May 29, 2024 – Finance Canada’s review of the scientific research and experimental development (SR&ED) tax incentive program should stay focused on the program’s raison d’être to encourage research and development (R&D), and remain separate from other activities in the innovation continuum, according to a new C.D. Howe Institute report. Further, the federal government should recognize that an intellectual property (IP) box is good public policy.
In “Spurring R&D: Canada Needs Focused Reforms to SR&ED and an IP Box,” Fellow-In-Residence John Lester examines questions related to Finance Canada’s consultations on a modernization and improvement of its SR&ED tax incentive program and the suitability of creating a IP box regime. These consultations are the first step in the SR&ED review process, which was first announced in Budget 2022, and are taking place against a backdrop of distressingly poor productivity growth; concerns about the amount and effectiveness of R&D taking place; and worries about the ability of innovative startups to scale up their operations domestically.
“Until now, the government has kept SR&ED, which supports R&D because of the spillovers it generates, separate from other innovative and commercialization activities, which are motivated by other considerations,” explains Lester, former Director of Research for the Expert Panel Review of Federal Support to Research and Development. “This is a sound approach and should be maintained.”
Lester explains that the rationale for subsidizing R&D is knowledge spillovers, and that the motivation for subsidizing non-R&D activities varies. Instead of broadening the list of SR&ED-eligible expenses, he says, reforms to the SR&ED tax incentive program should focus on maximizing spillover benefits and that separate programs should be used to support other innovation activities.
For example, the scale-up of startups should be supported by modifying the Industrial Research Assistance Program (IRAP) – shifting non-repayable support for R&D to repayable support for commercialization and scale-up.
The second round of consultation questions invites consideration of one rate for all firms. Reducing the credit rate for small firms and increasing it for large firms would increase the spillover benefits from the SR&ED incentive. However, instead of setting a single rate, Lester recommends setting the rate for small firms slightly above that for large firms, in order to recognize the higher costs incurred by small firms in applying for the credit.
The author also recommends the regular SR&ED tax credit be made refundable, primarily to avoid tying the value of the credit to the tax status of the firm, but also to eliminate the possibility that some of the incentive will be transferred to the US government through the application of minimum taxes on US multi-national enterprises. Refundability should be phased in to reduce its short-run cost. Refundable tax credits are effectively grants paid independently of a firm’s tax status, so assistance could be provided without being tied to filing an income tax return. This change would greatly improve the incentive’s timeliness. It should be implemented for small firms even if the regular credit is not made refundable.
A preferential tax regime for IP income would also be good public policy, according to Lester. It would be a cost-effective way of promoting additional R&D and encourage more commercialization activity in Canada. To maximize its favourable impact, income qualifying for the special low rate must be defined as broadly as possible.
Lester recommends that income from all assets, including those protected by trade secrecy, developed from R&D performed in Canada, not just patents, qualify for special treatment. Additionally, qualifying income must include not only explicit royalties and licensing fees, but also implicit IP income embedded in products sold, or in production processes developed from R&D performed in Canada.
“Canada’s innovation support system would be greatly strengthened by focused reforms of the SR&ED program, modification of IRAP, and implementation of an IP box,” concludes Lester.
For more information contact: John Lester, Fellow-In-Residence, C.D. Howe Institute, and former Director of Research for the Expert Panel Review of Federal Support to Research and Development; and Lauren Malyk, Senior Communications Officer, C.D. Howe Institute, 416-865-1904 Ext. 0247, lmalyk@cdhowe.org