Canada Tries To Solve Cross-Border Issues

This was submitted by Ian Palm and Patrick McCoy, Toronto-based attorneys with McCarthy Tétrault LLP.

Many international private equity investors, particularly US-based venture funds, have complained about the additional time and expense associated with an exit from Canadian-based investments. But a new Canadian Federal Budget announced on February 26 is expected to resolve some of these issues.

Current Canadian tax law creates barriers to efficient cross-border investment. For example, if a US-based fund invests directly in a Canadian operating company, on a disposition the fund will generally be required to obtain a certificate from the Canada Revenue Agency (typically referred to as a ‘Section 116 Certificate’ after the relevant section in the Income Tax Act), file a Canadian tax return and provide certain details regarding each of its limited partners. Private equity sponsors are often precluded from doing this pursuant to their limited partnership agreements and, even if they are so permitted, it creates an organizational headache.

To avoid these administrative burdens, many US venture funds have resorted to structuring their investments in Canada through an exchangeable share transaction. These funds invest directly in a newly established Delaware company into which all of the shares of the existing Canadian operating company are exchangeable upon the occurrence of certain events. Other US funds have been known to structure their Canadian investments through a corporate vehicle resident in a third jurisdiction (e.g., Barbados or Luxembourg) that mitigates the administrative burden and may otherwise be more favorable from a tax-planning standpoint.

These complexities have, in many cases, resulted in significantly higher transaction costs or have chased away investors that might otherwise have considered investing in Canada. In fact, some commentators have blamed the lack of venture funds available to Canadian entrepreneurs on these tax restrictions.

Through the Federal Budget, the Canadian government has proposed revisions to the Section 116 withholding and clearance certificate obligations, which will hopefully alleviate some of the cost and inconvenience associated with the these cross-border transactions. The effect of the proposals may be to ease the compliance burden imposed on certain non-resident sellers and to allow such sellers to avoid the related purchase price withholding on closing.

That being said, there are several requirements that must be satisfied to qualify for the proposed relief and buyers and sellers will need to carefully consider whether such criteria can be satisfied and with what comfort level. Given the potentially significant exposure to buyers seeking to rely on such proposals, it will be important for buyers to properly due diligence the relevant criteria which must be satisfied for the relief to apply. In certain instances opinions, representations and certificates may be inadequate to provide buyers with the required level of assurance.

On a separate note, but relevant to venture funds, the Budget also proposed enhancements to Canada’s scientific research and experimental development incentives in particular for R&D undertaken by Canadian-controlled private corporations and for certain eligible R&D to be undertaken outside of Canada.

These and other developments are discussed in our firm’s e-Alert which you can access here.

Ian Palm and Patrick McCay are Toronto-based attorneys with law firm McCarthy Tétrault LLP. Palm is a partner in the firm’s Business Law Group, while McCay is a Tax Group partner.