Is the SR&ED Tax Credit Appropriate Given Recent Industrial R&D Trends? Ron Freedman Partner The Impact Group Telfer Presentation, 5 October 2010 © The Impact Group 2010

Scientific Research & Experimental Development Program (SRED) Canadian-controlled private corporation (REFUNDABLE) Canadian-controlled private corporation (REFUNDABLE) Investment tax credit (ITC) of 35% up to the first $3 million of qualified expenditures for SR&ED carried out in Canada, and 20% on any excess amountInvestment tax credit (ITC) of 35% up to the first $3 million of qualified expenditures for SR&ED carried out in Canada, and 20% on any excess amount Other Canadian corporations Other Canadian corporations (NOT REFUNDABLE, CREDIT AGAINST TAXES) Proprietorships, partnerships, and trusts can earn an ITC of 20% of qualified expenditures for SR&ED carried out in CanadaProprietorships, partnerships, and trusts can earn an ITC of 20% of qualified expenditures for SR&ED carried out in Canada Covers expenditures such as wages, materials, machinery, equipment, some overhead, and SR&ED contracts Covers expenditures such as wages, materials, machinery, equipment, some overhead, and SR&ED contracts

What is Eligible? Basic research Basic research to advance scientific knowledge without a specific practical application in viewto advance scientific knowledge without a specific practical application in view Applied research Applied research to advance scientific knowledge with a specific practical application in viewto advance scientific knowledge with a specific practical application in view Experimental development Experimental development to achieve technological advancement to create new materials, devices, products, or processes, or improve existing onesto achieve technological advancement to create new materials, devices, products, or processes, or improve existing ones Support work Support work in engineering, design, operations research, mathematical analysis, computer programming, data collection, testing, or psychological research, but only if the work is commensurate with, and directly supports, the eligible experimental development, or applied or basic researchin engineering, design, operations research, mathematical analysis, computer programming, data collection, testing, or psychological research, but only if the work is commensurate with, and directly supports, the eligible experimental development, or applied or basic research

What’s Not Eligible? Social science and humanities research Social science and humanities research Commercial production of a new or improved material, device, or product, or the commercial use of a new or improved process Commercial production of a new or improved material, device, or product, or the commercial use of a new or improved process Style changes Style changes Market research or sales promotion Market research or sales promotion Quality control or routine testing of materials, devices, products, or processes Quality control or routine testing of materials, devices, products, or processes Routine data collection Routine data collection Prospecting, exploring, or drilling for or producing minerals, petroleum, or natural gas Prospecting, exploring, or drilling for or producing minerals, petroleum, or natural gas Development based solely on design or routine engineering practice. Development based solely on design or routine engineering practice.

The SR&ED Intellectual Framework 1970s thinking 1970s thinking Built on large in-house industrial laboratory model Built on large in-house industrial laboratory model Principles codified in OECD Frascati Manual Principles codified in OECD Frascati Manual

Part 1 – Understanding Industrial R&D Trends

Business Innovation Capacity = R&D Spending $ X # of R&D Performers Proposition: Improving Capacity Means Improving Spending AND Performers

Corporate R&D Spending: Real R&D Spending Dropping Source: StatCan Cat. No X +65%-2.4%

Corporate R&D Performers: Growth Continues % <>

SRED Applicants Growing Rapidly Source: CRA, StatCan

SRED Approval Rate Declining

Performer Growth Outstripping Spending Growth

R&D Companies: A moving target

R&D Participation Rate Growing

R&D Spending Becoming Less Concentrated

Average Spending Declining

R&D Intensity Declining

Part 2. Understanding Trends

Real $ R&D Spending Falling – Why? Mergers and acquisitions Mergers and acquisitions Large business failure Large business failure e.g. Nortel, JDS, 724 Solutions, Norandae.g. Nortel, JDS, 724 Solutions, Noranda Changing structure of R&D Changing structure of R&D Off-shoring, Downloading to suppliersOff-shoring, Downloading to suppliers Higher profitability of Canadian companies Higher profitability of Canadian companies U.S. firms trading lower profitability for higher innovation, productivityU.S. firms trading lower profitability for higher innovation, 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 research Ineligibility of SSH research Especially important for service economyEspecially important for service economy

R&D Companies Growing – Why? 3 Growth Periods DeclineSlow GrowthRapid Growth

More R&D Companies – Why? More companies/CEOs appreciating importance of R&D? More companies/CEOs appreciating importance of R&D? New fiscal incentives/rewards? New fiscal incentives/rewards? Changing guidelines for incentives? Changing guidelines for incentives? Changing guideline interpretation? Changing guideline interpretation? Other factors? Other factors?

Key SRED Developments Since 1998 CRA shifts from strict audit role to active promotion role since late 1990s CRA shifts from strict audit role to active promotion role since late 1990s Reduced paperwork burden Reduced paperwork burden (“We... streamlin(ed) paperwork and simplifi(ed) the claim process. It is easier for companies to benefit from the program, and feedback shows that industry is more confident about it.”) Established pre-claim review process Established pre-claim review process Improves program predictabilityImproves program predictability Presumably lowers unsuccessful applicant ratePresumably lowers unsuccessful applicant rate

Key Developments (cont’d.) Expanded software eligibility Expanded software eligibility Expedited technical review of IRAP grantee claims: Expedited technical review of IRAP grantee claims: “We are streamlining the processing of SR&ED projects that receive support under the Industrial Research Assistance Program (IRAP)” (Minister Herb Dhaliwal).

Key Developments (cont’d.) New provincial government research tax credit programs New provincial government research tax credit programs (e.g. BC, PEI, Ontario, Quebec, Alberta)(e.g. BC, PEI, Ontario, Quebec, Alberta) Growth of the SR&ED consulting industry Growth of the SR&ED consulting industry Actively “prospect” for (marginal?) R&D performersActively “prospect” for (marginal?) R&D performers

The Result … SR&ED program promotion increased SR&ED program promotion increased Project eligibility expanded Project eligibility expanded E.g. SoftwareE.g. Software Approval processes streamlined Approval processes streamlined Support programs expanded Support programs expanded The number of applicants grew The number of applicants grew Result: # successful firms increases Result: # successful firms increases Despite small decline in approval rateDespite small decline in approval rate

SR&ED: Is it working? From an R&D spending perspective: From an R&D spending perspective:No From an R&D performer perspective: From an R&D performer perspective:Yes 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 First PrinciplesNo clear articulation of First Principles Beyond … “R&D is good for you” Beyond … “R&D is good for you”

Direct vs. Indirect Funding Council of Canadian Academies: Innovation and business strategy: Why Canada Falls Short

Direct vs. Indirect Support: IRAP vs. SRED DIRECT (IRAP)-$200m Pre-approval Pre-approval No funding uncertainty No funding uncertainty Covers basic expenditures Covers basic expenditures Progress payments Progress payments Pays monthly Pays monthly Ongoing monitoring Ongoing monitoring Controls on misuse Controls on misuse Value-added technical support available Value-added technical support available INDIRECT (SRED)-$4b Pre- or post-approval Pre- or post-approval Much funding uncertainty Much funding uncertainty Some added expenditures Some added expenditures Lump-sum payment Lump-sum payment Pays annually Pays annually Post-project monitoring Post-project monitoring Few controls on misuse Few controls on misuse No value-added technical support No value-added technical support

Benefits of Increased IRAP No net cost increase to Ottawa No net cost increase to Ottawa Improved project oversight Improved project oversight Reduced mis-spendingReduced mis-spending Improved cash flow to companies Improved cash flow to companies Increased risk-taking by firms Increased risk-taking by firms

“Zero Sum Gain” Government’s total exposure = the sum of IRAP and SRED claims Government’s total exposure = the sum of IRAP and SRED claims Companies eligible either for IRAP or SRED (no double-dipping) Companies eligible either for IRAP or SRED (no double-dipping) Therefore, shifting $ from SRED to IRAP has no major financial implications Therefore, shifting $ from SRED to IRAP has no major financial implications

First Principles – A First Look Goal Produce high quality made-in-Canada commodities, goods and services that the world wants at prices it is willing to pay Be a highly efficient and environmentally responsible producer Be a highly efficient and environmentally responsible producer Utilize the talents of entrepreneurs Utilize the talents of entrepreneurs Support successful Canadian companies and industries Support successful Canadian companies and industries

First Principles – A First Look Involve as many companies as possible in formal research and innovation activities Involve as many companies as possible in formal research and innovation activities Company spending should be at the level of their direct competitors (size, industry) Company spending should be at the level of their direct competitors (size, industry) Maximize interaction, synergy among academic, corporate and government research activities, investments Maximize interaction, synergy among academic, corporate and government research activities, investments

First Principles – A First Look Balance support for startup and growth Balance support for startup and growth Provide appropriate risk-reward situation for investors Provide appropriate risk-reward situation for investors Provide foreign multinationals with a competitive advantage Provide foreign multinationals with a competitive advantage Buy Canadian ! Buy Canadian !

Implementing the Principles Put our resources closer to the commercialization end of the spectrum Put our resources closer to the commercialization end of the spectrum Focus on demand-driven (market-driven) research and commercialization policy and programming, rather than supply-driven Focus on demand-driven (market-driven) research and commercialization policy and programming, rather than supply-driven Shift support from indirect to direct support (e.g. IRAP vs. SRED) Shift support from indirect to direct support (e.g. IRAP vs. SRED) Put more emphasis on helping successful companies grow (and less on startup/early stage firms) Put more emphasis on helping successful companies grow (and less on startup/early stage firms)

Some First Principles Reduce early investor risk Reduce early investor risk cf. Flow-through sharescf. Flow-through shares Activate the commercialization potential of the social sciences and humanities Activate the commercialization potential of the social sciences and humanities cf. Services commercializationcf. Services commercialization Harmonize public sector programming and program delivery. Harmonize public sector programming and program delivery.

Thank you !