December 20, 2000
Joint Submission to the Department of Finance
by the CATAAlliance, CIPS, CME, ITAC, and the Software Working Group
The following submission has been developed in response to the Department of Finance's request for comment on their consultation paper on internal software, which was released this September. Our members are the innovative leaders of the aerospace, automotive, software and telecom sectors. Our comments reflect the common concerns of a wide spectrum of large and small firms in these sectors about the damage that could occur should the SR&ED tax incentives no longer support the innovative internal software developments of these sectors.
In response to these consultations, we organized a one-day workshop for officials of the Department of Finance on October 5th in which representatives of 18 of our members outlined the critical importance of internal software developments to their firms' business strategies, competitiveness and, ultimately, success in global markets. In these discussions, we explained how:
Before commenting on the discussion paper, we would like to compliment your officials on the open and frank way these consultations are being conducted. We have particularly appreciated the extra time that your officials gave us to work with the Canada Customs and Revenue Agency (CCRA) to better understand the CCRA's concerns about the carryover of problems from previous years into current filings, and the proactive way that the CCRA re-examined this issue in light of the most current information that they could obtain and share with us.
The Context of our Comments
The following should be looked upon as amplification and a summary of our presentations at the October 5th workshop. We refer departmental officials reviewing this submission to the formal handouts provided on October 5th with each presentation.
In this submission, we would like to summarize our thinking on the issues of whether:
We believe that:
In his response to the Auditor General's report on the program, Commissioner Wright of the CCRA has acknowledged the major difficulties created for the program by the huge influx of claims ("the bulge") associated with taxpayer requested adjustments (TPRs) in 1994. In fact, the CCRA's submission documents a breakdown in their risk management, oversight and managerial systems which led to conflicts amongst their staff on the underlying fundamental practices to be applied to the program's management.
We believe that this very difficult period accounts for much of the interpretive and administrative inconsistencies, and problems that were the concern of the Auditor General - not any fundamental flaw with the legislation. Specifically, the confidence of both those who use the program and those who manage it was lost in this period because of what are inherently managerial problems.
We also wish to note that the problems highlighted in the Auditor General's report are not simply associated with internal software. The problems the Auditor General highlights were systemic to the program. In fact, we understand that the major problem file highlighted in the Auditor General's report had nothing to do with internal software. It is wrong to believe that a simple legislative fix focused on internal software will resolve what is fundamentally a management issue.
These problems are now well on their way to being addressed through a unique, effective partnership of the CCRA and the community. This partnership is focusing on re-establishing the management base that permits interpretive and administrative consistency across the program. These initiatives of the community and the CCRA are rebuilding the lost credibility and bringing the incentive aspect back into the program.
We believe that it is simply not the time to bring in new changes which will raise further questions about the commitment of the government to the program and which can only exacerbate the situation by adding additional complexities and increased instability to the program. We advise allowing the current corrective measures underway to run their course before attempting new changes.
The TPR/MIS Problem
The Auditor General's report and the consultation paper of Finance raise concern about the inability of the CCRA to resolve a large number of old taxpayer requested adjustments (TPRs) associated with the 1994 bulge, and concerns of the CCRA that similar difficulties with claims for MIS developments may continue to be associated with current filings. Given improvements being made in the program's administration and the CCRA's relations with their clients, we asked the CCRA to re-examine this issue in light of their most current information from their software specialists. They reported back to us that the 1994 bulge problem files are clearing and will be cleaned up by March 31, 2001. As well, the CCRA report that while some problems in MIS are still present in current filings, the numbers are down and are not significantly different in numbers from those seen in the other, more difficult areas of the program. Furthermore, when problem files are identified, they are being managed and cleared.
We believe that these results demonstrate how far the CCRA have come with their administrative renewal and the ability of this renewal to provide a stable and consistent base of administration and interpretation.
The Definitional Issue
Over the last year, the community and the CCRA have achieved consensus on the key interpretive issues related to areas where the explanations of IC 97-1 were found to provide insufficient clarity, and on the documentation needs of the program. Both were real problems for both parties in dealing with the 1994 bulge. The consensus achieved by the community on what amounts to community based standards is set out in the Guidance document. The CCRA have found the Guidance to be well grounded in the legislation and to provide important advice to both parties on how to appropriately and effectively use the program and on how to substantiate a claim. This Guidance has become the basis for the training of the CCRA's software specialists on the program, and of the community as well. The intent is to promote a common understanding amongst both parties of how the program works and how to use it correctly. Rather than cast this material in stone as published CCRA Information Circulars, the community and the CCRA are treating the Guidance as an evergreen document which is to be proactively improved as problems arise.
We believe that it was naive to issue circulars in the past for software that were fixed in stone. We think that it is wrong to have expected the circular to stand on its own without continued training of both parties and without continued refinement to reflect the rapidly evolving nature of the sector. The Guidance puts a much greater emphasis than does IC 97-1 on the identification of tests and facts which support eligibility.
We and the CCRA's software specialists believe that the clarification in the Guidance provides a much sharper, less subjective, facts-based line than the CCRA applied to the troublesome cases of the bulge. The central issue with this earlier approach associated with the bulge years was the use of highly subjective judgments of "experts" about what was standard practice when most "experts" did not have the experience with the specifics of the applications being developed to make such judgments.
The Guidance draws heavily on the tests arising directly from the definition of experimental development in the legislation which emphasize what the technologies could do, could not do, why and what was done to solve a problem, or what was achieved (i.e., how a company's base of technologies is being pushed forward). These are tests which do not emphasize judgments about what is standard practice. They are tests for which facts should exist and which experience in the early years of the program has shown to lead to agreement between the CCRA and their clients about what is eligible.
The problem with the use of standard practice in most areas where experimental development exists is that it is often just too hard to get at what can be done with standard practice through the opinions of experts. It is often only in the failure of standard practice that the need for developers to innovate becomes apparent. Often, only the developers who experience the failures and understand why standard practice had to be abandoned know the need for new techniques.
We believe that the Guidance's regrounding of the program in facts-based tests which naturally arise from the definition of experimental development in the legislation, and the training of both parties in the use of these tests will go a long ways to avoiding the problems of the recent past. Specifically, we believe changes in the legislation or definition are not needed at this time.
In fact, we are concerned that any changes in the definition will simply further exacerbate the situation. Our discussions with the CCRA indicate that, like ourselves, they believe that an effective definition of eligible SR&ED that excludes MIS cannot be written and should not be attempted. Likewise, our members who have experience with the U.S. and Australian tax credit systems report that those authorities have not eliminated definitional problems but have only distorted the problem.
The Conseqiences of Change
Given the above, we are very concerned that any attempt to write a definition which excludes MIS or internal software from the SR&ED program will greatly impact on the support that Canadian business receives to develop more competitive product and process development systems and operations. Advancing the software component of these systems is the key by which many of our firms are achieving a competitive edge in global markets. The availability of the tax credits is an important consideration influencing their investment decisions.
Likewise, many web-centric investment opportunities associated with the new economy involve internal software which is now being supported by the credits. These opportunities would become less attractive should the definition be changed.
As well, any changes would lead some investors to question the Canadian government's support for these key drivers of current and future growth, and productivity gains. We hope that Finance officials will carefully consider the potential disruptive impacts of changes to the SR&ED program on the commitments of Minister Martin and Prime Minister Chrétien to the high tech industries, innovation, e-business, and research and development.
In this respect, we would also draw your attention to the recent Conference Board of Canada report that was commissioned by ITAC. This report documents the extremely important contribution of IT capital investment to improving Canada's labor productivity. As emphasized by the presentations on October 5th, internal software is an important component of these investments. The report shows that Canada is beginning to get its innovation policy right and we believe that this is the wrong time to tamper with a key element of this policy.
Spin-off Benefits of Internal Software
We understand that academic studies of the spin-offs from investments in R&D for use by companies in their internal operations report that spin-offs accrue relatively weak benefits to the community. These studies have not examined the highly fluid and rapid dispersal of knowledge that occurs throughout the IT sector. The creation and abandonment of new innovations in any one firm occurs very rapidly and there is always movement of the development teams and personnel from firm to firm in a community and across the country.
According to William M. Mercer Inc., a leading human resources consulting firm, employee turnover in the Canadian information technology industry is in the 12% - 14% range per annum across all occupations. Experience suggests that turnover in the design-oriented occupations is often two to three times this average.
As documented in our presentations on October 5th, established businesses in the IT sector are continually spinning off new businesses, as are their executives who on their own establish new ventures from scratch. We believe that the academic models of spin-offs associated with studies of what happens in old economy industries are not representative of the rapid knowledge flows in IT and that they severely underestimate the breadth of the benefits associated with investments in internal software.
We find it unfortunate that the consultation paper raises questions about the value of tax credits without acknowledging the deficiencies in the existing information and the need for more adequate studies focused on understanding what is really happening in the sector. We believe that any properly designed study would demonstrate the contribution of internal software to Canada's productivity, and the contribution of spin-offs associated with internal software to the economic growth of cities such as Calgary, Montreal, Ottawa, Toronto and Vancouver. We would be pleased to assist the Department should they wish to commission such a study.
We believe that the renewal is working. For the first time in years, all parties are working together and demonstrating a unique commitment to making this program work as an incentive. This is a long-term commitment to a common, continuous program of training of all who are involved in the program and to the proactive resolution of problems by both parties. We do note that while the CCRA management structure is greatly improved, it is still not ideal – given that it is highly regionalized. However, we believe that in the long run, this approach can work provided that the Agency puts in place a strong system of third-party monitoring and oversight to track improvements, and to track the application of policy and practices for consistency.
We are pleased that the CCRA have recently committed to putting in place such a system and that they are currently working on adapting the KPMG/CATA survey and metric for application across the program. We see the commitment and the dedication of the management team from across the CCRA to making this renewal work and the proactive way they seek solutions. We trust that the results of the third-party monitoring will let the CCRA identify any problems associated with the structure and resolve them.
As we have already noted, we believe that it is the wrong time to propose changes. The renewal needs to be finished. Changes at this time would only be counter-productive, and raise doubt in the minds of investors about the Government's commitments.
Russ Roberts, Senior Policy Director
phone: (613) 748-1993