Underlying the current financial crisis, developed economies continue to struggle with the twin challenges of a disruptive global re-ordering and the transition from industrial to knowledge-based economies. Given the huge impact on future jobs and prosperity, policy-makers have recognized the need to capture a share or, even better, a leadership position in what is called the "innovation economy." The Canadian government in its November 2006 Advantage Canada report stated that to make Canada a world leader for future generations, we have to "turn our ideas into innovations that provide solutions to environmental, health and other important social challenges, and to improve our economic competitiveness," and in its follow-up May 2007 report Mobilizing Science and Technology to Canada's Advantage, endorsed a strategy to commercialize knowledge for wealth creation, obtain the social and economic benefits and attract the most skilled workforce of the future.
The innovation economy refers to the commercialization process through which a discovery is brought to market. It is the place where the key ingredients, being scientific and technological discovery, entrepreneurship and risk capital, successfully converge to bring solutions in such important areas as life sciences, bioagriculture, waste and water management, renewable power and information technology. Access to risk capital is critical to the innovation economy because of the risk associated with commercializing new discoveries.
This paper advocates that Canada should take advantage of its capital markets strength to secure a leadership share of the innovation economy by extending the unique and successful flow-through share program available to resource companies under the Canadian Income Tax Act to qualified innovation expenditures in Canada.
Canada has an innovation deficit
A 2011 report of The Mowat Centre for Policy Innovation entitled Canada's Innovation Underperformance states:
"Canadian firms are regularly outperformed in terms of innovation. This is now conventional wisdom and governments have invested significant funds trying to remedy this failing with little impact."
The 2011 report of the Independent Panel on Federal Support to Research and Development entitled Innovation Canada: A Call to Action, chaired by Tom Jenkins, states the following:
"Studies have repeatedly documented that business innovation in Canada lags behind other highly developed countries. This gap is of vital concern because innovation is the ultimate source of the long-term competitiveness of businesses and the quality of life of Canadians. The ability to conjure up new products and services, to find novel uses for existing products and to develop new markets – these fruits of innovation are the tools that will ensure Canada's success in the twenty-first century."
This deficit is despite Canada's many competitive advantages, including a highly educated population, favourable immigration demographics, political and economic stability, access to the US market, a strong entrepreneurial culture and world-class capital markets.
Competition for a share of the new economy is global. In particular, there are significant recent US developments.
The Sarbanes-Oxley (SOX) reforms in the US that followed the bursting of the technology bubble in 2000 significantly increased the cost and regulatory burden of accessing US public capital markets. This sent emerging issuers scouring the world for more favourable listing opportunities. One of the beneficiaries was the Toronto Stock Exchange/TSX Venture Exchange, which capitalized on recognized expertise in resource listings and a lighter, less costly regulatory burden with the same basic investor protection and capital market integrity characteristics to become the world leader in resource listings. At the same time Canada became the centre for public venture capital for the resource sector.
The fallout from the 2008 financial crisis, particularly in relation to lost jobs, has caused the US to re-think the impact of SOX on its capital markets and the broader economy. This is reflected in the following initiatives:
- the establishment of OTCQX International, a stock quotation program that allows the shares of foreign listed companies to trade in the US without subjecting the issuers to US regulation – over 300 non-US issuers have taken advantage of this from early stage to well-known large cap issuers;
- the JOBS Act (Jumpstart Our Business Startups Act), which has eased the rules for IPOs and private capital formation; in particular, "crowdfunding," which allows many investors to invest small amounts through the Internet without regulatory burden;
- NASDAQ has formed the NASDAQ Venture Exchange to exploit the success of the TSX Venture Exchange and the New York Stock Exchange acquired and is rebranding the American Stock Exchange; and
- the Obama administration's Strategy for American Innovation and National Bioeconomy Blueprint, both discussed below.
In its February 2011 Strategy for American Innovation – Securing Our Economic Growth and Prosperity, representing a joint effort of the National Economic Council, Council of Economic Advisors and Office of Science and Technology Policy, the Obama administration laid out its innovation agenda based on the following principles:
- America's future economic growth and international competitiveness depend on its capacity to innovate;
- innovation-based economic growth will bring greater income, higher quality jobs, and improved health and equality of life;
- the essential role of innovation in past and future prosperity, the central importance of the private sector as the engine of innovation and the support role of government; and
- innovation relies heavily on a strong private sector culture of entrepreneurship and government facilitation where public support is needed to address "market failures" – the two principal failures being the funding of basic scientific research and commercialization, both areas where entrepreneurs struggle to raise funding.
In its April 2012 National Bioeconomy Blueprint, the Obama administration reiterated the innovation agenda for the bioeconomy with a strategy to promote sustainable growth and the creation of quality jobs by increasing commercialization of promising new technologies and products emerging from research laboratories. In particular, this Blueprint recognizes the economic importance of entrepreneurship and innovation and the challenges faced in commercializing research (commonly referred to as the valley of death), and promises a multifold strategy to encourage innovation, called The Startup America Initiative, to dramatically increase the success of entrepreneurs in moving their discoveries and ideas to commercialization. Of the five areas highlighted for action, the first is unlocking access to capital, followed by connecting mentors with entrepreneurs; reducing regulatory barriers, tax relief and other economic incentives for small business.
Access to capital can lead to a cluster
Successful innovation calls on several ingredients, including strong education and training and a culture that supports entrepreneurship. But the greatest challenge for innovators is the difficulty in accessing risk capital. The diagnosis is relatively easy: bringing innovations to market is risky and therefore the capital needed to advance them is high risk capital.
A recognized centre of risk capital formation draws not only financial capability and infrastructure but can be a catalyst for the formation of an industry cluster that is served by that risk capital. The economic benefits of a cluster are self evident.
There are two world-leading clusters that owe their success to a large extent to financial innovations for accessing risk capital:
- Silicon Valley, with the introduction of private venture capital for information technology and telecommunications; and
- the Canadian mining and oil and gas industries with the introduction of public venture capital pioneered by the TSX/TSX Venture Exchange and their predecessors, aided substantially by flow-through shares.
Flow-through shares – a Canadian financial innovation
Flow-through shares for Canadian resource (mining, oil and gas) exploration and development were introduced into the Income Tax Act over 50 years ago. While originally introduced to keep these cyclical industries going in tough times, the program has been a spectacular success. During this period, Canada's capital markets (led by the TSX and the TSX Venture Exchange) became the global leader in resource finance, and leadership in accessing capital led to industry leadership, notably:
- Canada became home to more mining companies than any other country in the world;
- Canadian companies are engaged in more global exploration and development than companies from any other country; and
- Canada now develops and attracts the top resource talent in the world.
A company that issues flow-through shares to investors must spend the proceeds on qualifying expenditures in Canada. 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.
Flow-through shares filled a funding gap for resource exploration by providing venture capital at premium valuations through the public markets. As a result:
- a robust public market, catalyzed by flow-through shares, attracted "hard" equity from investors inside and outside of Canada;
- while expenditures funded by flow-through shares are earmarked for Canada, the "hard" financings could fund global endeavours; and
- the result was global leadership in an important sector.
Flow-through shares are not a typical "tax-shelter," as the investor is at risk for more than 50% of his cash outlay – it is a tax-advantaged, risk investment, which offers the best opportunity for "smart" investing, with investment decisions made by the market. They are only attractive to industries that require significant capital to make expenditures that are not needed to offset current revenues, as revenues are uncertain and remote.
Have flow-through shares been a success?
There are few private sector studies on the effectiveness of flow-through shares, which is surprising given its longevity, the significant role it has played in one of our very important economic sectors and the fact that it has survived so long without public criticism or scandal.
There are two federal government reports, a Department of Finance Evaluation Report dated October 1994 and a Natural Resource Canada report in November 2007. It is worth noting the following quotes taken directly from the Executive Summary of the Department of Finance report:
"Evaluation findings are mixed in respect of the effectiveness of flow-through shares in achieving its objectives. On the positive side, flow-through shares:
- raised equity-based financing primarily for mining and petroleum exploration, especially gold exploration;
- accounted for a large share of all funding for mining exploration (averaging 60% for the period 1987 to 1991);
- resulted in significant incremental spending on mining and petroleum exploration and significant incremental exploration drilling activity;
- benefited the economies of Alberta, British Columbia, Ontario and Quebec; and
- benefited non-taxpaying junior exploration companies.
Offsetting this, the report found "little evidence that the incremental exploration spending and drilling activity resulted in incremental discoveries attributable to this financing mechanism."
"On one hand, flow-through shares resulted in substantially more incremental exploration spending than federal tax revenues foregone between 1987 and 1991: each dollar of federal tax expenditure resulted in incremental expenditures of, on average, $3 in the case of mining exploration and $2 in the case of petroleum exploration. Economic theory indicates that flow-through shares are the most cost-effective equity-based financing option for non-taxpaying exploration companies. Furthermore, empirical evidence reveals that they provided a significant incentive for exploration by non-taxpaying firms. On the other hand, flow-through shares performed poorly as equity investments in mining and petroleum."
"Regardless, flow-through shares were a cost-effective financing mechanism for non-taxpaying companies throughout the period and as effective as any possible equity-based financing alternative designed to achieve the same objectives.
The November 2007 National Resources Canada report found that $1 of tax expenditure under the program resulted in $2.60 of new (incremental) exploration spending, and "the direct costs to the government are modest."
According to these studies, flow-through shares generated significant incremental spending on mining and petroleum exploration and benefited the economies of several provinces as well as non-tax paying junior exploration companies. So while flow-through shares did not guarantee operating results, they did stimulate desired economic activity. However, as the financing strength grew, the overall economic benefits followed. This was recognized by the Coalition for Action on Innovation in Canada co-chaired by former Liberal Finance Minister John Manley and Paul Lucas in their October 2010 Action Plan for Prosperity which states: "By any measure, the program has been a success; it has helped make Canada a global leader in resource financing," and recommended extending flow-through shares to the innovation sector as one way of using fiscal stimulus to drive innovation. 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," calling it a unique made in Canada solution—a resounding success.
Criticisms of flow-through shares
Set out below are some of the criticisms of extending flow-through shares to the innovation economy and responses to these criticisms:
1. The cost to the government treasury could be unlimited:
- while theoretically accurate, the realistic cost in every scenario is manageable and limited;
- there is a limited pool of potential investors in Canada who will invest in tax assisted risk investments;
- the tax credit to the investor is at least partially offset by tax paid by the recipients of the expenditures (relevant when most of the expenditures are incremental);
- in addition, as the issuing company has renounced its expenditures, it will accelerate its own tax once revenues commence; and the investors have a zero tax cost base in their flow-through shares, thereby increasing the taxable capital gain on subsequent sale of their shares;
- the foregoing does not take into account the "spin-off" economic benefit arising from incremental spending to desired targets in Canada (note that the Department of Finance report finds that in the resource sector flow-through shares resulted in significant incremental spending);
- historically flow-through share volume has fluctuated with the resource markets, so usage reduces when market perception of the sector's prospects is low and vice-versa; consequently the cost to government tends to move with economic cycles; and
- because the investors are at risk, the program requires much less government administration.
2. Because the tax credit goes to the investor rather than the target, policy effectiveness is compromised and benefits accrue disproportionately to investors, promoters, the financial industry, lawyers etc.:
- in the resource sector where this program is well developed, costs are in line with straight equity and, when combined with valuation, are superior to private venture capital in other sectors;
- the investor gets the tax credit only by funding risk capital to a company, which must use the funds for qualified expenditures in Canada – a "win-win-win";
- in the flagship SR&ED program where accepted research expenditures trigger a payment directly to the target, a cottage industry has developed that helps targets make SR&ED claims for a contingent "success fee" – this has resulted in financing fees reported at up to 30%, whereas the history in the resource sector for flow through shares is fees in the 10% range; and
- another very important feature of flow through shares is that the investor makes the investment decision, relieving the government of the need to assess the quality and value of expenditures and pick "winners."
3. Flow-through shares are just another tax shelter, most of which have been discredited and shut down:
- the discredited tax shelters were discredited because they were designed to eliminate investor risk through a tax credit alone, and therefore had no underlying economic benefit;
- flow-through shares, on the other hand, require investors to make risky investments to which more than one-half of their investment remains at risk to the enterprise which must spend the investment proceeds (more than double the tax credit) in Canada as desired by the government through the definition of qualified expenditures; and
- flow-through shares have been successfully in place for over 50 years.
4. It is bad tax policy to use the tax system to encourage an industrial strategy or to favour sectors, and it would be preferable to eliminate special tax credits in favour of lower rates overall:
- most traditional sectors do not need and generally would not use flow-through shares;
- sectors that would use them are those where expenditures are required up front and corresponding revenues are uncertain and remote;
- it is this risk profile in the funding of bioeconomy discovery and commercialization the Obama administration identifies as "market failures"; and
- lower tax rates only assist taxable companies and have no value to the many pre revenue, early stage companies driving much of the innovation economy.
5. Flow-through shares will unrealistically bid up the values of early-state technology companies, will create many small, orphaned public companies that have gone public too soon and will entice retail investors into inappropriate, high-risk investments:
- Canada's resource sector created a global following in public venture capital with robust public markets;
- access to this capital spawned an entrepreneurial culture in resources that can extend to other deserving sectors;
- many flow-through investors invest through professionally managed limited partnerships which pool investors to invest in a diversified portfolio of flow through issuers; and
- flow-through shares will enhance the prospects for traditional venture capital investing (in retreat in Canada) through catalyzing a cluster and by offering the prospects for public market "exits."
6. Income trusts were also flow through vehicles.
- Income trusts could only flow out profits, eliminating the capital needed for investment in the future. Flow through shares are the exact opposite – they only flow through expenses which are investments in the future.
Conclusion and recommendation
Technological innovation is now a significant driver of economic growth, according to President Obama's National Bioeconomy Blueprint of April 2012. In Canada, we are witnessing the decline of the traditional industrial economy so we are more reliant on resources. Innovation offers another leg.
Like the resource sector, innovation is about discovery and commercialization, reliant on large amounts of high-risk, venture capital where revenues are uncertain and remote. Canada has world class capital markets (led by the TSX and the TSX Venture Exchange, with global leadership in the resource sector) and world class scientific research. As with the resource sector (and as with areas like Silicon Valley for tech venture capital), places where risk capital can be accessed will draw innovators, entrepreneurs and investors which, in turn, will draw talent and intellectual capital, becoming a self-reinforcing cluster resulting in high-quality jobs.
Flow-through shares will incentivize risk capital to those areas the government determines by defining qualifying investments; for example, qualified expenditures could be targeted towards jobs.
The competition for a share of the innovation economy is global and stiff, with jobs and prosperity at stake. Canada is competitive in most respects, particularly with respect to our human capital, but risk financing is important enough to offset that advantage. Many governments are engaged in incentive programs to encourage local innovation activity. Flow through shares, unique to Canada, are superior to other financial incentive programs and have the following advantages:
- flow-through shares represent government facilitation of private risk capital formation, which is far more valuable than direct government funding;
- flow-through shares have years of demonstrated success creating industry leadership without abuse or discredit;
- flow-through shares helped Canada introduce public venture capital which is a legitimate alternative to private venture capital;
- in addition to the benefits of an innovation cluster, flow-through shares will enhance Canada's stature as a leading financial centre;
- flow-through shares, according to Department of Finance and National Resources Canada reports, generate significant incremental spending that benefits local economies; and
- flow-through shares catalyze other private sector investment.
We cannot take the chance that our innovation initiatives are compromised by uncompetitive risk capital formation. Our future prosperity is tied to success in the innovation economy and entrepreneurial endeavours. Flow-through shares, a unique Canadian success, can provide the basis for private sector financial support for commercialization activity. They are not costly according to the government's own reports. The innovation economy is about taking and funding risk; extending flow-through shares to qualified expenditures in the innovation economy is a small risk for the government to take.
Norton Rose Group
Norton Rose Group is a leading international legal practice. We offer a full business law service to many of the world's pre-eminent financial institutions and corporations from offices in Europe, Asia, Australia, Canada, Africa, the Middle East, Latin America and Central Asia.
Knowing how our clients' businesses work and understanding what drives their industries is fundamental to us. Our lawyers share industry knowledge and sector expertise across borders, enabling us to support our clients anywhere in the world. We are strong in financial institutions; energy; infrastructure, mining and commodities; transport; technology and innovation; and pharmaceuticals and life sciences.
We have more than 2900 lawyers operating from 43 offices in Abu Dhabi, Almaty, Amsterdam, Athens, Bahrain, Bangkok, Beijing, Bogotá, Brisbane, Brussels, Calgary, Canberra, Cape Town, Caracas, Casablanca, Dubai, Durban, Frankfurt, Hamburg, Hong Kong, Johannesburg, London, Melbourne, Milan, Montréal, Moscow, Munich, Ottawa, Paris, Perth, Piraeus, Prague, Québec, Rome, Shanghai, Singapore, Sydney, Tokyo, Toronto and Warsaw; and from associate offices in Dar es Salaam, Ho Chi Minh City and Jakarta.
Norton Rose Group comprises Norton Rose LLP, Norton Rose Australia, Norton Rose Canada LLP, Norton Rose South Africa (incorporated as Deneys Reitz Inc), and their respective affiliates.
On January 1, 2012, Macleod Dixon joined Norton Rose Group adding strength and depth in Canada, Latin America and around the world. For more information please visit nortonrose.com.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.