TBA The Biotechnology Initiative

The Voice of Bioscience in Ontario



Tax Incentives for Scientific Research and Experimental Development

Submission to the Government of Canada’s Tax Incentives for Scientific Research and Experimental Development Consultation Paper


Introduction
Canada’s 532 emerging technology companies, spending over $1.7 billion annually, represent over 12% of the country’s business expenditures in research and development (R&D). It is critically important to the success of these emerging technology companies that the Federal Government continue to create an advantageous business climate to sustain and grow these R&D activities.
Canada’s biotechnology sector has grown and achieved a market capitalization of $22 billion. This would not be possible were it not for programs such as the Scientific Research and Experimental Development (SR&ED) tax incentive program. The technologically advanced products and processes that this research enables improve people’s lives, clean up the environment, and transform Canada’s economy.
A large gap has emerged in Canada between funds needed to commercialize products and the actual investment provided. This is especially true for small and medium sized biotechnology companies in Canada, three-quarters of which have fewer than 50 employees. The recently released BIOTECanada–PricewaterhouseCoopers Canadian Life Sciences Industry forecast 2007 highlights that more than 40% of these companies are looking to secure more than $20 million in their next round of financing Unfortunately, Canada’s capital market is too small and too risk-adverse to provide this assistance; thus, the SR&ED program needs to be an effective tool to prevent the hollowing out of the emerging technology sector in Canada. If Canada does not act, we not only risk losing the biotechnology industry to competing jurisdictions, but also risk not getting the return on investment back from investments in research in the emerging technology sector in Canada. These sectors provide a forum for employment for many of our advanced science graduates from universities in Canada whom taxpayers have subsidized throughout their education. If we have no jobs for these graduates and lose them to foreign employers, we will not see a return on our investment.
While this paper comments on the specific questions posed in the consultation paper, there are two changes to the current SR&ED program that are the business case for keeping attractive, high-paying, emerging technology jobs and investment in Canada, preventing the hollowing out of our industry and providing Canada’s emerging technology sector with the tools to compete in the global marketplace and provide a competitive edge to do R&D in Canada:
1.     Increase the annual R&D expenditure limit from $2 million to $10 million and adjust the taxable capital threshold from $10 million to $50 million; and,
2.     Remove the current Canadian-controlled private corporation (CCPC) restriction on SR&ED for refundable credits, while maintaining eligibility requirements (taxable income and taxable capital thresholds).
By making these two changes to modernize the SR&ED program, 40 percent of Canadian biotech companies would benefit immediately with a further 34 percent of all companies in the sector benefitting in the near future. It would be a clear indication of the Government of Canada’s support for small and medium sized emerging technology companies, directly enabling them to be more competitive globally and encouraging jobs and investment to remain in Canada.

About Canada’s Emerging Technology Associations
There are hundreds of emerging technology companies in Canada who are active in all industry sectors and who work in close partnership with academic and research institutions and other related organizations to drive Canada’s innovation agenda. These companies, and the Associations who represent them including BIOTECanada, Ag-West Bio Inc., Bio Alberta, Bio Nova, Bio Quebec, Life Science Association of Manitoba, Life Sciences British Columbia, Ontario Agri-Food Technologies, MaRs, Prince Edward Island Bio Alliance ,and The Biotechnology Initiative are all dedicated to the sustainable commercial development of technological innovation in Canada and regularly contribute to the policy discourse on government policies that impact our industry.

Government of Canada Consultation
In October 2007, the Government of Canada, through the Department of Finance and the Canada Revenue Agency (CRA), released a consultation paper on the SR&ED tax incentive program to garner feedback on how to build on the program’s success. First established in the 1980s, federal income tax incentives for SR&ED are intended to provide broad-based support for SR&ED activities in every industrial sector in Canada. They are also specifically aimed at supporting small businesses in the performance of SR&ED activities. The end goal of the consultation is to garner recommendations as to how best improve the SR&ED program both in terms of policy and administrative changes.
In order to facilitate the consultation, four questions were posed for organizations to consider. Our joint response is framed around these four questions, with particular emphasis on the impact of tax incentives on small and medium sized emerging technology companies.

Consultation Questions
1.     How do SR&ED tax incentives affect the performance of R&D in Canada, and how can they contribute to increasing private sector investment in R&D?

Our broad coalition of Emerging Technology Associations, and the member companies we represent, supports the need for fundamental changes to modernize the SR&ED program that was developed twenty-two years ago, in a pre-NAFTA environment. The economic conditions of 1985 are vastly different than the reality of 2007. While the SR&ED program is helpful and most generous for large, successful companies, it is not as effective as it needs to be for small and medium sized companies. The majority of our member companies are small and medium sized enterprises, with less than two years of operating cash on hand. The indicators used by the Department of Finance for the SR&ED program are all based on the assumption that companies will be profitable in the short term; this is simply not accurate for small and medium sized emerging technology firms who have very long lifecycles and who are often not profitable for years.
While it is clear that changes need to be made, it is important to recognize that the Government of Canada’s support for research and development is meaningful and has helped spur the creation of many emerging technology companies. It has also encouraged economic and labour market growth in areas of knowledge-based innovation; according to Statistics Canada, Canada’s biotechnology industry achieved 13 percent growth in employment over the past two years. As noted in Industry Canada’s Mobilizing Science and Technology to Canada’s Advantage document, “Organizations at the forefront of scientific development and technological achievement create high-quality, knowledge-intensive jobs with high wages. They make our economy more competitive and productive, giving us the means to achieve an even higher standard of living and better quality of life.”
The SR&ED tax incentive program is critically important in helping to foster research and development in all industrial sectors and in companies of all sizes. It is especially important for Canada’s emerging technology sector, whose major challenges remain access to capital and adoption of innovation. The SR&ED program is needed to help Canadian firms compete with companies in other jurisdictions who have access to similar, and in some cases stronger support. Companies locate their R&D operations wherever they can best align labour, facilities, and financing, and the economic support provided by governments plays a large role in their decision in terms of where best to place their R&D investments. While the Department of Finance has determined that the SR&ED tax credit creates a gross economic gain of $1.11 for every dollar spent on it, and a net economic gain of 11 cents per dollar, there are other jurisdictions whose tax incentives provide more significant returns. The Government of Canada can take real steps to mitigate that imbalance and make the SR&ED tax credit more attractive to investors by ensuring it has greater refundability, higher limits and fewer foreign ownership restrictions.
Canada is but one player in an active, global marketplace; both developed and developing nations have recognized the opportunities emerging technologies present and are investing heavily in R&D. For example, in OECD nations, the share of biotechnology in all business-sector R&D is used as an indicator of the level of the focus a country is placing on biotechnology research. In Iceland, biotechnology R&D accounts for 51.4 percent of all business sector R&D. Other countries including Denmark (23.8 percent) and New Zealand (20.9 percent) are significantly out-investing Canada (12 percent). Even developing nations such as China, India, Singapore and Malaysia are investing billions of dollars to capture the strategic value biotechnology offers to their emerging economies. They offer lower wage rates, larger knowledge-based labour pools in addition to the increasingly attractive support from their government. There is an urgent need to modernize the SR&ED program so that R&D investment in Canada remains viable in light of the global competition.

2.     Are there features of the SR&ED tax incentives that impede the growth of small and medium sized innovative Canadian companies, and how?
While Canada’s Emerging Technology Associations have member companies of all sizes, it is our small and medium sized members who are the most challenged as they try to access venture capital to take them through the early product development stages. Unfortunately, many small and medium sized emerging technology companies are not in a profitable position so the current SR&ED program does not allow them to take advantage of the tax credits or rebates, ironically just when they need them the most. In addition, emerging technology companies are forced to go public much earlier in the lifecycle than they used to and are losing tax assistance as a result. IPOs used to be used as an exit strategy for these small and medium sized companies; now they are used solely for financing. In recognition of this situation, there are two specific changes the Government of Canada should immediately make to the SR&ED tax incentive program to stimulate the growth and investment in small and medium sized emerging technology companies:
1)     Increase the annual R&D expenditure limit from $2 million to $10 million and adjust the taxable capital threshold from $10 million to $50 million.

The current $2 million expenditure limit for refundable tax credits was established in 1985, pre-NAFTA and does not accurately reflect either Canada’s current economic position or the global competition for corporate emerging technology investment. It has neither been adjusted to reflect inflation nor the increased costs of research and development as 70% of our small and medium sized companies spend above $2 million annually in R&D. The current taxable capital limits that determine entitlement to refundability pose another barrier, as they impose a size constraint thereby limiting value to growing companies. These limits do not reflect the need of emerging technology companies to raise more capital to support the entire product development life cycle. Adjusting the threshold to reflect the new expenditure limit and the reality of operations in 2007 will help extend the viability of firms to grow and meet the long term lifecycle demands of commercialization.
2)     Remove the current CCPC restriction on SR&ED for refundable credits, while maintaining eligibility requirements (taxable income and taxable capital thresholds).

This change to eligibility requirements needs to be made immediately so that the SR&ED program can be used to prevent the hollowing out of the emerging technology industry in Canada; at its core, this change presents the business case to keep these jobs in Canada. The CCPC restriction for refundability is counter productive to the original goals of the SR&ED program. Country of ownership is blurred in this modern global economy. Companies are portable, especially small, early stage companies. They want to be able to establish their companies and develop their products in Canada, through the entire product lifecycle, but we are losing out to competing jurisdictions that do not impose similar restrictions on foreign ownership. In fact, in 1999 the Government of Ontario recognized the barrier this posed to investment and revised the criteria for the Ontario Innovation Tax Credit, making it eligible for all qualifying public and private sector corporations, not just Canadian-controlled private corporations. Canada’s interest must focus on having the research and development activity, with the employment and investment it brings, located in Canada. While the solution may seem to be to secure domestic financing, Canadian capital markets and life science venture funds are simply too small and risk adverse to meet the demands of our industry. Small and medium sized emerging technology companies do not have the same access to venture capital in the early development stages as large companies. Due to the difficulty obtaining solely Canadian venture capital, many of the early-stage Canadian companies have no choice but to seek support from public and foreign markets, giving up their CCPC status in order to remain viable companies. Once these companies receive funding from jurisdictions such as the United States, it becomes easier for them to leave Canada and establish their operations, along with those jobs, elsewhere. These are the companies that need the refundability aspect of the SR&ED program the most, yet disqualify themselves as a result of the restrictive CCPC requirement.
     By making the recommended changes in these two areas to modernize the SR&ED program, the Government of Canada can meet its commitment to create a climate of innovation and discovery, “...providing an enabling environment that promotes private investment in R&D, advanced technologies, and skilled workers.”
     
3.     How could more private sector R&D be leveraged?
Earlier this year, BIOTECanada released its 2007 PricewaterhouseCoopers’ Canadian Life Sciences Industry Forecast. This forecast found that 78 percent of respondents identified financing as the most important critical success factor for Canadian biotechnology companies. In addition, the majority of respondents said that they will be seeking more than $10 million in their next round of financing. The Government of Canada has a real opportunity to create an economic climate where Canadian financial markets find R&D an attractive area in which to invest. In addition, the continuation and augmentation of tax incentives, such as the SR&ED program helps mitigate some of the risk for private sector investment in R&D activities, especially at the earliest stages.
However, as previously articulated, Canada is lagging behind in terms of the structure of the incentives it is offering. A solution can be found through the implementation of the recommended changes to the SR&ED program; it is estimated that these changes will result in a minimum net economic benefit of $160 million dollars annually, through increasing access to capital, lengthening the runway of each round of financing and further leveraging additional investment from private sources. It is critically important that the SR&ED program be an effective tool to lever private investment. We know that investments such as refundable tax credits for emerging technology companies make a large difference to investors, leveraging other investments and stimulating jobs in related sectors. In addition, increased investment in emerging technology companies also supports Canadian knowledge-based technology partners including colleges and universities, teaching hospitals and research institutes. It will only be through the private and public sectors working together that we will be able to secure Canada’s future as a leader in the knowledge-based economy.

4.     Given the improvements already implemented or under study, how could administration of the SR&ED tax incentives be further improved and their complexity reduced?
While administrative improvements to the SR&ED program are important, the far greater priority of the government should be to modernize the criteria of the program itself.
Having said that, we would make the following two recommendations:
1) The definition of R&D expenses should be reviewed to comprehensively reflect the true costs of R&D expenditures. For example, Intellectual Property (IP) expenses should be added as an eligible SR&ED expense with these costs being limited to IP firms that are located in Canada.
2) The applications process for claimants should be improved to ensure information, documentation and explanation needs are clearly detailed and allowable expenditures are clearly communicated. Sectors of specialization conducting novel R&D can be difficult to understand for SR&ED staff. Clearly stating the manner in which documentation for SR&ED tax credits must be submitted regardless of the terminology associated which would increase the efficiency of the program for both the government and the claimant.      

Conclusion
Canada’s biotechnology industry plays a pivotal role in the country’s productivity, aiming to turn excellent Canadian research and scientific discovery into commercialized products for the global marketplace and high-paying jobs for Canadians. While the Canadian SR&ED program is often cited as one of the most generous programs of its kind, its effective limitations to 1985 expenditure levels and a pre-NAFTA protectionist CCPC restriction work as a disincentive to grow Canadian knowledge-intensive companies. The program does not adequately reflect the true dynamic of financing required to sustain emerging technologies through development and regulatory trials.
The Government of Canada, through Industry Canada’s plan to Mobilize Science and Technology, has committed to increase the impact of its business R&D assistance program. Canada’s Emerging Technology Associations encourage the Government of Canada to modernize the SR&ED tax incentive program by:
1. Increasing the annual R&D expenditure limit (established in 1985, pre-NAFTA) for refundable tax credits from $2 million to $10 million and adjust the taxable capital threshold form $10 million to $50 million; and
2. Removing the current CCPC restriction on SR&ED for refundable credits, while maintaining eligibility requirements.
It can not be said strongly enough that these two changes are the business case for preventing the hollowing out of Canada’s emerging technology sector. They are easily implementable by the Government of Canada. They will allow Canada to secure and improve the future of our nation’s biotechnology industry and other knowledge-based industries. They will provide Canada’s emerging technology sector with the tools to compete in the global marketplace. They will stimulate jobs and encourage further, significant investment by the private sector. And they will have a positive and immediate impact on small and medium sized Canadian emerging technology companies. Canada’s Emerging Technology Associations strongly urge the Government to makes these changes immediately as the future of our industry itself is at stake.