SUBMISSION TO THE PUBLIC ACCOUNTS COMMITTEE ON THE AUDITOR GENERAL'S REPORT ON THE SR&ED TAX CREDIT PROGRAM

THE CATAALLIANCE

May 1, 2000

BACKGROUND: Over the years, the CATAAlliance has been the traditional champion of the SR&ED tax credit program and, more generally, of tax credits as the preferred way for governments to promote innovation in Canadian business. Our members are the leaders in their respective areas of technologies and they invest billions of dollars annually in R&D in Canada. Members range from small start-ups to the largest of the multinationals. For all of our members, the fairness, reliability, and consistency of the SR&ED tax credit program is a prime consideration when deciding on how much and where to invest. Since the program's inception, our members have insisted that making the program a success is a priority for us.

Many of our early members in the 1970's who have emerged as today's leaders in the software and telecom sectors relied solely on these credits as a source of government assistance. The credits were predictable and left the companies to set the directions for their businesses.

More recently, we led the coalition of 9 industry associations that called for the program's management to be overhauled in 1998. (Attached, please find our submission to Minister Dhaliwal in May 1998.) At that point, the consistency of the Canada Customs and Revenue Agency's (CCRA) interpretive and audit practices could no longer be relied upon; the courts were generally not supporting them; and the program had become too problematic to be an effective incentive. Something had to be done. In association with our colleagues and the CCRA, the CATAAlliance co-sponsored the Vancouver conference which laid out the action plan for the program's renewal. We have been working since then with our colleagues in other associations and in the Agency to turn the program around.

Industry and the Agency have created an unprecedented partnership to implement the action plan in an effort to re-establish the predictability that previously existed. The objective is to get agreement on clearer interpretive rules that are fully in line with the legislation; on effective ways to put together claims so that they are easier to assess; and on effective monitoring practices that do not punish, through unduly complex reviews, companies that are correctly seeking their entitlements for their SR&ED. This objective has been formally established amongst the parties working on the program's renewal.

We wish to assure the Committee that there is no intent to change what defines entitlement under the legislation, only to clarify what is legislated as entitlement. Within this partnership, it is the responsibility of the Agency to tell private sector participants when their suggestions stray from the legislative mandate or are unmanageable, and hence unacceptable.

OUR CONCERN: We believe that a great deal of progress is being made on the action plan and that we could have a successful turnaround this year. We are concerned that the members of the Public Accounts Committee not overlook the progress that is now being made as you review a report of the Auditor General which looks backward, not forward.

Specifically, the Auditor General's staff looked at audits from a period where the parties knew that there were major problem with the program - not at what is going on today, at what is now being achieved and what is not. Not surprisingly, the Auditor General found real problems. We have been equally concerned about the program. With the exception of the Auditor General's questions about the program's effectiveness, the problems underlying the concerns identified by the Auditor General are fundamentally those that industry brought to the attention of the Minister two years ago. They are the problems on which we are working with the Agency and the Department of Finance to solve through the implementation of the action plan. We wish to stress the importance to the Committee of looking forward as you review the report and the problems it raises in order to see

  • what are the solutions;

  • how the solutions are maturing; and

  • how we will know if they work.

For your consideration as you review the report, we would like to offer the following additional observations on the Auditor General's specific concerns.

AG's Concerns about the Effectiveness of the Program: Like the Auditor General, we are concerned by the paucity of hard, analytical information on the effectiveness of the tax credit system. We believe that the actual benefits are being severely underestimated even in the review by the Department of Finance. At the same time, we believe that the cost to the federal government is being severely overstated . Specifically, the program is not costing the two billion dollars implied in the Auditor General's report or even the 1.2 to 1.4 billion dollars suggested by the Department of Finance and the Agency. The true number is likely much less than a billion dollars.

These credits, like any form of government assistance, are actually taxed after they are used. This greatly reduces their cost. For the firms we have consulted in Quebec and Ontario, the effect of this clawback is to reduce the effective value of the credits by about 40% to 50%. As well, the majority of the credits are non-refundable. They cannot be used in years when companies are not profitable. Unused credits can be carried forward for 10 years to when a company becomes profitable but, again, their value is reduced due to the taxation of the benefit and, even further, due to the time value of money received in the future. In fact some are never utilized.

We would hope that you could encourage the Department of Finance to do a proper analysis of the real cost of the program.

We would also note that the SR&ED system is not just structured to promote increased R&D spending. It is designed to encourage investments of multinationals in R&D linked to even larger investments in manufacturing. Such investments, each on their own worth billions of dollars, can be found throughout the software, telecom, automotive and aerospace sectors in Ontario and Quebec. In fact, R&D manufacturing benefits worth billions of dollars and thousands of jobs would not have been captured in the Department of Finance's first tier evaluations. Finally, it should be noted that the Department of Finance's evaluation did not indicate " that the program generated only a net increase in Canada's real income of between $20 million and $55 million per year." Rather, this modeling was run as a worst case scenario by Finance to show that you would still find a benefit no matter how you cut it. Thus, one cannot fix a value on the benefits from this study.

Given that the program has been in place for more then a decade, we believe that careful studies of the benefits are justified. To be truly useful, studies must examine the full range of benefits that are expected from the way the system is structured, not just the issue of R&D spending.

AG's Concerns about the Inconsistency between Reviewers on What is Eligible and the Treatment of Similar Claims: We are equally concerned with this problem and highlighted it in our submission to Minister Dhaliwal. The Committee should note that while this was a problem in the first few years of the program, a relatively consistent line of interpretation and scientific audit practice had evolved by the early 1990s. A point at which all concerned considered the program to function and be successful. By that time, claimants had a good idea of what should be included in a claim. However, scientists are not trained in the discipline of audit and evaluation. Without careful training and management, when left to their own devices, anyone will come up with very individualistic and creative ways of approaching these claims. We believe that the decentralization of Agency management to the regions that occurred in the early 1990s without proper direction, oversight and training created a management and accountability vacuum which is only now being addressed by the action plan.

AG's Concerns about Second Opinions, Multiple Opinions and Fairness: The determination of the precise line on eligibility calls for a judgement on what is an advancement. Two years ago, there was a great deal of concern in the community that the audits were focused more on clearing out the claims and disallowing as much as possible instead of getting the judgement right. The recent overall reluctance of the courts to support the majority of the Agency's assessments of contentious cases reaching them gives some credence to this concern.

We had hoped the Auditor General would have addressed this issue since it is paramount to understanding what was going on. One of us, Dr. Russ Roberts, has extensive experience in peer review processes. He was the original manager who put together much of the early policy and practice for the scientific audits, and was responsible for dealing with the appeals on eligibility issues. Over the last two years, he has reviewed closely the recent claiming practices of more then 50 companies and a large number of contentious audits to help the CATAAlliance identify best practices for putting together successful claims in the software and telecom sectors, and to monitor how the renewal is progressing. (Please see the attached report of our work last year with KPMG for the most current results.)

He found that while there was room for the companies to improve their claims, most of the recent claims that were contentious in this group contained work which was dominantly eligible - not ineligible - as originally suggested by the Agency's reviewers. He found that this was normally the outcome of the cases after protracted, costly discussions had taken place with the Agency. He notes that no one should be surprised by the inconsistency, given the absence of strong management practices.

Totally independent Scientists on the review panels for NSERC grants have often disagreed on the merits of specific grant proposals. That is why independent committees or groups of objective, independent reviewers, not individuals or hired reviewers, are generally used when scientific articles and proposals are evaluated for merit. Why should the SR&ED program be more consistent and less difficult to manage than any other area in which judgements of scientific advancement are required?

In our opinion, it is only an issue of fairness to have truly independent, third-party reviews occur when negative opinions produced by individuals hired by the Agency are challenged. This was not occurring in the period reviewed by the Auditor General.

It was the CCRA's policy to either use their own staff or consultants dedicated to the CCRA for the original reviews and subsequent reviews. We believe that there has been a serious issue about the objectivity of the reviews and the training of the CCRA's reviewers in the period reviewed by the Auditor General that may be the core of the problem.

AG's Concern About the Need for Clearer Rules on Eligibility: The fundamental problem is that what business mostly does is not research per se, but product and process development and improvement. When these improvements are technologically based and new or improved technologies are created, then these improvements are well within the boundaries of what the credits are intended to support. One has to be experienced in scientific auditing and the technologies to understand and determine what is eligible or not. We are concerned that the Auditor General's staff may not have had the qualifications to thoroughly grasp this issue as they have little or no experience in scientific auditing or the technologies of the cases they examined. We wonder how they came to their conclusions and were able to sort out the source of the problem. We agree that there is a problem, but we do not consider that the primary rules for eligibility are the central issue.

In this respect, we are concerned that the Auditor General's report did not address the fact that the fundamental rules governing the program as outlined in the Agency's basic guide to eligibility, Information Circular IC86-4 R3, or similar rules in other countries are historically well rooted in successful incentive programs, as well as programs of the OECD and other tax regimes. The Auditor General's report may be interpreted to imply that these rules cannot work even when managed well. We do not agree. We also note that Industry's concern with the Agency's attempt to rewrite IC86-4 R3 was that their rewrite appeared to make the rules less clear, the interpretation of what is eligible more problematic and potentially more restrictive than what was envisaged by the legislation or what is supported by the courts. The courts are today clearly referring to the older version of the Information Circular for guidance - not to the Agency when CCRA staff appear to deviate from the Circular.

The challenge, in our mind, is not the primary rules which have worked well with proper management and carry a great deal of authority in a court of law, but the development of a clearer understanding of how these rules apply in specific sectors and situations, proper training and management. This is what Industry and the Agency are seeking at this time. In the software sector we have been able to get to a consensus with the Agency on the concepts and their application. We are now ready to start joint training of the Agency's staff and private sector.

Our Concerns about the Renewal and how to Entrench the Progress that is Being Made: As noted, we are now pleased that good progress is being made on the action plan. Given the costs to our members that occur when audits go awry, we have, of course, been concerned about the time the renewal is taking. However, we do recognize that this is a complex and major undertaking. We are very encouraged by the Agency's commitment to complete the plan by the end of the year.

The action plan had envisaged a strong, centrally managed structure to maximize the consistency of the program from region to region. We realize that this goal could only partially be achieved, given the regional orientation of the Agency. The result is a mixed regional-central management matrix. This is inherently a difficult management structure but we agree that it can work

We believe that the key to the success of the plan will be to put in place a transparent, third-party monitoring metric which will make visible to all what is working and what is not. You may want to examine this issue with the Agency. Historically, the Agency's internal monitoring has not proven effective at getting at problems or getting them resolved as indicated by the problems highlighted by the Auditor General.

Summary Comment and Recommendations: Finally, we want to stress the importance of the Auditor General's work in setting a reference point for the future. If the Auditor General were to review the program next year, he should not be able to write a similar report, given what the plan should have achieved by then. We are now receiving some positive comment from our members about the progress and, at this point, we would argue that the renewal process be given time to work or not work

Given the importance of the program to the Canadian economy and hence the importance of the renewal being successful, we recommend that the Agency be asked to report to the Committee on where they are at within 10 months.

We would also urge the Committee to ask the Agency to have an independent third party with the appropriate expertise prepare a full assessment of the success of the renewal to be tabled with the Agency's report to the Committee.

John Reid                                Russ Roberts, Ph.D.
President, CATAAlliance       Senior Policy Director

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