Finn Poschmann is president and CEO of the Atlantic Provinces Economic Council.
On St. Patrick's Day, Quebec Finance Minister Carlos Leitao's budget for 2016-17 landed heavily – a 50-page speech and summary, a 570-page economic plan and 228 pages of supplementary information.
With all that space, there was room for a major innovation in Canadian tax policy: a reduced tax rate for business income derived from innovation, the first of its kind in Canada.
Quebec calls it the "deduction for a qualifying innovative manufacturing corporation" or DIC, but let's go with the common nickname, "patent box." It allows income from innovation to be taxed at 4 per cent instead of the 11.8 per cent that would generally apply.
The patent box mechanism is simple. A Quebec manufacturing and processing firm calculates the share of its income derived from patents embodied in the products it sells. The share is determined by how much the firm spent in Quebec on research and development, including labour, in developing or acquiring the patents. In the case of an acquired patent, the underlying R&D must have been done in Quebec.
A qualifying patent does not have to have been granted, but applied for in any competent jurisdiction. If not granted within a few years, the deduction is clawed back.
Other measures restrain the size of the patent box, making the qualifying income easier to calculate. The underlying activity must qualify for the R&D tax credit, and a provision requires that the business has more than $15-million in paid-up capital. That means that small businesses, already at the 4-per-cent tax rate, can't use the patent box to take their rate to zero. And the measure affects only income derived from patents applied for after March 17, 2016.
Quebec's patent box offsets some of the obvious shortcomings in the federal Scientific Research and Experimental Development (SRED) credit. The SRED excludes capital spending, favouring labour and is more favourable to small businesses than large – which means it does less than it might for innovation and productivity.
So while R&D policy claims to support the innovation that drives productivity and income growth, the SRED credit and R&D deductions favour inputs, ignoring outputs. For the SRED, it is the spending that counts, and it doesn't have to be connected to any useful outcomes. And it has created a monstrous, lucrative business in tracking spending and applying for tax credits.
The rationale for a Canadian patent box, laid out in work I did with Scott Wilkie and Nick Pantaleo, takes the opposite approach. The patent box helps only you if you've generated taxable income by way of innovative activity.
There's also the international tax system, which favours businesses that locate operating companies in low-tax jurisdictions, such as Ireland. Typically, tech companies will locate ownership of their intellectual property there, and accrue income and royalties through their local operating company, so less income and tax liability is recognized in, say, Canada.
A number of mostly European countries have created patent boxes. The existence of a Canadian equivalent would reduce some of the incentive for domestic firms to move their activities offshore. Yet Canada shouldn't pursue such a measure simply to hang on to some taxable income. The economic rationale for the patent box is that it encourages businesses to co-locate their R&D activity and their manufacturing activity and spend less time arbitraging tax-deductible costs.
We get a productivity boost when manufacturing and R&D activity are physically located near each other. We know that productivity increases when density increases – not only do smart people do more business with each other, they bump into each other on the street and share ideas. More growth, innovation and income ensue.
Quebec's measure seems a little parochial, in that it applies only to manufacturing and processing firms and requires the R&D activity and the manufacturing and processing to be done in Quebec. But it certainly gets at the benefits of co-location. Should other provinces follow? Many have quietly indicated interest. Competing tax preferences among small provinces is not appealing, and it would take heavy lifting to implement, given their corporate income-tax collection agreements with Canada Revenue Agency.
Competing provincial plans could involve a lot of unproductive compliance activity. Better would be a similar proposal, or a commitment to investigate one, in Tuesday's federal budget, on which smaller provinces, such as those in the Atlantic region, could piggyback if they chose.
Quebec is the first mover, as it so often is. Its plan could be a preview of things to come.