February 6, 2012

Innovation funding for smaller companies threatened as PMO signals discontent over SR&ED program: By Julie King: CATA Comments


For approximately 24,000 companies in Canada in virtually every sector of the economy, the government’s Science Research and Experimental Development tax credit, SR&ED (pronounced 'shred'), has been an important indirect source of financing.

The SR&ED program is valued at between $5 billion and $7 billion a year. An estimated 80 per cent of firms that submit SR&ED claims are small and mid-sized companies, many of which use this funding to establish a first-mover status within their chosen niche markets.

Which is why small and medium-sized companies (SMEs) need to take note.

If the recommendations of Innovation Canada: A Call to Action, a report that outlines recommended changes to the SR&ED program, are adopted, SMEs can expect to see the refundable portions of the tax credit decrease over time as funding shifts to targeted investments in selected projects and companies.

This could result in money that is currently available to all companies with qualifying projects being funneled to roughly 20 per cent of projects, with the remainder being shut out.

In an international speech made in Switzerland last week, Prime Minister Steven Harper announced the report and signaled that significant changes are coming to the SR&ED program.

I applaud the Harper government for taking the necessary step of cleaning up a program that has developed problems over time, most notably fraud, inefficiencies and problems with some of the consulting firms that support the application process. Changes to SR&ED are needed.

Yet the tone of the Innovation Canada: A Call to Action, dubbed the “Jenkins report”, signals a disregard for the value of Canadian SMEs that is troubling.

As one of the largest online small business magazines and a strong proponent for small and mid-sized companies in Canada, CanadaOne is deeply concerned that a substantial support program that enables Canadian SMEs to innovate and remain competitive is poised to shift these funds to the interests of large companies and post-secondary education institutions.

SMEs must act now

The 2012 budget, where changes are likely to begin, is expected to be presented at the end of this month, so if you run a small or mid-sized business in Canada, you need to act now.

Please familiarize yourself with this issue and then contact MPs in Ottawa to make sure that the SME voice is not overridden by the interests of big business and big education. (We have made it easy to contact MPs through our Have Your Say advocacy tool.)

Here is an outline of some of our key concerns over proposed changes to the SR&ED program.

Where was the voice for smaller firms on the report panel?

The creation of the Innovation Canada report was led by Thomas Jenkins, executive chairman and chief strategy officer of Open Text, Canada’s largest software company.

Herein lies the crux of our concern: The six panel members tasked with the job of making recommendations for how the SR&ED program should change represented two stakeholder groups: big business and post-secondary education.

SMEs, which account for the majority of claims submitted, lack a cohesive voice or representative to champion their needs. They had no representation on the panel.

Understanding how Canada benefits from innovation in SMEs

Before the value of supporting innovation in the SME sector is dismissed, it is important to look at how and why these companies undertake R&D projects.

To learn more about the type of innovation happening in small to mid-sized firms I spoke to an SR&ED consultant, who asked to remain anonymous.

His company has approximately 50 SR&ED clients and adheres to a high ethical standard; they do detailed interviews with clients before accepting them and will only take on businesses that have a strong claim. (In fact, they welcome the idea of controls that will cut fraud and waste out of the program.)

The average claim his company handles is in the $40,000 to $60,000 range, with a handful of companies at the low and high ends (under $10,000 and over $200,000).

“The whole point,” he explains when asked why his clients undertake research work, “is they are trying to refine their internal processes so they have first mover advantage in niche markets where they can establish themselves and create stability for their business.”

While he is unable to talk about specific projects, he uses a plumber that develops a new piping method that is 23 per cent less expensive and 14 times more durable than traditional methods as an example of a typical innovation scenario.

The innovation then helps the plumber’s company establish its business  and results in it hiring more people. The clients are happy. In some circumstance there may be export opportunities, although he cautions that anything in manufacturing will always face the risk of copycat products with undercut pricing from emerging markets.

That, he explains, is one of the key reasons a first mover advantage is important. The value of selling Canadian-made innovations to Canadian companies also has value.

Is growing “big” the only goal for funding innovation in Canada?

The wording of recommendations in Innovation Canada: A Call to Action make it clear that the perspective on what makes innovation amongst SMEs “worthwhile” was measured in big business terms.

The second recommendation in the report call for a redeployment of funds “… from the tax credit to a more complete set of direct support initiatives to help SMEs grow into larger, competitive firms.”

To quote the report: “… within five years following incorporation, approximately 2 percent of innovative start-ups grow into large firms that continue to undertake R&D. This outcome suggests that the enhanced SR&ED tax credit is a blunt instrument for supporting the ‘gazelles’ among the many start-ups that are eligible for the enhanced SR&ED credit and that a shift in assistance for SMEs to other more targeted programs could be more supportive and cost effective.” (The term ‘gazelles’ refers to start-ups that ‘bound ahead’ are able to quickly grow into larger companies. They are the type of company typical sought by venture capital firms.)

The report goes on to suggest “… the refundable portion of the credit for CCPCs should be reduced over time so that a portion of the benefit would be claimed only if the company is profitable and therefore has tax owing against which the non-refundable portion of the credit could be applied.”

CanadaOne’s first response to these findings is simple: while large companies have a role to play in Canada’s economy, so too do the SMEs that account for 98 per cent of businesses in the country.

In fact, one could easily argue that a program designed to promote gazelle-style growth would be spending taxpayer dollars to build Canadian companies that are ready to be acquired by foreign investors. In fact, Canada’s most lauded high tech start-ups are those that have been bought by companies like Google, Salesforce.com and Microsoft.

The idea that only companies ready to grow are the ones that should be supported through SR&ED is contrary to what real small businesses had to say at a closed roundtable I attended with then Minister Stockwell Day last year.

At the event, when asked to provided input to the Minister all commented on the importance of the SR&ED program to their businesses. Some noted that the program had enabled their companies to stay in business and maintain their staffing levels during the worst of the recession.

These companies form the backbone of Canada’s economy. They have carved out specialized markets and often serve an international customer base. Most importantly, they are Canadian-owned and provide stable, professional jobs to Canadians.

Any changes to the SR&ED program needs to be based the actual needs of SMEs, rather than trying to select a tiny segment of this group to help them become large enterprise at the cost of the remaining firms.

Should Canada be picking “winners”?

The Jenkins report says that cutting funding to SMEs in one area is acceptable, because that money will be made available to select SMEs in other areas through “direct program spending”.

One of the very best aspects of the current SR&ED project is that it is completely open. From a small start-up to large corporations, if you have a legitimate project and are properly structured, you can do your research and receive a tax credit for qualifying costs.

Arguments have been made that it is time for Canada to pick the winners. This approach would focus funds into innovative start-ups believed to have the “right stuff” to grow into global powerhouses.

Yet is that reasonable?

Even venture capitalists, who would be expected to have the greatest ability to select ‘winners”, have a terrible track record in this regard.

Risk and Reward in Venture Capital, a Harvard Business Review case study William A. Sahlman published on December 3, 2010 notes that “Venture Capital investments are characterized by high failure rate (0ver 50%) and a small number of given successes (greater than 10% returns).”

If venture capital firms find it difficult to pick the winners, why would we expect an “arm’s length” government agency to do a better job?

Step back in time for a moment to 1997, when Alta Vista and Yahoo! dominated the search scene along with a number of other players like Hotbot, Excite!, Lycos and DogPile.

At that time, what would you have said to a start-up that wanted to finance a new search engine based on a map of how websites linked to each other? If forced to choose just 20 out of 100 projects, would you have put this concept in your approved or rejected pile?

Of course, the innovation I am referring to is the search giant Google, an idea that started as a university research project, evolved into a start-up operating out of a garage and is now one of the world’s largest corporations.

On a more personal note, as one of Canada’s first “dot.com” businesses, CanadaOne was around when the Chrétien government tried to pick winners. I can remember being devastated when two individuals on the east coast were given almost $500,000 to start a competing business to ours. The company the government seeded lasted less three years, while CanadaOne will enter its fifteenth year in business on March 4, 2012.

Money from efficiencies, fraud reduction should finance commercialization

In its report, Canada as a Canada as a Competitive Innovation Nation What Needs to be Done, the Canadian Advanced Technology Alliance (CATA) explains the “commercialization gap” they identified in their research into Canada’s alleged “innovation gap”.

“CATA's conclusion is that a Canadian ‘innovation gap’ is a misconception. In reality, Canadians have an excellent track record as innovators, but too often our innovations are not matured here in Canada and the major benefits are accrued offshore. What we actually suffer from is an ‘innovation commercialization gap’,” states the report.

Both in our role as the media supporting small business and through our own experience as a small business, we can confirm that this is one of the most important issues to address if we want to improve the innovation environment in Canada.

Yet the idea that redirection SR&ED funds to commercialization support for SMEs is an acceptable substation for the current flexible structure, which enables organizations to move ahead quickly with R&D projects and later recoup a portion of their costs, is not valid.

That is because this thinking does not take into account how the innovations that are currently being developed by SMEs impact the company’s ability to compete. A company generating $1, $2 or $5 million in sales due to its innovations can provide a stable framework of employment as well as spending that supports other businesses. The SR&ED program helps those companies maintain their leadership positions, something that has value even if they do not grow.

If growth is the objective, then the government would be wise to find ways to help these companies develop partnerships where companies in external markets can leverage the innovations that have been developed. This would have three benefits: both companies would profit from the partnership, companies would find it easier to see their innovations commercialized in broader markets and the company developing the innovation would be able to maintain the “right-size” for the business’s management team.

Revisions to SR&ED should target cleaning up fraud, efficiencies

It is well understood that the SR&ED program has systemic problems, starting with fraud and some consultants that take a significant portion of the SR&ED refund as a ‘consulting fee’.

The best source of funds to help SMEs commercialize their innovations would be from savings achieved by making the SR&ED program less wasteful and less fraught with fraudulent claims, an idea that CATA has called for in its own report on recommended changes to the SR&ED program.

Many great ideas have already been put forward. Here are just a few simple solutions that could also help reduce waste in the program:

Require SR&ED consultants to be licensed, with an agency being established that is responsible for maintaining setting a code of practice / ethics that must be adhered to.

Cap fees consultants are allowed to charge.

Require consultants to meet similar standards to other professionals like accountants when submitting claims.

Restrict the BDC and other government organizations from being able to generate revenue, either directly or indirectly, from SR&ED consulting and require all BDC offices to provide a comprehensive consultants list to clients.

Make reporting software available for claims up to a specified amount, so business can build a report throughout the year and then file it at year end. This would create the opportunity to have consultants perform a true advisory role, while a bookkeeping professional could assist with most of the data collection and entry.

We would also support CATA’s recommendation to simplify SR&ED (the current complexity is one reason consultants are usually hired) and eliminate retrospective claims where a business can reach back several years in their claim, after realizing they did qualifying work years after it was complete.

However, if retrospective claims are eliminated, it would be important to do a better job of communicating to the business community what qualifies for SR&ED.

Full disclosure: SR&ED changes and CanadaOne

In the interest of full disclosure, Biz-Zone Internet Group Inc., the company that owns and publishes CanadaOne.com, has been doing SR&ED qualifying projects for over 10 years.

Along with several other software systems, the SR&ED tax credit helped us finance the costly development of a content management system in the late 1990’s when such technology was only available for corporations with hundreds of thousands of dollars to spend on complex, unwieldy systems.

An upgraded version of the content management software developed in one of our initial SR&ED projects is still used today to run CanadaOne, as well as other websites, and has evolved into a sophisticated, bilingual content management system.

Act now and stand up for the SR&ED program for SMEs

Call your MPs. Write a letter. Or if you want to reach more politicians, we have made it easy to contact MPs through our free Have Your Say advocacy tool.

It is important to ACT NOW, as the final announcement of major program changes is expected at the end of this month.

Further reading & resouces

Innovation Canada: A Call to Action (Jenkin’s report)

http://rd-review.ca/eic/site/033.nsf/eng/h_00287.html

CATA report: Canada as a Competitive Innovation Nation What Needs to be Done

https://docs.google.com/document/d/11fY0TzekoDNzx34ONDP3ndtGYxt4xqMhGd1JD1xkhvk/edit#

Transcript of Stephen Harper's speech to the World Economic Forum

http://www.canada.com/Transcript+Stephen+Harper+speech+World+Economic+Forum/6057209/story