Today’s Canadian Federal Budget introduced a proposed amendment to the Income Tax Act (Canada) ("ITA") that will remove a major practical barrier to direct investments by U.S. and other foreign VC and private equity firms in Canadian technology companies by alleviating certain notification requirements to the Canada Revenue Agency. Currently, section 116 of the ITA requires non-resident vendors of "taxable Canadian property", which includes, among other things, shares of most private Canadian technology companies, to obtain a certificate of compliance ("Section 116 Certificate") on the sale or other disposition of their shares. Section 116 applies even if any capital gain realized on the disposition of the shares by the non-resident vendor would be exempt from tax in Canada by virtue of an applicable bilateral income tax treaty. The proposed amendment announced today by the minority Conservative government will eliminate the need for non-residents to apply for and obtain a Section 116 Certificate in connection with the sale or other disposition of shares of Canadian private companies whose principal value is not derived from real property in Canada, Canadian resource property or timber resource property.

The Canadian federal government has previously tried to "fix" the problems associated with the section 116 process. For example, the 2008 Canadian Federal Budget contained proposed amendments to the section 116 regime which were enacted and effective as of January 1, 2009. The 2008 amendments expanded the types of property that would be excluded from the section 116 requirements, thereby simplifying the compliance burden. Although the 2008 changes resulted in a simpler process, section 116 obligations remained a hindrance to direct investments by U.S. and other foreign VC and private equity firms. The current amendments, if passed into law, should decisively eliminate the application of section 116 of the ITA to the sale of shares of most Canadian technology companies.

Although the proposed amendment introduced in today’s Budget will not come into force until it is enacted by the Canadian Parliament, we are encouraged that the Canadian government has finally listened to numerous industry leaders who have pushed for this change for many years. The proposed amendment, when enacted, will apply in determining after March 4, 2010 whether a property is "taxable Canadian property" of a non-resident vendor.

Background

Section 116 requirements have resulted in significant roadblocks to timely exits for U.S. investors in Canadian corporations, creating a "chilling effect" on foreign investment in Canada’s technology sector. The process for obtaining a Section 116 Certificate has too often been long and frustrating, especially for U.S. funds with multiple limited partners or members. In order to obtain a Section 116 Certificate, these funds had to provide tax information for each of their limited partners or members, and in certain situations these limited partners or members also had to file tax returns in Canada. Processing delays, combined with requirements in the ITA to withhold proceeds of the sale until a Section 116 Certificate has been obtained, have increased risks for non-Canadian investors, particularly for sellers in "paper" M&A deals who have been involuntarily exposed to volatile public equity markets for months or longer. Over the years, negative experiences with section 116 requirements have led many U.S. funds to resort to expensive work-arounds using offshore vehicles for Canadian investments, or to stop investing in Canadian technology companies altogether.

Barrier Removed for New Investments in Canadian Tech Companies

For our clients and friends in the VC and private equity industry in the U.S. and overseas, we hope that you read this change as meaning that Canada is "open for business" and that this change, together with the already available generous tax benefits for certain Canadian technology companies, will lead to an increased investment flow into our very strong technology industries. More specifically, these proposed amendments will mean that U.S. and foreign investors can invest directly in Canadian companies without the costly and time-consuming need to either re-organize the business into a U.S. entity or invest indirectly through an offshore vehicle in Luxembourg, Barbados or elsewhere. This opens the door to the considerable benefits associated with a direct investment in Canadian corporations and particularly in "Canadian controlled private corporations" ("CCPCs"), including:

  • a generous program for investment tax credits for Scientific Research and Experimental Development ("SRED") performed in Canada, which for CCPCs are available at an enhanced rate and on a refundable basis – providing a valuable source of cash flow to early-stage companies;
  • availability of the lifetime capital gains deduction (currently amounting to C$750,000) for Canadian founders on the sale of shares of a CCPC;
  • tax deferral on the exercise of stock options, and a 50% deduction on the sale of optioned shares, for eligible Canadian employees who are granted options by a CCPC;
  • eligibility for small business deductions and a lower rate of federal tax for CCPCs earning income from an active business carried on in Canada;
  • more flexibility to go public on the Toronto Stock Exchange (or another stock exchange outside of the U.S.) as a "foreign private issuer", without having to register shares or become a reporting issuer in the U.S.; and
  • the ability, once a Canadian company is already listed on the TSX, for the company to go public on NASDAQ or another U.S. exchange using the multi-jurisdictional disclosure system (MJDS), which can provide a "fast track" to access U.S. capital markets.

The section 116 amendment complements recent government non-tax measures introduced by Canadian federal and provincial governments to kick-start Canada’s venture capital industry. These measures include an additional C$225 million over two years to support and expand the Business Development Bank of Canada’s venture capital activities, and the establishment by the Ontario government of the C$250 million Ontario Emerging Technology Fund (OETF), which co-invests with qualified VC funds in cleantech, life sciences, advanced health, digital media and information and communications technology companies. In terms of regulatory action, through the 2010 Budget the Government will remove the existing restrictions on foreign ownership of Canadian satellites, an important development in a sector that relies heavily on financing from international sources.

Tom Houston, the National Chair of FMC’s Technology Practice Group, was deeply involved in advocacy efforts to remove the application of section 116 to technology company transactions. He worked closely with the Canada-California Strategic Innovation Partnership, Canada’s Venture Capital & Private Equity Association (CVCA), the Canadian Advanced Technology Alliance, and many industry leaders.