THE IMPACT OF CANADIAN R&D TAX CREDITS ON FOREIGN BUYERS: DON’T SR&ED YOUR VALUATION!
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 anymore?), and the hybrid, multi-stage stock and asset sales 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. Oftentimes, this becomes a “tax tail wagging the dog” situation.
Just so that we’re 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 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’s 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 might 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 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 in Canada, 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.
Hypothetically, 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 they will lose the tax refund as a foreign owner, they revise EBITDA to $2.1 million, and suddenly their offer is $21 million rather than $30 million.
But 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?
- Clearly call out the SR&ED tax refunds (or credits) in the financial statements and educate the buyer on how that benefit will change under foreign ownership.
- 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.
- Seek qualified local tax counsel.