The Impact of Canadian R&D tax credits on foreign buyers: don’t SR&ED your Valuation!

New_Ventures (1 of 2)

Every transaction involving a Canadian technology company and a foreign buyer will include a negotiation on the treatment of Strategic Research and Experimental Development  tax credits (“SR&ED”), both for evaluating the historical P&L, and forecasting revenue and earnings.

Having worked on cross-border deals with Canada for the last 20 years, I’m convinced that tax avoidance is considered the most noble pursuit for a business, ranking ahead of actual profitability and growth.  Complex holding company structures, IP  domiciled in Barbados to take advantage of a 2% tax treaty, the Québec shuffle (can you even do that any more?) and the hybrid, multi-stage stock and asset sale are just some of the tax structures available to sellers.  Most of these structures result in tax deferral, not savings, and some even create a higher tax burden that may (or may not) be offset by gains during the deferral period.  Often this becomes a tale of tax wagging the dog of the deal.

Just so that we are clear on my perspective, I like a clean transaction that can be closed quickly. Nothing good happens between term sheet and closing, especially in a frothy market and an unstable political situation. A well-run process can bump the valuation up by 10%, 20%, 30% or more, whereas a complex tax strategy that adds two or three months to the closing can bring the valuation down to zero. This is not the message that a tax firm billing tens of thousands a month wants to hear, but it is the hard truth.  We always have to balance tax optimization against execution risk.

At a high level, here is how the tax credits (or refunds) work. Canadian companies that are small, and majority-owned by Canadian owners, can apply for federal and provincial tax credits based on the actual money they’re spending on experimental research and development. Work for hire, for example, does not qualify because that work is not experimental. On the other hand, trying to develop a new cloud widget that may or may not be commercially viable, may qualify for the R&D tax credit.

There is a cottage industry of consultants who work with companies to quantify what is appropriate in an application for the refund, and to actually complete the application in exchange for a percentage of the dollars garnered back from the government. The available federal R&D tax credit is 35% of the qualifying spend.  In British Columbia where I’ve done most of my recent work there is also a provincial tax credit available equal to 10% of the actual R&D spend. For example, if a privately held Canadian technology company spends $2 million on experimental research and development, they might qualify for up to $700,000 in tax refunds from the federal government and $200,000 from the BC provincial government, for a total of $900,000.

There are two important things to keep in mind about how this works. The first is that companies generally account for this as operating income. This is not a tax credit that offsets future tax liability, this is money that comes into the company in the form of cash, and is generally put above the line where it becomes a component of revenue.. The second critical thing to remember about these tax credits is that they are designed to help Canadian owned companies invest in R&D, and as soon as the company is owned by a foreign owner, the math and the mechanics change.

Let’s look at the impact on a foreign buyer.

The Canadian target is reporting $3 million in EBITDA.  The foreign buyer offers 10x EBITDA, or $30 million. On closer review they note that EBITDA is increased by a $900,000 tax refund based on $2 million in experimental R&D.  Assuming that they will lose the tax refund as a foreign owner, they revise EBITDA to $2.1 million, and suddenly their offer is $21 rather than 30 million.

In fact they will not lose the tax benefit completely.  The federal rate will go from 35% to 15%. The provincial rate will stay the same. But rather than a refund, it will become a tax credit. They won’t get cash back from the government, but they will get a tax credit against future taxes.

The $900,000 that was added to the EBITDA will now be reduced to approximately $500,000 in tax credits. This still has value to a buyer and it still has a positive impact on EBITDA, but the value is obviously much lower.

How do we avoid these problems?

  1. Call out the SR&ED tax refunds (or credits) clearly in the financial statements, and educate the buyer on how that benefit will change under foreign ownership.
  2. Negotiate in dollars rather than multiples.  Multiples will be part of the conversation, but you don’t want to agree to a multiple, only to have EBITDA adjusted out from under you.
  3. Seek qualified local tax counsel.  
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