Canada: The "Delaware - Canco Straddle" For Canadian Tech Start-Ups

Last Updated: June 1 2016
Article by Greg P. Shannon

Canadian start-ups, including those in the information technology sector (i.e. mobile apps, computer software and other information technologies ("IT")) may benefit from certain tax and corporate advantages of operating both a Canadian corporation ("CanCo") and a U.S.-based corporation (often a Delaware corporation, "DelawareCo"). There are plentiful tax and capital funding incentives offered to tech start-ups operating in Canada, particularly in provinces such as British Columbia and Ontario, (i.e. with Venture Capital Corporations and Labour-Sponsored Funds). In order to exploit the advantages of operating on both sides of the 49th parallel, entrepreneurs are considering innovative strategies to take advantage of these unique incentives. For those CanCo's and their seed shareholders having some operations in Canada and some operations in the U.S., the "Delaware-CanCo Straddle" is becoming a favoured cross-border structure. The following explores why Canadian entrepreneurs are seeking to structure their operations utilizing both a CanCo and a DelawareCo sister corporation.

Why Incorporate a CanCo?

For those carrying on business in Canada, contracting with Canadian resident suppliers, employing Canadian residents or simply seeking Canadian funding (whether it be seed capital, private equity, or venture capital), a presence in Canada, which is normally by way of a Canadian-Controlled Private Corporation ("CCPC"), is a very tax efficient and operationally useful approach. It permits CanCo to be eligible for certain investment tax credits under the Scientific Research and Experimental Development Program ("SR&ED"), both provincially and federally. Some provinces also offer additional SR&ED tax credits only to CCPC's while other or foreign-owned companies are only eligible for non-refundable tax credits up to 15% of eligible expenditures. CCPC's under the small business income limit of under $500,000 and the taxable capital requirements limit of under $10,000,000, may receive up to 35% of eligible expenditures as refundable tax credits. Eligible SR&ED expenses include labour, materials, overhead, and subcontracting costs, among other allowances.  For CanCo to qualify for the SR&ED program, all research and experimentation must be conducted in Canada and CanCo either has to own the intellectual property ("IP") or IT resulting from this work or have a legally binding agreement that confirms that all SR&ED tax credits belong to CanCo. 

Other government funding programs such as the Industrial Research Assistance Program ("IRAP"), the Canadian Renewable Conservation Expense ("CRCE"), Sustainable Development Technology Canada ("SDTC"), the Canada Media Fund ("CMF"), and the Canadian Feature Film Fund ("CFFF"), mandate that all eligible recipients be incorporated in Canada. Certain provincial funding programs also require that businesses be incorporated and operate in the provinces at issue and thus Canadian operations can exponentially increase federal and provincial government funding opportunities and tax incentive programs. Finally, because Canada is a less litigious country than the U.S., it is prudent to house the major assets of the operations (namely the IP, IT and other material agreements) in Canada.

Why Incorporate a DelawareCo?

There are many reasons why Canadian entrepreneurs consider incorporating in Delaware more often than any other state in the United States. Canadian entrepreneurs seeking to set up a DelawareCo do so to attract U.S. angel investors, U.S. venture capital companies, and U.S. institutional investors who are more comfortable investing in early stage or start-up technology businesses that are governed by U.S. state laws, preferably Delaware. In addition, U.S.-based tech incubators and tax driven funding programs may require U.S. incorporation in order to access those particular programs. Furthermore, creating a U.S.-based sister corporation may result in enhanced cross-border travel and freedom of movement of employees and key personnel and executives who have access to work visas (i.e. L-1A, L-1B and E-2 visas) and other opportunities for executive management habitually resident in Canada to move freely to and from the U.S.

Top 8 Reasons to Incorporate a DelawareCo:

  1. Corporate law expertise of the Delaware Court of Chancery – the Court of Chancery is a highly-respected court that focuses on corporate issues and, because of this specialization, the Court of Chancery has a great deal of expertise and a sizable body of case law for resolving complex corporate disputes.
  2. Established Delaware jurisprudence means more predictability in terms of the likely judicial result in the event of a business dispute. No corporation wants to be involved in litigation, but in such an unfortunate event it is comforting to know that the judges of the Delaware Court of Chancery are sophisticated and well-versed in adjudicating corporate law cases.
  3. The Delaware corporate statutes provide a great deal of flexibility in the organization of a corporation and in the rights and duties of board members and shareholders. The extensive case law mentioned above is a tremendous asset when determining how a Delaware statute is likely to be interpreted.
  4. Most corporate attorneys in the U.S. are familiar with the Delaware Corporate Code. Therefore, it may be more cost efficient and more effective to set up a company in Delaware than in any other state.
  5. U.S. angel investors, venture capital funds, and private equity firms tend to prefer to invest in companies incorporated as a Subchapter "C" corporation in Delaware versus any other state or any other type of corporate entity (i.e. Subchapter "S" corporation's, LLC's, or even LLLP's.)  Hence, if entrepreneurs are serious about receiving investments from these type of investors, they may wish to incorporate in Delaware. Note: LLC's and LLLP's are not favoured legal entities for Canadian entrepreneurs carrying on business in the U.S. due to adverse tax treatment under the Canada-U.S. Tax Treaty and, therefore, should be avoided.
  6. Many investment bankers also insist on a U.S. company being incorporated in Delaware before they attempt to take same public. Thus, if an IPO is a possible exit strategy, one may wish to incorporate in Delaware rather than having to later convert to a DelawareCo or continue same into Delaware.
  7. By incorporating in Delaware, you also send a message to the investment community and the angel/VC world that you are a "national company" by being a DelawareCo. This is helpful and sends a loud signal to investors that you understand the preferences in the marketplace and you are serious about receiving investments.
  8. There are greater privacy protections in the state of Delaware. Delaware does not require officer or director names to be disclosed on formation documents and it provides a layer of confidentiality that is not available in most other states.

The "Delaware - CanCo Straddle" Defined

This type of cross-border structure is becoming increasingly popular. The strategy involves establishing sister corporations, one in Canada ("CanCo") and one in the U.S. ("DelawareCo"), which are owned by the same shareholders and which have identical share ownership percentages. The DelawareCo is customarily a Subchapter "C" corporation.

Depending upon the particular facts, circumstances, and related considerations, including but not limited to the size and scale of operations and the location of seed shareholders, angels, founders, officers, directors, employees, and contractors, as well as the feasibility of entering into new jurisdictions, the Delaware - CanCo Straddle makes logical sense. 

On the one side, there is a significant benefit to be gained from the optimization of government grants in Canada. To do so, CanCo has to own the IP and any and all research or development associated with such IP with an effective licence strategy - usually under exclusive licensing arrangements to the DelawareCo for use in the United States. 

Often when a Canadian tech start-up is acquired by a U.S. company there could be significant tax complexities on both sides of the border. In the absence of an already established U.S. sisterco, the parties often attempt to mitigate cross-border tax issues through acquisition structures such as the "exchangeable share transaction". This is complex and adds significant costs to any merger or acquisition transaction.  In some cases an acquisition can reduce the complexities and additional costs associated with such "exchangeable share transactions" if a portion of the target is already set up as a DelawareCo. 

Furthermore, by creating separate sister corporations, Canadian shareholders of CanCo will be able to take advantage of Canada's lifetime capital gains exemption with respect to the sale of shares of a CCPC, and in the absence of the Delaware - CanCo Straddle, if U.S. operations were carried out under the Canadian company's governance and direction (either directly by the CanCo or by a U.S. wholly-owned subsidiary of a CanCo) and if such operations were substantial, the exemption may not be available.

While "dual incorporation" provides a broad range of corporate advantages, Canadian tech start-ups should be cognizant of the fact that operating sister corporations will result in additional legal, tax, and financial responsibilities, both administrationally and managerially, as follows: tax returns must be filed in both countries and there must be Canadian and U.S. tax paid; work visas will be required for Canadians travelling to and from the U.S. to attend to the DelawareCo operations; U.S. investors may be sensitive about IP being owned directly by CanCo and being outside the "reach of the U.S.", thus requiring a sophisticated agreement between the two sister corporations regarding the use and licensing of the IP.  IP licensing issues can also give rise to certain transfer pricing issues under Canadian and U.S. tax laws; therefore, careful planning is paramount. 

Ultimately, while there are operational and financial gains to be made when undertaking cross-border operations, every CanCo has its own needs and special requirements. Therefore, it is prudent to seek out specialized professional advice for legal, tax, and accounting issues to determine which cross-border structure is the most effective for your particular circumstances because each Canadian tech start-up has its own unique parameters. 

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.

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