Current Canadian tax law creates barriers to efficient cross-border investment. In particular, many international private equity investors, particularly US-based venture funds, have complained about the additional time and expense associated with exiting Canadian-based investments. Proposed changes to the Section 116 withholding and clearance certificate obligations, announced in the federal budget on February 26, 2008, should come as good news to US venture capital investors active in Canada.
Under current Canadian tax law, a US-based fund investing directly in a Canadian operating company, on a disposition, will generally be required to obtain a certificate from the Canada Revenue Agency (typically referred to as a "Section 116 Certificate" after the relevant section in the Income Tax Act (Canada)), file a Canadian tax return and provide certain details regarding each of its limited partners. Private equity sponsors are often precluded from doing this under the terms of their limited partnership agreements. Even if they are permitted to do so, compliance with the requirements can be an organizational headache.
To avoid these administrative burdens, many US venture funds have resorted to structuring their investments in Canada through an exchangeable share transaction. These funds invest directly in a newly established Delaware company into which all of the shares of the existing Canadian operating company are exchangeable upon the occurrence of certain events.
Other US funds have been known to structure their Canadian investments through a corporate vehicle resident in a third jurisdiction (e.g., Barbados or Luxembourg) that mitigates the administrative burden and may otherwise be more favourable from a tax-planning standpoint.
In many cases, these complexities have resulted in significantly higher transaction costs or have chased away investors that might otherwise have considered investing in Canada. In fact, some commentators have blamed the lack of venture funds available to Canadian entrepreneurs on these tax restrictions.
In the 2008 federal budget, the Canadian government proposed revisions to the Section 116 withholding and clearance certificate obligations, and the hope is that these revisions will alleviate some of the cost and inconvenience associated with certain cross-border transactions. The effect of the proposals may be to ease the compliance burden imposed on certain non-resident sellers and to allow such sellers to avoid the related purchase price withholding on closing.
To qualify for the proposed relief, several requirements must be satisfied. Given the potentially significant exposure to buyers seeking to hold-back, buyers will need to diligently assess whether the relevant criteria can be adequately satisfied. In certain instances, opinions, representations and certificates may be inadequate to provide buyers with the required level of assurance.
On a separate note, but relevant to venture funds, the budget also proposed enhancements to Canada's scientific research and experimental development incentives, in particular for R&D undertaken by Canadian-controlled private corporations and for certain eligible R&D to be undertaken outside of Canada.
For a more detailed discussion of the revisions to the Section 116 withholding and clearance certificate obligations, please read our firm's federal budget commentary.
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