“Hey High-Tech Corps, it Might Be a Good Idea to Talk to Your Corporate Lawyers and Tax Advisors about Transferring the Development of Your Technologies in Canada!”
The Opportunity
According to KPMG[1], Canada ranks 1st among ten major countries[2] and three of its cities[3] rank in to top four among 51 major international cities, for their business and corporate tax effectiveness, as they bolster the lowest tax burden imposed on corporations doing business on their territories. Canada also ranks second with respect to the costs of doing business (only trailing Mexico), since its labor costs, facility costs, transportation costs, utility costs, capital costs and tax costs are the lowest, or close to the lowest, among those same countries and cities.[4]
One reason for these attractive rankings is the well-developed network of governmental grants, funding opportunities, and refundable tax credits put in place at both levels of government, federal and provincial. Among the myriad of tax and capital funding incentives[5] offered to high tech businesses operating in Canada (the “R&D Start Ups”), particularly in provinces such as Quebec, British Columbia and Ontario, is the Canadian tax credit program for scientific research and experimental development (the “SRED Program”). This program has been for a while, and still remains, once coupled with its provincial counterparts[6], one of the world’s most generous tax incentive programs for R&D activities around the world. This program, which is available to businesses carrying out eligible research and development activities in Canada (the “R&D Activities”), can play a vital role in the financing of R&D Start Up by providing significant non-dilutive funding for R&D activities until their intellectual property assets under development (the “Developed IP”) can be successfully translated into commercializable products and services.
The SRED Program has two major components. It first allows for current eligible[7] expenditures generated by R&D activities (like labour, materials, overhead, and subcontracting costs[8]) to become fully deductible against business revenues for Canadian tax purposes. This is possible even if such expenditures would not otherwise qualify as such, for not having been incurred to generate business revenues per se.[9] Second, and more importantly for R&D Start Ups from a funding perspective, the SRED Program generates tax credits (“Investment Tax Credits”) that are fully refundable for qualifying corporations. In other words, when the Investment Tax Credits exceed the Canadian taxes payable by the R&D Start Up on its business revenues (which is commonly the case at the R&D Activities stage), the corporation get a cheque from the government for the difference. Combined with its Provincial counterpart, the refund can even reach up to roughly 73% on certain labour expenses related to R&D activities.
The Problem for Foreign Corporations and their Legal Advisors
In order to qualify for the SRED Program and get its generous Investment Tax Credits refunded, a R&D Start Up must not only be carrying on business in Canada, incurring qualified expenditures in Canada, and conducting eligible R&D activities in Canada, but it must also be, and must constantly remain at all times, a Canadian-Controlled Private Corporation (a “CCPC”).[10] Does that mean that no foreign corporation can benefit from the refundable Investment Tax Credits in the development of its IP assets? Not necessarily.
The Solutions
While for anyone other than a Canadian tax guru the actual definition of a CCPC might be quite mindboggling, it can however be roughly summarized as referring to a Canadian private corporation that is not controlled, directly or indirectly, in law or de facto, by any group of non-residents and/or public corporations, related or not. So, the corporate advisor of the foreign entity might then ask: “How can my client set up, fund and manage a Canadian subsidiary responsible for developing its intellectual property core if we cannot control it?”; “Is there really no other way than to be a minority shareholder in a Canadian controlled corporation?”
There might be two ways around this problem. [11]
First avenue: setting up a new Canadian R&D Start Up with a Canadian partner. In 2012, the Tax Court of Canada decided in Bagtech[12], a paradigm changing case, that even in a situation where most of the voting shares of a Canadian corporation would be held by non-residents and/or public corporations, a Canadian corporation could still retain its CCPC status if a unanimous shareholders’ agreement (a “USAgr.”) is in place and provides that the minority Canadian shareholders shall have the right to elect a majority of its directors. What is noteworthy here is that a proper USAgr. can not only restrict the ability of the foreign majority shareholder to elect a majority of the directors of the R&D Start Up, it can also, at the same time, limit the power of its board of directors to control some aspects of its management, such as the nomination of key employees or the fate of the Developed IP. The whole question is to take care not to transfer so much power to the foreign corporation shareholder that it amounts to granting de facto control over the R&D Start Up. Since the Bagtech decision, foreign corporations are starting to find innovative corporate structures to benefit from the generous tax incentives of the SRED Program and case law precedents addressing those structures are slowly emerging.
Second avenue: entering into a service provider agreement with a newly created Canadian R&D Start Up. There are no restrictions on the ownership of Developed IP eligible to funding under the SRED Program. To qualify for the SRED program, the R&D Star Up must either own the Developed IP resulting from its work or assign it to a third party, which can even be a non-resident corporation, as long as it has with such third party a legally binding agreement confirming that it will own all Investments Tax Credits. Hence, it is possible for a foreign corporation to engage in a commercial deal with a newly created Canadian R&D Start Up to carry out its R&D activities in Canada and generate its Developed IP on its behalf. In this case, the foreign corporation does not benefit directly from any refundable Investment Tax Credits but anyone can see that such refundable credit benefiting its newly created service provider, coupled with all other incentives and cost advantages referred to in our first paragraph, will highly impact the price at which the development services might be sold to the foreign corporation, especially if the foreign corporation participates in the financing of its R&D Start Up counterpart. Here again however, corporate lawyers must be vigilant not to grant so much powers to the foreign corporation client in their business deals that it amounts to granting de facto control over the R&D Start Up service provider. With proper agreements executed between the non-resident and its Canadian R&D Start Up service provider, ownership of any resulting Developed IP from R&D Activities funded in Canada could end up vesting in the non-resident corporation at a significantly lower cost.
To summarize, if a foreign corporation agrees to team up with a Canadian partner and if the business relationship between the foreign corporation and its Canadian partner is properly structured[13], be it as a parent/subsidiary structure or as a client/service provider structure, the foreign corporation could possibly end up indirectly benefiting from the generous refundable Investment Tax Credits available under the SRED Program.
Now What Lies Ahead?
One concern about the SRED Program is that while it funds expenditures without much discriminations, it leaves the income drawn in Canada from the resulting Developed IP taxable at regular rates. Foreign corporations are then justified to take their Developed IP back home, or even better, to send it to jurisdictions having tax regimes less demanding on income it generates. A year ago however, the Quebec government announced a new deduction for innovative manufacturing corporations (DIMC Program)[14] which shall apply to eligible innovating manufacturing corporation with paid-up capital of at least $15 million (The R&D Manufacturers). The announced purpose of the DIMC Program is to entice R&D Manufacturers to keep their Developed IP, as well as the ensuing manufacturing process, in Quebec, the whole by bringing the combined federal-provincial tax rate down to a low 19%[15] on eligible business income.
The DIMC mechanism would be relatively simple. A R&D Manufacturer residing in Quebec would have to calculate the share of its income that is derived from eligible patents[16] embodied in the products it sells. Such share of revenues would be determined by how much R&D Activities conducted in Quebec and funded by Investment Tax Credits under the SRED Program are at the source of the embodied patents. One can then easily envision the dynamic interaction that will be created between the SRED Program and the DIMC Program, once they are both available.
Now, does the R&D Manufacturer have to be a CCPC? Nothing points to such a requirement in the information made available by the government as of this date. A foreign corporation would then be allowed to set up a fully owned subsidiary in Quebec and benefit from the DIMC Program, without having to go through those arrangements with Canadian partners we were discussing in this paper. However, a set up involving an R&D Startup structured as a partner of the foreign corporation and funded under the SRED Program and a R&D Manufacturer fully owned by the foreign corporation as a subsidiary and founded under the DIMC Program might well end up being the best corporate tandem to conduct high tech businesses in Canada in the years to come.
By: François Boulianne, Lawyer, Tax Advisor and Partner at YULEX, Attorneys & Strategists.
[1] KPMG, Focus on Tax, KPMG’s guide to international tax competitiveness, Competitive Alternatives – Special Report, (2016 edition). http://www.competitivealternatives.com/reports/compalt2016_report.
[2] Those 10 countries are Australia, Canada, France, Germany, Italy, Japan, Mexico, the Netherlands, the United Kingdom and the United States.
[3] Namely Montreal, Toronto and Vancouver.
[4] KPMG, Competitive Alternatives – KPMG’s guide to international business location costs, (2016 edition). www.competitivealternatives.com/reports/compalt2016_report.
[5] Programs such as the Industrial Research Assistance Program (“IRAP”), the Canadian Renewable Conservation Expense Program (“CRCE”), the Sustainable Development Technology Canada Program (“SDTC”), the Development of E-Business Provincial Tax Credit Program, and the Production of Multimedia Titles Provincial Tax Credit Program, to name a few.
[6] Most provinces, including the province of Québec, have their own SRED tax credit program, complementary to the federal program.
[7] To be eligible, expenditures must be related to R&D activities aiming at eliminating a scientific or technological uncertainty that cannot be removed by standard practice. While the work will be eligible if it creates new or improves pre-existing products, it does not have to have a specific practical application.
[8] Unfortunately, capital costs are now excluded from SRED Program.
[9] No revenues can reasonnably be forseen at such an early and uncertain stage of technical development.
[10] If the R&D Start Up is not a CCPC, for instance if it is a subsidiary of the foreign corporation, the Investment Tax Credit will be significantly lower and, most importantly, will not be refundable.
[11] Here is where the usual disclaimer of liability is warranted for the undersigned author. We do not intend this paper to be providing any formal legal opinion or advice to readers, nor are we pretending to outline any implementable corporate set up. We merely invite corporate lawyers to have these considerations in mind and to work closely with Canadian lawyers and tax advisors if any of their clients ever wish to consider taking advantage of the SRED Program.
[12] Bioartificial Gel Technologies (Bagtech) Inc. v. The Queen, 2012 TCC 12 (Tax Court of Canada (TCC)), confirmed in 2013 by the Federal Court of Appeal. In this decision, the TCC found that the company was a CCPC even though a majority of the company’s voting shares were collectively held by non-residents. Tax authorities refused to refund the credit on the basis that the company was controlled by non-residents and therefore was not a CCPC. But since under the USAgr. in place the non-residents (even taken as a fictional one entity) did not have the ability to elect a majority of the company’s directors, the court found that the non-residents did not control the company.
[13] Caselaw must be analysed carefully and proper attention must be given to the General Anti-Avoidance Rules and Aggressive Tax Planning applicable rules before setting up these kinds of corporate structures.
[14] Upon sending my paper, draft legislation setting up this DIMC Program had yet to be released by the Québec government. For official documentations, see: http://www.revenuquebec.ca/en/salle-de-presse/nouvelles-fiscales/2016/2016-05-11.aspx“.
[15] The general corporate tax rate in Québec is currently 11.9% (8% on the first $500,000 earned by qualifying small business) and would be reduced to 4% under the DIMC Program.
[16] The underlying patent application would need to have been filed after March 17th, 2016 and the deduction could be clawed back if a qualifying patent is not granted within a few years.