Ottawa’s Covert War on SR&ED

This post originally appears at ProfitGuide.com.

To technology entrepreneurs, the 2012 federal budget, tabled in May, is conspicuous in not meddling with the Scientific Research and Experimental Development rebate program (SR&ED).  This despite numerous signals sent by the federal Conservatives throughout 2011 that, in their view, SR&ED is the object of rampant abuse and in need of reform.  However, as often happens in politics, a gentle ripple on the surface of the water can signify a massive shift in the current just beneath.

For the uninitiated, SR&ED exists to provide an incentive for Canadian companies to innovate in many aspects of doing business, whether that’s creating new technology-based products and services, or optimizing business process through the utilization of new or improved technologies.  Via SR&ED, which is administered by the Canada Revenue Agency (CRA), qualifying Canadian companies can seek partial reimbursement of labour, technology and even overhead expenses related to “eligible technological innovation.”  In the case of profitable companies, the reimbursement comes in the form of credit against taxes owed (up to 35%); for unprofitable companies, cash rebates apply. It’s not chump change, and the federal government doled out roughly $3.6Bn in SR&ED credits and rebates in 2011.

SR&ED is “sectorized” into multiple camps, and a substantial number, if not most of Canada’s startups, are associated with the information and communications technology (ICT) sector. Mysteriously, with relatively minor tweaks in the SR&ED program design in the 2012 budget, the Harper Government expects to reduce the outflow of SR&ED rebates to ICT companies this year by as much as $400 million.  How will they do it?

Before we get to that issue, let’s talk about what SR&ED means to startups.  Starting a company anywhere is difficult, but in Canada entrepreneurs face the added challenge of highly limited sources of early-stage financing.  Raising the money it takes to build your first product or prototype, or to test design theories and perform experimentation, is almost impossible from a cold start in Canada.  However, if you can scrape together a paltry sum from friends and family, that could be matched by an IRAP grant from the National Research Council or from Telefilm Canada’s New Media Fund (CNMF).  Then, at the end of your fiscal year, you could apply for your SR&ED rebate, which might provide the cash you need to conquer Year Two.  The first two sources of funding are pre-qualified (i.e., you know whether you’re going to get it before you start).  In contrast, the SR&ED program is retrospective—you spend the money, file your claim, and hope for the best.

This is all Greek to anyone from Silicon Valley, where I developed my first tech startup, and where public research grant programs and tax rebates are a largely irrelevant afterthought.  Silicon Valley is, of course, blessed with a very healthy ecosystem of investors hungrily gobbling up investment opportunities at every point of the spectrum and affording companies favourable valuations.  It is literally easier to meet an angel investor for an omelette at Buck’s of Woodside, walk through your six PowerPoint slides to glory, and hammer out a term sheet on your MacBook than it is to fill out grant applications and tax rebate claims.  So that’s what entrepreneurs in the Valley do.

In Canada, we are not so blessed.  So SR&ED, IRAP and CNMF are essential policy tools promoted to encourage domestic innovation and dissuade companies from heading stateside. They are the simplest answer (among a rather short list) that an entrepreneur can provide to the question, “So, why don’t you just move to Silicon Valley?” given that NAFTA visas are so easy to come by, and that there’s even a visa for relocating your company from Canada to the US.

That’s why, while on the surface it appears like business as usual, it’s disturbing that our government has chosen to meddle with SR&ED—not in the limelight of public debate, but behind the scenes—by tinkering with how it’s administered by CRA.  In recent months, a growing number of startups have reported aggressive auditing tactics by SR&ED reviewers that result in very significant clawbacks.  This is all but confirmed by a perusal of the 2012 federal budget, which earmarks $4 million for additional administration of SR&ED, and of LinkedIn, which reveals a flood of new auditors coming on to manage, and presumably cut down, the claim flow in the past 18 months as part of an effort to meet that $300 million to $400 million budget cut.

According to CATA, a leading non-profit advocate for R&D funding in the ICT sector, your odds of having your claim selected for audit by the SR&ED offices are somewhere between one in three and one in five.  And, if you’re selected for audit?  There is little evidence to suggest that any claim survives the audit process fully intact, regardless of legitimacy.  I have direct knowledge of a claim that was reduced by nearly 80%.

The reasons your SR&ED claim are perilous under the new regime are twofold:  First, the legislation that created SR&ED is incredibly vague about its definition of “eligible technological innovation.”  This means that judgment is left in the hands of CRA auditors, who are obviously not incentivized as objective midwives of the claim process, and who follow guidelines that have become much more restrictive in recent years—guidelines to which you and I do not have access.  The second reason is even more sinister, because it is an absolute killer:  CRA requirements for documentation of the research and development process for creating software are massively out-of-step with the best practices of software development organizations, particularly those who ascribe to the Agile methodology, which abhors paperwork.

The one-two punch of subjectivity and the ever-present shared knowledge that your tracking and documentation is, in the CRA’s view, not up to snuff means that SR&ED is actually becoming a highly unreliable source of financing for startups.  And if you are like most startups—underfunded and under-revenued—both you and your auditor know that if the game of chicken goes on long enough, you will lose.  Many startups already are losing these fights with the CRA and closing their doors, or being forced to sell out early.

Given our proximity to the more freely-flowing capital (and other advantages) of the U.S., Canadian startups need everything they can get to justify staying within our borders.  And, the country needs it too, because eventually we will run out of the dead trees and decaying dinosaurs upon which our economy has historically relied.

Like many government policies, ambiguity favours the politicians.  With the uptick in enforcement, and a markedly more aggressive tone from CRA auditors, SR&ED (particularly for startups) is becoming increasingly like a game of Russian Roulette: five out of six times you pull the trigger and nothing happens—you get your cheque and everybody’s happy.  But if you really are depending on that cash to move your business forward, each time you pull that trigger there’s a fair chance it’ll blow your head off.

Startups already have plenty of risk heaped upon them.  If Ottawa is determined to be of two minds about this program, then we should expect the sensible technology companies and workers to continue their southbound exodus.