Reform Canada's Defence Spending Obligations

Summary

Industrial and Technological Benefits (ITBs) are the most important policy for shaping how defence spending contributes to the Canadian economy. They require defence contractors to spend an amount equal to their contract value in Canada as "offset obligations". 

These obligations are articulated in a Value Proposition weighted based on factors like Canadian supplier development, developing sovereign IP, and increasing exports from Canada. 

The core aim is to make sure that spending on defence supports a broader ecosystem and promotes dual-use technologies. But today there are restrictions that are reducing the impact:

• As of 2024, ITB obligations account for over $64 billion in spending intended to be directed to the Canadian ecosystem but more than $15-billion remains unallocated¹. Billions of committed dollars are sitting wasted waiting to be deployed.
  
  
• The program has few mechanisms for contractors to purchase innovation as part of their obligations. The Venture Capital Fund (VCF) mechanism was meant to solve this by allowing investments in venture capital. But, current restrictions mean this mechanism is underused and a credit has never been publicly reported.
  
  
• In general the program requirements are too narrow. The definitions for what qualifies as a SMB and the need for Canadian content disqualifies many companies that would be a huge benefit to the defence ecosystem.

Canada could significantly increase the impact of the ITBs by:

1. Fixing the Venture Capital Fund within the ITB program so it can compete with simpler direct transactions and reflects best-in-class VC practices.
   
   
2. Adapting the existing VCCI program to improve the venture landscape for defence in Canada.
   
   
3. Updating the restrictions on company size and Canadian value to reflect the realities of building defence technology.

Canada spends tens of billions of dollars on defence each year and that amount is expected to rise dramatically in the years ahead. ITBs should ensure the work defence contractors do improves Canada’s ecosystem. But to create real investments it is essential the program can solve both contractors business objectives and develop sovereign Canadian capabilities.

Background and Motivation

Under ITB obligations, for every dollar the government spends on defence equipment as part of contracts over $100 million, the winning contractors must spend a matching dollar creating jobs, funding research, or building capabilities in Canada.

For example when the Canadian government contracts a new company to purchase $500 million of new signals equipment, under ITB the winning contractor must create an equal amount of economic activity in Canada. To achieve this, the firm might manufacture some components in Ontario, partner with other Canadian SMBs for encryption modules, fund $50 million in signals R&D with Canadian universities, commit to future exports from Canada, and provide training programs for Canadian engineers. 

These investments are described as part of a Value Proposition (VP) submitted to ISED alongside their primary submissions to the Department of Defence and Finance for the contract. In the VP the contractor lists all of the spending that will benefit the Canadian ecosystem with some of the spend receiving multipliers to count against a greater number of ITB credits to encourage particularly beneficial activity like investing in knowledge and skill transfer. At the end of the submission any economic activity that isn’t yet covered under the VP is listed as an “outstanding obligation.”

The program has a significant scale. Today active obligations cover over $64 billion in total economic activity. And, this spending is estimated to directly generate $4.7 billion in GDP and support 40,200 jobs in Canada every year². However, it also faces serious inefficiencies. Today, $15 billion of obligations are sitting unallocated with no clear path to deployment under the existing framework³. 

In practical terms this means ITBs have created a massive pool of investment capital specifically earmarked for developing the Canadian defence and dual-use ecosystem, but overly restrictive requirements mean there is no way for the money to flow to where it is needed most. 

One of the main drivers for this is that – while one aim of the ITBs is to drive more innovation – historically the program lacked any way for contractors to invest directly in Canadian defence startups. This means that all of the obligations were used on established companies or research and development completed prior to commercialization. 

Defence contractors want to meet their obligations and invest in technologies that could have significant long-term benefits, but the rules make it nearly impossible to deploy funds effectively into Canada's most promising technology companies while at the same time achieving their company objectives for growth.

The Venture Capital Fund (VCF) mechanism was designed to help solve this problem. Instead of contractors having to find individual companies to invest in directly, they could put money into professional venture capital funds that would then distribute it across multiple innovative Canadian companies. The VCF offers a 5x multiplier, meaning every dollar invested generates five dollars of ITB credit. It should be an attractive option. But, this mechanism no credit has ever been publicly reported due to overly constrained rules.

The rules include restrictions on the scale of investment, the size of the company that can be invested in, and how Canadian content is valued. Together they mean not only that ITBs are out of step with how the market operates to invest in defence companies but also that they don’t match the standards that are set across government for how to think about the Canadian SMB ecosystem. This creates a problem not just for investments via the VCF – where they are particularly onerous – it even prevents direct investments.

ISED can fix the VCF so that the mechanism has a competitive multiplier and follows best-in-class practices, making it an attractive option for contractors and freeing them to invest the funds that currently sit unallocated. At the same time the federal government can create a new fund to direct contractors to as part of fulfilling their obligations helping to stimulate the VC industry. 

To ensure these changes lead to the kinds of investments ITB requirements more generally should be reformed to better reflect the market dynamics of investing in early stage defence companies.

Under this system a contractor that previously struggled to fulfil their obligations could invest in professionally managed Canadian venture funds to earn ITB credits while supporting dozens of innovative companies. And, more individual companies working on cutting edge technology that is essential to the Canadian ecosystem would qualify to be invested in as part of a total value proposition. The result would be more domestic innovation, support for novel Canadian defence startups, and faster deployment of the billions currently sitting idle.

These changes are urgent. Canada's defence spending is set to increase significantly jumping to 2% of GDP in 2025⁴ and projected to grow to 3.5% by 2035. This expansion will create even more ITB obligations. It is crucial that the program is reformed to fix the deployment mechanisms now before more capital gets trapped in an inefficient system.

Real World Solutions

France’s Ministry of Armed Forces and Bpifrance run Definvest, a state‑backed co‑investment fund that takes minority stakes to secure and scale strategic defence SMEs. Definvest invests in equity and quasi‑equity alongside private investors to keep deals on market terms while anchoring critical suppliers in France’s defence industrial base. Typical investments range from €0.5–5 million with a ceiling of €10 million per company⁵. The fund’s co‑investment model has produced an average ~4× leverage from private capital illustrating how a government‑led VC instrument can stabilize key tiers of the supply chain while crowding in private finance⁶.

South Korea's Defence Acquisition Program Administration operates banking and multiplier systems for strategic investments. DAPA allows contractors to "bank" credits by pre-investing in approved Korean companies and technologies, then apply those credits against future obligations. The system uses multipliers to encourage investment in priority areas like manufacturing and engineering. This banking approach has facilitated $838 million in pre-implementation agreements, demonstrating how flexible credit systems can unlock stranded capital⁷.

United Arab Emirates’ Tawazun Economic Programme leverages investment vehicles to build domestic technology capacity. Contractors can earn offset credit by proposing “investment projects,” often structured with Tawazun’s Strategic Development Fund, which manages venture capital and venture debt programs for defence and dual-use SMEs. These fund to channel capital into high-growth UAE companies in aerospace, cyber, and advanced manufacturing⁸. Credits are negotiated case-by-case but the program’s design shows how venture funds can align foreign contractor obligations with national innovation priorities.

What Must Be Done

Transform the Venture Capital Fund mechanism into a competitive option. To ensure the VCF mechanism is attractive relative to administrative complexity the multiplier must be raised from 5x to 9x to match other ITB transaction types. In addition the mechanism must remove the restrictions that currently make it impossible for the underlying venture funds to be competitive. This means removing the $1 million investment cap per company, which artificially limits support for growing Canadian firms that need larger amounts of capital to scale and expanding eligible SMB definitions to match the standard for other ITB obligations (see more details below).

Create a dedicated Key Industrial Capabilities fund within the Venture Capital Catalyst Initiative. The federal government should establish a specialized investment vehicle targeting companies in the critical sectors identified for Key Industrial Capabilities like AI, aerospace, and advanced manufacturing. This fund could operate under VCCI and be preapproved under the enhanced VCF mechanism rules so contractors can earn ITB credits by investing in strategically important Canadian technology companies. Contractors get a clear path to fulfill obligations while Canada builds strength in sectors that matter most for economic competitiveness.

Update the ISED definition of Small and Medium-Sized Businesses (SMBs) to align with broader federal standards. Today, ITB obligations use ≤249 employees as the threshold for SMBs⁹, but across the Government of Canada, the standard definition of SMB includes firms with up to 499 employees. Statistics Canada¹⁰, the Business Development Bank of Canada (BDC)¹¹ and even ISED¹² state that firms up to 499 employees are considered SMBs. Updating the ITB definition would harmonize the policy with these federal standards, capture a larger pool of innovative and scaling Canadian firms, and ensure consistency in how defence procurement obligations support growth across the economy.

Update the Canadian Content Value carve-out to better align with the capital needs of scaling firms. Under Article 7.4.1.1 of the ITB Terms and Conditions, only the first $1 million of an SMB investment is deemed to have 100% Canadian Content Value, with any portion above that subject to standard CCV calculations. This threshold is far too low for defence and dual-use companies that often require multi-million-dollar financings to grow. Raising the carve-out to $5 million would streamline administration, reduce compliance costs, and ensure that larger early-stage cheques can flow without penalty while still protecting Canada’s interest in measuring CCV for bigger deals. This adjustment would unlock more capital for Canadian SMBs while preserving the discipline of CCV rules for larger, later-stage investments.

Common Questions

Won't relaxing restrictions reduce the Canadian content of ITB investments? The current system leaves $15 billion waiting to be spent. These reforms maintain strong Canadian requirements while making them achievable, dramatically increasing actual Canadian economic activity versus theoretical obligations that never get fulfilled.

Isn't increasing the VCF multiplier too generous compared to other programs? The 9x multiplier reflects the additional complexity and risk of venture capital investments compared to direct contracts. Other leading economies offer similar or higher incentives for strategic technology investments, and the multiplier ensures these transactions actually get used rather than remaining theoretical options that contractors ignore.

What prevents contractors from gaming the system by investing in low-quality companies just to meet obligations? Professional venture capital fund managers have strong incentives to make successful investments since their returns and reputations depend on portfolio performance. Additionally, ISED maintains oversight through existing ITB monitoring processes, and the market-based approach creates natural quality controls that bureaucratic selection processes cannot match.

Won't allowing larger investments and higher employee limits just benefit big companies that don't need government support? The reforms specifically target the scaling gap where Canadian companies lose competitiveness. Firms with 250-499 employees are still genuinely small compared to global defence contractors, and the $5 million CCV threshold reflects the capital requirements for developing complex defence technologies. These changes help Canadian companies grow large enough to compete internationally rather than being acquired by foreign firms.

Conclusion

Canada has built one of the world's most sophisticated defence procurement offset systems, but bureaucratic restrictions are preventing it from achieving its potential. With $15 billion sitting unused and defence spending set to increase dramatically, the country is creating a situation that actively prevents it from achieving its aims. By fixing the Venture Capital Fund mechanism and creating easier pathways for investments dual-use technology companies, Canada can transform ITB obligations from administrative burdens into powerful engines of economic growth and technological sovereignty.

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