

5,000

10,000

15,000

20,000

25,000

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Applicants Approved

Source: CRA, StatCan

SRED Approval Rate DecliningSRED Approval Rate Declining

Derived Approval Rate, 1990-2004

45.1%42.3%

88.7% 89.9%87.9%

39.3% 43.3%

85.5%85.5%

93.8%

94.0% 89.9% 90.6%88.1% 88.7%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Performer Growth Outstripping Performer Growth Outstripping Spending GrowthSpending Growth

R&D Company Growth vs. Real R&D Spending Growth

0

5,000

10,000

15,000

20,000

25,000

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Constant $ R&D Spending R&D Companies

3 per. Mov. Avg. (R&D Companies) 3 per. Mov. Avg. (Constant $ R&D Spending)

R&D Companies:R&D Companies:A moving targetA moving target

Persistenceof R&D Performers, 1994-2000

22.7

13.28.9 6.2 5.5

9.4

34.1

70.0

78.985.2

90.6

100.0

34.1

56.9

0

10

20

30

40

50

60

70

80

90

100

110

1 2 3 4 5 6 7# of Years Performing Research, 1994-2000

% P

erfo

rmin

g R

esea

rch

Percent of Firms Cumulative Total

R&D Participation Rate GrowingR&D Participation Rate Growing

Corporate R&D Participation Rate(R&D Companies as a % of All Companies)

1.2%1.4%

1.6%

1.9% 2.0% 2.1%

0%

1%

1%

2%

2%

3%

2001 2002 2003 2004 2005 2006

Participation Rate

R&D Spending Becoming Less R&D Spending Becoming Less ConcentratedConcentrated

Average Spending DecliningAverage Spending Declining

Average R&D Spending (Current $)

$679,752$741,900

$815,604$905,690

$989,575$1,043,343

$1,142,502

$1,013,620

$849,479$808,301$794,929

$896,172

$1,180,276

$0

$200,000

$400,000

$600,000

$800,000

$1,000,000

$1,200,000

$1,400,000

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Avg. Spending

R&D Intensity DecliningR&D Intensity Declining

R&D Intensity (R&D ÷ Revenue)

1.65% 1.60%1.71% 1.78%

1.89%

2.21%2.35%

2.07%1.95% 1.90%

1.80% 1.80%1.82%

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

R&D Intensity

Part 2. Understanding TrendsPart 2. Understanding Trends

Real $ R&D Spending Falling – Real $ R&D Spending Falling – Why?Why?

Mergers and acquisitionsMergers and acquisitions Large business failureLarge business failure

• e.g. Nortel, JDS, 724 Solutions, Norandae.g. Nortel, JDS, 724 Solutions, Noranda Changing structure of R&DChanging structure of R&D

• Off-shoring, Downloading to suppliersOff-shoring, Downloading to suppliers Higher profitability of Canadian companiesHigher profitability of Canadian companies

• U.S. firms trading lower profitability for higher U.S. firms trading lower profitability for higher innovation, productivityinnovation, productivity

Growing impact of commodities on GDP?Growing impact of commodities on GDP?• Requires less R&D spending (than manufacturing)Requires less R&D spending (than manufacturing)

Ineligibility of SSH researchIneligibility of SSH research• Especially important for service economyEspecially important for service economy

R&D Companies Growing – Why?R&D Companies Growing – Why?3 Growth Periods3 Growth PeriodsNumber of Corporate R&D Performers

11,132 10,7729,805 9,650 9,784 9,968 10,418

12,08713,363

15,728

17,95119,515 20,154

0

5,000

10,000

15,000

20,000

25,000

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Number of Performers

Decline

Slow Growth Rapid Growth

More R&D Companies – More R&D Companies – Why?Why?

More companies/CEOs appreciating More companies/CEOs appreciating importance of R&D?importance of R&D?

New fiscal incentives/rewards?New fiscal incentives/rewards? Changing guidelines for incentives?Changing guidelines for incentives? Changing guideline Changing guideline interpretation?interpretation? Other factors?Other factors?

Key SRED DevelopmentsKey SRED DevelopmentsSince 1998Since 1998

CRA shifts from strict CRA shifts from strict auditaudit role to active role to active promotionpromotion role since late 1990s role since late 1990s

Reduced paperwork burdenReduced paperwork burden(“(“We ... streamlin(ed) paperwork and simplifi(ed) We ... streamlin(ed) paperwork and simplifi(ed)

the claim process. It is easier for companies to the claim process. It is easier for companies to benefit from the program, and feedback shows benefit from the program, and feedback shows that industry is more confident about itthat industry is more confident about it..”)”)

Established pre-claim review processEstablished pre-claim review process• Improves program predictabilityImproves program predictability• Presumably lowers unsuccessful applicant ratePresumably lowers unsuccessful applicant rate

Key Developments (cont’d.)Key Developments (cont’d.)

Expanded software eligibilityExpanded software eligibility

Expedited technical review Expedited technical review of IRAP grantee of IRAP grantee claimsclaims::““We are streamlining the processing of SR&ED We are streamlining the processing of SR&ED

projects that receive support under the projects that receive support under the Industrial Research Assistance Program (IRAP)Industrial Research Assistance Program (IRAP)” ” (Minister Herb Dhaliwal)(Minister Herb Dhaliwal)..

Key Developments (cont’d.)Key Developments (cont’d.)

NNew provincial government research ew provincial government research tax credit programstax credit programs• (e.g. BC, PEI, Ontario, Quebec, Alberta)(e.g. BC, PEI, Ontario, Quebec, Alberta)

Growth of the SR&ED consulting Growth of the SR&ED consulting industryindustry• Actively “prospect” for (marginal?) R&D Actively “prospect” for (marginal?) R&D

performersperformers

The Result …The Result … SR&ED program promotion increasedSR&ED program promotion increased Project eligibility expandedProject eligibility expanded

• E.g. SoftwareE.g. Software Approval processes streamlinedApproval processes streamlined Support programs expandedSupport programs expanded The number of applicants grewThe number of applicants grew Result: # successful firms increasesResult: # successful firms increases

• Despite small decline in approval rateDespite small decline in approval rate

SR&ED: Is it working?SR&ED: Is it working?

From an R&D From an R&D spendingspending perspective: perspective:

NoNo From an R&D From an R&D performerperformer perspective: perspective:

YesYes

BUT … Working for WHAT?BUT … Working for WHAT?• Why are we doing it? What result do we want?Why are we doing it? What result do we want?• No clear articulation of No clear articulation of FirstFirst PPrinciplesrinciples

Beyond … “R&D is good for you”Beyond … “R&D is good for you”

Direct vs. Indirect FundingDirect vs. Indirect Funding

Council of Canadian Academies: Innovation and business strategy: Why Canada Falls Short

Direct vs. Indirect Support:Direct vs. Indirect Support:IRAP vs. SREDIRAP vs. SRED

DIRECT (IRAP)-$200mDIRECT (IRAP)-$200m Pre-approvalPre-approval No funding uncertaintyNo funding uncertainty Covers basic expendituresCovers basic expenditures Progress paymentsProgress payments Pays monthlyPays monthly Ongoing monitoringOngoing monitoring Controls on misuseControls on misuse Value-added technical Value-added technical

support availablesupport available

INDIRECT (SRED)-$4bINDIRECT (SRED)-$4b Pre- or post-approvalPre- or post-approval Much funding uncertaintyMuch funding uncertainty Some added expendituresSome added expenditures Lump-sum paymentLump-sum payment Pays annuallyPays annually Post-project monitoringPost-project monitoring Few controls on misuseFew controls on misuse No value-added technical No value-added technical

supportsupport

Benefits of Increased IRAPBenefits of Increased IRAP

No net cost increase to OttawaNo net cost increase to Ottawa Improved project oversightImproved project oversight

• Reduced mis-spendingReduced mis-spending Improved cash flow to companiesImproved cash flow to companies Increased risk-taking by firmsIncreased risk-taking by firms

““Zero Sum Gain”Zero Sum Gain”

Government’s total exposure = the Government’s total exposure = the sum of IRAP and SRED claimssum of IRAP and SRED claims

Companies eligible Companies eligible eithereither for IRAP for IRAP oror SRED (no double-dipping)SRED (no double-dipping)

Therefore, shifting $ from SRED to Therefore, shifting $ from SRED to IRAP has no major financial IRAP has no major financial implicationsimplications

First Principles First Principles – A First Look– A First Look

GoalGoalProduce high quality made-in-Canada Produce high quality made-in-Canada commodities, goods and services that commodities, goods and services that the world wants at prices it is willing the world wants at prices it is willing

to payto pay

Be a highly efficient and environmentally Be a highly efficient and environmentally responsible producerresponsible producer

Utilize the talents of entrepreneursUtilize the talents of entrepreneurs Support successful Canadian companies Support successful Canadian companies

and industriesand industries

First Principles First Principles – A First Look– A First Look

Involve as many companies as Involve as many companies as possible in formal research and possible in formal research and innovation activitiesinnovation activities

Company spending should be at the Company spending should be at the level of their direct competitors (size, level of their direct competitors (size, industry)industry)

Maximize interaction, synergy among Maximize interaction, synergy among academic, corporate and academic, corporate and government research activities, government research activities, investmentsinvestments

First Principles First Principles – A First Look– A First Look

Balance support for startup and Balance support for startup and growthgrowth

Provide appropriate risk-reward Provide appropriate risk-reward situation for investorssituation for investors

Provide foreign multinationals with a Provide foreign multinationals with a competitive advantagecompetitive advantage

Buy Canadian !Buy Canadian !

Implementing the PrinciplesImplementing the Principles

Put our resources closer to the Put our resources closer to the commercialization end of the spectrumcommercialization end of the spectrum

Focus on demand-driven (market-driven) Focus on demand-driven (market-driven) research and commercialization policy and research and commercialization policy and programming, rather than supply-drivenprogramming, rather than supply-driven

Shift support from indirect to direct support Shift support from indirect to direct support (e.g. IRAP vs. SRED)(e.g. IRAP vs. SRED)

Put more emphasis on helping successful Put more emphasis on helping successful companies grow (and less on startup/early companies grow (and less on startup/early stage firms)stage firms)

Some First PrinciplesSome First Principles

Reduce early investor riskReduce early investor risk• cf. Flow-through sharescf. Flow-through shares

Activate the commercialization potential of Activate the commercialization potential of the social sciences and humanitiesthe social sciences and humanities• cf. Services commercializationcf. Services commercialization

Harmonize public sector programming and Harmonize public sector programming and program delivery.program delivery.

Thank you !Thank you !