On March 19, 2007, Canada’s minority Conservative government announced the 2007 Budget, which includes a number of tax measures intended to give technology companies that are incorporated in Canada greater access to international sources of capital.
Canadian founders of technology start-ups face a difficult choice when deciding whether to incorporate in Canada or the United States. On the one hand, there are numerous tax advantages associated with carrying on business as a Canadian-controlled private corporation (CCPC), which can only be incorporated in Canada. For example, CCPCs are eligible for lower tax rates on certain income; CCPCs are eligible to receive investment tax credits (ITCs) for scientific research and experimental development (SRED) at a favourable rate and on a refundable basis; Canadian founders may be able to take advantage of the lifetime capital gains exemption on the sale of shares of a CCPC (increased in the Budget from $500,000 to $750,000); and certain tax deferrals and deductions are only available for stock options granted by a CCPC. On the other hand, U.S. and other non-resident investors can experience tax problems on an exit from a Canadian-incorporated company. These tax issues have meant that many U.S. venture capitalists will not consider a direct investment in a Canadian corporation. As a result, some of the most promising Canadian technology companies have either incorporated in the U.S. in the first instance, or have reorganized as U.S. corporations, in order to secure U.S. venture capital investment.
What has been addressed?
The Budget proposes to address some of the more serious tax issues encountered by U.S. and other non-resident investors in Canadian corporations, as detailed below.
1. LLCs under the Canada-U.S. Tax Treaty
Many U.S.-based venture capital funds are structured as limited liability companies (LLCs). Currently, the Canada Revenue Agency (CRA) does not recognize LLCs as U.S. residents for the purposes of the Canada-U.S. Income Tax Convention (the "Treaty"), because of the status of such corporations as disregarded entities for U.S. tax purposes. As a result, any gain (or loss) from the sale of shares of a Canadian corporation by a LLC is fully taxable in Canada. For this reason, a direct investment by a LLC in a Canadian corporation is not tax effective for the LLC or its shareholders, and LLCs have been forced to either decline the investment or put in place costly off-shore holding company structures as a "work around". The Budget proposes to extend Treaty benefits to LLCs. However, the implementation of this proposal depends on finalizing treaty negotiations with the United States, currently expected to occur in the near future with effect likely to be in 2008.
2. Elimination of Withholding Tax on Interest
A Canadian corporation is required to withhold and remit withholding tax on interest payable to non resident lenders. The withholding tax rate is either 10% or 25%, depending on whether the payee is covered by the Treaty. The Budget proposes to eliminate non-resident withholding tax on interest on all arm’s length payments of interest to non-residents and eventually to non-arm’s length U.S. treaty residents. This is good news for Canadian-incorporated technology companies that want to access the well-established U.S. venture debt market without having to agree to tax gross-ups typically required by non-resident lenders. In addition, this measure will make it more attractive for U.S. venture capitalists to finance Canadian corporations through bridge debt and other debt instruments. Timing of the elimination of non-resident withholding tax vis-ŕ-vis U.S. lenders depends on finalizing treaty negotiations with the United States. This measure will only be effective for the calendar year following ratification by the two countries (making 2008 the earliest possible date for implementation). The proposal to eliminate withholding on non-arm’s length interest is expected to be implemented over a 3-year transition period commencing with the implementation of the Treaty.
3. Public Offerings on AIM
Some Canadian technology companies have recently had success in raising substantial capital on the Alternative Investment Market (AIM) of the London Stock Exchange plc. However, AIM is not a "prescribed stock exchange" for the purposes of the Income Tax Act (Canada) (the "ITA"). This means that the shares of a Canadian-incorporated company are "taxable Canadian property" for the purposes of the ITA, and that shareholders not resident in Canada will be subject to Canadian capital gains tax when the shares are traded (unless a treaty exemption is available). Non-resident shareholders will also be required to obtain a clearance certificate from CRA prior to disposing of the shares. These factors have forced some Canadian technology companies to employ complex "work-arounds" (such as reorganizing as a mutual fund corporation) if they wish to undertake an AIM-only IPO. The Budget has proposed a wholesale rewrite of the concept of "prescribed stock exchange" which means that a Canadian corporation will be able to go public on AIM without extraordinary tax structuring. This proposal will be effective immediately on Royal Assent to the Budget. However, as we currently have a minority government in Canada, there can be no assurance when or if Royal Assent will be obtained.
4. Other Announcements
The Budget also included other positive developments for the Canadian technology sector. For example, the Budget included commentary that the federal government will, over the coming year, identify opportunities to improve the SRED tax credit program to further encourage R&D within the business sector in Canada. However, investors are reminded that Canada is currently in a fairly volatile minority government situation and that there can be no guarantee that the government will not be forced to call an election before the proposals described above can be implemented.
What was not addressed?
Unfortunately, the Budget failed to address certain tax issues that have driven many Canadian start-up companies to incorporate or reorganize in the U.S.:
1. Non-Resident Withholding Tax on a Sale of Private Company Shares
Currently, 25% of the proceeds of disposition of the sale of shares of a private Canadian corporation by a U.S. or other non-resident seller must be withheld by the purchaser and remitted to CRA to cover the seller’s tax liability. The purchaser is only relieved of this obligation if it obtains a clearance certificate (sometimes referred to as a s. 116 certificate) from CRA. In theory, the clearance certificate is an administrative requirement only and should be available if the sale of shares is exempt from capital gains tax under the Treaty. However, in practice the withholding tax and clearance certificate requirements have created numerous problems for U.S. venture capital funds disposing of a Canadian portfolio investments. First, it can be difficult for a fund structured as a limited partnership to obtain a clearance certificate, since CRA will require detailed tax information regarding a fund’s limited partners in order to determine if a Treaty exemption is available. This can cause privacy concerns for limited partners and/or the required information may simply not be available (particularly if limited partners are themselves structured as partnerships or LLCs). Second, it has not been possible to obtain a clearance certificate at all for a seller that is LLC since these entities have not been covered by the Treaty. While the recent Budget proposals to extend Treaty coverage to LLCs will partially address this problem, we are concerned that even once this proposal is implemented that LLCs may, like limited partnerships, be required to disclose detailed tax information regarding their investors which may impair the ability to obtain a clearance certificate on a timely basis (or at all). Third, the time to process clearance certificate applications has often extended to two or three months which remains problematic for transactions which typically are required to close in a shorter time frame. Finally, in the case of a share-for-share acquisition of a portfolio company by a publicly-traded acquirer, sellers can be exposed to fluctuations in equity markets while they wait for CRA to process their clearance certificate applications.
2. No Roll-over Treatment for Canadian Shareholders
Currently, Canadian shareholders of a Canadian corporation do not receive a tax-free roll-over on a share-for-share acquisition by a U.S. acquirer. This means that a Canadian shareholder will incur a tax liability in the year of the acquisition. If the acquirer’s shares are illiquid or subject to resale restrictions, the Canadian shareholder may be in a position where he cannot sell the shares to satisfy the resulting tax liability. This issue is commonly addressed by using an exchangeable share structure, which may be costly to implement and can result in reduced liquidity for Canadian shareholders. In November 2000, CRA announced a proposal to provide roll-over treatment in a share-for-share acquisition, but to date we have not seen any action on this proposal, and this item was not addressed at all in this year's Budget.
There are of course other issues that influence where to incorporate, such as U.S. tax rules (including CFC and PFIC rules) and the stringent minority shareholder protections available under Canadian corporate statutes relative to the more permissive Delaware statute. However, if the remaining Canadian tax issues discussed above can be addressed, the new Budget proposals mean that more Canadian technology companies can be expected to incorporate in Canada and attract U.S. venture capital investment.
In summary, while impediments to direct investments in Canadian companies will continue to persist, when and if the Budget proposals described above become law, some meaningful progress will have been made to level the playing field for Canadian companies seeking U.S. or other foreign investment.
For more detailed information on these proposals please click here.
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