Canada’s technology market can be very attractive to American tech companies. Whether you are considering buying a Canadian tech company or licensing your software and other technology to Canadian users, you need to understand that there are numerous legal differences between Canada and the U.S. that will impact your deal. The good news is that these issues can all be managed well if approached pro-actively with Canadian legal counsel that has encountered them many times before.
Cross-Border Tech M&A – U.S. Tech Company Buying Canadian Tech Company
Nearly two-thirds of the dollar value of M&A activity in Canada now involves cross-border transactions, with activity at its highest level since 2000. U.S. companies have been regular acquirors of Canadian tech businesses. These cross-border M&A deals have their own particular risks, such as having to deal with the "tax man" on both sides of the border. Fortunately, these risks are manageable, especially if the deal team understands the important, unique Canadian issues that are associated with the key assets that are being acquired: technology, revenues and people.
The legal spotlight in cross-border acquisitions of technology companies is generally on the usual suspects of tax, employment and intellectual property. To add a little twist to the plot, U.S. acquirors also need to appreciate there are certain aspects that are "uniquely Canadian."
SR&ED Tax Credits
A uniquely Canadian feature is the SR&ED investment tax credit regime applicable to scientific research and experimental development. Under this program, certain Canadian companies known as "CCPCs" can earn refundable federal tax credits of up to 35 percent of their SR&ED qualified expenditure pools, and where they are available, tax credits will be refunded even if there is a net operating loss. This means the Canadian government essentially makes a cash contribution for up to 35 percent of the qualified SR&ED expenditures. This is a valuable program, especially for early stage growth Canadian technology companies.
CCPC stands for Canadian-controlled private corporation. One of the key requirements is Canadian ownership and control. Once a company is controlled by a U.S. shareholder, it loses its CCPC status, with the result that the investment tax credit is no longer refundable so it may only be set-off against the tax otherwise payable on its income and drops from 35 percent to a maximum of 20 percent. Indeed, the right to acquire control can result in the loss of CCPC status.
As SR&ED refunds lag the R&D expenditures, on the sale of a Canadian tech company, the vendors will often insist that the outstanding SR&ED credits must be accounted for in post-closing adjustments. As an American purchaser of a Canadian tech company, this is obviously a point for negotiation.
Canadian Government Funding For R&D And IP
An important common due diligence item is to confirm that none of the target’s R&D or intellectual property development was funded under Canadian government funding arrangements, such as through the National Research Council. As these government funding programmes are structured to benefit the local Canadian economies during developmental stages of technology, often they either restrict the exploitation of the technology or require cash payments on a change of control to foreign shareholders. For example, funding agreements may require the manufacturing in Canada of products incorporating the intellectual property combined with an automatic assignment of the intellectual property to the Canadian government on breach.
Retroactive Proposed Tax Legislation For Non-Competition Payments
There is proposed tax legislation that will make certain non-competition payments taxable as ordinary income, and it will be retroactive to 2003. For a U.S. purchaser doing a deal in 2006, there are two aspects about this proposed legislation that are unexpected: first, it is not often that tax legislation is effective retroactively, and second, as this proposal has been pending since 2003, it is no longer on the radar screen of current issues.
As a result of this proposed legislation, Canadian sellers may request a mutual election to improve the tax treatment of the payment to them. While the election may be neutral to the purchaser, the details of the election provisions and the possibility that the legislation may change before enacted requires drafting certain "outs" for the purchaser in case the result is in fact prejudicial to the purchaser.
Foreign Investment - Video Games Are Canadian Culture
Depending on the size of the deal, type of assets/business and the foreign status of the purchaser, foreign investment is subject to notification and review under the Investment Canada Act. Canadian "cultural" businesses are one type of assets/businesses that trigger a notification obligation under the Act. Unexpected activities can end up being "cultural" businesses, such as developing video games. Yes, in Canada, producing and distributing video games is a "cultural" business. Therefore, for U.S. acquirors the prudent approach is to confirm early on in the deal whether or not notification and/or approval is required and, if necessary, seek approval or "no action" before closing.
Tax: Cash Or Shares
An important deal point in determining structure is whether the purchase price will be in cash or shares in the U.S. acquiror. If it is shares, then tax (and securities) laws on both sides of the border become key factors in the structuring negotiations.
The problem with shares as consideration is that the Canadian sellers will generally have to pay an immediate tax bill without the benefit of a liquidity event. In Canada, roll-over provisions allowing tax-deferral are only available where the share consideration is provided by a Canadian company, not a foreign company. From a Canadian seller’s perspective it would be great if we could just view the U.S. as the 11th province in Canada, or maybe it could be the 4th territory, so that tax deferral provisions would be available until the cash is received. The Canadian government has proposed extending the rollover rules, but several years have gone by now without any specific action being taken.
Exchangeable shares are a common solution to the cross-border share for share issue; however, the primary downside to these structures is that they are expensive and complicated. There are a number of alternatives for dealing with founders and employees holding stock options in a Canadian target including earnouts (treated as full income unless careful planning is undertaken to achieve capital gains treatment, and tax is payable only when cash is received), options in the U.S. purchaser (taxable income but with the possibility of an offsetting 50 percent deduction), and exchangeable securities (tax structuring costs make this impractical for smaller deals).
The U.S. "employment at will" concept is foreign to Canada, which has minimum notice periods for termination and, in some cases, severance pay for terminated employees. Employees that have been terminated without notice in Canada will likely end up with generous settlements given Canada’s common law regarding reasonable notice.
Canadian employment agreements often state that the employee is entitled to the notice period provided in the applicable employment legislation. This language creates a floor, not a ceiling, for notice obligations and allows generous common law requirements to be read in by the courts, much to the surprise of the unsuspecting purchaser. Given employee favourable law in Canada, U.S. acquirers should price the employment termination liability of the target into the deal.
U.S. purchasers should be aware of differences in the intellectual property regimes in Canada and the U.S. Importantly, the U.S. "work for hire" approach is turned on its head in Canada where, generally, the author of the work owns the copyright unless an agreement provides otherwise or the author is an employee that creates the work in the course of their employment.
Similarly, IP agreements purporting to transfer copyright should not only assign copyright from the respective authors to the target but also waive "moral rights" as well. Moral rights, among other things, give the author a right in the integrity of the work and must be waived to protect the value of derivative works.
Some other notable differences are that patent licensees may be precluded from challenging the validity of patents by contract; licensors can be entitled to future royalties even after a patent or trademark has been held invalid or has expired; co-owners of patents require consent of other co-owners to license patents; and, licensee’s rights are less certain after the bankruptcy of a licensor as there is no Canadian equivalent to section 365(n) of the U.S. Bankruptcy Code (as discussed further below).
Privacy and data protection legislation in Canada is similar to the European model. Each of the federal and provincial data protection Acts focus on providing broad, general protection for an individual’s personal information and are not limited to specific industry sectors, such as financial and health, as is the U.S. approach, under the U.S. Gramm-Leach-Bliley Act and HIPAA, for example. The Canadian data protection regime is built around ten core fair information practice principles, the most fundamental of which is that one may not collect, use or disclose personal information without the consent of the person concerned. This principle has a wide range of effects on carrying on business in Canada, in both expected (marketing practices) and unexpected (due diligence, asset transfers) ways. Certain Canadian jurisdictions have built in specific exceptions to the consent rule that apply to the treatment of employee information or personal information transferred in the context of a business transaction, but these provisions have to be reviewed carefully to avoid falling off-side. A second "hot button" privacy consideration relates to recent Canadian legislative responses to the USA Patriot Act. Specifically, an increasing number of provinces have adopted privacy provisions intended to stop the flow of personal information to the U.S. to the extent that such transfers might lead to subsequent disclosure to U.S. authorities without the knowledge or consent of the data subject. This issue must be handled carefully, particularly in the context of cross-border outsourcing.
Challenges Of Cross-Border M&A Deals
Since cross-border acquisitions require dealing with two sets of laws, what can be a reasonably straight forward issue on either side of the border quickly becomes complicated, expensive and slow if not properly managed. A helpful technique for managing exponential deal growth is to ensure the deal team understands what is driving the deal. Is it the technology, the revenues, the senior executives or the R&D team including how long must they be retained? This allows the business and legal teams to sideline less important issues while focusing efforts and negotiations on the key risks associated with the most valuable assets.
French Language Requirements
Finally, for those U.S. companies who are considering carrying on business in Quebec, particularly those who will have a physical place of business in the province, it is important to be aware of the French language requirements imposed by the Charter of the French Language, which requires the use of French in such areas as communications with employees, packaging, advertising (including on the Internet), contracting and invoicing and, in certain circumstances, the use of information technology.
Commercial Issues For U.S. Companies Buying, Selling Or Licensing Technology In Canada
For a U.S.-based technology company that wishes to enter or continue doing business in the Canadian market, the good news is that Canadian laws and industry practices affecting commercial contracts are quite similar to those in the U.S. But there are a number of subtle and not-so-subtle differences which, if not addressed in the contract, could introduce unforeseen risks into the transaction. A few of these differences are summarized below.
Governing Law And Enforcement
Before entering into a commercial contract with a Canadian counterpart, it will be useful to agree on the governing law of the contract. Too often, choice of law is an afterthought in negotiations or regarded as simply a "boilerplate" issue, but (as further explained below) the parties’ choice of law can have a significant impact on their rights and remedies. A jurisdiction with a highly developed commercial jurisprudence such as Ontario is generally to both parties’ advantage, including the U.S. licensor of technology.
If a dispute under the contract is litigated in Canada (which would be the preferred strategy if a Canadian-based licensee were using the U.S. licensor’s technology in an unauthorized manner), then an Ontario (or other Canadian province) choice of local law allows for quicker adjudication in local courts. Additionally, litigants in Canadian courts can avail themselves to certain procedures and remedies that are absent from the U.S. system and which may be advantageous in the context of a technology contract dispute. For example, Canadian courts can issue so-called Anton Piller orders, which are essentially civil search warrants permitting the plaintiff to search the defendant’s premises for vital evidence where there is a danger that the evidence will be destroyed. Canadian courts also routinely award litigation costs (i.e. attorney’s fees) to the successful litigant.
Implied Warranties And Conditions
It is standard practice in the U.S. to disclaim all implied warranties, including warranties of merchantability and fitness for a particular purpose. Indeed, the Uniform Commercial Code (UCC), which applies to contracts for the sale of goods and has been adopted in the majority of U.S. jurisdictions, requires exclusions or modifications of these implied warranties to be expressly and conspicuously stated.
Canadian provinces also have sale of goods statutes that apply to non-consumer sales, such as Ontario’s Sale of Goods Act. But while the UCC has implied warranties, Canadian sales statutes have implied warranties and conditions. And while the UCC has an implied warranty of "merchantability", Canadian sales statutes have an implied warranty of "merchantable quality" and British Columbia, in particular, has an additional implied warranty of "durability". These differences should be reflected in the disclaimers in any commercial contract for the sale of goods (including the supply of software) in Canada that U.S. technology suppliers enter into with Canadian-based customers.
Limitations Of Liability
Like disclaimers of warranties and conditions, limitations of liability provisions can trip up a contract under Canadian law if it has terms that may otherwise be standard and enforceable in the U.S. While in the U.S. disclaimers of liability may be broadly worded to exclude "all liability", in Canada it is necessary to expressly disclaim negligence. In Quebec, the Civil Code prohibits exclusions or limits of liability for material injury caused to another through an intentional or gross fault or which limit or exclude liability for bodily or moral harm. Moreover, the concept of gross negligence, while widely used in Canadian contracts, has a more developed jurisprudence in the busiest U.S. court systems such as New York’s.
Unlike in the U.S., where contracting parties have broad discretion to vary statutory periods of limitations in the contract, some Canadian jurisdictions limit or altogether void such variations. An extreme example is Ontario’s Limitations Act, which imposes a "basic" limitation period of two years and an "ultimate" limitation period of 15 years on all actions, with certain exceptions. The limitation periods under the Limitations Act apply despite any agreement to vary or exclude them, though in Ontario this rule is under review.
The sale of technology – particularly software – in Canada is subject to varied tax treatments depending on the type of technology and the applicable jurisdiction. Generally, provincial sales tax will apply to off-the-shelf software, but not to custom developed software. When software comes from outside Canada, the federal Goods and Services Tax distinguishes between off-the-shelf software with shrink-wrap licenses and custom developed software for the purposes of determining whether the software has been imported by the user, in the case of the former, or supplied to the user’s premises, in the case of the latter. It goes without saying that U.S. companies should seek specialized tax advice on the nuances of Canadian tax law before entering the Canadian market.
Bankruptcy Of Licensor
When contracting with a Canadian supplier of technology, the bankruptcy risk of that supplier warrants careful consideration by their U.S. counterparts. In the U.S., under section 365(1)(n) of the Bankruptcy Code, if a trustee in bankruptcy rejects an executory contract of a bankrupt licensor of intellectual property, the licensee can nonetheless assert its rights to use the intellectual property. This is known as the Lubrizol exception.
By contrast, the same situation under Canada’s Bankruptcy and Insolvency Act is uncertain; indeed, the law is unsettled as to whether a trustee in bankruptcy could disclaim an executory contract, let alone whether a licensee could assert its license rights under those circumstances. As a result, licensees of software in Canada often require a source code agreement or other means of attaining the right to continue to use the software in the event the licensor becomes insolvent, with the most comfort being provided by a partial assignment of the copyright in favour of the counterparty.
The Canadian provinces have adopted electronic commerce statutes that address a variety of issues that arise in doing business electronically, such as the validity of using electronic documents to meet the writing requirements for legal documents. Ontario’s Electronic Commerce Act, for example, provides that a legal requirement that a document be in writing is satisfied by a document that is in electronic form – such as e-mail - if it is accessible so as to be usable for subsequent reference. In Quebec, the legal value of a document, particularly its capacity to produce legal effects and its admissibility as evidence, is neither increased nor decreased because of the medium or technology chosen. Nevertheless, under the Quebec regime, it is critical to be able to establish that the "integrity" of a technological document has been maintained throughout its life cycle. In this regard, certain legal presumptions apply. Generally, Canadian e-commerce statutes are based on the same model as their U.S. counterparts; however, before doing business in Canada, a U.S. company should seek assistance interpreting the nuances among the numerous provincial, state and federal regimes.
As this discussion illustrates, knowledge of the key differences between U.S. and Canadian corporate and commercial law is critical to mitigating the legal risks of doing business in Canada. Your Canadian counsel should be able to guide your company around these and other common pitfalls.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.