As you may have seen, back in July 2017, the Canadian Advanced Technology Association (CATA) published its “Update on SR&ED Tax Credits” and the news was concerning, to say the least. The headline news was that in the 7 years from 2009 to 2016, the aggregate tax credits issued to companies by CRA declined, according to CATA estimates, by a whopping $5.3 billion! This news comes during the rollout of the federal government’s new “Innovation Agenda”, which touts the importance of funding for innovation and announcements on several new programs aimed at incentivizing innovation activities by Canadian businesses. So, I’m sure that there are many folks out there who might find this news surprising.

What Happened to SR&ED?

To give you some historical perspective, prior to 2009, the program was exhibiting a compound growth rate of 11%. Suddenly, in the government’s 2009-2010 financial year, the tax credits provided to businesses decreased by 19.5%, or $800 million. Now, this could be attributed to reduced R&D spending in the year preceding due to the 2008 recession, as the tax credits are paid out up to several years after the period in which the R&D activities took place. Further, reduced profits for large corporations and non-CCPCs could have reduced the amount of non-refundable tax credits that could be applied in that period. However, the tax assistance provided has remained low ever since this time, even as the economy rebounded to the point where Canada is expected to top the G7 for economic growth in 2017. Even amidst the release of the 2017 Budget including the “Innovation Agenda”, the 2017 Report on Federal Tax Expenditures issued by the Department of Finance made a further 24% (or $500 million) downward revision from 2016 to the budgeted SR&ED tax credits.

How Did We Get Here?

So, how did we get here? Is this something that Canadian businesses should have expected based on announced changes to government policy and programs, or is this major cut to the most significant incentive program for innovation carried out covertly?

Although there were signs of more restrictive policies by CRA in its administration of the program in the mid-aughts, up to 2010, where the first significant decrease in the scope of the program was recorded, there had been no official changes made to administrative policy by CRA. In 2011, a federal R&D panel, led by Tom Jenkins of OpenText, released a report with a number of recommendations for changes to innovation funding, including the simplification of the SR&ED program to make it easier for companies to access without the need for an SR&ED consultant, and to make the credit be based on labour costs only. Effectively, this would have reduced the size of the SR&ED tax credit program, and the panel wanted these funds to be redirected toward direct support initiatives, like grants and subsidies, geared toward helping SMEs grow into larger firms.

The federal government did, indeed, respond by making cuts to the SR&ED program, through changes to both eligibility rates for qualified SR&ED expenditures and tax credit rates, announced in the 2012 federal budget. These changes, which took effect in 2014, were expected to amount to a total of $1.3 billion cut from program expenditures from 2014 to 2017, with a maximum annual reduction of $500M relative to 2012; the results of which would be realized in the 2016-2017 period. It is worth noting that no changes were made to the legal definition of SR&ED from the standpoint of what constitutes scientific research or experimental development at this time.

However, when we examine the actual reduction to the SR&ED tax credit assistance provided, as per the Department of Finance’s 2017 Report on Federal Tax Expenditures, the result is far in excess of the forecasted $1.3 billion cut. This analysis takes in to account only the change to the SR&ED refundable tax credits plus SR&ED non-refundable tax credits earned and applied in the current year. This provides a more clear indicator of annual program trends since non-refundable credits earned in the past and applied later to offset tax were potentially processed from an eligibility perspective as far back as 20 years in the past. This shows that the change from 2011 to 2017 is actually double the forecasted change, at $2.6 billion. This drop began to take effect well before the implementation of the legislative changes in 2014. Canadian-controlled SMEs receiving the refundable SR&ED tax credits alone saw a $970 million decrease in their assistance during that time.

So, where did the extra reduction of $1.3 billion come from, if it did not result from legislative changes? According to Statistics Canada, R&D spending in natural sciences and engineering by the business enterprise sector has increased overall since 2011, so the reduction cannot be attributed to less R&D activity.

Based on CATA’s analysis, CRA is spending more money on staff to administer program compliance. This increase was up by 60% since 2005, or equivalent to over 200 full-time staff on the CRA SR&ED administrative team. CRA leverages this team to disallow more from those claims that are selected for detailed review; also known as increasing tax recovery.

The average ‘recovery’ amount processed per claim increased by 17%, translating into $14,600 2011/2012) and $17,130 (2015/2016). But this figure relates to all claims filed and not all claims are reviewed and therefore subjected to adjustment. Roughly 25% of claims are subjected to a detailed review—either a desk review or site review—this means that the average adjustment through reduction for a claim selected for a site review was almost $70,000 in 2015/2016. Another report by CATA that was released in November 2017 cited that as of 2012-2013 the average SR&ED tax assistance per claimant was down to $156,522. Thus, we can infer that the average claimant subjected to a site review can expect to have their claimed SR&ED-eligible expenses cut down by approximately 40%. In practice, roughly 60% are actually reduced by CRA during a site review; thus, the average size of a downward adjustment if CRA makes one is closer to 66%. Anecdotally, the frequency of reviews appears to have increased over the past 12 months and the change rate target for SR&ED reviews most recently reported to the Parliament by CRA is now 75%, so we can expect the amount of recovery to increase. This has caused the number of annual claims to drop by 6,000 from its high of 29,000 in the 2011-2012 fiscal year.

The increased average recovery combined with decreased average claim sizes overall serves to demonstrate that CRA is applying a more restrictive definition of SR&ED tax credits to its administration of the program. This is surprising, because, although they issued new interpretive policies in 2012, the legal definition of the scientific/technological eligibility criteria did not change and even the CRA itself stated that the 2012 reissue was to simplify and streamline existing policy, not to change the policy in any material fashion. This was all done under the guise of making the program easier to access without the assistance of an SR&ED consulting professional. In fact, many businesses can attest to the fact that it has only gotten harder to understand what types of activities CRA will accept as being SR&ED-eligible. If eligibility is indeed being progressively narrowed, why aren’t the details of these administrative changes being transparently disclosed to the public?

For one thing, the complexity of the SR&ED legislation and the somewhat subjective nature of definitions for technological advancement and systematic investigation, which are the cornerstones of eligibility, offer a great deal of latitude for CRA to make claims that companies are abusing the program and to increase its recovery. Presumably, this latitude could also be applied to allow more claims through and increase the SR&ED funding provided, so one can only surmise that the current approach is aimed at reducing the program’s size.

Where Are We Going?

Given the absence of a reversing trend, can we surmise that the federal government wants the SR&ED tax credits program to play a reduced role in supporting its Innovation Agenda? If so, why? especially when other countries, such as the UK, Sweden, Mexico, and Germany are enhancing or announcing new R&D tax programs of their own?

With the 2017 budget, a promise was made to “review the Scientific Research & Experimental Development program to ensure its continued effectiveness and efficiency” with no indication of sweeping changes to the program. Will the review include a look at whether the current definitions of SR&ED effectively foster innovation?

The current administration of the program reduces experimental development to its lowest level elements, attempting to restrict eligibility to small pockets of experimental work focused on incremental knowledge gains within an overall product or process development projects. One key change we have seen in administrative practices over the past few years is the eligibility determination of work intended to resolve what is called “system uncertainty”, where the advancement is made not with respect to individual modules or components, but with respect to those modules or components acting as an integrated system.

In the past, work carried out to develop an understanding of unexpected behaviours of integrated systems of pre-existing technologies or components would have been considered eligible, assuming that solutions could not be obtained through commonly available sources of knowledge and the company’s experience within its business context. Today, we often see this type of work dismissed as insufficiently low-level, and the knowledge gain is deemed “technical” rather than “technological”. However, is it not just this type of new knowledge that allows different technological building blocks to be combined in new and heretofore unexplored ways that lead to invention and innovation?

A great example of this can be seen with ICT claims. Prior to the 2012 re-work of its eligibility guidance, CRA offered an extremely detailed and nuanced 66-page application paper with respect to eligibility for software projects, which was developed in collaboration with industry through a consultative process with participation from more than 40 members of the tech community. This paper covered in detail the concept of “Systems Uncertainty”. This type of uncertainty and its corollary advancements could exist even if the building blocks were standard, off-the-shelf components or known technologies. Systems Uncertainty is present as long as the way in which they were assembled was sufficiently novel to create uncertainty around how the system as a whole would function, technologically.

Today, CRA has replaced this detailed industry-specific guidance with a single program-wide guide on Eligibility of Work which does not cover the concept of System Uncertainty (although it is given a few lines of explanation in the SR&ED Glossary) and provides no software sector-specific guidance. One positive sign is that CRA has recently released a seminar on the eligibility of work in SR&ED projects that contain software development; it provides some industry-specific eligibility examples, although the explicit concept of system level uncertainty remains conspicuously absent. Will the current review of the SR&ED tax credits program lead to the re-introduction of more sector-specific policy guidance to ensure that CRA’s administrative practices continue to foster the innovation economy, particularly in the high-tech and digital sector which was named as a priority in the 2017 budget?

We hope that 2018 will bring answers to more of our burning questions about the future of SR&ED tax credits, such as:

  • Will the government carry out a proper, and transparent, review of the SR&ED program efficacy at fostering innovation?
  • Will this review include, as it should and as past reviews have, input from the technology community to align CRA’s administrative practices with the Government’s Innovation Agenda?
  • Alternately, will this review be carried out behind closed doors and only serve to further quietly slash the program along the lines of what we have seen over the past decade?
  • Will the resulting program changes make SR&ED clearer and easier for eligible companies to access? And will the outcome of claiming to be more predictable again?

These are questions that all Canadian businesses who currently access the SR&ED program should be asking themselves, and more importantly, their elected representatives.

Andrea McPhail is Vice President of Operations at RDP Associates.