It was a story that sounded too good to be true: Could American tech startups really relocate to Canada and have 80 per cent of their labour costs covered by government subsidy?
According to Wall Street Journal columnist Christopher Mims, that was the bargain U.S. transplant Adam Adelman’s company Mighty Cast couldn’t resist. Mr. Mims reported the “Canadian government is paying almost 80 per cent of his developers’ salaries,” and says the money isn’t a tax credit, it’s “a check he gets from the government whether or not his startup makes money.” Such an enticing offer seemed like enough to make even the truest -blue American consider joining the true north.
But when you dig a little deeper, the case of Mr. Adelman – a New York native who, along with his Quebec-born wife and co-founder grew disenchanted with Silicon Valley – appears somewhat unique, and the Canadian subsidy program more complex and fraught than Mr. Mims supposed.
Mr. Adelman, 45, told us the main source of Mighty Cast’s government support came in the form of tax rebates from Scientific Research and Experimental Development program (SR&ED), which hands out about $4-billion annually to companies of all sizes in Canada. If you don’t work in tech startups or tax circles you may never have heard of SR&ED (pronounced “shred”) tax breaks, but it’s one of the nation’s biggest sources of government cash for private sector innovation and research.
So, can you build a startup on government SR&ED money alone?
“I can tell you that’s a little bit of an illusion,” says Peter van der Velden, CEO of Lumira Capital and president of of Canada’s Venture Capital & Private Equity Association.
“I’m a big fan of SR&ED, it’s a fantastic source of capital and it’s a competitive advantage for Canadian companies,” says Mr. van der Velden. “Can I point to a company in my portfolio where it has been the enabling thing? I can’t. But I can tell you its in every discussion ... I hear from lots of VCs and lots of angels whose companies fundamentally rely on that capital as part of their total strategy.”
SR&ED funding has its biggest impact on a company like Mighty Cast: the two-year-old tech startup has six employees (three are developers), it’s pre-revenue, located in Quebec and is spending a relatively small amount of angel and self-funded capital on applicable research. Mighty Cast’s first product will be the Nex wristband, which features modular components that can be swapped out and updated (so the band can stay relevant in a rapidly changing wearable computing market).
The base federal rate for SR&ED refunds is 35 per cent, but almost all the provinces and territories add some top-up funding for companies in their jurisdiction. For example, in Ontario there is an extra 10 per cent available while in Quebec as much as 35 per cent for “Quebec Canadian-controlled corporations with less than $50-million in assets ... up to the spending limit of $3-million of R&D wages.” Mighty Cast is not a total outlier, but, as an example, many of Mr. van der Velden’s healthcare/biotech startups spend over the applicable caps, lowering his total SR&ED recovery rates well below that enticing 80 per cent figure.
Also, in recent years it has gotten more difficult to secure SR&ED funding. Chris Bodnar, a manager in the SR&ED Tax Services department of PricewaterhouseCoopers LLP, says that in the last 18 months the Canada Revenue Agency has hired more technical advisers (to help the agency assess whether claimed research is eligible) and startups have seen more information requests than ever before to substantiate eligible expenditures. After media reports of abuse and fraud, and federal government concerns that the program wasn’t generating enough original research, the CRA began to more closely scrutinize applications.
“Over the last five years, the market has become highly saturated with third-party tax practitioners,” says Mr. Bodnar. The CRA’s new focus has only enhanced the standards that tax professionals must adhere to. “PwC’s applicants have become more diligent in tracking costs to optimize their SR&ED filing process.”
The big four accountancy practices – as well as the second-tier and even boutique firms – compete to take care of the increasingly difficult paperwork for startups as well as large, established companies such as BlackBerry Ltd., Bombardier Inc., General Motors Co. and Open Text Corp. Some reports suggest as many as 20,000 claims are filed in a year.
In response, the government is taking steps to limit the share of SR&ED dollars available to large and foreign-owned firms: In late 2012, the federal budget lowered the general tax credit rate to 15 per cent from 20 per cent (the rate change took effect in 2014) and slashed capital expenditures from claimable expenses. And in 2011, a Conservative-government commissioned reform panel suggested scrapping more of the tax rebate dollars and replacing them with direct investments. One key reason for the reforms is that it’s hard to argue that those established entities would not spend research money if they weren’t getting that small reimbursement by SR&ED.
“I know there’s people who question SR&ED, but on the flip side, look at what it has allowed us to build, and now contribute back,” says Randy Frisch, co-founder and COO of UberFlip, a Toronto-based marketing software startup founded in 2009 that has never taken venture capital funding. “In a nutshell, we wouldn’t be here without all these programs.”
Avvey Peters, who manages external relations at Waterloo startup hub Communitech says SR&ED is a popular funding tool for startups because it helps “capitalize companies as they grow ... Canada has figured out that the first thing a company will spend it’s tax refund on is to hire another developer/engineer.”
One final note, Mighty Cast also received a funding grant from the Canadian Media Fund, which contributed toward the 80 per cent coverage of labour costs figure. But recent tax court rulings against double-dipping for government dollars also means that funding had to be spent on work not claimed in Might Cast’s SR&ED filing.
And, despite all this generous government support, Mr. Adelman is in negotiations to secure his first round of venture capital financing.
Editor's note: A previous version of the story mispelled Mr. Adelman's name.