The minority Harper government released its fifth Budget on
March 4, 2010 ("Budget 2010"). The Budget 2010 provides
that effective immediately, non-resident investors in Canadian
corporations no longer need to obtain a clearance certificate under
Section 116 of the Income Tax Act ("ITA") for equity
disposition of non real property interests. The budget narrows the
taxable Canadian property definition by excluding shares of
corporations that do not derive their value principally from real
or immovable property situated in Canada. Consequently,
non-resident investors will no longer be subject to the existing
tax withholding and compliance burdens, except where the equity
disposition constitute real property interest.
Currently, subject to applicable treaties, non-residents are
taxed on their gains from disposition of "taxable Canadian
property." Most of Canada's tax treaties exempt
non-resident investors from tax on gains except where the shares
derive their value principally from real property interest. Despite
this fact, a purchaser is generally required to withhold tax from
the amount paid unless the non-resident entity obtained a clearance
certificate. To obtain such a certificate, a non-resident must pay
to Revenue Canada an amount equal to the non-resident's
potential Canadian tax liability, post security or satisfy the
authorities that no tax will be owed.
The process of obtaining a clearance certificate has been very
burdensome especially for private equity and venture capital funds
since most are structured as limited partnerships. These funds
needed to disclose the identity and treaty status of their limited
partners. The process took at least six months or more to complete.
This required non-resident sellers, typically to have 25% of their
proceeds in escrow while they waited for Revenue Canada to issue
the clearance certificate. This has proven to be a major challenge
in Canadian companies finding investors outside of Canada.
Most investors were required to establish offshore "blocker
entities." A widely used structure by U.S. investors involved
the use of Exchangeable Shares. This structure involves setting up
a U.S. corporation typically a Delaware corporation, into which the
U.S. investor would make their investment. U.S. investors by
utilizing this structure were not subject to the requirement of
applying for a tax certificate at the time of exit because there
was no taxing event in Canada. The use of exchangeable shares and
other mechanisms to avoid the need for a "section 116"
compliance was very expensive. The 2010 Budget specifically states
that in no longer requiring section 116 clearance certificate it
"...is intended to enhance the ability of Canadian businesses
to attract foreign venture capital."
The 2010 Budget is not yet law but it is expected that it will
be enacted shortly. Failure of parliament to approve the Budget
would cause the government to fall. There is currently no
expectation that this will happen. Similar changes are expected to
be made by the government of Quebec.
The implications of this change go beyond future capital
investment by venture capital investors and operating companies.
Many of the exchangeable share transactions and third country
blockers carry high maintenance costs. Consideration should be
given to collapsing these arrangements. The decision to keep the
structure in place or collapse it is not obvious. One factor to
consider is possible loss of Canadian research credits, another is
U.S. and third-country exit costs which would be absorbed in a
taxable exit transaction such as the exercise of exchange rights
and the liquidation of a third country entity. These structures
should also be reviewed in cases where a Canadian ULC is involved
because of the changes in the U.S.– Canada tax treaty
brought about by the 2007 Protocol. These costs may be a small
factor in the case of portfolio companies with little built-in
gain. Nevertheless, each case must be dealt with on its own, and
there is no general rule as to the wisest course of action.
This significant modification to the tax treatment of cross
border investment was a long time in the making. In January, Burns
& Levinson was pleased to have co-hosted a meeting with U.S.
investors and the Minister of Industry, Tony Clement. At that
meeting, the Minister was informed of the obstacles that the
current tax regime presented to U.S. investors. The Minister took
to Cabinet the importance of removing the requirement of section
116 certificate, which was reflected in the 2010 Budget.
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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