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It's Canada's marquee innovation program. And it's broken.

The Scientific Research and Experimental Development tax credit cost Ottawa roughly $4.5-billion last year – the largest source of federal research and development funding.

Thousands of Canadian companies tap the scheme every year, leveraging the credits to spend billions more developing the kinds of products that, in theory, should drive the economy of the future.

But there is growing evidence that SRED is becoming dysfunctional. Far too much of the money is going to consultants in fees, rather than R&D. And a flood of dubious claims, some crafted by former Canada Revenue Agency employees-turned-consultants, is bogging down an already complex and unpredictable application process.

At a recent town hall meeting with tax consultants in Burlington, Ont., CRA officials from across the country painted a disturbing picture of a program gone badly astray, according to people in the room. Among the problems:

- Tax offices across Canada are experiencing a surge of bogus and unsubstantiated claims.

- An exploding cottage industry of consultants is pushing large volumes of dubious claims.

- Consultants are sometimes blanketing entire geographic areas, coaching companies that do little or no R&D how to apply for credits.

- Many applicants are abruptly withdrawing applications at the first hint of a review by tax authorities.

CRA officials warned consultants they will crack down on abuse by slapping penalties on applicants involved in "negligent or misleading claims."

CRA spokesman Andy Meredith insisted that a "majority" of SRED claims are legitimate, but he confirmed the agency is witnessing "a growing trend" toward a deteriorating "quality" of claims. He would not offer details, citing confidentiality rules.

RLM Manufacturing Inc. of Whitby, Ont., is just the kind of small manufacturer that SRED was designed to help. The company, which makes and exports sophisticated metal roll-forming machines, uses the credits to help it develop advanced products that keep it a step ahead of foreign rivals.

The company has stubbornly resisted more aggressive tactics pitched by outside tax consultants, president Richard Hastings said.

"We want to make sure we stay on the right side [of the program]," Mr. Hastings said. "If the program was diminished or hurt because of people taking advantage of it, that would be truly unfortunate."

Some tax consultants also worry their reputations, and those of their clients, are threatened by those who push the envelope. Industry sources said numerous former CRA employees are out working as SRED tax consultants, presumably trading their knowledge of screening methods for big fees.

If this all sounds familiar, it is. Cash rebates on the goods and services tax triggered a proliferation of consultants, and eventually, a litany of fraud cases in the 1990s and early 2000s. Hundreds of millions of dollars leaked from the system.

Like GST rebates, SRED offers refunds in cash. Small Canadian-controlled private corporations can earn 35-per-cent refundable tax credits on their first $3-million of qualified R&D expenditures, including wages, materials, machinery and equipment. The credit drops to 20 per cent on expenditures beyond $3-million.

Businesses, of course, like the fact that it's refundable. It means they get cash back for eligible R&D, injecting valuable liquidity to companies that are often unprofitable during product development.

The downside is that the refunds make the program a magnet for unscrupulous consultants, who see the refunds and contingency fees of up to 30 per cent as a gold mine. Do the math, and as much as $1.3-billion of taxpayers' money may be going to consultants rather than R&D.

Nor is it clear how much Ottawa may be losing in bogus claims. But the Auditor-General should investigate.

The government knows there are problems. Last fall, Ottawa appointed a six-person expert panel headed by Open Text Corp. executive chairman Tom Jenkins to review all of its R&D efforts, including the pros and cons of refundable SRED credits. His report is due out later this year.

Federal Taxpayers' Ombudsman Paul Dubé is also looking into whether the CRA is administering the SRED program fairly. Kimberley Boyer, the ombudsman's spokeswoman, said the report – more than 18 months in the making and now being finalized – has been delayed owing to the volume of technical comments from stakeholders and by extensive "consultations" with CRA.

The awkward truth is that the government has known for years that SRED is leaky. And yet Ottawa has allowed its size to swell, making it a potential target of budget cuts.

Worse, every dollar squandered is money that isn't available for legitimate R&D at a time when Canada faces unprecedented global competitive threats.

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