Opinon Leader: David Hearn, managing director, Scitax Advisory Partners LP

Probing the astounding differences in provincial R&D tax credits

By David R Hearn

In Canada R&D tax credits come from both federal and provincial governments. However it's all too easy to lose sight of what comes from where. That's because in most cases provincial credits are automatically triggered by eligibility for the federal Scientific Research & Experimental Development (SR&ED) tax credit which in turn is determined by the Canada Revenue Agency (CRA). The distinction is further blurred because (except for Quebec and BC) the refund payments for Canada and the province both come on the same cheque, which is issued by CRA.

To be entitled to claim any provincial R&D tax credit, companies must meet certain conditions. Generally speaking, a company must file a tax return in that province and must have a permanent establishment (PE). In most cases, a company can only claim a provincial tax credit on R&D expenditures for work performed in that province.

Canada's 2012 federal budget inflicted significant cuts to the amount of money available through these tax credits. However because the 2012 legislation was phased in from 2013 to 2014, many companies are only now seeing those 2012 cuts hit their bottom lines. The fact that those cuts made in Ottawa have a knock-on reduction on the provincial credits often goes unnoticed - provincial treasuries save money while Ottawa takes the heat for the changes.

ONTARIO VS QUEBEC

Given this linkage between federal and provincial tax credits, it's more important than ever to understand the considerable differences between provinces. To highlight, we'll compare Canada's two largest provinces, Ontario and Quebec. For other provinces, go to www.scitax.com/ provinces.

There are three principle tracks of comparison. One, what R&D expenses attract the provincial tax credit? These are not always same as for federal SR&ED. Two, what is the provincial benefit rate and what ceiling or limits are imposed on the maximum amount of benefit? Unlike SR&ED, some provincial credits (most notably B.C., Alberta and Ontario) are capped in the range of $300,000 to $400,000 regardless of how much is spent. Three, is a cash refund offered if the corporation has no taxable income and, if so, is all of the benefit refundable? Quebec, Newfoundland / Labrador, Nova Scotia and New Brunswick - offer a tax credit that is 100% fully refundable to all types of corporations.

With respect to eligible expenditures, the 2012 federal budget eliminated capital outlays altogether, allowed only 80% of eligible contract payments and reduced the proxy overhead from 65% to 55% of R&D salaries. Except for Quebec, all of these cuts flow through to the provincial level. For example, Ontario pays its Ontario Innovation Tax Credit (OITC) and Ontario Research and Development Tax Credit (ORDTC) on whatever expenditures qualify for SR&ED at the federal level, including proxy overhead, materials and (up to Jan/14) 40% of capital.

Quebec provincial tax credits apply only to R&D salaries or the labour component of contracted R&D services. Quebec excludes overhead, materials and capital that count federally. Interestingly, Ontario tax credits exclude payments to non-arm's length contractors, while Quebec tax credits apply to 100% of non-arm's length but only 50% of arm's length (80% if the arm's length party is a university or other institution).

The 2012 federal SR&ED cuts had no adverse knock-on in Quebec because the expenditure types cut by Ottawa didn't qualify for the Quebec provincial credit anyway. But in December 2014, Quebec's newly elected Liberal government introduced legislative changes to its R&D tax credits. The first was the introduction of a minimum claim threshold requiring a minimum spend on R&D ($50,000 for small companies, $225,000 for large). The second was a standardization of benefit rates for certain types of transactions. For small firms, the benefit rate on all R&D labour wherever sourced increased from 28% to 30%. For large corporations the benefit rate on R&D out-sourced from universities, consortiums or partnerships fell from 28% to 14%.

While the 2012 federal cuts are generally viewed as net-negative to the pool of R&D funding available to the private sector, many economists view the 2014 Quebec changes positively. They reduce the government's administrative burden in processing large numbers of small claims, curtail potentially abusive small claims and more effectively contain the disbursed funds within the provincial economy.

In addition to differences in what expenditures attract tax credits, there can also be very significant differences in the Investment Tax Credit (ITC) benefit rate and whether or not the ITC is refundable or not. Benefit rate is the percentage by which you extend (multiply) eligible expenditures to compute the amount of tax credit. All provinces offer some form of refundable tax credit whereby if there is no tax payable at year end, the ITC is paid as a cash refund.

For public or foreign-owned companies, the refundable provincial tax credit is the only cash entitlement. Provincial benefit rates are different, ranging from 10% (BC), 14.5% (ON), 14% (QC large corp.) 15% (SK, NB, NS, NL, YT), 20% (MB) to 30% (QC small corp). Some provinces limit the maximum cash refund according to the federal expenditure limit (i.e. between $300,000 and $400,000). Quebec, Manitoba, Newfoundland / Labrador, Nova Scotia and New Brunswick do not.

DIFFERENCES ACUTE

It is here that the comparison between Ontario and Quebec becomes most acute. In Ontario, the provincial R&D tax credit benefit rate is 14.5% (10% OITC+ 4.5% ORDTC) for all corporations plus an additional 20% for the Ontario Business Research Institute Tax Credit (OBRI) for R&D services purchased from qualifying institutions.

The maximum cash refund available from Ontario is $4 million (OBRI) but only if $20 million of R&D services were purchased from a qualifying institution; otherwise the cap is $300,000 (OITC) for other R&D expenditures. The 4.5% ORDTC is not refundable. Even more worrisome is that $300,000 Ontario cash refund is ground down to zero if the corporation's taxable income exceeds $800,000 or taxable capital exceeds $50 million.

For larger firms that are profitable, this typically obliterates entitlement to any Ontario tax credits except the non-refundable 4.5% ORDTC and the 20% OBRI which only apply to institutional contracts.

Quebec, Manitoba , Newfoundland / Labrador, Nova Scotia and New Brunswick do not set any limit or ceiling on the maximum amount of refundable R&D tax credit.

In addition to having the highest maximum benefit rates (30% for small corps, 14% for large corps), Quebec imposes no limit whatsoever on the maximum amount of refundable cash benefit available from its' R&D tax credits. Furthermore, unlike Ontario, Quebec has no expenditure limit grind that obliterates the eligibility for larger corporations.

The only ceiling or limitations applicable to the Quebec credit is the new minimum claim thresholds discussed above and a benefit that drops from 30% to 14% as the company's assets exceed $50 million. Compare this to Ontario where the maximum amount of cash refundable provincial tax credit available in Ontario is $300,000 under (OITC) or $4 million (for institutional contracts under OBRI).

The provincial tax credits offered by Quebec, Manitoba , Newfoundland / Labrador, Nova Scotia and New Brunswick are particularly advantageous for private corporations with high R&D spends, corporations with profits over $500,000 and any corporation that is public or foreign-owned.

It is often assumed that Quebec's richer R&D tax credits are offset by higher corporate and personal tax rates that repel profitable corporations and high-earning individuals. In fact, in 2015 the top blended federal/provincial tax rates in Quebec are 26.9% for corporations and 49.97% for individuals, which compares favourably to Ontario where the top rates are 26.5% and 49.53% respectively.

Rate percentages and ceilings aside, what most dramatically effects the availability of R&D tax credits is how CRA assesses the technical/scientific eligibility of the work for which expenditures are claimed. Regrettably, denial of claims by CRA seems to be at an all-time high.

Firms with long histories of eligibility have found themselves suddenly cut-off on grounds that their R&D is either not sufficiently scientific to qualify as SR&ED or lacks the records to prove it. According to CRA's own statistics, the number of SR&ED-related notice of objection filings increased 25-fold between 2007 and 2014. This is another example of Ottawa-made decisions having adverse "knock-on" to provincial economic development policies.

A total of 43 SR&ED actions were raised in the Tax Court Canada in 2014. As of this writing, just over 70 SR&ED cases are pending resolution in the TCC.

David Hearn is managing director, Scitax Advisory Partners LP.