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February 11, 2015

Does Canada need to adopt patent box IP treatment?

Earlier this year the Canadian Manufacturers and Exporters (CME) asked the Federal government, via its submission for the 2015 Federal Budget, to adopt patent box treatment for the income derived from intellectual property, notably patents. This request is similar to one made by the Canadian Advanced Technology Alliance (CATA) in 2013.

Such requests stand as responses to both domestic industry dynamics as well as an evolving international rule book that sees 11 EU countries as well as the United States offer “patent box” tax treatment for profits earned on innovation.  The CME noted in its request that “patent boxes … generally target the commercial or manufacturing activities that follow development rather than R&D activities themselves. A patent box tax incentive would support companies at a critical point in their product development and financing cycle and encourage them to commercialize new products in Canada.”

While we’re certainly in favour of appropriately expanding the range of supports available to Canadian firms, doing so should be based on either evidence of a positive net impact or atleast a strong push in that direction. Unfortunately on the patent box, the research, although relatively nascent, doesn’t seem to support it.  A recent report from the European Commission notes that “patent boxes seem more likely to relocate corporate income than to stimulate innovation.”

To explain what this risk means, let’s assume OpenText has its headquarters in Waterloo but significant R&D activity in India. The company takes a patent created in in India, files it in Canada, and thus profits that flow from it are provided a tax reduction. Measuring the benefit to the Canadian economy is quite difficult given the initial employment is in India and the margin increase resulting from the tax incentive is distributed globally.

Other critiques of the Patent Box model includes OECD research that highlights similar propensity to benefit multinationals rather than strictly domestic SMEs. The European Commission also notes that “the few studies on patent boxes do not provide evidence that firms become more innovative.”

This dearth of evidence shouldn’t be surprising. As it stands, R&D activities are heavily subsidized, especially in Canada through the richest tax incentive program of its kind. A patent box would create a significant tax cut for the follow-on commercialization activities. But is that what’s standing in the way of more innovation?  If it were, then in theory, it would point to an issue with our current system of taxation. Yet as it stands our blended small business rate is amongst the most competitive in the world, as is the general corporate tax rate (see figure below). I have a hard time seeing our tax rates as being the driver of an innovation problem.

Taxrates

As other jurisdictions move to cut rates on specific types of income, there’s certainly need to revisit our system. Yet in so doing we need to take account that “patent box” type schemes privilege certain sectors over others, and as noted by the above mention of profit transferring, carry significant costs related to public revenues and the privileging of large firms over small ones.

In late 2013 Warren and I first tackled the topic and then wrote that this type of initiative “ fails to address the most widely recognized barriers to commercialization in Canada. Preferential tax treatment itself will do little to ameliorate the funding environment for start-up companies and SMEs, nor will it help firms navigate the “valley of death” that fells a significant share of innovative firms. This is because small firms are often unprofitable, and thus pay no taxes, for several years. As a result, the patent box provides preferential treatment to large established firms while ignoring the needs of smaller innovators.”

All this brings us to a fundamental question – what’s in the way of more competitive/growing Canadian firms? Is it tax rates? The data doesn’t seem to support this. It is incentives for R&D? Again the data doesn’t seem to support this. Is it other forms of fiscal support – such as accelerated capital allowances or direct grants?  This is definitely worthy of more investigation. As are questions regarding the availability of funding and the barriers, perceived and real, facing firms as they consider investment decisions. As what matters most is productivity and if firms aren’t willing to make investments to boost productivity then we’re unlikely to see sustainably competitive firms, regardless of how long we’re willing to go on tax rates.

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