Budget's tax reduction initiatives please business crucial change to federal R&D tax credit program raises concerns

The federal government has initiated a series of cautious but encouraging tax reduction measures geared to bringing Canada business in line with its major competitors, particularly in the high technology sector. The announcements in the recent Budget to cut personal and corporate taxes, as well as decrease capital gains taxation and enhance stock options, have been greeted with moderate enthusiasm by the technology community. "Right direction, wrong speed" seems to sum up the reaction from industry associations and tax policy experts, although some acknowledge that further reductions in the near term may be beyond the ability of the government to deliver, given the plethora of pressures on its budget surplus.

"We're delighted at the scope of changes but there's a lot of work to be done to improve the timetable," says Bob Crow, VP policy for the Information Technology Association of Canada (ITAC). "It's a job well done in concept but now we must work to accelerate much needed tax reform."

The lukewarm response to changes in the larger tax environment stands in stark contrast to reaction by the business community to a key change in the scientific research and experimental development (SR&ED) program, which provides qualifying corporate R&D spenders with tax credits to encourage and support their work. The decision to treat provincial deductions for SR&ED that exceed the amount of expenditure as government assistance is perceived as being aimed directly at so-called super deductions for R&D provided by Ontario and Quebec. As such, it has generated a politically charged debate on the rationale for the decision and the consequences for firms working within those jurisdictions. When the new measure takes effect, it will kick in for taxation years ending after February 2000.

More specifically, the change is intended, to "base the cost of the expenditure for federal ITC (investment tax credit) purposes on the cost of the eligible investment net of any other government assistance or reimbursement" resulting in "SR&ED deductions and credits having comparable value, reduce stacking of benefits and make the tax system fairer".

Finance officials at the federal and provincial levels have been getting an earful from corporations that have planned their R&D expenditures based on the benefits derived from all tax and non-tax assistance, including the super deductions. Ontario is now considering its options for a response to the federal measure, which the Finance ministry estimates will reduce the value of the incentives by almost half. Support for the Ontario super allowance costs the province about $125 million annually.

"It's kind of nasty. The feeling we get is the federal government introduced the change to stop what Quebec had done in its 1999 budget," says Jack Parkinson, an economic specialist with the Ontario Ministry of Finance's corporate commodity tax branch. "Firms have crunched the numbers and (the new measure) severely mitigates the value of the incentives. ... I think it would be a fair statement that there will be some sort of reaction (from Ontario)."

Parkinson adds that the federal government does not seem to have taken into account the circularity of R&D assistance in Ontario, whereby a firm is assessed for provincial credits, followed by the federal credit and then deductions like the super allowance.

"It's like a spread sheet going around in circles and the federal government doesn't seem to be able to explain how the new law will work," he says.

Ontario has had a super deduction for R&D for 12 years to offset federal taxation of its own R&D tax credit. But it was Quebec's introduction of an even more generous counterpart in last year's budget that prompted the federal Finance department to act, conclude observers. The Quebec super-deduction gives firms the choice of using the provincial tax credits for R&D or forgoing them in favour of a super-deduction of between 240% and 460%, shifting the cost of the assistance to the Ottawa. Last year, federal finance officials told RE$EARCH MONEY that the Quebec measure was being singled out for further study Ottawa (R$, March 24/99).

Revenue Canada acknowledges that the greatest impact of the federal measure will be on Ontario-performing firms, given the long track record of the super deduction in that province. But officials contend that if the Ottawa had allowed the Quebec super deduction to be implemented without a response, other provinces may have looked at introducing similar measures, drawing even more dollars from the federal treasury.

"The end result of the new law is, whether you receive provincial assistance in the form of a tax credit or a super allowance, it's going to grind your federal credit," says Jim Mullen, director of program administration for the SR&ED program at the Canada Customs and Revenue Agency (RevCan). "The greatest impact is going to be in Ontario because they've had this deduction for some time. The other option for the government would be to leave Ontario and Quebec alone, but other provinces would be forced to make the same move and the feds would end up paying a bigger contribution to R&D."

Ken Murray, a senior partner with Deloitte & Touche, says the SR&ED program is designed to encourage more development by the private sector, but there also needs to be a level playing field. The federal move will result in a common approach for all jurisdictions, but it may make it more difficult for large foreign-based corporations to convince their head offices to allocate additional R&D spending to their Canadian operations.

"For multinationals, the selling point for getting more R&D into Canada is the credit and these companies plan on a five-year basis," says Murray. "The federal move represents a change in mid-stream so it's negative in terms of attracting foreign investment."

"We're working with officials to determine the best course of action, but I feel the best course of action would be to forget the whole thing," asserts ITAC's Bob Crow. "The implications of this law could be fairly profound because it claws back firms that have already made plans in 1999."

Budget revives discussion of internal software development

The Budget also signaled the government's intention to re-visit the controversial area of internal software development and its eligibility for SR&ED support. Budget documents acknowledge that Revenue Canada is grappling with several large and complex claims in the area of information technology by firms whose core focus is not software development. They continue to drag on despite the government's contention that most are inconsistent with RevCan's administrative guidelines for software development.

"Substantially all of these claims reflect the application of available technology, which result in business improvements but do not embody technological advancement that the SR&ED program is intended to benefit," states The Budget Plan 2000. "The Government will consult with industry representatives to ensure that the guidelines on software development, in particular internal use software, both reflect government policy and provide clarity and certainty of application. ... Once completed, thee Government will determine whether amendments to the Income Tax Act are required."

"Finance has raised the flag," says Rev Can's Jim Mullen. "In Australia, there is a multiple sales rule which excludes this type of software development, while in the United States, there is a higher bar before this is made eligible. If the federal government invests in R&D, it wants to get leading-edge, globally competitive products flowing from it. There should be a spillover effect on other economic fronts. The rationale for SD&ED is greater spillover."

Federal officials note that the guidelines now in place were agreed to by industry following extensive consultation, although the value of the outstanding claims is apparently prompting the firms in question to

avoid closure on their files. All sides seem to agree that the continuing impasse is leading to an unhealthy situation that undercuts attempts by Finance to establish firm, clear policy and by RevCan to administer the program in a way that maintains the integrity of the three criteria for eligibility. Budget documents state that the type of internal software development in question is largely for management information systems and automated services.

"I expect this is Finance wanting to have a close policy look at the work being done at Revenue Canada. The act is quite clear," says Crow.

Problems dealing with software development for internal use stems back to 1993 when the government slapped a moratorium on back claims. Following a flood of dubious claims from the telecom and financial sectors, software claims under SR&ED were frozen in 1995 to allow time for re-examination and consultation (R$, March 8/95). That process was completed in 1996 and the moratorium was lifted, but many contentious files remain open, leading to the most recent decision to consult before deciding whether further legislative changes ware necessary.

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