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The case for giving businesses incentives to innovate has always been compelling.

Everyone wins when business invests in research and development. It spurs economic growth, drives productivity and creates the jobs and companies of the future.

The return on investment should be several times the tax dollars spent.

But a major new report by the Organization for Economic Co-operation and Development finds that sophisticated tax-avoidance techniques by multinational companies are badly eroding the benefits of the billions of dollars that governments spend on R&D tax credits.

Companies are shifting massive amounts of profits they generate from R&D conducted in one country to other countries with lower tax rates.

The result is that "countries may be losing tax revenue on the output from subsidized R&D and also losing out on domestic knowledge spillover associated with production," according to the 362-page report.

Tax shifting and other measures used by multinationals to avoid taxes have two main consequences. Companies are ducking corporate taxes, while enjoying "very high levels of overall tax relief on investments in R&D," it says in the report, Supporting Investment in Knowledge Capital, Growth and Innovation.

Tax avoidance by multinationals may also make it more difficult for governments to assess how well their various incentives are working. The paper says trade and investment flows suggest the problem is widespread. The U.S. Treasury alone is losing as much as $60-billion (U.S.) a year from income shifting.

One way multinationals avoid tax is through so-called "treaty shopping." This works when a company based in a high-tax country – say, Canada – shifts income to related entities in a low-tax regime, such as Ireland. Because the two countries are bound by a tax treaty, the Canadian company pays tax just once, presumably in Ireland.

Earlier this year, the federal Finance Department issued a consultation paper on "treaty shopping," often a prelude to a tax crackdown.

This all presents a potentially serious conundrum for Canada. No other OECD country is more dependent on tax credits to encourage companies to do R&D. And Canada's credit scheme is among the most generous anywhere, even after a batch of changes announced in the 2012 budget.

The Scientific Research and Experimental Development (SR&ED) program costs Ottawa and the provinces $5-billion a year, representing the vast majority of R&D incentives available to businesses in Canada.

The U.S. and many other innovation leaders, on the other hand, spend the bulk of their innovation dollars on specific research projects and companies – so-called direct spending.

And that's precisely what the OECD report recommends for countries such as Canada. The report pointed to new evidence that suggests "direct support measures may be more effective in encouraging R&D than previously thought."

In Canada, the federal government has made noises about shifting away from tax credits. The recent Speech from the Throne, for example, highlighted the government's main business R&D grant program – the Industrial Research Assistance Program (IRAP) – but made no mention of the much larger tax incentive-based SR&ED.

A 2011 federally appointed panel, headed by Open Text Corp. chairman Tom Jenkins, similarly urged Ottawa to shift more of its R&D dollars to direct spending.

But that's not the current reality. In 2012, Ottawa issued $3.6-billion in SR&ED tax credits to more than 20,000 companies. IRAP, on the other hand, spent $110-million on roughly 1,100 companies.

Beyond the economic benefits highlighted by the OECD, Ottawa likes direct grants because they pay political dividends, explained David Hearn, managing director of Toronto-based Scitax Advisory Partners LP.

"The funding programs are more attractive to this government," Mr. Hearn said. "They are more publicity rich."

Canada is moving in the right direction. But it's not clear the federal government is doing so for the right reasons, or that it has a clear vision of the kind of R&D it wants to foster.

For a country that already suffers from lagging productivity and chronic underinvestment in business R&D, getting innovation policy right is crucial.

It is too small a country to squander scarce resources or stand idly by as other countries siphon off its tax revenue.

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