March 23, 2017

CATA Tax & Finance Advocate Denis Lajoie Offers Insights into the 2017-18 Federal Budget & Innovation

federal-budget
Federal Finance Minister Bill Morneau tabled his second budget on 22 March 2017 in which the government delivered on its promise to prioritize innovation.

For those who followed the run up to the budget, it actually contains very few “surprises” as it reflects many of the innovation‐specific recommendations from the “Advisory Council on Economic Growth” (the Advisory Council on Economic Growth was established by the Minister of Finance in March 2016 to develop advice on concrete policy actions). The Council’s recommendations are themselves in line with the vast majority of those who weighed in on the issue of innovation, and are therefore based on largely accepted principles (including the importance of innovation for Canada in the current climate).

Innovation requires a certain level of capital investment, whether human or financial. The presence of a higher than average risk inherent in innovation investments is a well‐accepted premise. This explains why knowledge‐based industry Angel Investors or Venture Capital firms will use a significant discount factor in their valuations (despite the fact that their investments constitute “smart money” for these firms who carefully select, follow and nurture them).

One of the roles of government is to create a climate that will foster investment in innovation, not only in spite of the risks (given the potential benefits in financial terms and in terms of other benefits to society), but because of the risks. As such, the role of government is to help, to a certain extent, to de‐ risk otherwise risky investments.

Ways to assess whether a given measure succeeds at somewhat de‐risking an investment include whether it decreases the net cost of an expenditure, decreases the cost of capital inherent in the investment, and/or increases a project or venture’s probability of success. An example of the former would include leveraging project expenditures through incentives, while a cost of capital example would include a greater choice and availability of financing options to innovators. Once a given measure or program is in place it is important that it be delivered in a consistent and predictable manner, otherwise it is likely to introduce risk that neutralizes its “de‐risking” purpose.

Below are Budget announcements and measures that were not changed that can be grouped within one or more of the first three criteria above (decrease project cost, decrease cost of capital, or increase probability of success). The announced review of programs will be discussed separately in the context of the consistency and predictability criteria.

Programs expected to decrease net cost of innovation projects

Programs that were created with a view to decrease net project costs include the following:

 The New Strategic Innovation Fund to consolidate and simplify existing business innovation programming. The Fund is expected attract and support new high‐quality business investments – continuing to be available to aerospace and automotive firms but also support other dynamic and emerging sectors such as clean tech and agri‐food.

 The New Impact Canada Fund innovating to solve Canada’s big challenges in clean technology and smart cities.

 New Innovative Solutions Canada – a new procurement program where a portion of funding from federal departments and agencies is allocated to early‐stage research from Canadian innovators and researchers in exchange for access to the latest, most innovative products and services. De‐risking occurs by having a “client”‐ the government, who pays for a firm’s early stage development.

Programs expected to decrease cost of capital to innovation ventures

Programs that are expected to decrease the cost of capital include the following:

 New Venture Capital Catalyst Initiative – increasing late‐stage venture capital available to Canadian entrepreneurs – with more details on competitive selection process in coming months; increased availability of venture capital should logically translate in a lower cost of capital.

 New intellectual Property Strategy – Government will develop a new IP strategy over the coming year making sure the regime is modern and robust and supports Canadian innovations in the 21st Century; intellectual property protection is an important element in investment decisions, particularly in the early stages of a venture. The better protected a given technology, the lesser the risk it is to invest in it.

Programs expected to increase the probability of success

Programs put in place to increase the probability of success of innovation projects include:

 The creation of a number of business‐led innovation “superclusters” that have the greatest potential to accelerate economic growth. Clusters – dense areas of business activity that contain large and small companies, post‐secondary institutions and specialized talent and infrastructure – energize economies and act as engines of growth. The sharing of risk and knowledge, and the potential for synergy and interconnectivity increase the probability of achieving successful innovation projects.

 The skills agenda which includes:

o Increased training and learning

o Improved access to global talent

o Growing the number of Canadians with STEM skills

The above intends to increase the pool of available talent in Canada, allowing firms to appropriately staff their innovation projects.

Conclusion on above programs and measures

While the above programs, measures and actions would appear poised to meet the criteria set above,they are effectively still “on paper” at this point in time, and the key to their success will be in their execution, particularly in their coordination. The Government should nevertheless be commended forputting forward such a large number of initiatives which can be potentially beneficial to innovation in Canada.

Measures not changed: the capital gains inclusion rate and taxation of stock option benefits

These unchanged measures come as a huge relief to knowledge‐based Industry stakeholders. Stock options are a popular and inexpensive vehicle to attract talent in early stage ventures, without being an immediate drain on cash flow. From the investor perspective, any increase from the current 50%inclusion rate would increase the effective tax rate on capital gains, decreasing the after‐tax return on the investment, which, all else being equal, would raise the cost of capital.

Programs subject to review

The Government also announced it would, through Innovation Canada, initiate a whole‐of‐government review of business innovation programs encompassing all relevant federal organizations. In parallel, theGovernment will also review the SR&ED tax incentive program to ensure its continued effectiveness and efficiency.

Regarding the review of programs through Innovation Canada, their sheer number would certainly support a review of what can be streamlined, consolidated, or abandoned.

As for the SR&ED program, this will be the fourth time in the last decade that it is under some form of a review (the first three being: Finance 2007‐2008, Mueller 2009 (for the Ombudsman), Jenkins et al., 2011). It would be fair to be concerned that the high frequency of reviews cannot create the consistency and predictability needed for the program to meet its objectives. It fact it may cause a circular problem: near‐constant reviews of the program’s effectiveness may indeed end up hurting its effectiveness. This being said, given that yet another upcoming review is now a fait accompli, let’s make sure that it is evidence based and perhaps makes use of techniques now available such as data analytics. Among others, it would be helpful to ensure there is evidence as to the extent of so‐called abuses once believed to be wide spread, and which formed the basis of past policy decisions, but where supporting data has been very limited to date. (1)

. The study could also benefit from some benchmarking to other country R&D regimes. The UK, for example, has an R&D incentive program that is similar to Canada’s, has been successful in improving its OECD business R&D expenditure ranking, while Canada’s has been deteriorating. (2)

. What causes the difference? Is it program execution? Or better targeted incentives (e.g. the “above the line” tax credit)?

It will be important that these reviews be done right, and hopefully that these programs, the SR&ED program in particular, be put on a long term path where they can be counted on and therefore consistently factored into investment decisions. It will also be important to have a sense of urgency.

For instance, certain factors south of the border, such as the current immigration climate and proposed budget cuts in scientific expenditures will likely give Canada a competitive advantage in terms of attractiveness for investment and talent. Others, such as the upcoming NAFTA renegotiation and the US tax reform pose potential threats, to which, once we get more clarity, we will have to react quickly and decisively. It would be a shame to still be in “innovation program review mode” when this happens.

1 Cauchi, Laura (2012): The drive to innovation: the privileging of science and technology knowledge production in Canada p.123

2 For a thorough discussion see RDP ASSOCIATES INC (2016) : A comparison of the administration of the Canadian Scientific Research and Experimental Development (SR&ED) tax credit program to the UK R&D tax credit program

lajoieAbout Denis Lajoie
 Denis Lajoie CPA, CA: Denis has over two decades of experience as a tax advisor in the technology sector and now assists CATAAlliance with its tax and finance advocacy. He has served clients ranging from entrepreneurial start-ups to Canada’s largest companies by market capitalization, primarily in the technology, communication, life sciences, and financial sectors. As such, he has observed first hand hundreds of leading technology companies in an advisory capacity. His current focus includes tax as well as a broad range of value-added support for technology entrepreneurs, allowing them to devote more time and effort to innovation.

Denis can be reached at Lajoie@Live.ca  or www.linkedin.com/in/dlajoie