Penalties for high-growth tech companies prompt mounting calls for tax system overhaul

Canada’s tax system is failing to support innovative companies, productivity and competitiveness and needs an overhaul, say innovation advocates.

The system discriminates against and penalizes innovative and high-growth technology companies that go public to raise equity capital, Pierre Lortie, senior business advisor at Dentons Canada in Montreal, told RE$EARCH MONEY. Yet studies worldwide show that these very companies are the key to economic growth, job creation and productivity, he says.

“A tax regime that penalizes the fast-growth companies that are going public is like shooting in your own goal. It’s a dumb policy,” Lortie says.

A former governor of the Council of Canadian Academies and a former president of the Canadian Academy of Engineering, Lortie has detailed his concerns about Canada’s tax system in two reports published this year: one for the School of Public Policy at the University of Calgary; and the other for the C.D. Howe Institute.

Lortie notes that the federal income tax rate increases to 15% from 10.5% for a small company going public, while the federal Scientific Research and Experimental Development (SR&ED) tax credit shrinks to 15% from 35%. At the same time, new companies listed on an exchange lose their eligibility for a cash refund under the SR&ED program, and can thereafter only access tax credits.

“Those tax credits are worthless, because these companies are in the growing phase so they’re barely profitable,” Lortie says. “They’re not generating enough cash to fuel that growth, so they need an equity infusion.”

However, the size of equity investments in the private market in Canada is much smaller than in the U.S. or U.K. So to obtain sufficient cash equity to sustain their growth, promising young Canadian companies typically sell to foreign companies or investment funds, rather than scaling up in Canada, Lortie says. “The end result is the hollowing out of high-tech and innovative companies.”

To increase the depth of Canada’s public and private equity markets, Lortie recommends a gradual reduction in capital gains tax on shares issued by eligible SMEs when they list on a Canadian stock exchange, and when those shares are held by individual investors for a reasonable period.

He also recommends implementing an “intellectual property box” measure, which would provide for a reduced rate of income tax on the commercialization of IP developed or acquired by a Canadian company.

As for tax credits and other subsidies provided by government, Lortie says: “It would be better to replace all forms of subsidies to entrepreneurs with reductions in the taxes they pay when they start a business, but also beforehand, when they are still accumulating capital with a view to starting a business.”

Organizations call for full tax system review

In a letter to federal party leaders, Chartered Professional Accountants (CPA) Canada has called on the next government to appoint an independent expert panel to do a full review of the tax system (the last review was in 1967). In a report last year, CPA Canada said the country is lagging other jurisdictions in promoting innovation, with a tax system that is “in disrepair and is adversely affecting our prospects, productivity and prosperity.”

CPA Canada’s survey of chartered professional accountants found that 61% agreed that Canada’s tax system hinders or strongly hinders competitiveness. Only 15.6% believe the system supports competitiveness.

The system is overly complex, with “incredibly complicated rules” on income splitting, passive investments in a private corporation, abusive tax avoidance, cross-border flow of funds for multinationals, and other issues, said Bruce Ball, CPA Canada’s vice president of taxation in an interview with RE$EARCH MONEY. “The current government isn’t drawing as good a balance as it could, between tightening rules but also making them reasonable to comply with."

Calls for an independent, comprehensive review of Canada’s tax system have come from many corners: Parliamentary committees, Canadian Chamber of Commerce, Business Council of Canada, Canadian Manufacturers & Exporters, as well as leading think tanks, economists, academics and the Organization for Economic Cooperation and Development.

The Canadian Advanced Technology Alliance (CATA) also wants an independent review of the tax system, focused on issues to help grow businesses, IP and investment, says Russ Roberts, CATA’s senior vice-president, tax, finance and advocacy.

CATA members are still struggling with problems with the SR&ED program, including overly aggressive auditing, Roberts says. Finance Canada conducted an internal review of the program, but has never issued a report on the results and needs to be held more publicly accountable, Roberts says.

“Uncompetitive” tax regime hinders prosperity

“Canada’s tax policy regime needs updating for the 21st-century digital economy in order for Canadian firms to be globally competitive,” says Ben Bergen, executive director of the Canadian Council of Innovators (CCI), in an email to RE$EARCH MONEY.

A recent survey of 80 CCI chief executive officers who lead high-growth, Canadian-headquartered companies found 54% of them believe Canada’s current corporate tax structure isn’t competitive with the U.S.

As just one measure, the SR&ED tax credit eligibility criteria should be broadened to include more activities and expenditures related to commercialization and continuous improvement of innovative products and services, Bergen says. “If the SR&ED system does not become more responsive to new competitive realities of the digital economy, we will continue to see significant R&D activity migration out of Canada.”

CCI is calling on the next government to begin consultations with industry on expanding the use of flow-through shares to the technology industry, similar to those that support growth of the mining and natural resources sectors. This would allow investors in the life sciences and clean tech sectors to realize tax deductions associated with companies’ eligible business expenses, notably exploration and development, Bergen says.

Entrepreneur Paul Parisi, president of ElectroSep, a Quebec-based chemical engineering technology company, says unlike in the U.S., Canada taxes both capital gains and dividends on shares sold by a private company to family members, employees or partners. This discourages keeping businesses in Canada because it’s more financially advantageous to sell to foreign interests, most often in the U.S., Parisi said in an interview.

“This, I believe, is one of the major reasons we don’t see the growth of Canadian companies, as we do in the U.S., and the reason why much less R&D is done here,” Parisi says.

Out of 34 OECD countries, Canada had the seventh-highest combined federal and provincial income tax rate for high-income earners in 2017, according to a report by the Fraser Institute. Studies show a 1% increase in personal tax rates at the top income level can dampen entrepreneurship and prevent up to almost 700 new businesses from being started, the think tank says. “High and increasing marginal tax rates discourage people from engaging in productive economic activity, ultimately hindering economic growth and prosperity.”

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