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Ottawa's grant scheme to encourage research and development is beeing abused by some companies.Reuters/Reuters

A flood of questionable tax claims pushed by an exploding cottage industry of consultants is threatening Canada's signature research and development incentive.

Tax authorities are warning they'll start hitting companies claiming this wildly popular tax break with punitive penalties and even criminal charges to stop the abuses.

This year, Ottawa and the provinces will dispense $4.7-billion to more than 20,000 Canadian companies under one of the richest R&D tax regimes in the world. But a third or more of that cash is being wasted and paid to consultants as a result of hazy rules on what's legitimate R&D and limited government auditing resources, according to dozens of interviews with consultants, claimants and government officials.

The program is prone to abuse because the risk of getting caught is low. Tax authorities routinely accept a significant percentage of refund claims with little or no vetting in what one CRA source called the R&D industry's "dirty secret."

At a time when experts worry Canada is falling badly behind in the global innovation race, Ottawa often touts its Scientific Research and Experimental Development program as a key part of the answer - a powerful lure to get companies to invest here and generate wealth. In fact, the government's own studies have found the program generates almost no economic benefits. And the low risk of getting caught means too much of the money winds up in the hands of people who do little or no R&D, including small manufacturers, consultants and lenders.

The dilemma is that many claims may meet the agency's minimum filing guidelines, and yet constitute highly dubious R&D. The result, experts said, is that Canadian taxpayers are spending billions on a program that too often delivers little or no new R&D.

Senior Canada Revenue Agency (CRA) officials exposed the growing scourge of bogus claims at a series of recent meetings with industry consultants and accountants, The Globe and Mail has learned. At one of the gatherings, a CRA executive complained about unscrupulous consultants "carpet bombing" entire area codes and then flooding the agency with claims for many companies that do little or no R&D.

Money is often paid out to decidedly low-tech and routine manufacturing, such as baking gluten-free cake, making injection-moulded auto parts or growing potted roses. Carefully documented and presented as scientific investigation, this kind of work is worth millions in government cash.

The refund industry is so lucrative that it's even spawned a new breed of lenders, who give claimants cash up-front for a cut of any eventual refunds.

Thanks to a revolving door between the government and the industry many consultants know the ins and outs of the claims process better than government auditors.

Many of the same CRA officials who helped design SR&ED are now working as consultants for the country's major accounting firms. Ernst & Young, Price Waterhouse, and Deloitte Touche all have former agency executives in key positions in their lucrative R&D tax practices.

Top CRA officials acknowledged significant and growing problems with the program at a recent meeting with several hundred claimants and consultants in Burlington, Ont. Among the revelations: a proliferation of SR&ED consultants, a surge of dubious and poor-quality claims and far too many cases of companies making claims they can't back up with documentation, according to David Hearn, a veteran consultant and manager of Scitax Advisory Partners in Toronto, who was at the meeting.

CRA officials also told the meeting that some consultants are blanketing entire geographic areas and submitting unfounded claims for virtually every business on every street, Mr. Hearn said.

CRA officials contacted by The Globe and Mail confirmed the account and acknowledged they're facing "a growing trend" of bogus and fraudulent claims. CRA spokesman Philippe Brideau said the agency is also "aware" that some tax preparers are providing "incorrect information to potential claimants."

Recent meetings with the industry are part of an effort to "promote awareness and compliance," he said.

But Mr. Brideau insisted most companies are playing by the rules.

"It is important to note … that the vast majority of claims are compliant with filing requirements," he said.

But another CRA source said as many as two-thirds of SR&ED claims - often worth millions of dollars apiece - are merely accepted "as filed," with minimal vetting.

Mr. Brideau would not confirm what percentage of claims are approved without thorough review. He said the agency's "risk assessment criteria, coverage rates and review strategies" are confidential.

Nor would he discuss specific claims or consultants, citing confidentiality rules. But he said the agency is vigilant about pursuing tax evaders and is consistently improving its administration of the program and "promoting greater compliance."

Erin Filliter, a spokeswoman for Revenue Minister Keith Ashfield, insisted the government is aggressively pursuing cases of potential fraud and laying charges when there's evidence of abuse.

"This is a very serious issue and we take it as such," Ms. Filliter said. "We are taking appropriate action."

Ottawa and the CRA owe it to Canadians to do a much better job of ensuring taxpayers' money is going to legitimate R&D, Mr. Hearn argued.

"SR&ED is something that CRA and the government can and should fix. They just need the will to do it," he remarked. "We mustn't allow them off the hook on this. It's like any policing. It's a tough job, but it has to be done. It's their job and they should do it."

The federal government has known about gaping holes in the program for more than a decade. Numerous studies, including a 2000 Auditor-General's report, warned of rampant problems with SR&ED, including poor controls, inconsistent decisions and exaggerated benefits.

The Auditor-General urged both the CRA and the Department of Finance to bolster internal controls and tighten the rules. Instead, Ottawa has made the program progressively more generous. The result was predictable. The cost of the federal SR&ED program has climbed to an estimated $3.5-billion a year from $2.7-billion in 2005.

At the same time, Canadian companies are doing less R&D than they were before the recession - $14.8-billion in 2010 versus $16.6-billion in 2007, according to Statistics Canada. And numerous studies suggests Canadian businesses are doing a relatively poor job of converting that R&D into successful new products and higher exports.

What's worse, there's no evidence generous tax incentives are leveraging any more R&D than would occur anyway. The Department of Finance concluded in 1997 that the SR&ED program barely pays for itself, generating just $20-million to $55-million a year worth of net "real income" for the country.

Unlike most other developed countries, Canada chooses to pump cash into business R&D indirectly, through tax breaks, rather than directly through grants, investments or government purchases.

Nor is the fraud problem a new phenomenon. The SR&ED program replaced the defunct Scientific Research Tax Credit (SRTC) program, which was abruptly cancelled in the 1980s after costing the government more than $1-billion in tax revenues and spawning a litany of fraud convictions.

Like the SRTC, the great lure of the current system is that the credits are payable as cash refunds. Smaller Canadian private companies get an instant refund on up to 35 per cent of their first $3-million in eligible R&D costs, including salaries, equipment and outside contracts. Most provinces tack on additional credits of 10 to 20 per cent.

SR&ED is also producing lucrative fees for a thriving cottage industry of consultants, who promise big payouts for navigating the program's arcane rules. Google "SR&ED" and you'll get listings for hundreds of consultants offering advice on how to get hefty refunds.

Exploiting grey areas in the law has become big business for consultants. Some even brag about pitching SR&ED to businesses who don't do conventional R&D, such as restaurants and bakeries.

"Many people think that the access to Canadian government-funded R&D incentives is limited to manufacturers and research labs," Mark Sorkin, part owner and director of business development for Toronto-based Tripol Management Services, wrote recently in an online newsletter. "Small businesses in the food industry (like bakeries and restaurants) are also prime candidates who can and should take advantage of this amazing funding program."

A Tripol sales training document obtained by The Globe and Mail highlights the perceived low risk in the industry of pushing the envelope.

"There is no punishment for anything that you (we) write in the claim," according to the document. "The best-case scenario - 90 per cent of cases that Tripol handles - is that the client simply receives the cheque from the government for the dollar amount of the claim."

The document, for example, urges its consultants to embellish claims by lifting technical jargon from the Internet for "scientific flavour," changing employee titles to make them sound more technical and playing with percentages to make them "look more convincing to reviewers." Tripol refers to these tactics as "decorating the reality."

Reached by phone, Mr. Sorkin acknowledged the document belongs to Tripol, but insisted it's only a draft.

"It's a confidential file," he said. "We drafted it for business comment. We don't have a final version yet."

The risk of getting caught for making bogus claims remains low.

The CRA's Mr. Brideau said the agency is reviewing an unspecified number of cases dating back to 2007, but it hasn't imposed any penalties yet.

The odds of criminal prosecution are also low. Just four people have been convicted since April, 2006, in connection with false SR&ED claims - two in 2010 and one each in 2008 and 2007, according to Mr. Brideau.

The CRA is trying to cope with the sheer volume of claims by arbitrarily rejecting many of them and imposing onerous new documentation requirements on everyone, according to numerous consultants and claimants.

The result is that the approval process has become increasingly inconsistent and unpredictable. Faced with near-identical R&D projects, the agency may approve one, while arbitrarily rejecting others.

"The program has lost its focus," lamented Dean El-Sedfy, president of SR&ED Engineering Inc. in Burlington, Ont.

Tax authorities should be focused on whether companies are doing legitimate R&D in Canada, he said. Instead, they're wasting their time making sure forms are filled out correctly and contain the right buzz words, Mr. El-Sedfy scoffed.

"The abuses are a real problem," Mr. El-Sedfy added.

The result is that CRA is rubber stamping large volumes of smaller claims that look legitimate because more thorough reviews are too costly and time-consuming. Meanwhile, many larger claims are being arbitrarily scaled back or rejected.

Toronto-based iSkin Inc., which developed antimicrobial covers and wireless accessories for iPads and iPhones, recently ran into the CRA's get-tough policy. The company applied for $1.8-million in tax credits, but was rejected after an audit on the grounds that its work amounted to routine engineering.

"The act is vague to begin with, and interpretive," complained Ron Juliani, iSkin's director of business affairs. "One company can get approved for something minor, while another like us, is summarily dismissed … We should be the poster child for R&D, yet we're punished for it."

There seems to be a "mandate from the top" to reduce the number of claims, whether they're legitimate or not, Mr. Juliani said.

Ms. Filliter, the Revenue Minister's spokeswoman, said the government is anxiously awaiting the results of a government-appointed panel of experts, headed by Open Text Corp. chairman Tom Jenkins, which is reviewing Ottawa's various R&D efforts, including SR&ED.

Based on submissions Mr. Jenkins has received so far, leading business groups and accounting firms are pushing for an expansion of SR&ED, rather than a sweeping overhaul. Many want refundable credits for all companies - regardless of whether they're public or private, small or large.

Mr. Hearn of Scitax suggested that a better alternative to refundable credits for all companies would be a flow-through share scheme, similar to those currently offered in the mining and resource sector.

"What we need to do it fix the malfunctions, not destroy the system," he said.

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