Non-resident investors finally obtain relief
In a welcome move, Budget 2010 proposes that non-residents will no longer need to obtain clearance certificates or pay withholding tax on the sale of shares in a Canadian corporation (and certain other interests), as long as the shares do not derive their value principally from real or immovable property situated in Canada, Canadian resource property, or timber resource property. This change will be particularly beneficial to the high tech sector, which has lobbied for years for this change. It is widely thought that foreign investment in Canada has been impeded by the existing rules, which impose onerous tax and administrative requirements on non-resident investors.
The change proposed by Budget 2010 is important because it takes these investments entirely out of the section 116 compliance regime, provides long-awaited administrative relief for treaty-based foreign investors, and also provides tax relief for non-treaty based foreign investors.
Foreign investors in private Canadian corporations are not taxable on capital gains derived from certain Canadian investments if they reside in a treaty jurisdiction and are entitled to treaty protection. However, despite the entitlement to treaty protection, it was necessary for them to obtain a section 116 clearance certificate from Canada Revenue Agency. A recent case made it clear that the withholding tax mechanism in section 116 is applicable even where treaty protection applies.
Obtaining a section 116 clearance certificate imposes a significant administrative burden on non-resident vendors. The non-resident vendor must obtain a Canadian business number for reporting purposes (which must be subsequently cancelled or the vendor will continue to receive demands for tax returns) and must provide detailed information and background on the vendor and the property. The processing of the clearance certificate by the Canada Revenue Agency can take several months, so it is rare to see a section 116 clearance certificate issued to the vendor prior to the closing of the transaction. Consequently, the purchaser must withhold funds at closing to satisfy its obligations, and escrow arrangements must be entered into pending delivery of the certificate. In some cases, the Canada Revenue Agency may insist on the payment of withholding tax where treaty protection is unclear, the reby necessitating the investor to file a tax return and claim a refund.
Prior amendments were not effective
Previously, Budget 2008 had introduced some measures that purported to relieve the burden of obtaining a section 116 clearance certificate for non-resident vendors of treaty-protected property. However, the effect of the rules was to place a burden on purchasers to determine whether the vendor was entitled to the benefit of a tax treaty and whether the property met the conditions to be treaty-protected property. In an arm’s length situation, purchasers are generally not prepared to take the risk of tax liability so they often required a non-resident vendor to obtain and deliver a section 116 certificate. For these reasons, the Budget 2008 changes did not go far enough, and the need to obtain a section 116 clearance certificate remained a practical reality.
For foreign venture capital funds, many of whom are structured as limited partnerships or US limited liability corporations comprising hundreds or even thousands of individual investors, the compliance burden has been a serious bone of contention and has resulted in real restrictions to access to foreign capital for Canadian business. The section 116 compliance burden was often cited by foreign VCs as a sufficient reason to look elsewhere for investment opportunities. The problem was not limited to Canadian technology and life sciences sectors, but efforts to raise funding in these sectors were especially hampered by section 116 requirements. Despite changes to the Canada-US tax treaty, which attempted to accommodate LLC’s, the administrative burden remained significant.
The new changes are far-reaching
The changes announced in Budget 2010 are far-reaching because they eliminate altogether the application of section 116 for shares of private Canadian corporations, partnership interests and interests in trusts - unless the value of the investment is derived principally (more than 50%) from real property, resource property or timber resource property in Canada (or was so derived at any time within the previous 60 months). As a result, Canadian technology and life sciences corporations, as well as other Canadian corporations who meet the value test, will no longer be handicapped by the administrative burden of section 116 that was imposed on foreign VCs and other non-resident investors who reside in treaty jurisdictions.
Further, the changes apply to all investors, including those who reside in non-treaty jurisdictions and investors from treaty jurisdictions who are not eligible for treaty protection per se, such as LLC’s. Under existing law, a non-treaty investor was liable for Canadian tax on the gain, was required to pay withholding tax on account of its Canadian tax liability, and was required to file a Canadian tax return reporting the capital gain realized on the sale of its Canadian investment. By excluding private Canadian corporations, partnership interests and interests in trusts altogether from the definition of “taxable Canadian property” (unless the value is principally derived from real property, resource property or timber resource property in Canada at any time in previous 60 months), capital gains on investments in the hands of foreign investors are no longer taxable in Canada even wher e treaty protection is not available to them.
Purchasers should still exercise caution
In many circumstances, a purchaser will have sufficient knowledge and information about the target corporation, partnership or trust and its operations and assets during the prior 60 months to determine whether the property it is purchasing is “taxable Canadian property”. However, the purchaser is at risk if there is uncertainty or if it is subsequently determined that the purchased property was “taxable Canadian property”. For example, there may have been a point in time during the 60 months prior to a sale when more than 50% of the value of the property was derived from real property in Canada. Therefore, in certain circumstances it may be prudent for purchasers who acquire property from non-residents to obtain protection, by way of indemnities or otherwise, with respect to the target’s asset mix during the preceding 60 months.