Unintended Consequences

However, the real world isn’t completely black and white, and SR&ED’s current rate structure causes the following problems that hurt innovation and efficient use of SR&ED dollars.

Issue #1. Promotes excessive executive compensation

Consider a company that is making $1 million in net business activity (excluding executive pay) and having $3 million in qualified SR&ED expenditures. This company is also 100% owned by a single executive.

Scenario #1

The executive compensates themselves fairly at $200,000/year. This is what it looks like:

Scenario #2

The executives optimize their compensation to maintain a net corporate income under $500,000 in order to qualify for the high 35% SR&ED rate:

Analysis

If you look at the difference between scenario #1 and scenario #2 over 5 years you’ll see that excessive executive compensation results in $2.4 million more in SR&ED grants/money into the owner’s pockets. The increased SR&ED amounts don’t contribute to increased R&D, but fattening the wallets of ownership.

SR&ED’s qualifying income rules can be easily manipulated by bumping up executive/ownership pay. Furthermore, it promotes bad corporate sustainability behavior, as profits are being funneled out for personal gain. Finally, as you can see above, it is actually beneficial to partake in poor compensation practices that aren’t conducive to growing a company.

Issue #2. Promotes offshore IP and business activity

Since the qualifying income limit is based on previous year net income and taxable capital employed in Canada, companies (and their associated corporations) are incentivized to reduce their total taxable income to under $500,000 to qualify for the high 35% SR&ED rate. One way companies do this is to move as much income generating activity out of Canada as possible. While there is already an incentive for companies to find tax havens for earnings, SR&ED further encourages companies to look offshore since its beneficial even if the corporate tax rate were equivalent or higher (think the US).

The strategy would be simply to treat the companies in Canada as development/R&D shops, with minimal profitability and IP flowing back to the contracting offshore company. This completely defeats the purpose of driving innovation in Canada, as we are essentially funding IP development for foreign companies with little to show for it in terms of taxes recouped from the Canadian corporation. While this may not be patriotic, SR&ED’s current rate structure drives companies towards this rational business decision.

We’re paying foreign entities to take IP and profits out of Canada. Not a very good use of taxpayer dollars, is it?

Issue #3. Removes emphasis on sustainable growth

Consider a company that raised $4.5 million. In their first year, they developed a product and spent $3 million on R&D and $4 million in total. They had no sales in the first year.

Company #1

Strove to have significant sales in year 2 ($3.75 million) and achieve profitability in year 3 ($4.35 million) before SR&ED credits

Note the oddity above. Even though year 3 has much higher sales than year 2, net income remained the same due to decreased SR&ED amounts. SR&ED is not incentivizing people to aggressively grow a sustainable business, as it wouldn’t have that much impact on the bottom line.

Company #2

Strove to achieve sales, but did not focus on profitability or sustainability of their product.

Analysis

Company #2’s sales significantly lags expenditures. The net difference between Company #1 and #2 is only $300,000/year on a sales difference of $900,000. However, the growth trajectory of both companies is significantly different.

Company #1 has built a self-sustainable, growing business while it’s unlikely Company #2 has. Some may argue that short term profits should not be the focus of a growth business, since you want to employ all capital back into the growth of the business. I agree with this statement. However, I am describing a scenario where expenditures are identical. The only difference is their sales strategy/business model.

It’s really easy to make something for a dollar and sell it for less. It’s exponentially harder to sell it for more. SR&ED provides too much of a safety net, allowing companies that should have died to remain in mediocrity. This hurts innovation in Canada, as we need failures to learn from and the highly talented workforce from these companies to go out and provide value in new companies.

Issue #4: Provincial SR&ED Rates

Some provinces follow this same rate model (e.g. Ontario). This further compounds the issues already described.