Regulatory and tax considerations private equity firms should focus on when investing in Canada
The first nine months of 2022 have seen global M&A activity levels fall substantially from the records reached in 2021. However, with a continuing abundance of dry powder, private equity investors have remained relatively busy: data firm Refinitiv reports that, despite being down 25% compared to a year ago, private equity M&A activity accounted for a record 23% of global M&A activity in the first three quarters of 2022.
Canada has also experienced a decline in deal activity. Based on a report from Refinitiv, some C$12.2 billion worth of private equity buyout and related investments have been announced in the first three quarters of 2022, down 65% from the same period in 2021.
With increasing talk of an economic slowdown, we expect that private equity funds will continue to seek to profit from market timing opportunities in Canada, including through buyouts of public companies whose trading price may not be representative of their underlying value and through later stage private company growth equity investments.
Factors Relevant to Foreign Investors
Non-Canadian investors must be aware of a number of potential regulatory and tax issues that arise in the context of their investments in Canadian businesses. Regulatory issues may be triggered pursuant to the Investment Canada Act (ICA), Canada's foreign investment regulation, which applies to any acquisition of control of a Canadian business by a non-Canadian investor. Where they meet certain financial thresholds, acquisitions may be subject to economic review (and, extremely rarely, prohibited) if, based on factors such as the nature of the acquired business and the identity of the investor, the government determines that the transaction is not of "net benefit to Canada." In recent years, the number of acquisitions subject to economic review under the ICA has declined, owing to welcome increases in the financial thresholds triggering a review (particularly for investors from jurisdictions with trade agreements in place with Canada, such as the United States and the EU). Most investments instead proceed by way of an administrative notification to the government, with no review under the ICA required.
In addition, even where they do not meet the financial thresholds triggering an economic review, or do not constitute an acquisition of control (such as minority investments), investments by nonCanadians are also subject to potential national security review under the ICA. Under this process, investments may be reviewed and prohibited where they are deemed injurious to Canadian national security. In this respect, the ICA is similar to CFIUS in the United States. Investors must also be aware of applicable requirements of Canada's antitrust statute, the Competition Act.
Tax issues that non-Canadian investors often face include the potential loss of a corporation's tax-advantaged status as a Canadian-controlled private corporation (CCPC). Structuring routes that foreign investors should explore for their Canadian acquisitions include the so-called "leveraged equity" structure discussed below.
I. Regulatory Matters
Investment Canada Act
The ICA allows the Canadian federal government to screen certain proposed foreign investments to ensure that they are likely to produce a "net benefit to Canada." Direct acquisitions of Canadian businesses by non-Canadians are subject to automatic economic review if the enterprise value of the Canadian business exceeds a specified threshold. For 2022, the threshold for a "WTO investor" (i.e., an investor ultimately controlled by nationals of a WTO–member country) is C$1.141 billion in enterprise value, a figure which is indexed annually to Canadian GDP growth. For investors from countries party to certain trade agreements with Canada (which include, notably, the United States, the EU, and parties to the Trans-Pacific Partnership), this threshold is even higher, at C$1.711 billion (also subject to annual indexing). Lower thresholds apply in the case of other types of investors, such as non-WTO investors, or state-owned enterprises. Lower thresholds also apply in the case of acquisitions of control of cultural businesses—generally, businesses involved in activities such as the production, sale, publication, or distribution of film, audio, books, newspapers, or magazines. If a transaction does not meet the applicable monetary threshold, no pre-closing review is required from the investor to the government; however, a notification is required to be filed by the investor within 30 days after closing. In most cases, this notification is an administrative formality.
A transaction that is reviewable under the economic review sections of the ICA will be approved only if the Canadian government determines that the transaction is likely to produce a "net benefit to Canada." In making this determination, the government will take into account the following:
- the effect of the investment on the level and nature of economic activity in Canada;
- the degree and significance of participation by Canadians in the Canadian business and the relevant Canadian industry;
- the effect of the investment on productivity, industrial efficiency, technological development, product innovation, and product variety in Canada;
- the effect of the investment on competition within any industry in Canada;
- the compatibility of the investment with national industrial, economic, and cultural policies; and
- the effect of the investment on Canada's ability to compete in world markets.
It is very common for the government to require investors to provide legally binding undertakings as a condition to receiving a net-benefit-to-Canada ruling. These undertakings, which will vary from transaction to transaction in light of the particular facts, may include commitments to maintain employment levels in Canada, to appoint and maintain a certain number of Canadians to board or senior management positions, and to make minimum capital expenditures in Canada. The government will generally monitor the investor's compliance with the undertakings during the period in which they are in place (typically three to five years following closing) with periodic progress reports.
Transactions in which the applicable monetary threshold is not met may nevertheless be reviewed by the government where it has "reasonable grounds to believe" that the investment "could be injurious to national security." This concept is not defined in the ICA or its regulations, though the government has released guidelines as to the factors it will consider. The government has 45 days from the date it receives notice of a transaction that must be notified to advise the investor that it may undertake such a review. For certain minority investments that do not otherwise trigger a notification obligation, the government has either five years or 45 days from the date the investment is voluntarily notified to advise the investor that it may undertake a national security review.
Our experience since the national security review rules were implemented in 2009 is that very few transactions attract the scrutiny of the Canadian government on national security grounds, but any investment in Canada by a non-Canadian investor can trigger this process regardless of:
- whether it is reviewable or notifiable according to the rules above;
- whether by a US investor or other;
- whether it is for the establishment of a new Canadian business, the acquisition of control of a Canadian business, or the acquisition of a minority interest in a Canadian business; and
- the dollar value of the transaction.
That said, investors from certain countries and into sensitive industries may attract the most scrutiny under the national security provisions of the ICA. Notably, national security review applies not only to the acquisition of control of a Canadian business but also to minority investments in Canadian businesses. Furthermore, there is no minimum dollar threshold for national security review (i.e., investments in targets with low enterprise values are nonetheless potentially reviewable). Since the beginning of the COVID-19 pandemic, we have observed that the government has applied a heightened degree of national security scrutiny to transactions that might not have raised any national security concerns prior to the pandemic.
In April 2020, the Canadian government issued guidance indicating that certain types of transactions (namely, transactions impacting the healthcare industry, transactions involving the supply of critical goods and services to Canadians or to the Canadian government, and transactions involving state-owned or state-influenced investors) would be subject to greater scrutiny under the ICA.
In March 2022, the Canadian government issued guidance indicating that investments that have ties, directly or indirectly, to individuals or entities associated with, controlled by or subject to influence by Russia will likely be subject to national security review.
In October 2022, the Canadian government issued a policy statement noting that investments from state-owned enterprises involving Canadian businesses or entities operating in a critical mineral sector in Canada will likely be subject to national security review. Shortly afterwards, the Canadian government announced that three foreign investors were ordered to divest their interests in Canadian critical mineral companies.
The timeline for a national security review is prescribed by regulation and can add significant delays to the process of obtaining required regulatory approvals. If the maximum periods under the regulations are fully utilized, a national security review could take 155 days or longer (upon the consent of the investor). As there is no formal pre-closing notification requirement in relation to a national security review if government approval is not otherwise required prior to closing (i.e., the mandatory threshold for economic review is not met), it is possible that an investor may learn that the transaction is subject to national security review only following closing upon receipt of a notice from the government. However, even if a pre-closing ICA review is not required, an investor may choose to file a notification in advance of closing in order to trigger the 45-day period in which the government must give notice of a review or possible review under the regulations.
Canada's federal antitrust statute, the Competition Act, applies equally to Canadian and non-Canadian investors. The Competition Act requires mandatory pre-merger notification if certain monetary thresholds are met. This is determined based on a complex formula that considers the revenues and assets of the target and its affiliates and, potentially, the investor and its affiliates. In the case of acquisitions of interests in partnerships or corporations, certain voting interest or shareholding thresholds must also be met before a notification is triggered. We have developed a Merger Notification Assessment Tool to guide companies through the process. It can be found on our website and in our report Canadian Competition and Foreign Investment Outlook 2020. For 2022, the Size of Transaction threshold is C$93 million, while the Size of Parties threshold is C$400 million.
If a transaction exceeds the applicable thresholds, it will require a pre-closing notification to the Commissioner of Competition. Even if the transaction does not meet the threshold, the Commissioner can investigate any transaction (within a year after closing) if he believes that the transaction "would or would be likely to prevent or lessen competition substantially" in a relevant market. This is the same test that the Commissioner uses when deciding whether to initiate an application to the Competition Tribunal, and it is also the test that the Tribunal uses in its adjudication of an application. In applying the test, the Commissioner and the Tribunal may consider a number of antitrust factors and arguments, depending on the facts of the case. These may include the extent and availability of acceptable substitutes for any overlapping products or services supplied by the parties, potential barriers to entry in the relevant market(s), whether the transaction would result in the removal of a vigorous and effective competitor, the extent to which there would be effective remaining competition following the transaction (including considering in some cases competition from foreign competitors), the nature and extent of change and innovation in the relevant market, and whether the business of a party to the transaction has failed or is likely to fail in the absence of the transaction. In an analysis unique to Canada, the Bureau and Tribunal may also consider an efficiencies defense if raised by the parties—that is, where the efficiency gains likely to result from the transaction are large enough to offset any likely anticompetitive effects, the Tribunal may not make an order in respect of the transaction. The merger review filing fee in Canada in 2022 is C$77,452.36.
The Competition Bureau maintains a steady flow of cases. In 2021–2022, it concluded 256 merger reviews. While the Bureau's initial statutory waiting period following receipt of a notification is 30 days, the majority of mergers are cleared prior to this period. In 2021–2022, for instance, most mergers fell into the noncomplex category and were cleared within the 14-day non-binding service standard. About 25% of mergers were classified by the Bureau as complex and took on average 38 days to review, below the Bureau's nonbinding 45-day service standard.
The Bureau also has the ability to issue a supplemental information request (SIR) in complex cases, similar to the US second-request system under the US Hart-Scott-Rodino Act, which can require significant documentary productions. Where the Bureau issues an SIR, it triggers an additional 30-day waiting period following both parties' filing of certified responses to the SIR, during which the transaction cannot be closed. However, SIRs have been used sparingly and were invoked in only 9 complex merger transactions concluded in 2021– 2022.
We continue to see transactions proceed to close despite not receiving positive clearance (once the applicable statutory waiting periods had run out)— this remains an ongoing trend in Canadian antitrust practice. The Bureau retains the ability to challenge a transaction in such a case within one year following closing.
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