On March 4, 2010, the Canadian federal government tabled its Budget. Included in the Budget is a proposal which would eliminate, with effect from March 5, 2010, what has been a longstanding thorn in the side of foreign private equity and venture capital investors.

Current Rules

Non-residents are subject to tax in Canada on gains from the disposition of "taxable Canadian property" unless relief is available under an applicable tax treaty. Shares of a private, Canadian-resident corporation currently constitute taxable Canadian property. Even shares listed on a designated stock exchange will constitute taxable Canadian property if the holder, alone or together with non-arm's length persons, held 25% or more of any class of shares of the corporation at any time in the 60-month period before the disposition (the "Ownership Test").

Under recent amendments, where relief is available under an applicable tax treaty, non-residents may be exempt from Canadian tax on a gain from a disposition of shares that are taxable Canadian property and from the obligation to file Canadian tax returns in connection with the sale of such shares. However, Canada imposes on the purchaser an obligation to withhold and remit from the purchase price an amount in respect of Canadian tax unless the non-resident seller applies for and obtains a certificate in respect of the disposition (a "Section 116 Certificate"). Pursuant to recently enacted amendments, a purchaser could also comply with section 116 by notifying the Canada Revenue Agency of the disposition provided that (i) the purchaser concluded after reasonable inquiry that the seller is resident in a country with which Canada has a tax treaty, and (ii) gains on the shares would be exempt under the tax treaty if the seller was so resident. If the purchaser withholds and remits to the Canadian tax authorities, the non-resident must file a Canadian tax return in order to obtain a refund of such taxes, to the extent that the amount remitted exceeds the non-resident's final Canadian income tax liability, which would be the case under most of Canada's bilateral tax treaties.

Proposed Amendment

The Budget proposes to amend, with effect from March 5, 2010, the definition of "taxable Canadian property" to generally exclude shares of any Canadian-resident corporation, whether or not the shares are listed on a designated stock exchange, unless (i) in the case of shares which are not listed on a designated stock exchange, more than 50% of the value of the shares is derived from real property situated in Canada, Canadian resource properties or timber properties (the "Share Value Test"), and (ii) in the case of shares listed on a designated stock exchange, both the Share Value Test and the Ownership Test are met.

As a result of this proposed amendment, the Section 116 Certificate process will not apply to a disposition of shares of a Canadian corporation except where the value of the shares is derived from real property situated in Canada, Canadian resource properties or timber properties. This will eliminate what has long been an irritant to foreign private equity and venture capital investors, particularly those structured as limited partnerships.

Significantly, this amendment also eliminates the liability of non-residents for Canadian income tax on gains from the sale of shares in the capital of Canadian corporations unless the Share Value Test is met, whether or not the non-resident shareholder is entitled to the benefits of one of Canada's bilateral tax treaties. Accordingly, in most cases, the amendment will provide relief from Canadian tax to (i) persons resident in non-treaty countries; (ii) persons resident in a country (such as Japan) whose tax treaty with Canada does not exempt from Canadian tax gains realized on a disposition of shares of Canadian-resident corporations; and (iii) persons resident in a treaty country who would not otherwise qualify for benefits under the applicable treaty (such as, for example, under an applicable limitation on benefits clause or certain US hybrid entities that are classified differently for US and Canadian tax purposes).