PACC Committee Report
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HOUSE
OF COMMONS
CHAMBRE DES
COMMUNES
CANADA
Pursuant to Standing Order 108(3)(e), the Standing Committee on Public Accounts has the honour to present its
FIFTEENTH REPORT
The Standing Committee on Public Accounts has considered Chapter 6 of the April 2000 Report of the Auditor General of Canada (Canada Customs and Revenue Agency and Department of Finance – Handling Tax Credits Claims for Scientific Research and Experimental Development) and the Committee has agreed to report the following:
INTRODUCTION
Recognising the contribution of research and development in improving a nation’s productivity and the standard of living of its citizens, the federal government, since 1944, has used various incentives to encourage research and development activities in the private sector.
According to the Income Tax Act, eligible scientific research and experimental development (SR&ED) is defined as a "systematic investigation or search carried out in a field of science or technology by means of experiment or analysis". SR&ED activities include any work undertaken to advance scientific knowledge or to achieve technological advancement for purpose of creating new (or improving existing) materials, devices, products or processes. Certain activities directly supporting SR&ED and that are commensurate with the needs of SR&ED are also eligible to the tax incentives and deductions. Activities such as market research or sales promotions are excluded from SR&ED tax credits.
The government currently makes available tax credits for work in scientific research and experimental development (SR&ED). These incentives take the form of
(1) Accelerated deductions for qualifying capital expenses of scientific research and experimental development incurred in Canada directly, or on behalf of, a taxpayer’s business;
(2) Investment tax credits for qualifying current and capital expenses incurred in Canada. These can be claimed at rates of 20 percent or 35 percent and are refundable in some cases. Unused investment tax credits can be carried back three years or forward 10 years.
Several provinces also have additional tax incentives for research and development. The combined federal and provincial tax deductions and credits can reduce the cost of SR & ED by about half.
The SR&ED program is administered by the Canada Customs and Revenue Agency (CCRA) through 37 tax service offices (TSO). The Department of Finance is responsible for developing overall tax policy in general, and the fiscal measures that encourage research and development activities in particular.
Prior to 1994, taxpayers could claim credits on SR&ED expenses anytime after the year in which they incurred them by requesting an adjustment to the income tax return they had filed for that year. The federal government decided that the SR & ED tax credit program should favour new research instead of reopening already filed tax returns or recalculate tax credits of expenses of prior years. The federal government proposed amendments in its February 1994 Budget that would restrict expenses qualifying for SR &ED tax credits to those taxpayers identified no later than 18 months after the year in which they incurred them. These amendments became law in June 1994.
As a result of these amendments, the Agency received 16,000 taxpayer-requested adjustments representing $ 2.8 billion in tax credits. These requests created a huge backlog of claims that the Agency had to process.
The Standing Committee on Public Accounts wanted to know how well the Agency had administered the tax incentive program, particularly, how it processed the huge backlog of tax claims resulting from the 1994 amendments. As a result, it decided to examine Chapter 6 of the April 2000 Report of the Auditor General of Canada on June 8th 2000. Representing the Office of the Auditor General of Canada were Mr. L. Denis Desautels (Auditor General), Mr. Shahid Minto (Assistant Auditor General) and Mr. Barry Elkin (Principal, Audit Operations Branch). From the Canada Customs and Revenue Agency were Mr. Rob Wright (Commissioner), Mr William V. Baker (Assistant Commissioner, Verification, Enforcement and Compliance Research Branch), and Mrs. Norine Heselton (Director, Scientific Research and Experimental Development Directorate, Verification, Enforcement, and Compliance Research Branch). Mr. Len Farber (Director General, Legislation, Tax Policy Branch), and Mr. Paul Berg-Dick (Director, Business Income Tax Division, Tax Policy Branch) represented the Department of Finance.
OBSERVATIONS AND RECOMMENDATIONS
In examining the processing of the huge backlog of tax credit claims, the audit identified four major areas of concern in the administration of the SR&ED program.
(1) Inconsistencies in the handling of retroactive claims, which raised questions about the fairness of the process. The audit found cases where claims were rejected for lack of proper documentation, while in other circumstances, taxpayers received assistance in the preparation of eligible claims. Claims initially rejected were approved after a second science review. Other claims, also initially rejected, did not receive a second review.
(2) Unclear rules and definitions over eligible SR&ED activities. Legislative and administrative rules require a clear definition as to what constitutes eligible scientific activities. The lack of clear rules has led to instances of unresolved disputes over the eligibility of science work in the financial and telecommunication sectors that involved hundreds of millions of dollars in outstanding tax credit claims.
(3) Absence of an effective mechanism to resolve serious internal differences of opinion on the appropriate treatment of individual claims. The audit noted that the Agency was unable to demonstrate that it had effective procedures in place to deal with major internal disputes on significant claims.
(4) Risk assessment of taxpayers’ claims need to be improved. The Agency needs to focus its energies and resources to deal with claims with the highest risk.
The Auditor General noted that in 1998 the Agency had developed in partnership with industry an action plan to resolve the administrative problems of the SR&ED program. The plan was being implemented at the time the audit was completed.
The Committee was very concerned about the perceived lack of fairness in the treatment of claimants. One member observed that large corporations or organisations with established experience in research and development activities could reasonably expect to secure financial assistance in the form of SR&ED tax credits. But it was considerably more difficult for small and medium sized businesses to fulfil all the eligibility requirements for the SR&ED program. It was claimed that in some cases, projects submitted by small and medium sized enterprises are given the initial go-ahead to proceed with the project, but when the time comes to claim the tax credits, the same project is no longer considered eligible for the financial assistance. The inconsistent treatment of claimants was attributed to the lack of trained scientific advisors and financial auditors required to adequately carry out the project review.
The Commissioner for Canada Customs and Revenue Agency, Mr. Rob Wright, indicated that one of the key issues was a large backlog of unprocessed claims, which affected the overall administration of the current files. To process the huge backlog of claims, the Agency has targeted a 120 day period in which to respond to each small company’s SR&ED tax credit claims. Mr. Wright indicated that currently over 80 percent of claimants were getting responses to their claims within the 120-day period.
The Assistant Commissioner, Mr. William Baker, also indicated that part of the administrative burden is the large number of claims from small businesses that has to be processed each year. The Agency receives between 10,000 to 12,000 claims in any given year, 90 percent of which are for tax credits. After completing the required scientific and financial analyses, the Agency allowed 70 percent of the tax credit amounts requested. As a measure to alleviate the administrative burden, Mr. Baker indicated that the Agency has introduced a shorter application form for small and medium sized businesses in order to simplify and expedite the processing of claims.
Mr. Denis Desautels agreed that the issues identified were in large part due to administrative problems resulting from the large backlog of SR&ED tax claims. However, as the audit report indicated, it is also important to clarify as much as possible the rules and eligibility criteria in order to avoid uncertainty in the administration of the program and to provide claimants with a clearer idea as to what constitutes eligible SR&ED activity.
This leads the Committee to recommend the following:
That the Canada Customs and Revenue Agency immediately implement the provisions in its action plan to clarify the eligibility criteria governing the work eligible under the SR&ED program. That the Agency report the progress of these initiatives in its Departmental Progress Report, beginning for the fiscal year ending March 31st 2001.
That the Canada Customs and Revenue Agency immediately implement the provisions in its action plan to clarify the documentation requirements for the SR&ED program. That the Agency report the progress of these initiatives in its Departmental Progress Report, beginning for the fiscal year ending March 31st 2001.
That the Department of Finance complete the review of its legislative rules in order to clarify the concept of eligible SR&ED activity. That the Department of Finance report the progress of this initiative in its Departmental Performance Report, beginning for the fiscal year ending March 31st 2001.
Another issue of concern was the lack of an effective dispute settlement mechanism to resolve outstanding internal differences of opinion on significant claims. Mr. Len Farber of the Department of Finance, indicated to the Committee that a program such as SR&ED, where the definition of what constitutes an eligible research or development activity is not a precise concept. As such, differences of opinion between the field offices and headquarters will arise from time to time. While there were some established procedures that deal with legitimate differences of views, serious divergence of opinion can occur and persist.
One particular area of concern, was how the Agency resolved an internal dispute over a SR&ED tax credit claim that eventually involved tens of millions of dollars. In that case, according to the audit, the Agency’s head office overturned an initial decision made by one of its tax service office without adequate documentation and verification. The manner in which the claim was eventually settled raises a number of questions that as of yet have not been addressed.
One aspect of the claim that preoccupied the Committee, was that one taxpayer could claim tax credits for another taxpayer’s research and development expenses. Although, at that time, the legislation permitted both taxpayers to claim for the same SR&ED credits, the Committee is clearly satisfied to note that this particular legislative provision has recently been amended to deny such practices. Nonetheless, the Committee remains concerned as to why such a situation was allowed to happen in the first place and in the interest of protecting public funds against possible abuses proposes the following:
That the Department of Finance, when drafting future tax credit legislation, endeavour to take all the necessary measures to insure that taxpayers can no longer claim tax credits for another taxpayer’s eligible expenses.
In response to the recommendations found in the audit report and the SR&ED action plan, the Agency instituted two new initiatives designed to strengthen the dispute resolution mechanism. One project is what the Agency designates as a "second review process". In this initiative, management will take steps early in the review of claims to ensure that the proper process is being followed and to resolve any issues that may arise before they have the opportunity to go to the more complicated and expensive appeals process. Another "dispute resolution" mechanism will be implemented in two major urban centres later this year. This mechanism will also mitigate the need to go to the appeals process. The Committee considers these new initiatives as positive developments but wondered if the same scientific and financial staff who undertook the initial review would carry out the second review process. In the interest of further promoting fairness and transparency in the review process, the Committee makes the following recommendation:
That Canada Customs and Revenue Agency, to promote and ensure greater fairness and transparency in the claims review process, investigate the possibility of using outside expertise when executing the second review process. That the Agency report the results of its findings in its Departmental Performance Report, beginning for the fiscal year ending March 31st 2001.
The Committee was interested in the action plan the Agency developed in collaboration with its private sector partners in order to improve the delivery of the SR&ED program. Some enquired if the plan contained provisions designed to ensure more coherent and standardised treatment of tax credit claims in the review process.
The Director General of the Scientific Research and Experimental Development Directorate of the CCRA, Mrs. Norine Heselton, agreed that the Agency should have better promoted the second review process in order to ensure fairer treatment of claimants. The Agency is currently collaborating with various sectoral industry associations in promotion activities to ensure everybody is aware of the renewed review process.
That the Canada Customs and Revenue Agency immediately implement the provisions of its action plan to establish a standard mechanism to resolve internal disputes within the Agency. That the Agency report the progress of these initiatives in its Departmental Performance Report, beginning for the fiscal year ending March 31st 2001.
That the Canada Customs and Revenue Agency immediately implement the provisions of its action plan to resolve all outstanding disputes about past claims. That the Agency report the progress of these initiatives in its Departmental Performance Report, beginning for the fiscal year ending March 31st 2001.
That Canada Customs and Revenue Agency immediately implement the provisions in its action plan to ensure that the claims review process is carried out in a more consistent, coherent and timely fashion. That the Agency report the progress of this initiative in its Departmental Performance Reports, beginning for the fiscal year ending March 31st 2001.
The Committee was also concerned about the Agency’s lack of standard criteria for assessing and identifying high-risk claims for review and audit and whether it was undertaking any initiative to address the issue. The Assistant Commissioner of Verification, Enforcement and Compliance Research Branch, Mr. William V. Baker indicated that the Agency has recently been making significant investments in the area of risk assessment to further strengthen its scientific and financial capacity to identify and manage risk.
That the Canada Customs and Revenue Agency develop standard criteria for assessing the compliance risk for claims. That the Agency report on the progress if this initiative in its Departmental Performance Report, beginning for the fiscal year ending March 31st 2001.
Finally, the Committee was interested about the program evaluation that assessed the economic impact of the SR&ED program. The main findings was that the federal SR&ED tax credit did encourage the participants to incur more spending in research and development than they would have in the absence of the program. Estimates indicate that for every dollar of tax revenue foregone, the tax credits managed to leverage an additional $1.38 in SR&ED expenditure. The other principal finding is that the program generated a net increase in Canada’s real income of between $ 20 million and $ 50 million per year.
The Committee was concerned about the fact that among the G-7 countries Canada has one of the most generous tax regimes regarding the encouragement of SR&ED activity and yet has the lowest amount of research and development expenditures relative to its Gross Domestic Product. Some enquired whether other means to stimulate research and development activities could be considered.
The Committee recognises the importance of review, program evaluation and audit in order to evaluate the progress of the SR&ED program and assess its performance and results. For instance, program evaluations provides information to support decisions about resource allocation, determines the value obtained from tax dollars, assists public servants in managing for results and supports transparency to Parliament and the Canadian public. Given the rapid evolution in research and development activities, it is imperative to know whether the SR&ED program as it is structured can continue to provide useful services to the Canadian economy or whether other types of arrangements could be considered. In light of the above, the Committee recommends the following:
That the Canada Customs and Revenue Agency and the Department of Finance prepare an annual report on the results of the Scientific Research and Experimental Development (SR&ED) program to be tabled in Parliament, and that the report be referred to the House of Commons Standing Committee on Industry.
That the Canada Customs and Revenue Agency and the Department of Finance carry out every five years an in-depth evaluation of the Scientific Research and Experimental Development (SR&ED) program in order to assess its impact on SR&ED activity and its contribution to productivity and economic growth in Canada and that the Minister of Finance table the report in Parliament.
CONCLUSION
Having reviewed Chapter 6 of the Auditor General’s April 2000 Report on the SR&ED program, the Committee is clearly concerned by the slow progress in the resolution of the outstanding claims. Many of the issues identified in the 1994 audit still persist to this day, specifically the unresolved disputes in the financial and telecommunication sectors, the persistent inconsistencies in the treatment of tax claims, the treatment of internal disputes, etc. The Committee acknowledges the efforts by both the Department and the Agency to address the many outstanding issues identified in the audit and views favourably the proposed action plan developed by the Agency and industry partners. However, action plans remain only as plans as long as they are not implemented. The Committee now expects to see progress in the resolution of the issues identified in the audit. The time for action is long overdue.
Pursuant to Standing Order 109, the Committee requests that the Government table a comprehensive response to this Report.
A copy of the relevant Minutes of Proceedings (Meetings Nos. 29 and 31) is tabled.
Respectfully submitted,
JOHN WILLIAMS, M.P.
Chair