Chapter 3. The business environment for SMEs and entrepreneurship in Canada

This chapter assesses the business environment for SMEs and entrepreneurship in Canada. It examines relevant macroeconomic conditions, overall productivity conditions, taxation, product-market regulation, access to finance, the R&D system, human resources, the labour market, and foreign direct investment. The chapter points to generally favourable business environment conditions. The macroeconomic framework is solid, the labour market is flexible, business regulations are light, and taxation is friendly to business in general and SMEs in particular. On the other hand, Canada’s innovation and R&D system is relatively weighted to higher education and basic research, adult literacy and numeracy skills are below the OECD average and inward foreign direct investment in knowledge-intensive sectors is limited. The banking system is healthy, but SME lending decreased in relation to total bank business lending over the period 2007-14.

Macroeconomic conditions

Canada offers relatively favourable macroeconomic conditions for the development of SMEs and entrepreneurship, although there have been important fluctuations on some key measures associated with the global economic crisis of 2008/09 and its aftermath (Figure 3.1). Canada is one of the Organisation for Economic Co-operation and Development (OECD) countries that better weathered the global economic crisis, reaching gross domestic product (GDP) levels above those of the pre-crisis period as early as 2010. In the aftermath of the crisis, growth was supported by commodity exports, which had responded to a commodity price boom extending until mid-2014. Since then, following a fall in the oil price, Canadian GDP growth is projected to drop to less than 2% on a year-to-year basis and is projected to drop below the OECD average for the first time since 2008.

Commodity-driven growth came with a redistribution of wealth within Canada, with resource-rich provinces such as Alberta and Saskatchewan forging ahead of others such as Ontario and Quebec. However, more recently, the economy of resource-rich provinces has started to suffer. In Alberta, drilling activity has been severely curtailed and the provincial unemployment rate has increased to above the national average, with the overall decrease in spending on goods and services impacting other sectors of the economy.

The fall in the global oil price and the depreciation of the Canadian dollar vis-à-vis the United States dollar should in principle provide a boost to non-commodity exports, although a recent analysis by Statistics Canada shows that Canadian manufacturers had partially adjusted to a stronger Canadian dollar vis-à-vis the United States dollar by increasing the share of exports bound to destinations other than the United States (e.g. China and the European Union) and by increasing the share of Canadian consumption over foreign consumption (Carrière, 2014). Nonetheless, in 2012 non-commodity exports had not yet recovered to the pre-crisis levels, thus contributing to a deterioration of the national current account balance.1

In line with other major OECD economies, Canadian monetary policy has been highly accommodating, with the Central Bank keeping the policy interest rate at historic lows (0.5% in July 2015) to encourage consumer demand and business investment. This monetary policy stance is aimed at returning inflation to the middle of the Bank of Canada’s 1-3% target band. Unlike the major central banks (i.e. the Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan), the Bank of Canada has not had to undertake quantitative easing (QE), i.e. increased money creation to purchase assets, primarily government bonds. The Bank of Canada’s Monetary Policy Report of January 2016 shows that inflation has been near the bottom of its target band and that the risks to the projected inflation path are roughly balanced due to the interplay of both upside risks (e.g. the depreciation of the Canadian dollar) and downward risks (e.g. the slump in the global oil price).

Productivity and competitiveness

In the period 2005-14 Canadian labour productivity increased only 5.5%, whereas United States labour productivity rose nearly 9%. At the same time, the Canadian compensation rate and unit labour cost increased markedly by 21.5% and 18%, compared to 19% and 12.5% in the United States (Figure 3.2). The relatively strong rise in unit labour costs has provided a relatively difficult context for Canadian SME competitiveness. While most of the difference in the rise of the unit labour cost is the result of the long-run appreciation of the Canadian dollar, the rest reflects slower labour productivity growth in Canada (OECD, 2014a).

Growth in multifactor productivity (MFP), a concept which is used to capture technological progress and the efficiency of production, has also been moderate in Canada, in particular compared to the United States over the period 2001-13 (Figure 3.3). This evidence points to a shortfall in innovation and technology adoption by Canadian businesses that could affect Canadian SMEs through the quality of the domestic supply chains they participate in. The difference in MFP growth between Canada and the United States is not the consequence of the different sector composition of the two economies. Gaps in MFP between the two countries exist across most sectors and are particularly wide in sectors which in Canada are protected from competition (e.g. utilities, professional and technical services, and high-tech manufacturing) (OECD, 2012a). Another strong determinant of intra-sector productivity gaps appears to be lower per-worker investments in ICT in Canada than in the United States (Rao et al., 2008), while low business R&D intensity in Canada is also likely to drag on MFP growth rates (OECD 2012a; Jaumotte and Pain, 2005).

Taxation affecting small business

General provisions

Canada’s tax system is generally favourable to business. Its total tax burden – i.e. total tax revenues in relation to GDP – was 30.5% of GDP in 2013, compared with an OECD un-weighted average of 34.2% (Figure 3.4). Compared with the OECD average, Canada raises a greater share of its fiscal revenues from income taxes (the personal income tax and the corporate income tax) and a smaller share from social security contributions and the taxation of goods and services (Table 3.1). The total tax burden in Canada fell by more than four percentage points over the period 2000-13 (Figure 3.5). This is partly the consequence of a series of corporate income tax and goods and service tax reductions introduced during the last 10-15 years by the federal and provincial/territorial governments and partly the result of Canada’s sustained growth in this period.

Table 3.1. Tax structure of Canada, 2013
Percentage contribution to total fiscal revenues by tax source
	CAD billions	Canada (%)	OECD unweighted average (%)
Taxes on income, profits and capital gains	277.6	47.5	33.7
Individuals	213.6	36.6	24.8
Corporate	56.7	9.7	8.5
Unallocable	7.3	1.2	0.8
Social security contributions	92.3	15.8	26.1
Taxes on payroll and workforce	12.3	2.1	1.1
Taxes on property	60.6	10.4	5.6
Taxes on goods and services	141.1	24.2	32.7
Other	0.3	0	0.6
Total	584.2	100	100
Source: OECD based on OECD Tax Database.
https://doi.org/10.1787/888933554354

Personal income taxation

The personal income tax is the main source of taxation from the self-employed and unincorporated businesses, which are not subject to corporate taxation on profits. Canadian average income tax rates for singles and two-earner families are in line with the OECD average, while the rate for one-earner families is lower in Canada than in the rest of the OECD. Personal income tax revenues in relation to GDP (i.e. personal income tax burden) have declined in the last 15 years but are still above the OECD average (11.2% vs. 8.9% in 2013). About 60% of these revenues are raised at the federal level, with the remaining 40% levied at the provincial level.

Corporate taxation

Canada’s federal corporate income tax stood at 15% in 2016. In addition, each province and territory sets its own general corporate tax rate, which ranged from 11% in British Columbia to 16% in Nova Scotia and Prince Edward Island in 2016, with a weighted average of 11.8%. When federal and provincial rates are combined, Canada’s average corporate tax rate is 26.8%. This is above the OECD un-weighted average of 25% in 2015 but lower than the average of other G7 countries at 31.8% (Figure 3.6 Panel A). The corporate tax burden (i.e. corporate tax revenues in relation to GDP) was roughly the same in Canada as the OECD un-weighted average in 2013 (3% vs. 2.9%).

Canada’s combined central and sub-central corporate income tax rate declined significantly between 2000 and 2015, from more than 40% to its current level of 26.8% (Figure 3.6, Panel B). This reflects reductions in the federal corporate tax rate over the past 15 years, from some 29% in 2000 to 15% in 2012, with the intention to support investment and job creation.

Taxation of goods and services

The taxation of goods and services also falls within the remit of both federal and provincial governments in Canada. At the federal level, the Goods and Services Tax (GST) is levied at a rate of 5%. The federal government has lowered the GST rate twice in the last ten years, from 7% to 6% in 2006 and from 6% to 5% in 2008, in contrast to the trend in most other OECD countries (OECD, 2014b).2

Five provinces have harmonised their provincial sales tax with the federal GST to create the Harmonized Sales Tax (HST) administered by the federal government. The HST includes the 5% federal GST, as well as a provincial component (ranging from 8-10%) that is set by each of the harmonised provinces. The province of Quebec imposes and administers its own VAT, the Quebec Sales Tax (QST), at 9.975%, and the QST base is being harmonised with the GST base on a going forward basis. Other provinces, with the exception of Alberta, impose and levy retail sales taxes.

The average, weighted, combined federal and provincial VAT/sales tax rate in Canada is 11.8%, which is well below the OECD un-weighted average GST/VAT standard rate of 19.1% in 2014 (OECD, 2014b).

Labour taxation

The tax wedge on labour – i.e. the difference between total wage costs (including social security contributions) and the salary (net of family transfer payments) – is lower in Canada than in most other OECD countries. This reflects lower social security contributions combined with payroll taxes, which make up 18% of Canadian tax revenues compared with the OECD unweighted average of 27%. Low labour taxation is expected to foster job creation especially among low-skilled workers and second-earners, whose labour demand and supply is more elastic than that of skilled workers.

Tax compliance

Canada’s tax administration is light in comparative terms (Table 3.2). In the 2016 edition of the World Bank Doing Business Survey, Canada ranked 9th worldwide in the ease of paying taxes, with only one OECD country (Ireland, 6th) doing better. There are 8 tax-related payments per year in Canada for the representative business, compared with the OECD and G7 average (excluding Canada) of 11, while it takes 131 hours a year for an incorporated business to deal with tax forms (corporate income tax, VAT and labour taxes), compared with an OECD average of 181 hours and a G7 average (without Canada) of 207 hours.

Table 3.2. The ease of paying taxes in Canada
Number and hours
	Canada	OECD	G7 (without Canada)
Tax payments (number)	8	11	11
Time to prepare and pay taxes (hours)	131	181	207
Source: OECD based on World Bank Doing Business database
https://doi.org/10.1787/888933554373

A significant level of harmonisation between federal and provincial taxation has helped make the tax system easier to navigate for businesses. For example, most provinces adhere to the Tax Collection Agreement with the federal government, by which a common federally-defined tax base for personal income tax and corporate income tax is defined (exceptions are Quebec for the personal income tax and Alberta and Quebec for the corporate income tax). Significant convergence has occurred among provinces in the corporate income tax rate, with the four largest provinces all applying a rate between 11-12%, and, as seen earlier, five provinces have harmonised their sales tax with the federal GST to create the HST.

Special tax provisions for SMEs

Besides being affected by the general tax provisions discussed above, small businesses in Canada benefit from special tax provisions which are targeted to or are particularly relevant to them.

The small business tax rate

A Small Business Deduction applies to the first CAD 500 000 of active business income of Canadian-Controlled Private Corporations (CCPC), an increase from CAD 400 000 in 2007.3 This deduction reduces the corporate income tax rate from the general rate of 15% to the small business tax rate of 11% in 2015. Following an announcement in the May 2015 Budget, the small business tax rate was legislated to be reduced by one-half percentage point per year starting in 2016, to reach 9% by 2019. However, in its first Budget (2016), the newly elected federal government deferred any further reductions beyond the one-half percentage point reduction in 2016. To ensure that the small business deduction is targeted at SMEs, this concession starts being phased out when corporate taxable capital reaches CAD 10 million and is eliminated beyond CAD 15 million. The measure had an estimated cost of CAD 3.1 billion in 2014 and CAD 3.2 billion in 2015, which is projected to increase to CAD 3.6 billion in 2016 (Department of Finance Canada, 2016).

Provinces also have their own small business tax rates and small business limits (i.e. the income and capital thresholds below which small business tax rates apply).4 In 2016 the weighted average small business tax rate at the provincial level was 4.2% (as against the weighted general corporate tax rate of 11.7%). Altogether, the total (federal and provincial combined) small business tax rate was 14.7% in 2016. This small business tax rate is very favourable to SMEs from an international perspective. The median value for the OECD and non-OECD G20 economies which had small business corporate tax rates was 20% in 2015, while the only OECD countries with a lower tax rate on small business income than Canada in 2015 were Hungary, Ireland and Korea (OECD, 2015b).

The objective of the small business tax rate is to provide incorporated privately-owned small businesses with additional after-tax income that can be used for re-investment and expansion. Thus, the policy acts like an annual tax refund which small businesses can spend on capital investment or hiring, although they are not required to do so. As such, a limit of this policy is that it does not send a strong signal to beneficiaries about the behaviour the government intends to promote. Since small businesses are not obliged to reinvest this income in business growth, the associated public expenditures may deliver smaller impacts than targeted programme measures that support specific growth and development activities in SMEs.

A common criticism levelled at special tax regimes for small businesses is that they favour threshold effects by which a disproportionate number of enterprises are found close to the limit beyond which the preferential tax treatment ceases, thus discouraging growth (Chen and Mintz, 2011). However, a recent study shows that for Canada there is not a significant unusual clustering of firms near the business income and capital asset thresholds beyond which the small business rate is phased out, partly because these thresholds are high enough only to affect a few firms (Dachis and Lester, 2015). For example, only 5% of firms eligible for the small business tax rate had a business income between CAD 350 000 and CAD 500 000 in 2009, and only 0.3% had more than CAD 8 million in capital assets. By comparing the current distribution of companies by income and capital assets with an underlying trend distribution, Dachis and Lester (2015) find that the number of “excess firms” clustered near the taxable income threshold (between CAD 425 000 and CAD 500 000) exceeded the trend distribution only by 48 000 firms in 2009, representing 8.5% of firms eligible for the small business tax rate, while only very few “excess firms” were found in the cluster near the capital asset threshold, i.e. with between CAD 8 million and CAD 10 million in capital assets.

On the other hand, there is stronger evidence that the small business tax rate may be used for tax planning purposes especially by wealthy families. For example, Finance Canada finds an increased concentration of small companies at or just below the profit limits for the small business deduction (CAD 200 000 in 2000, CAD 400 000 in 2007 and CAD 500 000 in 2011). This would suggest that small business owners have some flexibility over the timing and form of distributions from their company (Department of Finance, 2013; OECD, 2016a).5 Similarly, Mintz (2015) finds that 60% of the tax benefits stemming from the small business tax rate go to households earning more than CAD 200 000, which would also partly reflect tax planning opportunities. The Federal Budget 2016 introduced measures which intend to counter such tax planning strategies (OECD, 2016a).

An alternative policy to further reductions in the small business tax rate, as originally announced in Budget 2015, would consist in strengthening direct small business support programmes targeted on supporting growth or upgrading of productivity, for example through increased management advice or workforce training. This would reduce the scope for stronger “threshold effects” to emerge in the future. Dachis and Lester (2015) find that in 2000, when the tax advantage from remaining below the business limit was one-third greater than in 2009 (because of a higher general corporate tax rate), the proportion of “extra firms” in the cluster next to the small business limit (CAD 200 000 at that time) was much higher than in 2009 (i.e. 15% of eligible companies in 2000 vs. 8.5% of eligible companies in 2009). Furthermore, although direct SME programmes tend to feature higher management costs than tax incentives, public resources can be better targeted to addressing market failures affecting particular groups of SMEs. For example, more resources could be spent on young firms, rather than simply on small firms, better addressing the fact that young firms are more likely than small firms to be faced with market failures in capital markets (Mirrlees et al., 2011).

The lifetime capital gains exemption

The personal income tax system provides an individual with a lifetime tax exemption for capital gains realised on the sale of qualified small business corporation shares. The Lifetime Capital Gains Exemption (LCGE) is intended to bolster investment in small businesses, help small business owners save for their retirement, and facilitate the intergenerational transfer of small businesses. To qualify, small business shares must be from a CCPC of any size, although the overwhelming majority are SMEs. The amount of the LCGE was CAD 813 600 in 2015 and is indexed to inflation annually. The measure cost the federal government CAD 715 million of foregone tax revenues in 2014 and is projected to cost CAD 790 million in 2016.

The measure supports investment and risk-taking in small companies by both owners and external equity investors, encourages entrepreneurs to save for their retirement (often compensating for a pension that is lower than for dependent workers) and eases intergenerational business succession. On the downside, Chen and Mintz (2011) report how the LCGE has sometimes been used for tax avoidance, for example through large public companies which have provided additional benefits to specific shareholders through the creation of CCPCs. In addition, marginal benefits may be rapidly exhausted for external retail investors given the level of the ceiling of the lifetime exemption threshold.

On the whole, the LCGE appears appropriate for small business owners, while for external investors an alternative could be a reduction in the capital gains tax rate for the disposal of shares issued by small businesses, for example in line with a measure available in the United States which offers a 100% reduction in the capital gains tax rate on the disposal of shares of small businesses which become public companies (OECD, 2016a).

Small business capital gains rollover

Through the Small Business Capital Gains Rollover (SBCGR), a taxpayer is allowed to defer the taxation of capital gains realised on the sale of common shares issued by an eligible small business corporation to the extent that the proceeds are reinvested in common shares of another eligible small business corporation. Shares must be issued by a CCPC having under CAD 50 million in assets, less than half of which may be in real estate. The aim of the measure is to overcome the capital lock-in effect of capital gains taxation.

While a welcome measure, the delay within which the new investment needs to occur (120 days) may not provide entrepreneurs and investors with much flexibility in the way they dispose of their capital gains. Chen and Mintz (2011) therefore suggest a self-managed “capital gains deferral account” in which investors and small business owners could place their capital gains without being taxed until the assets are sold for purposes other than general investment. In this proposal, any assets that yield taxable capital gains (e.g. investments in real estate, public corporation securities, etc.) would enable entrepreneurs and other investors to roll over assets on a deferral basis. An alternative option more supportive of small businesses (and less fiscally expensive) would consist in limiting such an account to investments in eligible small business corporations (i.e. CCPCs). This would reduce the pressure to re-invest within the existing 120 days and could be combined with the establishment of preferential capital gains tax rates (once all small business shares are disposed and not reinvested in the small business sector within, for example, one year) linked to the number of investments in eligible companies over the life duration of the “account”, which should be maintained for a minimum number of years.

Changes in the SBCGR along the lines suggested above and a more general reduction in the capital gains tax rates applied to the disposition of non-public small business shares (see above) would be similar in nature, so that one of the two approaches would make the other unnecessary.

Income tax deductions for allowable business investment losses

Capital losses on small business investments can be used to offset ordinary income tax in Canada through what are known as income tax deductions for Allowable Business Investment Losses. In other countries it is more common for capital losses to be eligible to offset tax only on realised capital gains. Under the current rules, 50% (i.e. the allowable portion) of a capital loss incurred from the sale of a share or debt owned by a small business corporation may be deducted against any source of income for that year.6 The measure aims to support start-ups, which are more likely to endure capital losses in the first years of the business life which are not offset by capital gains. In 2014, the fiscal cost to the federal government of this measure was CAD 40 million.

The small business job credit

The Small Business Job Credit (SBJC) was introduced in September 2014 and applies to Employment Insurance (EI) premiums paid by small business corporations in 2015 and 2016. Any CCPC that pays employer EI premiums equal to or less than CAD 15 000 is eligible for the credit.7 The SBJC is expected to save small employers more than CAD 550 million over 2015 and 2016. Almost 90% of all EI premium-paying businesses in Canada will receive the credit, reducing their EI payroll taxes by nearly 15%.

This measure is intended to reduce social security contributions and thereby favour job creation. As noted earlier, however, social security contributions (and labour taxation) are already low in Canada, which might limit the impact of the measure. Therefore, it is suggested that this temporary measure, which is scheduled to expire at the end of 2016, should not be extended.

Product market regulations and the ease of doing business

Product market regulations (i.e. administrative paperwork, licenses and permits, etc.) affect the degree of competition and openness of the economy. The OECD Product Market Regulation Index, which measures state control of the economy and national barriers to entrepreneurship and to trade and investment, shows that Canada performs in line with the OECD (un-weighted) average, which is a small setback compared with 10 years before (2003) when Canada was ahead of the OECD average by a larger margin (Figure 3.7).

A disaggregation of the index (Figure 3.8) brings out that Canada has a more favourable regulatory climate for product market competition than most OECD countries with respect to both the level of “state control of the economy” and “barriers to entrepreneurship”. On the other hand, it does better than only four other OECD countries in “barriers to trade and investment”. This is mainly the result of existing restrictions linked to FDI screening and prior approval requirements (see also last section of this chapter).8

The World Bank Doing Business survey provides further evidence of the strength of Canadian business regulations (Table 3.3). Canada is among the world leaders in the ease of starting a business, as measured by the time and cost it takes to establish a limited company. Canada is also a top performer in other “Doing Business” categories such as the administrative and fiscal burden of the tax system (see previous section), the soundness of the insolvency regime, and the comprehensiveness of credit market information. On the other hand, areas where there is still room for improvement involve receiving an electricity contract and dealing with construction permits, both falling under the responsibility of provincial and municipal governments.

Table 3.3. Canada’s World Bank Doing Business performance, 2015
	Ranking	Distance to frontier (% points)
Starting a Business	3	98.2
Protecting Minority Investors	6	76.7
Getting Credit	7	85.0
Paying Taxes	9	93.0
Resolving Insolvency	16	81.4
Registering Property	42	75.1
Trading Across Borders	44	88.4
Enforcing Contracts	49	65.5
Dealing with Construction Permits	53	73.7
Getting Electricity	105	63.8
Source: World Bank Doing Business survey, www.doingbusiness.org/data/exploreeconomies/canada/.
https://doi.org/10.1787/888933554392

Canada has placed great emphasis on the regulatory simplification agenda in recent years, first through the Paperwork Burden Reduction Initiative (PBRI), which has been in place since 2004 (annual budget of CAD 1 million), and more recently through the Red Tape Reduction Action Plan, launched in 2012, and the Canada-United States Regulatory Cooperation Council, launched in 2011.

One of the main objectives of the PBRI was to measure the cost of regulatory compliance for small businesses. The three surveys carried out between 2005 and 2011 concluded that in this period compliance costs had dropped by 0.3% per year. In particular, in 2011, the average “regulatory bill” was CAD 3 500 per business and CAD 370 per employee, corresponding to 0.29% of business sector revenues. The surveys also emphasised that costs are proportionally higher for small employer firms up to a certain threshold, after which regulatory costs decrease (ISED, 2013a).

The aim of the Red Tape Reduction Action Plan was to reduce administrative burdens and improve the services and predictability of Canadian public administration for small business owners. As part of this Plan, Canada introduced the “one-for-one rule” and “forward regulatory plans”. The first requires regulators whose new or amended regulations increase the administrative cost of doing business to take remedial action by withdrawing an equal amount of administrative burden on business from past regulations. The second is a description of future regulatory changes and proposals that a government department or agency intends to bring forward, the objective being to help entrepreneurs plan for future changes in regulations.

Finally, the goal of the Canada-United States Regulatory Cooperation Council (RCC) is to facilitate closer regulatory co-operation and alignment between Canada and the United States. The RCC was launched in 2011 recognising that regulatory differences and duplicative procedures impose unnecessary costs on citizens and businesses. This led to a Joint Forward Plan in 2014, which established the means of co-operation between United States and Canadian government departments, and to 12 Regulatory Partnership Statements between 16 similarly mandated Canadian and United States government departments and agencies in 2015. The RCC is expected to smooth regulatory differences not only between Canada and the United States, but also across Canadian provinces.

Access to finance

Credit market conditions

Sound underwriting practices and portfolio diversification in Canadian banks together with prudential regulation of the banking sector have helped the Canadian banking system to weather the 2008/09 financial crisis well, with no banks having to be bailed out by the government. Market players in Canada’s small business lending include federally-regulated chartered banks (consisting of six major nationwide banks and smaller banks operating at the national and regional levels), 655 provincially regulated credit unions (Caisses populaires in Quebec) (Credit Union Central of Canada, 2015), crown finance corporations (e.g. Business Development Bank of Canada, Export Development Canada and Farm Credit Canada), leasing companies, and non-bank mortgage lenders (e.g. First National). Chartered banks are the major source of small business lending (55% of financing requests), followed at a distance by credit unions (17%) and government institutions (7%) (ISED, 2013b). Direct government lending, at CAD 6.5 billion in 2014, is high in Canada compared to other OECD countries.

SME loan approval rates are high in Canada (between 88-97%, depending on the SME size class), which compares for example with approval rates in the range of 60-70% in the United Kingdom (OECD, 2015c).9 However, larger SMEs in Canada are much more likely than smaller SMEs to request a loan; only one in five Canadian micro-enterprises (1-4 employees) request a loan, but one in two medium-sized enterprises (100-499 employees) does so (ISED, 2013). ISED’s survey data also show that firms with less than 20 employees have loan approval and authorisation rates 10% lower than SMEs in larger size bands, which might reflect weaker structural conditions in smaller SMEs (Table 3.4).

Table 3.4. Debt request and approval rates by size of business, 2011
Percentage values
	Employees	Request rate	Approval rate	Amount authorised/ requested
All SMEs	1-499	25.5	89.9	94
Size classes	1-4	19.9	88.4	90.4
	5-19	29.9	88.5	88.6
	20-99	36.9	97.1	97.2
	100-499	47.6	97.7	99
Source: ISED (2013), Summary of the Survey on Financing and Growth of Small and Medium Enterprises 2011, www.ic.gc.ca/surveys.
https://doi.org/10.1787/888933554411

As shown in Table 3.5, in nominal terms, SME lending volumes increased from CAD 83 billion to CAD 94 billion in the period 2007-14. Loans to large firms, however, expanded faster, resulting in a decline in the proportion of SME lending in total bank business lending from 17.4% in 2007 to 14.2% in 2014. This placed Canada in the middle of G7 countries on changes in small business lending, behind countries such as France, where the stock of SME loans increased more (+20%) and others such as the United Kingdom (-16%) and the United States (-14%) that experienced negative growth rates (OECD, 2016b; OECD, 2015c).10 Lending volumes are affected by the overall level of confidence of business owners in the economy, which has recently been reported to be low in Canada (BDC, 2016).

Table 3.5. Main debt financing indicators of Canada, 2007-14
	2007	2008	2009	2010	2011	2012	2013	2014
SME business loans (CAD billion)	83.4	83.4	86.4	85.7	90.1	87.8	92.2	93.7
Total business loans (CAD billion)	479.8	533.9	482.3	489.5	514.5	557.4	602.3	658.5
Perc. SME loans of total business loans (%)	17.4	15.6	17.9	17.5	17.5	15.8	15.3	14.2
Government guaranteed loans, SMEs (CAD billion)	1.2	1.3	1.2	1.3	1.3	1.1	1.1	1.5
Direct government loans, SMEs (CAD billion)	4.4	4.1	5.5	4.7	6	5.8	4.6	6.5
Perc. of short-term loans of total small business loans	41.6	..	43.4	36.3	35.1	39	46	55.6
Interest rate, average (%)	7.5	..	6.2	5.8	5.3	5.4	5.6	5.1
Risk premium for small businesses (%)	1.4	..	3.1	3.2	2.3	2.4	2.6	2.1
Perc. of small businnesses required to provide collateral (%)	47.7	..	56.1	66.7	64.8	76	56	66.6
Note: SME loans are outstanding commercial loans under the authorised value of CAD 1 million (it excludes non-employer firms). Small businesses are defined as enterprises with 1-99 employees. Thus, small business loans are loans to these firms.
Source: OECD based on OECD (2016b), Financing SMEs and Entrepreneurs 2016: An OECD Scoreboard, OECD Publishing, Paris.
https://doi.org/10.1787/888933554430

Table 3.5 also shows that loan terms and conditions for Canadian SMEs are on the whole good. However, they are not as good as in other G7 economies (OECD, 2016b). Short-term loans (i.e. loans whose maturity is 12 months or less, lines of credit and credit cards) were more than half of the total authorised small business loans in 2014, which limits the opportunities for Canadian SMEs to use debt finance for investment. The average interest rate applied to SMEs ranged between 6.2% and 5.1% in the period 2009-2014, which is higher than the United States, the United Kingdom and other major European Union economies that share with Canada historically low policy interest rates. The risk premium (i.e. the difference between the interest rate paid by small businesses and the interest rate charged to the most creditworthy borrowers) dropped from 3% in the aftermath of the financial crisis in 2009 and 2010 to 2% in 2014, but this is nonetheless higher than the interest rate spread (i.e. the difference between the average interest rates applied to SMEs and large firms) in United Kingdom and France, respectively 1% and 0.75% (OECD, 2016b).11 Finally, the percentage of collateralised loans is higher in Canada than in other G7 countries – roughly 50-75% compared with 30% in the United Kingdom and 50% in Italy. The need for collateral constrains access to finance for those SMEs that do not have strong tangible assets.

The G20/OECD High-Level Principles on SME Financing (G20/OECD, 2015) highlight the important potential role that can be played by credit guarantees in improving loan volumes and terms for SMEs lacking fixed collateral. Government-guaranteed loans in Canada amounted to only CAD 1.1 billion in 2013 (CAD 1.5 billion in 2014), compared with USD 22.5 billion in the United States, EUR 9 billion in France and EUR 10.8 billion in Italy (OECD 2016b, OECD 2015c). An option to strengthen bank lending in Canada could therefore be to expand federal and/or provincial loan guarantee programmes. Direct government lending (which amounted to CAD 6.5 billion in 2014) could also be further enhanced, although its focus should remain on filling credit market gaps unlikely to be served by commercial banks, such as small business loans for socially disadvantaged entrepreneurs or for innovative projects.

Equity market conditions

The venture capital industry

Canada’s aggregate performance in venture capital is good in international comparative terms; in relation to GDP, the volume of Canada’s venture capital investments is third among OECD countries, behind only Israel and the United States (Figure 3.9). The proportion of seed, start-up and early-stage investment in total venture capital investment is 56% in Canada, higher than in the United States (33%) and the United Kingdom (48%), but lower than in Israel (70%) and Finland (69%). The Canadian venture capital industry also came out of the 2008 global recession well, growing at an average annual rate of nearly 20% in the period 2009-14 (Figure 3.10).

The public sector plays an important role in the Canadian venture capital industry. In 2014, government direct commitments were 15% of the total (i.e. CAD 183 million). However, government-backed sources also included retail funds supported by government tax credits (CAD 400 million, 33%) and funds of funds involving government participation (CAD 250 million, 20.5%). Altogether, government-backed sources represented more than two-thirds of new commitments to the venture capital industry in 2014 (i.e. CAD 833 million). By contrast, there is a relatively limited involvement of large domestic institutional investors such as pension funds, insurance companies, corporations and banks, although the recent Venture Capital Action Plan (VCAP) is partly changing this trend (see Chapter 5 for more details).

In 2014, the deal flow of the Canadian venture capital market was CAD 2.36 billion. This surpassed pre-2008 recession investment levels, but was still between 20-40 times smaller than the annual deal flow in the United States venture capital market. Canadian deal sizes, which averaged CAD 4.53 million in 2014, were also relatively small compared with those in the United States. Moreover, Canadian venture capital is stronger on late-stage financing than on earlier, A-round financing and follow-on deals are more common than new deals, with the former increasing by 33% between 2013 and 2014 and the latter decreasing by 14% over this period (ISED, 2014).

Investments in Canada by US venture capital funds have accounted for a substantial part of the increased fundraising over the last five years. The majority of these investments are in late-stage deals, suggesting that large United States venture capital investors are cherry-picking the successful firms. One potential reason for this is the lack of large funds in Canada capable of large late-stage investments. In turn, this could drive down returns to the typically smaller Canadian funds that have taken on the early-stage risk. Other factors in the Canadian venture capital industry are also at play. Canada has a much smaller domestic market than the United States, making it harder for venture capital-backed growth companies to scale quickly and generate the returns needed by venture capital investors, while Canada’s Initial Public Offering (IPO) market is dwarfed in size by New York. Many Canadian entrepreneurs with promising start-ups have therefore sought and obtained funding from United States investors. While some of these entrepreneurs remain in Canada, others move their operations south.

Business angel financing

Business angels are high net worth individuals, often cashed-out entrepreneurs or investors, who invest their own wealth in small numbers of ventures, either alone or in conjunction with other angels. Business angels tend to make much smaller investments in start-ups than venture capitalists do, but they have a substantial impact on high-growth entrepreneurship and SME development in many countries.

The Canadian business angel investment market is difficult to quantify but is believed to be disproportionately small compared with its United States counterpart. Nevertheless, the Canadian business angel market is developing and growing in size. Like venture capital, it is concentrated in a few cities, with strong regional variations. It is most prevalent in Ontario, British Columbia and Quebec, although it is growing throughout all the western provinces as well. For example, a recent CAD 1.5 million investment by the RDA Western Diversification in the National Angel Capital Organization (NACO) is expected to triple the number of visible angel investors in Western Canada. In British Columbia, business angels benefit from a sizeable income tax credit on their investment (30% of the investment up to a ceiling of CAD 60 000) which has been in place since 2003.

The Canadian business angel market appears to be sophisticated in terms of its deployment of value-adding practices, company selection and due diligence. The market spans most industry sectors, with an emphasis on technology, in line with countries like the United States and the United Kingdom. Typically, an individual level investment is around CAD 25 000-50 000, whereas syndicated angel investments average CAD 1 million. As in most other countries, there is a gap in deal sizes between the point where business angel finance dries up and venture capital starts. According to the NACO, the VCAP has increased the size of venture capital deals, leaving an equity gap in the range of CAD 2‐5 million.

The R&D system

Canada’s gross domestic expenditure on research and development (R&D) in relation to GDP was below the OECD average in 2013 (Figure 3.11). This covers R&D carried on a national territory from all sources. Figure 3.12 breaks down the relative contribution made by different performing sectors. Within the G7 group, Canada has the largest proportion of total R&D accounted for by higher education institutions (39.8%) and the smallest proportion undertaken by business enterprises (50.5%), the share of which has fallen by 6.6 percentage points since 2003.12 This breakdown suggests that basic research is relatively more important compared with applied research in Canada’s R&D system than in other G7 countries’ systems, given that basic research remains highly concentrated in universities and government research organisations across OECD countries (although university research is not only basic in nature) (OECD, 2015d). This basic research weighting is only partly mitigated by Canada’s comparatively high share of higher education R&D that is funded by businesses (8.1%) or private non-profit organisations (9.4%) (Figure 3.13). While basic research (i.e. work undertaken for the advancement of scientific knowledge without a specific practical application in view) is instrumental to achieving breakthrough innovations with multiple industrial applications in the long-run, applied research (i.e. R&D undertaken with a specific practical application in view) tends to have the most immediate commercialisation potential.

Business investment in R&D was only 0.82% of GDP in 2013. This puts Canada’s business R&D back to the levels of the early 1990s after having climbed to 1.26% of GDP in 2001. It is below the OECD median value and only one-half of the business expenditure on R&D adjusted by GDP of the United States. The decline can only partly be ascribed to a shift in the industrial structure of the Canadian economy in which extractive industries (which are not R&D intensive) have contributed a growing share of GDP compared to manufacturing industries (which are more R&D intensive). Canadian investment in information and communications technologies (ICT) is also low by international standards at around 2.5% of national GDP. This has prompted some to advocate for tax breaks not only for investments in R&D but also for the purchase of ICT hardware and software (Deloitte, 2013).

Human resources

Education outcomes

The OECD Programme for International Student Assessment (PISA) survey – which assesses 15-year-old students’ performance in literacy, numeracy and science – shows positive results for Canada. This augurs well for the supply of an educated labour force in the future. The mean scores of Canadian secondary-school were 7th in numeracy proficiency and 4th in literacy proficiency across OECD countries in 2012, well above the OECD un‐weighted average (Figure 3.14). The percentage of weak performers (i.e. those who are ranked at level 2 or below in the six-grade scale of proficiency) was also low in Canada, which suggests a national school system which does not leave behind large groups of the student population (Figure 3.15).

On the other hand, the OECD Programme for the International Assessment of Adult Competencies (PIAAC) survey found that the mean scores of Canadian adults aged 16-24 years were below the OECD average for literacy and numeracy skills (Figure 3.16), although Canada did well in “problem solving in technology rich environments”. Furthermore, Canada’s proportions of adults aged 15-29 and 30-54 with low numeracy and literacy skills (i.e. proficiency level of 2 or below out of 6) were above the OECD average (Figure 3.17). The relatively low adult literacy scores are the result of the share of immigrants in the population of Canada (26% compared with 12% of the OECD average), rather than poor scores of immigrants or non-immigrants relative to the same groups in other countries (Parkin, 2015).

Apprenticeship training programmes

Apprenticeship training programmes in Canada typically last between two and five years, depending on the specific trade and jurisdiction, and comprise 80-85% on-the-job training under the supervision of a certified journeyperson and 15-20% technical in-class training. The in-class training usually takes place in a block of 8-10 weeks once a year in a specialised community college, union or private training institution. Apprentices are paid by the employer only for the on-the-job component of the training. The apprentices have to pay the costs of their technical training. In order to move through the programme, apprentices must pass an exam each year, with a final exam leading to a trade certification validated by the province or territory where it is taken.

Based on data from the Canadian National Apprenticeship Survey (NAS), 16% of apprentices have less than secondary-level education, about 47% have completed secondary-level education, and around 37% have post-secondary education. Moreover, almost two-thirds of the apprentices surveyed by the NAS reported that they had work experience related to their trade prior to registering in their programme, which suggests that a significant proportion of those who enrol in apprenticeship training programmes do so to strengthen their skills profile and wage prospects after having worked for some time as unskilled or semi-skilled workers in the same job (O’ Grady, 2007; Lehman, 2012). Unsurprisingly, the average age of Canadian apprentices is high by international standards, with more than two-thirds of registered apprentices aged above 25 and 44% aged above 30 in 2013,13 while only 1-2% of students completing secondary education move into apprenticeship programmes directly from school (Lehman, 2012).

The number of registered apprentices has grown considerably in Canada over the last decade, from 200 000 in 2000 to 445 000 in 2012, as has the number of apprenticeship training completions, from 20 500 in 2005 to 41 500 in 2012 (CCDA, 2014). This is linked to trends such as lack of job opportunities for unskilled workers, a growing demand for skilled trades in certain regions and sectors, and the introduction by some provinces of secondary-school-based youth apprenticeship programmes (e.g. the Ontario Youth Apprenticeship Programme).

Nonetheless, completion rates are still low, at around 50% nationwide. A frequently reported reason for this is the cost of the technical training component of apprenticeship programmes, both the actual costs (i.e. tuition fees, living costs and sometimes relocation expenses) and the opportunity cost of having to quit a job for 8-10 weeks. To help students complete their training, the federal government has set up a number of financial aid measures (see Box 3.1). Other common explanations are the high average age of apprentices, which means that most of them start their programmes while they already have family obligations, and the duration of apprenticeship programmes, which is longer in Canada than in most other OECD countries. Most apprenticeship programmes last four years in Canada – though the average time to complete a programme is in fact five years – while the official duration of apprenticeship programmes in Germany and Austria is between two and three years and in the United Kingdom, France, Finland and Spain between one and three years (European Commission, 2013).

Box 3.1. Federal financial support for apprenticeship training in Canada

The Apprenticeship Job Creation Tax Credit encourages employers to hire new apprentices in eligible trades by providing a tax credit of 10% of the wages payable to apprentices in the first two years of their apprenticeship programme (up to a maximum credit of CAD 2 000 per apprentice, per year). More than 11 700 businesses benefitted from the credit in 2013.
The Apprenticeship Incentive Grant is a taxable grant of CAD 1 000 per year, up to a maximum of 2 000 CAD per person, available to registered apprentices once they have successfully finished their first or second year/level of an apprenticeship programme. More than 387 000 grants have been disbursed since 2006.
The Apprenticeship Completion Grant is a taxable grant of a maximum of CAD 2 000 available to apprentices who have successfully completed their apprenticeship training and obtained their journeyperson certification in a designated Red Seal trade. Since 2009, approximately 137 000 grants have been disbursed.
The Canada Apprentice Loan is an interest-free loan of up to CAD 4 000 per period of technical training to help registered apprentices in Red Seal trades with the costs of training. Introduced in 2014, it is estimated that at least 26 000 apprentices will apply every year.
In addition, the federal government grants registered apprentices some tax credits which can be deducted from federal income tax, notably: i) the Tradesperson’s Tools Deduction referring to the cost of eligible tools which must be acquired as a condition of employment; ii) the Tuition Tax Credit relating to tuition and examination fees.

There are a number of reforms which could be considered to improve the provision of apprenticeship training in Canada. First, the overall cost of Canadian apprenticeship programmes could be reduced, either by expanding existing federal financial support measures or shortening the duration of the training.

Second, the block training component could be reformed. It is likely to be beneficial to integrate the block training component more closely with the on-the-job training component. In countries with a tradition of “dual apprenticeship training”, for example, technical training usually takes place one or two days per week, with the remaining days of the week spent in the business. Rather than spending longer blocks of time in the college or the business, this arrangement tends to produce stronger learning outcomes, as students can immediately apply on the job what they have learned in classrooms. In addition, the block training component could be made more flexible by making part of it available online. Valuable insights for the development of new approaches can be expected from the government’s three-year pilot project Flexibility and Innovation in Apprenticeship Technical Training, started in 2014. The programme is administered by the government department Economic and Social Development Canada (ESDC) and provides selected training providers with funding for the development of alternative approaches to block training, including through the use of new technologies.

Third, collaborative training arrangements could be supported in order to increase participation by small businesses in apprenticeship training. For example, two or more companies, using a common training provider, could share the cost of the training and the time of the apprentice based on a contract which sets out tasks and responsibilities of each party.

Fourth, successful provincial models that integrate apprenticeship training into secondary education – e.g. the Registered Apprenticeship Program in Alberta and the Ontario Youth Apprenticeship Program – could be expanded nationally or to other provinces and territories. These models typically hinge on very flexible work arrangements between schools, students and employers, ranging from co-operative placements to full apprenticeship contracts (Lehmann et al., 2014). They offer secondary students a seamless transition into post-secondary apprenticeship training, valuable work experience, employability skills and an understanding of employer expectations. At the same time, employers are given the opportunity to assess students before committing to a full apprenticeship. To raise awareness and interest for these programmes, enhanced labour market information should also be provided to secondary students to offer career guidance that does not focus only on university education.

Work-integrated learning

Work-integrated learning (internships, co-operative education, work placements, summer jobs, etc.) helps students understand better their professional interests and acquire useful work experience. However, at least in Ontario, more than half of university students and almost one-third of college students complete their studies without any such experiences (Peters et al., 2014).

Canada’s main federal youth employment policy consists of the Youth Employment Strategy (YES). Through this strategy, the federal government invests CAD 330 million annually to help young people between 15 and 30 years old to develop the skills and work experience needed to succeed in the school to work transition. The federal government department ESDC leads the YES, which consists of three main activity streams:14

“Skills Link”: primarily targeted at youth who face barriers to employment, this offers funding for employers and business organisations who commit to developing the skills of this target group.
“Career Focus”: this helps post-secondary graduates make a transition to the labour market through paid internship and career advice.
“Summer Work Experience”: this offers financial incentives for employers to create summer job opportunities for students.

ESDC also has initiatives focused specifically on small businesses. It allocates CAD 15 million annually to fund up to 1 000 internships for post-secondary graduates in SMEs. Small businesses are also the main target of the Mitacs Accelerate Programme, which is run by a not-for-profit organisation (i.e. Mitacs) whose mission is to build industry-university linkages and which is co-financed by the federal government. The Mitacs Accelerate programme allows graduate students and post-doctoral fellows to use their specialised academic expertise for applied industry projects. Students receive a stipend of at least CAD 10 000 during the Accelerate internships which last four-to-six months, with 50% of work time spent at the host company. Through its Accelerate programme, Mitacs supports more than 2 000 internships every year in every sector and academic discipline across Canada. Participating enterprises, most of which are SMEs, often create new positions for the graduates following completion of participation in the programme.

Something which could further enhance the school-to-work transition in Canada, especially towards small businesses, is the establishment of dual-study programmes which combine tertiary studies at specialised colleges or universities with paid on-the-job training in companies. In this type of programme, SMEs benefit from new staff members who can quickly perform in their existing workforces and students benefit from a good mix of academic qualifications and company-specific job experience. Germany has been a leading country in this area and could provide inspiration for policy development in Canada in this area (see Box 3.2).

Box 3.2. Dual-study programmes, Germany

By combining academic studies with practical on-the-job-training, dual study programmes develop considerable benefits both for employers looking for university graduates with work experience and for young people in search of tertiary education with promising career prospects.

Dual study programmes have become ever more popular in Germany. In 2014 there were a total of 1 505 dual study programmes in the whole of Germany, the majority in business administration (487), mechanical engineering (232), ICT (182), social work/education/health/nursing care (158) and electrical engineering (127). Almost 95 000 students and 42 000 companies participated in these programmes.

Description of the approach

A dual study programme refers to a system that combines academic studies leading to a Bachelor or Master degree at a University of Applied Sciences (UAS) with practical paid on‐the-job training in a company. As jurisdiction for education polices in Germany lies with the 16 federal regions (i.e. länder), a variety of different dual study models exist in Germany. The dual study programme of the federal state of Bavaria is, therefore, described in more detail. In 2006, all 19 Bavarian UASs created the initiative “Hochschule Dual” (dual higher education) in order to pool their dual study programmes under one common brand name. “Hochschule Dual” is supported by the Bavarian State Ministry of Education, Science and the Arts und funded by the Association of Bavarian Industry.

The Bavarian “Hochschule Dual” offers three different models of study:

Combination of academic studies for a Bachelor degree (e.g. in mechanical engineering) with apprenticeship training (e.g. in the recognized training profession of an industrial mechanic): The programme lasts for 4.5 years, thereof 27.5 months of practical on the job-training. Graduates earn an academic degree and an official, Germany-wide recognized apprenticeship degree.
Combination of academic studies for a Bachelor degree with a series of intense on-the-job training periods: The programme lasts for 3.5 years, thereof 16 months of practical on the job-training. Graduates earn only an academic degree.
Combination of academic studies for a Master degree with a series of intense on-the-job training periods: The programme normally lasts for 1.5 years, thereof 9.5 months with practical job experience.

In all three models, on-the-job training usually takes place during the holidays between the university semesters, in a practical internship semester, and while writing the bachelor/master thesis. Moreover, in all three models, the training company concludes a training or work contract with the dual student. Companies have to provide their dual students with financial remuneration at least equal to the period of on-the-job training (in 80% of cases ranging between EUR 500 and 1 000 per month). Students who want to engage in the dual study programme must first apply to a training company which co-operates with “Hochschule Dual” and sign with them a training or work contract. As a final step, students apply for a place at the chosen UAS.

Factors for success

The dual study programme develops considerable benefits for all involved parties. Participating enterprises are able to secure early access to highly-qualified and performance-oriented young professionals, while students acquire valuable social skills and non-cognitive competencies. Moreover, companies and students have enough time to get to know each other and find out in which area the young students can contribute best. Companies also benefit from a strong sense of loyalty and identification which dual students develop during their dual studies, which leads to very high retention rates (between 80% and 100%). In addition, the companies’ close ties and good co-operation with the respective UAS facilitates and encourages collaboration in other fields, such as technology transfer or joint research projects.

Obstacles and responses

Although a large variety of dual study programmes exist in the 16 German federal states, they are often not coordinated in terms of contents, quality control and branding. Due to this lack of coordination and transparency, interested companies and students may experience difficulties in accessing the programmes. These problems were the main driver for the 19 Bavarian UASs to pool, coordinate and promote their dual study programmes under the common umbrella brand “Hochschule Dual”. In order to develop the three different models of study, “Hochschule Dual” carried out extensive consultations among business, student and policy stakeholder groups.

In order to coordinate the dual study programmes of the 19 UASs, “Hochschule Dual” has established two permanent institutional bodies. First, a specific working group composed of senior representatives from the participating UASs elaborates the framework conditions for the dual study models. Second, the working group is supported by an advisory board with members from enterprises and business chambers where their representatives bring in their suggestions to improve the dual study programme from a business perspective.

Relevance for Canada

Canadian businesses often complain that many university graduates do not have sufficient work experience and social skills. Graduates of dual study programmes, by contrast, can immediately start working and take over positions of responsibility. Dual study programmes also have a high relevance for Canadian youth who want to safeguard a smooth school-to-work transition thanks to the extensive company-specific on-the-job training which a dual study programme provides.

Further information

www.hochschule-dual.de.

The labour market

Canadian SMEs benefit from a flexible labour market. The OECD employment protection legislation (EPL) indicators measure “procedures and costs involved in dismissing individuals or groups of workers” and “procedures involved in hiring workers on fixed-term or temporary work contracts”. Canada’s regulations are relatively favourable to labour market flexibility on both indicators compared with other OECD countries, ranking third in the flexibility of dismissal regulations and first in the flexibility of temporary work regulations (Figure 3.18).

A risk of flexible regulations in hiring temporary workers is that they could lead to a segmentation of the labour market where permanent workers benefit from much greater protection and benefits than fixed-term workers. However, this does not appear to be a major issue in Canada, which may partly reflect the flexibility of dismissal rules as well as hiring rules. In Canada, there are higher than average job reallocation rates among existing firms, which suggests a flexible labour market where workers can easily move between jobs in existing companies (OECD, 2016a).

In addition, OECD PIAAC data suggest that Canada does not have major skills mismatches nationwide. In particular, only a relatively small proportion of Canadians are over-skilled in their current job and a near-average proportion of Canadians are under-skilled in their current job compared with other OECD countries (OECD, 2014a). Stable post‐secondary education earnings premiums also indicate that Canada does not have major skills shortages. Localised skills shortages had occurred in certain industries (e.g. construction related to the energy sector) and regions of the country (e.g. the Atlantic Provinces and in the territories) during the last boom in the oil and gas industry, but they have vanished following the sharp fall in oil prices since mid-2014.

Foreign direct investment

Foreign direct investment (FDI) can support SME and entrepreneurship development in multiple ways. First, multinationals are an important source of knowledge spill-overs for the local economy, particularly through buyer-supplier relationships. Second, local suppliers of FDI affiliates gain exposure to international markets, which can lead to exporting to other parties. Third, especially in knowledge-based industries, FDI affiliates may spin out new start-ups whose growth potential is typically higher than the average new business.

In the period 2010-14, the stock of FDI in Canada grew steadily from CAD 592.5 billion to CAD 732 billion. Canada’s inward FDI stock is high in relation to GDP compared with other G7 economies and the OECD and G20 areas, although it dropped by 5% in 2015 following a sharp fall in oil price since 2014 (Figure 3.19). Major FDI attractors in Canada are vast natural resources, sound legal framework conditions, and the geographical advantage of neighbouring the United States and being part of the North America Free Trade Agreement.

A geographical disaggregation of the origins of FDI (Figure 3.20) shows that the United States takes the lion’s share of Canada’s inward FDI stocks (49% in 2014), followed by Europe (34%) and Asia/Oceania (12%). However, the weight of the United States in Canada’s total FDI stocks has steadily declined in the last six years, from 58% in 2008 to 49% in 2014, while the share of emerging economies has grown, especially China and Brazil.

As a result of the commodity price hike over 2009-2014, inward FDI has increasingly shifted towards oil and mining, which represented 21% of Canada’s inward FDI stocks in 2014. Manufacturing remains the main sector destination of FDI, with a total proportional weight which has hovered around 30% since 2010. However, the three manufacturing sectors most favoured by foreign investors are linked to natural resources, i.e. petroleum and coal, primary metals and chemicals. Following the collapse of global oil prices since mid-2014 and the associated depreciation of the Canadian dollar, FDI in natural resource exploitation can be expected to fall and other FDI to rise. However, there is still a need to diversify inward FDI flows more towards knowledge based sectors with strategic opportunities for the development of domestic economic activity, including supply chains involving domestic SMEs.

The OECD measures regulatory restrictions on FDI through the FDI Regulatory Restrictiveness Index, based on an assessment of: i) foreign equity limitations; ii) screening and prior approval requirements; iii) restrictions on the employment of foreign staff; and iv) other operational restrictions (e.g. restrictions on branching, capital repatriation or land ownership by foreign-owned enterprises).15 With respect to this index, Canada scores higher than the OECD average overall (Figure 3.21). Of the four areas covered by the Index, Canada is relatively more restrictive than the OECD average with respect to screening and prior approval requirements, which involve the presence of thresholds on the amount of the investment and share of foreign equity above which FDI prospects are reviewed. Sector-level data additionally show that restrictions to FDI are higher in the media, fishing, telecommunications and transport sectors (Kalinova et al., 2010).

The main piece of legislation affecting FDI to Canada is the Investment Canada Act (ICA). This requires that investments by non-Canadians to acquire control of a Canadian business that exceeds CAD 600 million in enterprise value be reviewed, under what is known as the net benefit test, to determine whether or not they will be approved. There are some exceptions to this threshold value. For foreign state-owned enterprise investors, the threshold for the Canadian business to be acquired is CAD 375 million in asset value. These large investments are reviewed for their likely net benefit to Canada, in accordance with factors set out in the Act, for example, relating to the impact of the investment on employment, innovation, productivity and market competition in the economy. Different thresholds apply to cultural sector investments.

It is important to keep review criteria flexible enough so as not to discourage FDI which can indirectly benefit SMEs. In particular, it is important to encourage inward FDI in knowledge-based sectors with potential to stimulate domestic SME supply chains. It is also important that the reviews are undertaken efficiently and rapidly so as not to discourage potential investors. The thresholds should also be consistent with the national interest and not overly hinder smaller investments that could have benefits for SME development. In this regard, the Government’s recent announcement of its intention to raise the review threshold to CAD 1 billion for World Trade Organisation private investors in 2017, two years ahead of schedule, is a positive development that should reduce the number of “reviewable” FDI prospects.

Conclusions and policy recommendations

Canada enjoys a solid macroeconomic framework that is supportive of investments by small businesses. The labour market is flexible, which enables small businesses to expand and contract employment according to their needs. The tax system is also friendly to business in general and small businesses in particular. Business regulations are light, partly reflecting a series of recent regulatory simplification reforms. Furthermore, the banking system has proven solid even at the peak of the last global financial crisis.

At the same time, there are aspects of the business environment for SMEs and entrepreneurship that could be improved. Although Canada has one of the most generous R&D tax credits among OECD countries, its business R&D intensity is relatively low. Furthermore, compared to other G7 countries, Canada’s R&D system is relatively weighted to higher education institutions and basic research. SME tax preferences are relatively generous and some tax incentives could be fine-tuned and possibly downsized. Conversely, more resources could be spent on targeted SME programmes. In terms of human resources, OECD PIAAC data bring out that numeracy and literacy skills in adult workers could be stronger in Canada. Furthermore, apprenticeship training in Canada is affected by very low completion rates. Finally, Canada’s banking system is solid but its loan terms and conditions are not always as favourable to SMEs as in other G7 countries.

Based on this analysis, the following policy recommendations are offered to strengthen Canada’s business environment for SMEs and entrepreneurship:

Key recommendations on business environment for SMEs and entrepreneurship

Discontinue the trend of reductions in the small business tax rate unless further reductions can be shown to address important market failures affecting all SMEs. Instead favour targeted programme measures that address market failures for particular groups of SMEs and start-ups.
Consider expanding loan guarantee programmes at the federal and provincial levels with a view to boosting bank lending to SMEs.
Consider enhancing direct government lending while keeping its focus on credit market niches which are unlikely to be served by commercial banks, such as entrepreneurship by socially disadvantaged groups (e.g. women, youth and indigenous communities) and innovative entrepreneurship.
Strengthen the apprenticeship training system for SMEs by shifting from a block release model towards a closer integration of practical and theoretical training, offering some of the training online and introducing collaborative training arrangements for SMEs where one company provides apprenticeship training in co-operation with other firms or specialised training centres.
Consider the introduction of a system of dual studies at the tertiary education level, combining studies at specialised colleges or universities with paid on-the-job training in companies.
Create new work-integrated learning programmes and increase funding for existing programmes (such as Mitacs) that arrange internships for post-secondary students in innovation-oriented SMEs.
Increase FDI promotion efforts in knowledge-based sectors of strategic importance to Canada and reduce regulatory barriers to inward FDI flows.

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Notes

← 1. Based on the Remarks to the House of Commons Standing Committee on Finance by Jayson Myers, President and CEO of the Canadian Manufacturers & Exporters (The Impact of the Oil Price Plunge on Canadian Manufacturing), three-quarters of Canadian manufacturers were sanguine that lower oil prices, stronger US demand and a cheaper Canadian dollar would boost sales, profits, and employment in 2015.

← 2. The GST is a broad-based value added tax levied on a comprehensive base with limited exceptions, such as basic groceries and prescription drugs. As it is a tax on consumption in Canada, the GST does not apply to exports, and exporters can claim input tax credits for tax paid on their inputs.

← 3. A CCPC is a special type of Private Corporation that is not controlled, directly or indirectly in any manner whatever, by public corporations, non-residents or a combination of the two.

← 4. The provincial small business tax rate ranges from 0% in Manitoba (on the first CAD 450 000) to 8% in Quebec.

← 5. For example, in 2000, it would have been more profitable for a small business owner facing a personal income marginal tax rate of less than 45% to increase his/her wages instead of accruing profits beyond the CAD 200 000 thresholds, which would have been taxed at 45% (Department of Finance, 2013; OECD, 2016a).

← 6. If the Allowance on Business Investment Losses exceeds net income for the year, any excess will be treated as a non-capital loss, which may be carried back three years and then forward twenty years, after which it is again treated as a net capital loss which can be carried forward indefinitely tobe applied against future capital gains.

← 7. The credit is calculated as the difference between premiums paid at the legislated rate of CAD 1.88 per CAD 100 of insurable earnings and the reduced small business rate of CAD 1.60 per CAD 100 of insurable earnings in each of those years. Since employers pay 1.4 times the legislated rate, the 28-cent reduction is equivalent to a reduction of 39 cents per CAD 100 of insurable earnings in EI premiums.

← 8. Screening and prior approval requirements involve the thresholds for the amount of the investment and share of foreign equity above which foreign investments are reviewed by the receiving government.

← 9. Data are not strictly comparable because they refer to two different national surveys that do not have harmonised methodologies.

← 10. The definition of SME loans vary country by country, so that figures are not strictly comparable. In Canada, SME loans are authorised loans up to CAD 5 million.

← 11. The two indicators – i.e. SME risk premium and SME-large firm interest rate spread – are slightly different. Central Banks in OECD countries do not all collect the same type of information on enterprise finance.

← 12. In 2015, higher education accounted for 39.8% and business enterprises for 50.1% of total R&D expenditure.

← 13. Information retrieved from: www.statcan.gc.ca/pub/81-582-x/2015001/tbl/tbld1.2-eng.htm.

← 14. Since 2006, YES has involved more than 450 000 students through 75 000 internships and 390 000 summer jobs.

← 15. Restrictions are evaluated on a 0 (open) to 1 (closed) scale, based on the statutory elements of the law, i.e. implementation issues are not addressed. Further information on this index is available at: www.oecd.org/investment/fdiindex.htm.