The Federal System of Scientific Research and Experimental Development Tax Incentives: Renewing the Partnership Through Consensus, Consistency and Predictability

May 1998

Consultation Report and Recommendations of the Canadian Advanced Technology Association (CATA)

in association with the

Aerospace Industries Association of Canada (AIAC)
Alliance of Manufacturers and Exporters Canada (AMEC)
Canadian Chemical Producers' Association (CCPA)
Canadian Manufacturers of Chemical Specialties Association (CMCSA)
Canadian Vehicle Manufacturers' Association (CVMA)
Information Technology Association of Canada (ITAC)
B.C. Technology Industries Association (TIA)

SUMMARY AND RECOMMENDATIONS

This report is the commentary and observations of executives from more than 50 companies, and 14 accounting and consulting practitioners on their historical and recent experiences with Revenue Canada's audits of Scientific Research and Experimental Development (SR&ED) claims. It was commissioned by the Canadian Advanced Technology Association (CATA) and prepared with the assistance of the following associations who generously contributed to the research, the report, and who support the recommendations: the Aerospace Industries Association of Canada (AIAC), the Alliance of Manufacturers and Exporters Canada (AMEC), the Canadian Chemical Producers' Association (CCPA), the Canadian Manufacturers of Chemical Specialties Association (CMCSA), the Canadian Vehicle Manufacturers' Association (CVMA), the Information Technology Association of Canada (ITAC), and the B.C. Technology Industries Association (TIA). Members from all 8 organizations contributed to this report. It was prepared by the former Senior Science Advisor for the program from 1985 to 1991 to promote objectivity in the reporting.

The firms represented experiences from a wide spectrum of industrial sectors covering aerospace, automotive, chemical, electronics, information technology, manufacturing, pulp and paper, and telecommunications. As well, they included a broad range of both large and small firms in Calgary, Montreal, Ottawa, Toronto and Vancouver. They contributed observations on their experiences in recent audits and past audits, on how their experiences have changed, and on how these audits had impacted on their investment strategies. R&D is considered a critical factor to these firms.

From the perspective of these corporations, the SR&ED program administered by Revenue Canada has clearly encountered a 3 to 4 year period of instability, increasing complexity, confrontational and protracted audits, restrictiveness, and variability. Almost without exception, the corporations had historically established their willingness to comply in previous audits of their earlier claims. They expressed concern about Revenue Canada's interpretive practices and administrative practices, and their variability; as well as the way the audits were being conducted and the retroactive application of new policies and practices in recent audits. Without exception, interviewees are losing confidence or have lost confidence in the program. Some have even abandoned the program. They question whether the program can function as an effective incentive in its present paradigm. Their detailed observations and commentary on their experiences, the impacts of today's audit on their firms and what needs to be done to re-establish their confidence in the program's management are set out in the report.

This program is considered to be critically important if companies developing leading edge technologies are going to be able to justify keeping their Research and Development in Canada. Industry is clearly supportive of this program. However, even with the considerable effort that both the Department and industry have put into "fixing" the program over the last two to three years, the problems outlined in this report are seen to be negating the viability of the program as an incentive.

It is with a view to re-establishing the predictability and the "agreed upon line in the sand" between what is eligible for the incentive and what is not that we respectively submit these recommendations.

The bottom line that must be conveyed is a real sense of urgency. It is the understanding of those working with Revenue Canada that many of the concepts are already being examined by senior Departmental officials. We ask the Minister not only to accept our recommendations but to announce time frames in which a program of renewal will be implemented.

RECOMMENDATIONS FOR RE-ESTABLISHING THE COMMUNITY'S CONFIDENCE IN THE SR&ED PROGRAM

  1. That management objectives and mandates be set for the program that are commensurate with the delivery of an incentive program which act as a catalyst for SR&ED in all industrial sectors. Accountability, client orientation and responsiveness to the way individual companies manage their R&D should be emphasized.

  2. That the program be managed by individuals who have the seniority, level, and experience in the program delivery that is commensurate with the management of a $ l.4 billion program. At the highest level of management, an official at the Assistant Deputy Minister or Director General level should be dedicated solely to this program and have no other program responsibilities. A new, national, client oriented management structure should be established which is focused on delivering the incentives with accountability, timeliness, sensitivity, stability, consistency, and objectivity across all regions. The addition of senior sector specialists is a welcomed move in this direction by Revenue Canada.

  3. That codes or standards for administration, audits, and for client rights be developed and published specifically for the program. The codes/standards should be consistent with the needs of an incentive program for, simplicity, flexibility, clarity, predictability, timeliness, cost effectiveness while enabling the Department to maintain an appropriate level of accountability and the ability to demonstrate results. The codes/standards should address:
    • client service, objectivity and fairness;
    • the need to be flexible and tailor requirements to the capabilities of clients;
    • the need to minimize complexity;
    • the need to avoid retroactive changes;
    • timeliness;
    • the need to minimize program costs for both the participants and Revenue Canada;
    • the need for an appropriate level of accountability, program evaluation and transparency in terms of results; and
    • the need to recognize the realities of the individual business environment and industry in which a company performs its R&D.

  4. The Department and the private sector should participate in developing these codes/standards and should both sign off on them to avoid misunderstandings. The objective should be to establish the least intrusive system that can establish entitlement.

  5. That the goal be to establish management, training, oversight, program evaluation and audit practices so that the Department can obtain ISO certification for the SR&ED tax incentive program within 2 years.

  6. That the Department establish a client oriented accounts management approach available to all its clients that involves working with individual companies to establish tailored agreements for claiming, including contemporaneous record keeping and systems verification by Revenue Canada and the company. This approach would focus auditors' time on setting up these agreements (analogous to the protocol approach that the Department is piloting with some companies) and on establishing and reviewing these internal control systems. With this approach, detailed audits by Revenue would be reserved for situations where systems had become unreliable. This approach should be voluntary and should complement the program to make pre-approvals on SR&ED eligibility available.

  7. That the Department commit to developing user oriented information circulars and application guidelines through objective third parties to maximize the authority of their guidelines from the perspective of the community and the courts. These detailed guidelines should emphasize how to make the appropriate judgements on eligibility (i.e., the methodology and criteria for determining between eligible and ineligible projects and activities).

  8. That the Department adopt an efficient and unbiased alternate dispute resolution process specifically for the SR&ED program which will ensure timely, equitable and consistent treatment for all taxpayers and technology categories participating in the program regardless of their resources.

  9. That the Department's development and management of interpretive policy and practices be in the hands of individuals with broad, extensive hands-on experience in the management of SR&ED projects at senior levels in the private sector.

  10. That the Department look upon today's difficulties as an opportunity to rethink its practices and to re-establish the private sector partnership and commitment that has historically made the program a success. In this respect, the Department should formally commit to a plan for the program's stabilization which includes consultations on the elimination or restriction of consultant/practitioner contingency fees once the program again functions in a predictable manner.

REPORT

BACKGROUND

Throughout most of the eighties and all of this decade, Income Tax incentives for Scientific Research and Experimental Development have been the federal government's primary way of promoting investments in technological innovation by Canadian businesses. In 1992 alone, Canadian businesses partnered more than $5.65 billion of their own funds with $1.25 billion of SR&ED federal tax incentives(1) to improve the quality of their products and cost effectiveness of their production processes through research. The effectiveness of these tax incentives and the important economic benefits they generate for the Canadian economy have recently been highlighted in a joint evaluation report of the program by the Department of Finance and Revenue Canada(2) , and in the Report of the Technical Committee on Business Taxation released by the Minister of Finance(3).

Over the years, business has been a strong supporter of these incentives because the decisions on where to invest are left to individual businesses, and Revenue Canada's administrative expectations for record keeping and auditing were deemed acceptable. This support is evidenced by their development of tailored documentation and associated tracking systems to support claims, and employee training programs costing millions of dollars. In addition, senior technologists from the private sector have worked closely with Revenue officials to provide industry's perspective on the realities of how industrial research is conducted in today's rapidly evolving and highly competitive environments which govern their markets.

In fact, the period from about 1988 to around 1995, the early part of which was examined closely in the reviews of the tax credits noted above, reflects a time when the program was recognized to have been managed through a highly interactive partnership of business and government that promoted a convergence between Revenue's administrative practices and the way research is conducted by business.(4) Over the last three years, the private sector has become concerned about the reduced predictability of the credits, as well as new interpretive positions, and more exhaustive administrative practices of Revenue Canada which increase the level of documentation and proof needed to demonstrate eligibility. The following report has been prepared to examine the impact of today's environment on the program and on business.

HISTORICAL CONTEXT

This report examines the recent experiences of companies with the current status of the program, their comments about today's environment, and the implications of their observations for the continued effectiveness of these incentives and the program's effective management. This report covers a much more volatile period, from the mid-90's to date, for the program than the one that existed from 1988 to 1992, the period covered most closely in the program's recently released evaluation by Departments of Finance and Revenue.

Understanding the sources of this volatility is an important factor in understanding the commentary outlined in this report. Specifically, the period since 1992 has been characterized by:

  • Exceptionally rapid technological advancements in many sectors. This arises from the complex integration and convergence of established technologies, as well as from the emergence of new technologies. The thrust of much experimental development today is directed at solving intricate problems that arise as technologies are integrated with each other to rapidly form new technologies and improved technologies. What is routine practice today may have been eligible research just a short time before. Revenue Canada practice often leads to a significant lag between the occurrence of a project and its audit. Consequently, Revenue's staff cannot simply rely on today's current practice as a base for confidently evaluating eligibility of a project being claimed as SR&ED.

  • Product and technology cycles continually being shortened - in some areas to even less than a year. The result has been the development of product, production, launch and marketing strategies that are highly integrated and multi-disciplinary. In contrast, historically, more step-wise, linear, segmented development, production and marketing processes have permitted the experimental stage to be more easily identified and separated from other activities, greatly simplifying the assessment process of claims.

  • A Department (Revenue Canada) which was undergoing a series of major structural "modernizations" which saw the transfer of much interpretive and administrative control to individual field offices and officers. The result was that for a time, in some regions, requirements for eligibility were much more relaxed and in others they became more variable. The result was confusion about what was within the boundaries of SR&ED.

  • A period in which taxpayers were encouraged to quickly file claims for prior periods by the Department of Finance's announcement of a deadline on retrospective claims (taxpayer requested adjustments - TPRs). Companies had once and for all to capture all back claims or lose potential past credits. The result was more than a doubling of the number of claimants and the amount claimed in a period when there was considerable uncertainty about Revenue's interpretive position. This inevitably led to speculative filings and claims developed by consultants on a contingency basis during this period.

  • A period in which a significant number of regulatory changes and associated changes in administrative practice occurred. These resulted in a sequence of changes in the details that companies were required to provide to support their claims and in the way companies were expected to present this information.

In response to the added workload and the challenges it created, in the last several years, Revenue has further refined its audit practices and documentation requirements to promote more in-depth examinations of claims, and it has begun a series of initiatives to refine its interpretive guidelines on what constitutes SR&ED.

In 1997, the former Minister of National Revenue, the Honourable Jane Stewart, announced a series of initiatives designed to bring added stability to the program through:

  • the hiring of additional staff, including sector specialists;
  • simplified reporting requirements; and
  • preclaim reviews;
  • the provision of more explanation of and information on the program, including revised guidelines;

New guidelines have been issued for the identification of eligible software development activities (Information Circular, IC 97-1, Scientific Research and Experimental Development - Administrative Guidelines for Software Development). A proposed rewrite of the key interpretive guide to the Department's position on what R&D activities are truly SR&ED has been released for comment (Information Circular, IC 86-4, Scientific Research and Experimental Development); and a "simplified" form for claiming SR&ED (Form T661) has been circulated for comment.

RESPONSE OF THE PRIVATE SECTOR

The private sector has been supportive of the Department's efforts of the last several years to bring stability to the program. On the other hand, there is considerable concern that while the concepts are appropriately directed, the audits appear to be getting more difficult and less predictable from the point of view of the information that is needed to substantiate a claim and the effort required from the taxpayer. Specifically, there is concern that the Department is:

  • requiring documentation which is inconsistent with the ability of the private sector to document claims in a cost effective way;

  • moving to interpretive guidelines most appropriate and easiest to apply in areas closely allied with the pure sciences or the applied extensions of academic research rather than with the experimental development on improving products and processes which dominates the SR&ED conducted by business;

  • promoting unproductive audit practices which raise compliance costs far beyond those which are reasonable and necessary to demonstrate accountability; and

  • demanding levels of documentation and proof of an advancement more onerous than those which companies are subject to in other countries which places Canadians at a competitive disadvantage.

Because of these concerns, the Canadian Advanced Technology Association (CATA) in association with the Aerospace Industries Association of Canada (AIAC), the Alliance of Manufacturers and Exporters Canada (AMEC), the Canadian Chemical Producers' Association (CCPA), the Canadian Manufacturers of Chemical Specialties Association (CMCSA), the Canadian Vehicle Manufacturers' Association (CVMA), the Information Technology Association of Canada (ITAC), and the B.C. Technology Industries Association (TIA), sought the input of their members on their experiences with current and previous audit practices. This work was initiated by CATA which provided overall leadership and coordination for the coalition of associations involved. This initiative has included a series of interviews and meetings with officials of companies in a wide spectrum of sectors who were responsible for their companies' claims, and with accounting practitioners who have a broad range of experience with the tax credits throughout the country.

THE PROCESS

Almost all of the firms whose comments have contributed to this report have business strategies that demand technology excellence and leadership through research for their success. Generally, they have had years of experience with the program and have experienced a number of audits. A few were first-time filers with solid SR&ED efforts. The majority were representative of a wide spectrum of both large and small firms in Calgary, Montreal, Ottawa, Toronto and Vancouver. Over 50 firms from the aerospace, automotive, chemical, electronics, information technology, manufacturing, pulp and paper, and telecommunication sectors contributed observations on their experiences in recent audits and past audits, and on how these audits had impacted on their investment strategies. Twenty-two firms were interviewed individually and 3 focus groups were held to explore and test the generality of observations.

The officials in the firms who were responsible for developing a company's claims were asked to review their documentation and claiming practices, as well as their audit experiences with an interviewer familiar with the program(5). Also, the company officials were asked to comment on what worked well in the audits and what did not, the source of problems, solutions, and to comment on the recent initiatives of Revenue Canada to stabilize the program, the guidelines and reporting requirements. As noted, much of the commentary was collected through one-on-one, in-depth interviews with company officials responsible for a firm's claims. The specific details of individual audits and the names of the companies have not been included in this report in order to encourage openness and to maintain confidentiality.

In addition to the observations of company officials, the observations of 14 practitioners with major accounting \consulting \technology practices in Calgary, Ottawa, Toronto and Vancouver were collected - 9 of these practitioners were interviewed individually. One banker in Ottawa was interviewed. The subjects covered in individual interviews were the same as those covered with the company officials. Likewise, their comments have been treated as confidential and their names have not been used in this report.

The interview techniques were designed to seek out patterns and to test them.

THEMES AND ISSUES

Regardless of which industrial sector dominated a company's business or which local Revenue office was responsible for its claims, a relatively consistent set of themes emerged from the interviews. This report summarizes the commentary underlying these themes, and subsequently puts forward a set of recommendations which were tested in interviews and then through the associations involved in this work.

In assessing the significance of the observations collected in the course of this work, it is important to note that the firms in the study had, almost without exception, established excellent historical compliance rates (generally 80-90% percent or better) and their concerns reflect those of companies that are trying to work with what they understood to be correct and reasonable at the time of filing. The consistency of the commentary suggests a systemic problem and there is every reason to ask why any firm that has a reasonable filing record and is trying to do what is correct should experience audits that are described as "forensic" in nature. The practitioners noted that, more normally, such techniques are associated with much more abusive situations, if used at all.

The following are the key themes and issues which emerged most often:

  • audit practices which lead to unnecessarily protracted and contentious reviews;

  • audit and interpretive practices, and documentation requirements, which are continually changing and becoming more complex, less predictable and/or more restrictive;

  • interpretive positions of the science auditors(6) which do not reflect the realities of what constitutes SR&ED in the private sector and how it is conducted;

  • the need for rapid and effective ways to resolve issues and disputes;

  • the need for effective guidelines that assist private sector technologists in the various sectors to understand what documentation and what type of information is required to support the three criteria set historically for eligibility;

  • questions about whether those conducting the scientific audits have the appropriate expertise, experience and training needed to assess SR&ED conducted in today's business settings;

  • difficulties caused by confusion about who is in charge of what and their roles in respect to the auditors, the science auditors, and the staff in both the head office and the local offices of Revenue;

  • the impact of current practices on firms - their bottom lines and strategies; and

  • the impact of the present audit practices on the program as an effective instrument for promoting innovation by Canadian businesses.

The following provides details of the observations which were collected in the course of the interviews for this report and which underlie these themes and issues.

ISSUE 1

Audit practices which lead to unnecessarily protracted and contentious reviews

Many firms reported that their most recent audits had become highly confrontational, costly, and protracted. Those with perseverance and resources generally reported that the ultimate decision was acceptable to them. The exceptions were with some firms who were conducting research on process development or after some commercialization was achieved. The scientific audit practices most generally associated with this problem relate to demands that a project be broken down into its subprojects to the point that the relation of the work to the central technological advances is very hard to see or is totally lost. In addition, the following were major problems:

  • science auditors who start from the position that all work in a company's area of research, such as incremental improvements to established technological bases, is routine development;

  • changing positions on interpretations, and retroactively applying new positions and information requirements to previously filed claims;

  • setting inflexible information and documentation requirements that cannot be tailored to what are effective business practices for the firm,

  • policies which discourage science auditors from explaining what they are looking for in terms that are understandable and common to businesses' technologists;

  • the issuance of science reports that lack substance in terms of providing facts and clear explanations of how these facts support the opinion on which a decision is ultimately based;

  • entering into audits with a stated preconceived model of how a company should conduct its SR&ED and how much SR&ED the company should be performing, rather than helping company officials to understand what information is needed in order to demonstrate eligibility;

  • using the threat of protracted audits and refund delays to obtain closure, as well as attempts to avoid conducting scientific audits or to ignore the conclusions of scientific audits by offering compromise "saw-offs".

Furthermore, several experienced senior accountants interviewed for this report commented that they have "not encountered such unprofessional and aggressive audit practices". All practitioners commented on:

  • the amount of unnecessary work and costs created for their clients by the above practices; and

  • the concern that only firms with sufficient resources could work their way through the audits and the lack of fairness to the clients of other accountants who do not have contacts in the local Revenue offices responsible for their clients' files or in Revenue head office. Most found that they had to use their contacts to keep the process moving forward.

To put these comments in perspective, it is important to note that about one -third of those interviewed reported some very effective and professional audits where the Revenue staff assisted the client to get it right. There did not seem to be any particular regional pattern as good practices and difficulties were reported throughout all regions and sectors, and from within the same offices.

The majority of the reported problems were associated with the scientific audits although the problems associated with pressure to short-cut the process (e.g., saw-offs) in order to close files was generally associated with the financial auditors. The problems seem to arise when a science auditor starts with a highly positional, pejorative, preconceived understanding of what SR&ED the company could be performing, if any, and does not work with the company to understand the complexity of what the company is doing. The problem is compounded when the scientific audit report is tabled with little or no opportunity for the science auditor to work with the company to understand the basis of the report and resolve differences.

ISSUE 2

Audit and interpretive practices, and documentation requirements, which are continually changing and becoming more complex, less predictable and/or more restrictive

All of the firms and most of the practitioners commented on this issue. They emphasized that the audit had only recently became unacceptably difficult and unpredictable. Specifically, they generally noted that, in the past, a point would be reached after a number of audits had been completed where firms became fairly certain about how to put together their claims and supporting documentation, and that they had become fairly confident about the tax credits they would obtain. While some firms are still not encountering problems, many who thought that they had acceptable record systems and well established understandings with Revenue about the kinds of activities and expenditures were eligible, reported that Revenue was no longer maintaining these understandings in recent audits. This problem is particularly aggravating when new documentation requirements are applied to old claims. It simply may not be possible to reconstruct the records to the new standards. Attempts to do so can tie up key executives in the small firms for weeks in what is considered unproductive work. From the perspective of a small company, the diversion of a technical manager from their R&D effort can even impact on their ability to meet delivery targets. Even the larger companies find this to be a problem for they must reconstruct complex tracking and management systems which cost hundreds of thousands of dollars that then have to be reconstructed.

It is important to note that some firms, after discussing the documentation problem with the science auditors, did agree that their documentation could be improved by using better reporting templates and/or by up-front preparation of their documentation rather than developing it when the claim is prepared. However, companies cannot accept being asked

  • to retroactively reconstruct claims to new standards that they were not aware of at the time of filing because they did not exist or were not being enforced, or

  • to create excessive amounts of detailed information outside their own normal corporate needs and what are good business practices from the firm's perspective.

Likewise, the application retroactively of new interpretive positions which contradict established practices and agreements can lead to unexpected disallowance of tax credits that smaller firms had counted on for their survival. The difficulty is that firms cannot meet the new requirements in their previously filed claims which were based on their understandings with Revenue at the time of filing. This problem is being encountered by firms in all of the regions and sectors examined for this report. On the other hand, it is often the case that a company with similar claiming practices to companies with problems - even in the same region - may not be experiencing problems with its claims. It was noted that these understandings are not formalized and tend to be lost when a new Revenue audit team takes over a company's files and does not continue where the other team left off. Some companies with subsidiaries in different regions reported that different approaches and positions are being applied to their claims. A concern of such companies is the difficulties this raises in setting up and managing any standardized company-wide reporting system to track their SR&ED.

ISSUE 3

Interpretive positions of the scientific auditors which do not reflect the realities of what constitutes SR&ED in the private sector and how it is conducted

Most SR&ED conducted by the private sector is associated with incremental improvement of established technology associated with the development of both new and improved products and processes. Little of the work of the private sector is closely allied to the extension of academic studies or, for that matter, to the pure sciences. The interpretive positions of Revenue's auditors described in the interviews reflected the relatively linear, segmented research models associated with academic research or the near academic research found in many government laboratories. In these settings, projects tend to be focused on individual, publishable advancements since publications are critical to the careers of these scientists.

In business, the measure of success for SR&ED is not publications. Rather, for business, it is the overall technological advancement as it is measured in the improvement of products and processes. This is, essentially, the objective of almost all experimental development in the private sector. Often many small, incremental advancements must be made to produce any truly significant advancement that achieves market advantage - the overall goal of experimental development in the private sector. It is the higher level advancement that is most easily recognized in experimental development projects rather than the numerous small advances associated with the numerous individual technological barriers that must be overcome to achieve these improvements.

In many of the problematic audits reviewed for this report, projects were being broken down into individual subprojects and then eligibility was assessed based on the science auditor's ability to recognize advancements at the subproject level. This is where it is most difficult to demonstrate experimental development. If one examined the work that went into developing the Canada Arm in this way, little eligibility would be found. As well, in many of these audits, the fundamental challenges created by the integration of complex beds of relatively established technologies or, for that matter, in improving them seemed not to be understood by many of the science auditors. It is unclear whether this comes from the science auditors' lack of experience with the rapid evolution that is occurring today as technologies are integrated or to the establishment of audit practices which emphasize breaking down projects to too low a level before establishing eligibility. The net result is that the audits examined in preparing this report and recent suggestions for how Information Circular IC 86-4, Scientific Research and Experimental Development, should be revised, indicate that Revenue has inadvertently moved most of the SR&ED of the private sector into, at best, the gray area - areas to be closely challenged in audit. Instead, interviewees believe that Revenue should have developed clear methodologies and criteria for the identification and assessment of the underlying challenges created by integrations (i.e., methodologies and criteria to identify when the complexity of technologies and/or their integration create uncertainties which require significant advancements).

A representative of one technology company noted that the desire on Revenue Canada's part to fully partition SR&ED eligible activities into separate projects apart from mainstream R&D programs is simply not viable from an administrative or development context for most small and medium sized technology firms. While this approach may be viable for some firms, it is a hardship on the vast majority of technology firms that are very small and as such well under the size threshold required to effectively implement segregated research programs.

Particularly frustrating in this respect, for those interviewed, has been the handling by the science auditors of the SR&ED that is associated with process development and the improvement of established products, much of which involves the integration of technologies and the incremental improvement of a firm's base technologies. Problems of this nature were found throughout the audits involving software and manufacturing developments. The comments of those interviewed suggest that the problem could be related to a prejudice against some settings for conducting research (e.g., plant floor research) and some areas of product development. Much process development in Canada is conducted in a manufacturing setting rather than in a dedicated SR&ED facility. Revenue is reportedly announcing as a starting position in audits and public meetings that what is done in some business sectors and in some situations is not SR&ED. This is simply not realistic as, according to Regulation 2900, it is the process and the results that define eligibility - not the situation. Such comments were associated with work on established software, work in the pulp and paper sector, and work in the food and beverage sector. The interviewees had the impression that the science auditors were focused on finding shortcuts to the audits and revenue recovery rather than on finding out what is being done that is beyond standard practice in a given sector and business environment.

ISSUE 4

The need for rapid and effective ways to resolve issues and disputes

In the audits examined for this report, fundamental issues had been raised with Revenue for which there had been no adequate resolution. These issues included concerns about the qualifications of science auditors, interpretations, consistency, and practices. In the case of simple procedural issues, a quick, simple way to have a neutral party resolve the problem consistently and fairly was not available. In some audits these concerns were carefully addressed and in others they were reportedly summarily dismissed. When this happened - short of a notice of objection - nothing could be done

but to fight it out in a protracted process. Practitioners noted that many smaller firms are making the decision to not pursue their claim even though they believe that their claim has not been reviewed properly, the costs are considered too high to pursue. These companies often do not file in subsequent years having made a conscious decision not participate because of their audit experience.

Many of those felt that Revenue was less interested in objectively resolving problems in these audits, than in maintaining position and pushing for closure. A great deal of concern was expressed about the need for a more neutral, efficient redress process to replace or supplement the normal appeals process. The local reviews by appeals staff of science issues is seen as being too vulnerable to the influence of the original science auditors and policy makers. Ottawa is generally seen as not having the experience needed to provide authoritative or objective second opinions. As well, the process is perceived to be slow and too costly for small firms. One case was reported to have ended up in tax court simply because the firm wanted a truly objective review and did not feel that the appeals review was providing it.

ISSUE 5

The need for effective guidelines that assist private sector technologists in the various sectors to understand what documentation and what type of information are required to support the three criteria historically set forth for eligibility

The new guidelines on eligibility of software development, and the proposed rewrite of IC 86-4, Scientific Research and Experimental Development, raised a great deal of concern amongst all those interviewed. Specifically, the following are all looked upon by interviewees as attempts by Revenue to redefine SR&ED to a more restrictive, academically oriented concept:

  • the issuance of new guidelines for software and how they are being applied;

  • statements by Revenue officials that the automotive, and food and beverage guidelines have been or are being withdrawn; and

  • proposals to revise IC 86-4, Scientific Research and Experimental Development.

To put this concern into context, it is important to understand that Revenue is not seen to be following the same consultative approach as in the past. In contrast to the process used to develop the original IC 86-4 and the associated application guidelines, recent consultations increased the influence of Revenue over the final product.

Specifically, both the original release of IC 86-4 and the associated application guidelines were developed through processes aimed at maximizing the usefulness, objectivity, and authority of the products from the point of view of the business community, the legislation and its intent and the courts(7). The development of IC 86-4 was actually managed through an independent third party, a university professor, who sought out senior, neutral authorities with business experience to develop the fundamental guideline and who obtained their sign-off on the final product. The earlier application papers were developed to provide further sector specific extensions of IC 86-4 that reflected the consensus of business technologists on the key issues concerning their sectors. They were written by consultants working on behalf of the private sector. This is not the case today.

The rewrite of the software guidelines and the recent proposal for the rewrite of IC 86-4 are seen by the interviewees to reflect the direction of the thinking of Revenue's head office staff who are seen to have "maintained the pen" to a great extent. The final results are seen to be documents that benefit the Department's auditors, not industry.

Specifically, interviewees who participated in the development of the new software guidelines found that they were influenced by Revenue's constraints on the product even when they strongly questioned them. For example, Revenue is reported to have refused to maintain the balancing of indicators for and against eligibility that has characterized earlier application papers. The final product was seen by interviewees to provide strong grounds for disallowance leaving Revenue with a great deal of discretionary latitude to disallow. This is in contrast to the attempt, in the past, to produce balance in the guidelines. The final software guidelines were considered to be functional only if Revenue was reasonable in its application of the guidelines' suggestions for documentation and project structuring. In fact, the need for care is noted in the guidelines.

Industry's concerns seem justified given the problems observed in the audits examined for this report. As noted, the interviewees report that science auditors are asking that projects be broken down beyond the point where eligibility can be detected and that extremely detailed records be provided. One interviewee mentioned that time sheets were being examined to see if short personal breaks were included in the claim. As well, whole areas of software development identified as problematic in the guidelines are being outrightly challenged in the audits rather than being looked at for what is actually being achieved.

The interviewees generally did not find that the software guidelines helped their software developers understand how to sort out their SR&ED from their standard practice, to understand how much detail to provide, nor how to demonstrate when integration problems create eligible projects. The general consensus of those involved in these interviews is that these guidelines are not functional in their present form given Revenue's current application practices. They find that the guidelines do not provide adequate guidance to business on the indicators that help show that their work is eligible. Simply providing examples of cases that are eligible and not eligible is not working because the examples do not adequately explain how particular facts are indicative of standard practice in a given case and which facts help support eligibility.

The guidelines were considered to have developed a jargon that is not readily understood by software developers who are not academically oriented. Interestingly, interviewees with an academic orientation generally found the guidelines useful and had few problems with their claims. On the other hand, those without this orientation questioned the guide's usefulness even when they were successful with their claims.

The reasons behind Revenue's proposed revision to IC 86-4 are unclear to the interviewees. Line-by-line comparisons of the old version to the proposed version are required to understand the implications of the changes. With few exceptions, the revision is seen to be providing support to a new, more restrictive position by Revenue on what is clearly within the boundaries of SR&ED. It was generally seen as setting higher barriers and providing less assistance to the taxpayer and giving Revenue much greater discretion as to what is eligible, in part because of what is left unstated. The draft rewrite of IC 86-4 (86-4R4) is seen as most clearly giving support to the academically linked, near academic work of the private sector, as well as the work of the private sector that is most closely linked to the pure sciences. It was considered to naively reflect the more linear, segmented development models which are not common to much of the experimental development conducted by business. Its treatment of SR&ED during commercialization, in commercial settings, for process development, and for the incremental improvement of technologies was considered to have the potential to be applied extremely restrictively and not to reflect the realities of what business does.

The explanation in the original IC 86-4 which provided balance by emphasizing

  • the eligibility of incremental research and experimental development;

  • the need to have advancements accessed within the context of the business environment by those knowledgeable about the practices in a given area of the business; and

  • how economic considerations can require technological advancements to be made;

are examples which were considered to have been diluted to the point that they are of little or no assistance to the private sector.

Until recently, the interpretive base was considered to be improving - it is now considered to be very unclear by the interviewees. They are very concerned that the new guides are not helping the situation and that Revenue's consultative processes are now being driven more to raise the barriers and control expenditures than by the need to develop objective, legislative- based, useful assistance for claimants.

ISSUE 6

Questions about whether those conducting the scientific audits have the appropriate expertise, experience and training needed to assess SR&ED conducted in today's business settings

In the audits examined in this report, a perennial issue was the way the verification processes were being conducted. Many interviewees reported that, as previously noted, the audits tended to begin with predetermined positions, that the science auditors were not helpful or exploratory, that they disregarded, were dismissive of, or lacked knowledge of the taxpayer's business realities (i.e., of how true, technological challenges arise in the specific business environment associated with the claim). In many of these cases, the claims were ultimately found to be dominantly eligible indicating that these protracted, confrontational and expensive audits were unnecessary. As noted, claims involving disputes on process development and when commercialization occurs were not resolving to the same extent as others.

The contrast between audits involving the practices outlined in ISSUE 2 above and those using more traditional techniques was very striking. Some excellent, helpful science auditors were identified who quickly showed claimants how to straighten out their claims where problems were detected. These audits tended to be associated with science auditors who had years of experience, who are looking at the program as an incentive program, and who used interactive verification techniques and explanation to obtain closure on a file.

It is important to realize that auditing is a new discipline for scientists. One can speculate that Revenue's new training procedures accompanied by the restrictively positioned guides and academic concepts of how SR&ED challenges arise are not helping new staff understand how to scope out SR&ED in business settings. As well, it was noted by one interviewee, that auditing requires interpersonal skills that are not normally associated with many scientists and that these skills should be emphasized more by Revenue in the selection of science auditors.

ISSUE 7

Difficulties caused by confusion about who is in charge of what and their roles in respect to the auditors, the science auditors, and the staff in both the head office and the local offices of Revenue

While the problems were mostly reported to be with the science audits, problems did arise due to confusion about who was in charge of what, both locally and nationally. Interviewees complained that it was often unclear to them who had the responsibility or ability to deal with a problem. For example, sometimes interpretive issues seemed best resolved locally and, at other times, Ottawa seemed to be the best recourse. There was concern expressed about offending local auditors. In some cases, claimants have found that established approaches to allocating between eligible and ineligible activities and transactions, and documentation requirements were dismissed as incorrect when others took over a file or responsibilities were moved from one Revenue office to another.

Also, the sequencing of some science and expenditure audits precluded effective team audits in some large files. This led to situations where the taxpayers would reach one understanding about a claim and then see it changed or ignored in the final result.

Interviewees described situations where explanations on decisions could not be obtained or discussed because a science auditor's work was "finished". This was particularly a problem where consultants' reports were not subject to rebuttal other than in writing. As an example of this, see Exhibit I.

ISSUE 8

The impact of current practices on firms - their bottom lines and strategies

Almost without exception, the firms interviewed for this report had developed confidence in the system to the point that they felt that they understood how to make a claim and what the final value of the claim would be. As noted, historically, they had generally established good track records. The same firms are now very concerned about how their claims will be treated and they are no longer "booking" the tax credits as they make the claims, or, at best, they are now discounting them. A number of companies have gone so far as to drop out of the program because of their experiences with recent audits even though the bulk of their claims were eventually allowed.

With few exceptions, the attitude of the practitioners towards the tax credits has similarly shifted. They expressed a great deal of caution saying that they are normally telling their clients to be careful about booking the credits. They are particularly frustrated by the increasing complexity and high cost for their clients. Ironically, these practitioners are generally able to get the bulk of their claims through the process albeit at what they consider to be inordinate costs to their clients. Some individuals estimated that the cost of these protracted audits can be 3 to 5 times what they had experienced in the past. This includes the time their senior officers are tied-up in the audit, as well as the cost of highly paid consultants which need to be hired to reconstruct the claim and provide expert opinion.

One of the results of today's audit environment is that firms, including multinationals, which had used the tax credit to justify research mandates and highly technologically risky SR&ED investments in Canada are expressing reluctance to do so today and are looking off-shore. As well, smaller Canadian Controlled Private Corporations, CCPCs ,are particularly hit by the uncertainties and the difficulties they are encountering with the tax credits. When they are certain that they are claiming correctly and that refunds will be timely, they can build these credits into their plans for funding their SR&ED. The protracted nature of today's reviews, their costs, both in dollars and professional time, and the associated uncertainties about credits, can impact materially on the cash flow of small firms even when credits are eventually approved. For firms dependent on equity financing, the uncertainties around these credits can raise the costs significantly. It was noted in Vancouver that bridge funding for tax credits which was just beginning to be available as the program stabilized is now drying-up. Bridge funding is still available in Ottawa where it was noted by the banker interviewed for this report that the claims of his clients were getting through, but seemed to be taking longer than previously.

From the perspective of the smaller CCPCs, the de facto cancellation of partial advanced refunds for those with historically good compliance records has added further stresses.

In summary, the credits are seen by the interviewees only as an incentive for firms working in areas where Revenue's interpretive position remains stable. For the bulk of the SR&ED performed by the interviewees, and their work is representative of most of the SR&ED performed by the private sector, this is not the case.

ISSUE 9

The impact of the present audit practices on the program as an effective instrument for promoting innovation by Canadian businesses

For the SR&ED tax credits to be effective incentives, the private sector must be confident that both the interpretive policies and administrative practices will be transparent, stable, predictable and consistently applied. As well, changes in interpretive and/or administrative practices must be clearly announced and not be applied retroactively. Issues must be effectively and efficiently resolved through transparent, objective, neutral processes available to all claimants - not just to those with the resources. This has generally not been the recent experience of the majority of companies and practitioners participating in the discussions.

To give perspective to these observations, it should be noted that the claims of the companies participating in these interviews represent the bulk of the total dollars claimed in the SR&ED program and are from both large and small firms in a large number of sectors.

From this perspective, the system can no longer be looked upon as providing a sound incentive for investments in SR&ED. Likewise, the interpretive drift to "white coat" models of SR&ED which do not reflect why, how and where SR&ED is really performed by Canadian business further exacerbates the problem. A number noted that this is not the direction being taken in other countries in which their companies do research. Specifically, they report that Revenue Canada is much stricter in their interpretations of what is supportable R&D.

Ironically, many of the firms interviewed in this work have set up costly record and transaction tracking systems to support their SR&ED claims. Both large and relatively small firms have done so. Given their overall excellent track records, companies in this position are ready to move from repetitive, detailed financial audits to approaches which maximize accountability through

self-assessment and systems verification by Revenue. This is parallel to what is done in ISO audits. In fact, some firms are already meeting ISO standards for the documentation of their research efforts for other regulatory authorities. These third party certifications should have gone a long way to satisfying Revenue's interests in respect to the documentation issue. Many of those interviewed, both large and small firms, are anxious to move to such an approach. For this to be achieved requires an SR&ED system that is managed for consistency and objectivity - one in which changes are normally applied only after companies have had time to adjust their own systems to the change.

For others, particularly the smaller CCPCs many of which have dropped out of the program because of recent experiences, their confidence in the system has been lost. They questioned whether

tax credits are the correct form of incentive for small firms if improvements are not shortly forthcoming. A large number of the practitioners expressed a similar view in light of their experience with the current audits of the smaller firms.

IMPLICATIONS

A general concern was that government's innovation policy is being set by individual officers without due regard for the impact on firms, their competitiveness, and, for that matter, on the success of the policy.

More specifically, the interviewees are concerned that the program has lost its ability to function as an incentive because of the resulting instability. Both the company officials and practitioners strongly supported the objective of Revenue's commitment last year to improve the program by simplifying the T-661 form; augmenting the science staff; improving the guidance available to claimants; and providing pre-approvals of claims.

The program's complexity is not seen to be decreasing and its stability is not seen to be improving. The interviewees see a real disconnect between what is put forward by Revenue Canada as manageable and consistently deliverable by the Department's officials responsible for the development of policy and practices, and what is ultimately delivered in many of the audits. In part, this was suggested to arise from the regionalization of Revenue's management structures, and from the lack of seniority and authority of the program's immediate managers in Ottawa. As well, those developing the interpretive positions were seen to be too academically inclined and to have insufficient knowledge of, or experience in, how technological challenges arise across the spectrum of businesses conducting SR&ED in Canada.

Many of those interviewed said that they were willing to improve their record keeping and, with one or two exceptions, all expressed their willingness to work with Revenue to do so. They recognized the importance of documenting their SR&ED at the start of a project. However, they insisted that any requirements need to reflect how SR&ED occurs, realistic project structures, and how it is really managed in their firms - not artificial concepts which just create complexity and cost for them. They also insisted that if a company develops understandings on eligibility and record keeping that Revenue's officials should be equally committed to respecting them and that new standards should not be applied retroactively.

Many large, and even small, CCPCs with historically good track records in the program are interested in committing to established claiming systems tailored to their capabilities as long as Revenue commits to a systems verification focused on demonstrating accountability rather than annual audits aimed at dollar recovery.


1. Report of the Technical Committee on Business Taxation, Department of Finance, April 1998, page 5.13. back

2. Canada. The Federal System of Income Tax Incentives for Scientific Research and Experimental Development: Evaluation Report December 1997, Department of Finance Canada and Revenue Canada. back

3. Report of the Technical Committee on Business Taxation, Department of Finance, April 1998, section 5. back



4. The early startup period of the program was characterized by a difficult evolution in the thinking of the private sector and Revenue Canada about how the program could be made to function. Eventually, exhaustive consultations resulted in what was described by some interviewees as a common and mutually supportive understanding of interpretive policies and administrative practices which set the stage for this period. back

5. The interviewer and author of this report is Russ Roberts, Ph.D., former Senior Science Advisor for Revenue Canada from 1985 to 1991. At that time, he was responsible for setting up and managing the program's scientific audits and providing oversight on appeals of interpretive issues related to SR&ED. He conducted the research on the legislative intent and historical interpretation of Regulation 2900(1) of the Income Tax Act which was used in developing Information Circular IC 86-4 and he was instrumental in developing the 1992 revision of Regulation 2900(1). Today, he is establishing Regulatory Science Associates - RSA in Ottawa. back

6. In this paper, the term, "science auditor", refers to both the science staff of Revenue Canada and to outside consultants engaged by Revenue Canada who determine the eligibility of companies' activities for SR&ED incentive purposes. back

7. For details of the process and comments by the Department of Finance on the legislative intent see appendices A to D in one of the earlier versions of IC 86-4. This explanation of the document's independent origins and consultations used in its original development has been deleted by Revenue Canada in the most recent version of the circular . back