How the Jenkins report can positively shape the future of Canada’s Life Sciences Industry

On October 17, 2011, the report “Innovation Canada: A Call to Action” was released by the Independent Panel on Federal Support to Research and Development, commonly known as the Jenkins report. For general observations regarding the Jenkins report, please refer to PwC’s November 3, 2011 publication Developments: Narrowing Canada’s innovation gap: PwC’s Observations on the Jenkins report. On the positive side, the recognition that government procurement can play a critical role in stimulating innovation is a welcome message. The report’s specific endorsement of the Small Business Innovation Research (SBIR) program in the United States (U.S.) could represent a significant source of new funding for the Canadian life sciences sector if a similar program is ultimately adopted here. Of course, the significant caveat is that the Canadian version would allow all types of companies to participate. The debate over the inclusion of so-called “majority investor owned” small businesses continues to rage in the U.S. and currently any company where venture capital (VC) investors have collectively more than 49% control is not eligible for SBIR funding.

Also positive is the call for increasing access to risk capital for high-growth innovative firms. As noted in our 2009 and 2011 reports on the Canadian Life Sciences industry (see figure 8 in our report, Inflection Point: Canadian Life Sciences Industry Forecast 2011), there is a strong demand from the industry for incentives to increase risk capital. The significant assumption here is that the life sciences sector is included in the definition of high-growth innovative sectors when this recommendation is implemented. Interestingly, the Jenkins report focused on disbursing additional funds through the Business Development Bank of Canada to solve this problem rather than creating new tax or other incentives to create a better ecosystem for risk taking.

A significant potential negative is the proposal to remove the refundable mechanism for small- and medium-size enterprises (SMEs). Currently, SMEs can receive up to $1,050,000 annually from the federal scientific research and experimental development (SR&ED) program and, when combined with provincial incentives, this has been a significant source of non-dilutive funding for many SMEs, particularly those in life sciences. Since it is no secret that the early stage funding environment in Canada has been bleak for several years, the potential loss of SR&ED refunds could have a severe impact. Some may debate whether the recommendation to redeploy the “savings” from the SR&ED program changes into new incentives to support the growth and profitability of SMEs will provide an equal or greater benefit for the Canadian life sciences sector. Without any details, it is difficult to know. However, clearly there should not be any gap in time between any phase out of SR&ED refunds and the new programs.

Where does Canada’s life sciences industry go from here?

At PwC, we believe the critical next steps for the Canadian life sciences industry with respect to the Jenkins report are to come together with a common voice and clearly articulate how the recommendations could be implemented to maximize the positive impact on the sector.

We need to recognize that it is still early days in terms of helping the federal government understand the potential impact of the Jenkins panel for Canadian life sciences. In our view, it is very likely the government will implement some or all of the Jenkins report recommendations over time likely starting with the 2012 federal budget. Presenting a united front should improve the odds of ending up with positive change. Inherent in this discussion is continuing the dialogue on why further supporting the life sciences industry is important to the long-term health and wealth of Canadians. On this point it is interesting to note many other countries clearly are linking success in life sciences to economic success. For example, since the global economic crisis began in 2008, a number of established and emerging economies have announced significant programs which in whole or in part were designed to increase economic support for the life sciences sector. These include Australia, France, Norway, the United Kingdom and the US as well as China, India, Singapore and Taiwan. Innovation in life sciences cannot occur without investment. Canada should seize the opportunity to utilize our success in weathering the global economic crisis and invest in 21st century sectors such as the life sciences.

To start a consensus building on how the Jenkins recommendations can be favourably implemented for the life sciences sector we offer some “straw man” suggestions for consideration:

• Tax policy can be a much more powerful tool than direct funding
  For example, a $200 million “investment” by the federal government in a flow-through share regime for life sciences would yield far more capital for the industry than $200 million of direct funding. The reason is that in order to provide $200 million of tax relief to flow through investors, these investors must invest $800 million if their average tax rate is 25%. Since federal corporate tax rates (15%) are much lower than top marginal personal tax rates (29%) a flow through share regime that includes profitable corporations in the definition of eligible investors may generate even more capital than one solely focused on individual investors. In fact, this type of a program may be just the edge Canadian life science companies need to increase partnering transactions with large pharma, large biotech and large medtech players. And if the government were willing to provide other incentives for investors such as improved market access or improved intellectual property protection there could be a significant demand-push by corporate Canada to invest that would complement the supply-pull from companies seeking flow through investors. As a reference point, in 2010, PwC estimated that a mature flow-through share mechanism for life sciences would generate nearly $1 billion of economic output in Canada.
• The proposed phase out of the refundable SR&ED tax credit mechanism should be implemented in a way that takes into account the inherent risk of failure in the industry along with long development and approval cycles
  The panel recommended the SR&ED tax credit be targeted at growing and profitable SMEs. It is clear that imposing an annual profits test as a criterion for refund eligibility would exclude virtually all Canadian headquartered life science companies. A more favourable approach would be to consider profitability over say a ten year period and include any deferred revenues existing at the end of year ten to account for licensing or partnering deals that may have occurred but are not yet included in profit. For example, for the first ten years a company would continue to be entitled to receive refundable SR&ED tax credits but if the profitability criteria is not met at the end of 10 years the company would become liable to repay the credits previously received. A further enhancement could include a three year look-back provision. For example, if sufficient income is not generated in year 11 and 12 then year one and two credits are repaid but if sufficient income is generated in year 13 then, not only would the company remain entitled to the year three credits but, there would also be an opportunity to recover some or all of the repayments made in year s 11 and 12.
• The types of organizations eligible to receive funding from an SBIR-type program in Canada should include all VC-backed, publicly listed and other majority-owned companies
  Given the current state of funding within the Canadian life sciences sector and recognizing that there are strong scientific capabilities in both public and private companies, all types of companies should be eligible in order to maximize the potential benefit to the sector and maximize the potential results for the government. From a practical perspective, if companies with VC investors collectively having majority control, subsidiaries of foreign companies and Canadian public companies are excluded there would be relatively few eligible applicants. Accordingly, the criteria to receive the funding should be based on the merits of the attributes within each applicant rather than the identity of the applicant’s investors.

In closing, we believe the Jenkins report can become a catalyst for positive change within the Canadian life sciences sector. However, the implementation of the recommendations must take into account the unique features of the industry in order for this positive change to occur.