Richard Sutin is a partner at Norton Rose Fulbright in Toronto.
Canadian policy-makers have long recognized the importance of capturing a share of the innovation economy – or even better, a leadership position. And much has been written and proposed to that end. With labour markets caught in the transition from an industrial to a knowledge economy and extreme global competition, the stakes keep getting higher. But while successful innovation calls on several factors, the greatest challenge and most important ingredient is access to sufficient risk capital.
Flow-through shares for Canadian resource exploration and development were introduced into the Income Tax Act approximately 60 years ago. While originally introduced to keep these cyclical industries going in tough times, the program became a spectacular success, positioning Canada's capital markets as a global leader in resource finance. Leadership in accessing capital led to industry leadership and, as a result, Canada became home to more mining companies than any other country in the world. Canadian companies engaged in more global exploration and development than companies from any other country, and Canada developed and attracted top resource talent.
The Prospectors and Developers Association of Canada said it best: "Flow-through shares have helped make Canadian mining firms world leaders, with head offices, consultants, contractors, suppliers, legal and financial structure and other expertise – in Canada."
This unique made-in-Canada solution was recognized by the Coalition for Action on Innovation in Canada, co-chaired by former finance minister John Manley and Paul Lucas, in their October, 2010, Action Plan for Prosperity. "By any measure, the program has been a success; it has helped make Canada a global leader in resource financing," they said, recommending an extension of flow-through shares to the innovation sector as one way of using fiscal stimulus to drive innovation.
A company that issues flow-through shares to investors must spend the proceeds on prescribed qualifying expenditures, which, in the case of Canadian resource flow-through funding, are exploration and development. These expenditures are renounced by the company in favour of the investor, who is able to deduct the renounced expenditures against other income, thereby effectively reducing the risk of investment by approximately one-half.
The tax cost of the investor's flow-through shares is reduced to zero and the company cannot expense or amortize expenditures that have been renounced to investors. The tax credits can be recouped by the government in the future through more capital gains on share sales and less tax-loss carry-forwards available to the company. In addition, the recipients of the qualifying expenditures, such as employees, contractors, landlords, etc., will also pay tax on the amounts received by them. There are few private-sector studies on the effectiveness of flow-through shares, which is surprising, given their longevity, the significant role they have played in one of our very important economic sectors and the fact that they've survived so long without public criticism or scandal.
However, a Department of Finance evaluation report dated October, 1994, found that flow-through shares, while not guaranteeing successful outcomes, did generate significant incremental spending on mining and petroleum exploration and benefited the economies of several provinces, as well as non-taxpaying junior exploration companies.
Innovation is similar to the resource sector in that both require the successful convergence of discovery, entrepreneurship and risk capital, with adequate capital being scarce given the risk of commercializing new discoveries. As with the resource sector, and as with areas such as Silicon Valley for tech venture capital, centres of risk capital formation will draw innovators, entrepreneurs and investors, which in turn will draw talent and intellectual capital, becoming a self-reinforcing cluster with high-quality jobs.
Flow-through shares can open the door to the private-sector funding needed to commercialize important discoveries in life sciences, clean technology and information technology, and government can target how flow-through funding is spent by defining the qualifying expenditures. Because the investment decision is made by the investor, who is still at risk for one-half of his cash outlay, there is a natural discipline built into the investment decision process, making it easier for the government to administer and removing government from picking winners.
Canada has world-class capital markets, successful entrepreneurs and world-class scientific and technology research and skills. Adding adequate risk capital formation to this mix will generate new jobs that will feed the development of an educated and skilled work force, creating the opportunity to participate in the leadership of the innovation economy.