What you need to know: US venture capital and private equity funds should soon be able to sell stock of most Canadian companies in which they invest without the cumbersome and costly Section 116 tax clearance procedures now required.

What you need to do: Funds should reevaluate the attractiveness of investing in Canada. Funds that have invested in Canada through an offshore intermediary company should consider liquidating the intermediary.

For typical US and other foreign venture capital and private equity investments in Canadian corporations, the onerous tax clearance requirements of Section 116 of Canada’s Income Tax Act should soon no longer apply. For many years, partners at this firm have been honored to play an important role in advocating for the proposed rule change. The firm welcomes this rule change and believes that it is especially beneficial for US venture capital and private equity firms who invest, or would like to invest, in Canada.

Canada’s Budget 2010 proposes to amend Section 116 so that it no longer applies to shares of corporations (except for those that derive more than 50% of their value from realty situated in Canada or from the exploitation of Canadian natural resources such as oil and timber). Thus, a US venture capital or private equity fund currently holding shares of a Canadian corporation would not need to run the Section 116 gauntlet upon the sale of the corporation’s stock, so long as the corporation met the value test described above. Furthermore, US investment firms can invest directly in stock of such Canadian corporations without incurring the cost and risk associated with the use of complex offshore holding company structures.

It is expected that this rule change will spur investment in Canadian technology, life sciences and similar industries. Once enacted, the amendment will apply to sales of Canadian shares occurring after March 4.

Background

The US-Canada income tax treaty provides that investors of each country, when investing in the other, will be taxed on capital gain on the sale of stock only in the investor’s home country. The US automatically recognizes a Canadian investor’s treaty benefits without tax, paperwork or delay. On the other hand, US investors have not enjoyed this type of seamless process when investing in Canada. To avoid Canadian tax on capital gain, a US venture capital or private equity firm selling shares in a Canadian corporation must apply to one of 45 Canadian government offices for a Section 116 clearance certificate. An application is required for every investor in a US venture or private equity fund, and many funds have dozens or even hundreds of investors. This process normally involves delays of months or even years, thereby introducing economic risk into the deal. Moreover, a withholding tax of 25% of the gross sale proceeds must be withheld by the buyer until the Section 116 clearance certificate is granted, at which time the proceeds are released to the US sellers.

As a result of the Section 116 requirements, many US investors either forgo investment in Canada or pursue investment in Canada using costly and complex legal structures, such as by forming a Luxembourg subsidiary to invest in a Canadian company. Adverse Canadian tax consequences could result if such investments are not structured properly, adding to the risk of investing in Canada. The rule change announced yesterday will allow US investment funds to avoid many of the problems associated with Section 116 requirements when investing in Canada.