Ron Freedman

Zero Sum Gain

By Ron Freedman

It is not often that governments get something for nothing and in the process do the right thing. This year and next are exceptions. This year the federal government doubled the budget of the National Research Council's IRAP (Industrial Research Assistance Program) by adding an extra $100 million to the pot. The temporary increase was meant to address the fact that last year IRAP's budget was fully committed in the first quarter of the fiscal year and many eligible companies were left in the lurch.

Demand vastly outstripped supply, as is happening this year too. Ottawa is committed to maintaining the increased funding level next year, but there are question marks over subsequent years.

So, a question for the mathematically-minded: How much did the additional money cost the treasury? If you said $100 million (or $200 million for the two years) you'd be wrong. The net cost was actually zero, or possibly even less. How so?

First off, it is important to note that the federal government underwrites two major programs to support corporate research and development. The Scientific Research and Experimental Development (SR&ED) tax credit program contributes around $3.7 billion to support corporate R&D. IRAP provides an additional $200 million, making the federal government's total "exposure" around $3.9 billion. SR&ED will provide eligible SMEs (small and medium-size companies) with refundable tax credits, whereas IRAP provides SMEs with equivalent financial contributions. Both programs use the same funding formula for eligible expenses, so the payment levels are the same. (In fact, SR&ED will cover some items that IRAP will not, but this does not affect the argument.). The eligibility criteria for IRAP and SR&ED are also virtually identical.

Under the terms of the SR&ED program, Ottawa is obligated to reimburse SMEs for a portion of every dollar of eligible research. But if the companies receive IRAP funding, then their SR&ED credit is reduced on a dollar-for-dollar basis, and vice versa. For the most part it is an either-or proposition — companies either receive IRAP funding for a defined piece of research, or they receive SR&ED, but not both. In either case Ottawa picks up the tab.

Thus, when it added the $100 million to the IRAP budget this year and next, the government simply reduced its SR&ED exposure by the same amount. Therefore, the net cost to the treasury — and to taxpayers –—was effectively zero. The outgoing money simply came out of one pocket instead of the other. That's the "zero-sum" part of the equation. Where does the "gain" come in?

Firstly, there are the gains to the companies that receive IRAP funding. An important gain is that IRAP funds are predictable. When an IRAP recipient firm is approved for a contribution agreement it can be sure that the money will be paid. In the case of SR&ED there is no guarantee in advance that its claim will be deemed eligible. Companies can obtain a prior eligibility ruling, but there is no assurance that when the claim is actually submitted — up to 18 months later — that it will qualify. There is always an element of uncertainty.

IRAP increases chances of R&D success

An additional albeit less tangible benefit for IRAP companies, is that as part of its due diligence process IRAP requires them to formalize their research proposal in a written plan. This forces companies to focus on goals, objectives, markets, milestones and so forth. By so doing, IRAP increases their chance of R&D success. IRAP will also provide technical advice to firms and link them up to additional sources of technical assistance in the national system of innovation.

Most importantly for most SMEs — to which cash-flow is crucial — is that IRAP will reimburse the company monthly in arrears on submission of the completed paperwork. This is a huge benefit to firms. In contrast, a company can wait up to two years or more from the start of a project to receive SR&ED money. By that time it may have depleted its cash reserves … or worse.

In the second place IRAP also helps the government spend its money more efficiently, because the chances of fraud or misrepresentation are close to zero. That is because every IRAP claim is vetted by an IRAP staffer and each project is closely monitored. In the case of SR&ED, only a small portion of all (20,000 annual) claims is audited, which means there is a predictable level of misrepresentation and, in some instances, outright fraud. The elimination of misspending in IRAP covers some of the administrative costs of the program. Thus, the more money that is shifted from SR&ED to IRAP, the lower the overall incidence of misspending.

Given the obvious advantages to the government and to companies of IRAP funding over SR&ED funding, and the fact that adding to the IRAP budget has little or no net cost for the federal government, it is a mystery why Canada is not shifting a substantial portion of the reimbursable tax credit component of SR&ED to IRAP. That would be a true win-win scenario. It would address a major criticism of Canada's system of corporate R&D support; that it relies to heavily on tax measures and not enough on direct support of innovation.

shift resources to irap

There will be objections from treasury officials, who will argue that while they can budget for IRAP in advance, they cannot budget for SR&ED, because it is demand-driven. Surely this is a technical hurdle that can be overcome by creative administrative measures.

Such a shift will also introduce federal-provincial inequities. Whereas some provinces top-up their companies' SR&ED tax credits, they do not support the IRAP contributions those same firms receive. Those provinces would thus be receiving a "free ride" on the additional federal IRAP spending. However, federal-provincial negotiations based on the principle that their shared objective is to support corporate innovation should be able to address this point.

So here we have the elements of a true "zero sum gain": no net cost to government and substantial benefits to companies … and the economy. Let us hope we at least see a flurry of memoranda in the weeks to come, and possibly even some face-to-face meetings among stakeholders to explore the idea.

Ron Freedman is a partner with The Impact Group and co-publisher of RE$EARCH MONEY