Canada is a breeding ground of next-generation technology. Combine this with the country’s low cost of doing business and convenience to the United States and it’s easy to imagine the potential investment opportunities that Canada represents for U.S. venture capitalists. Unfortunately, Canada’s cross-border tax rules create a minefield for unwary U.S. VCs when they later sell stock in their Canadian portfolio companies.
So, let’s take a look at the issues.
Whatever your focus—IT, life sciences, or environmentally “clean” technologies to name a few—sooner or later you will see next-generation technology coming out of Canada. That is hardly surprising. Canada has world-class universities and a highly educated work force. The country also invests billions of dollars each year in R&D in direct funding of its outstanding hospitals and universities and in indirect funding of its emerging technology companies through R&D tax credits.
Respected international agencies often rank Canada at or near the top among nations of the world in many areas—science, engineering, research and higher education—and sometimes ahead of countries such as the U.S. with far larger economies and populations.
The cost of doing business in Canada is about one-third less than in the United States as a result of the favorable U.S.-Canada dollar differential (though recently narrowing), traditionally lower costs of doing business (especially labor), and the beneficial impact of Canada’s extremely generous R&D tax credits for emerging companies. Add to those advantages the fact that the valuations of Canadian companies may be more reasonable than those in the United States—and that U.S. VCs investing in Canada encounter less competition there than in the United States for investment opportunities—and you have the total package.
There is also the convenience. It’s a short plane ride from Boston and New York to the technology centers of Eastern Canada: Toronto, Waterloo, Ottawa, Montreal and Québec City, and an easy plane trip from San Francisco and Seattle to Western Canada’s technology crown jewel: Vancouver.
If you know where the landmines are and how to avoid them, there is a goldmine of opportunity waiting to be found in Canada.”
Stephen A. Hurwitz, Partner, Choate Hall & Stewart
While Canadian management teams may have less experience with the important U.S. marketplace than their U.S. counterparts, the U.S. venture investor in a Canadian company has a unique opportunity to add value by helping in strategy and U.S. hires. And although U.S. VCs have expressed concern in the past that certain Canadian labor sponsored and government subsidized VC fund co-investors may have sometimes focused (in their board roles) on economic development at the expense of return on investment, the truth is ROI is now the holy grail for all.
So where’s the dark cloud? Why isn’t everyone investing in Canada?
Canada’s cross-border tax laws create a veritable minefield for U.S. VC investors to navigate. To understand this point, some background is necessary. The Canada-United States tax treaty provides that investors of each country, when investing in the other, will be taxed on investment gain only once—in the investor’s home country. For example, a Canadian venture capitalist investing in a private U.S. company will be taxed on gains only by Canada, and not by the United States. The United States strongly encourages Canadian investment in the United States by automatically recognizing a Canadian VC investor’s treaty exemption from double taxation—no paper work, no delay and no U.S. tax—and the Canadian VC is immediately free to take his sale proceeds back to Canada.
In sharp contrast, U.S. VCs investing in Canada face nightmarish red tape and delays to achieve the same treaty benefit in Canada. When selling shares in a private Canadian corporation, they must first apply for a so-called “Section 116” clearance certificate to one of 45 Canadian government offices that grant it. An application is required for every investor in a U.S. VC fund, and, of course, many U.S. funds have dozens or even hundreds of investors. Therefore, a single stock deal can require hundreds of applications and hundreds of signatures. No fund wants to chase its partners for signatures.
Inconsistent practices and procedures in these 45 Canadian offices, wholly unpredictable in their timing and requirements, often lead to protracted waits of up to four or eight months for U.S. VCs to obtain clearance certificates. Further, 25% of the gross sale proceeds must be withheld by the buyer of the VC-backed company until the clearance certificate is granted. When those sale proceeds are in the form of stock of a public company that is listed on an exchange (e.g., AIM) that is not “prescribed,” and the stock declines in value during the long wait for tax clearance, it can cost U.S. VC investors millions of dollars. Some U.S. VCs have experienced this first-hand and are not anxious to live through it again.
All these individual U.S. venture investors may also have to deliver copies of their prior U.S. tax returns and must apply for and obtain Canadian taxpayer ID numbers and file Canadian income tax returns—even though in virtually no case is Canadian tax ultimately due. Worse still, the charters of many U.S. venture firms prohibit them from investing in countries where foreign (or prior private) tax returns have to be filed by their investors.
As a result of both the administrative burdens and economic risks of delay, some U.S. VCs just say no to investing in Canada.”
Stephen A. Hurwitz, Partner, Choate Hall & Stewart
As a result of both the administrative burdens and economic risks of delay, some U.S. VCs just say no to investing in Canada. Those that do invest must adopt complex legal workarounds to escape the deleterious red tape, such as forming a Luxembourg or Barbados subsidiary to make the investments (but only after an assessment of its legality under Canada’s anti-avoidance tax laws), or adopt a so-called “exchangeable share program” through a reorganization involving creation of a new Delaware holding corporation that owns 100% of the Canadian company. The U.S. VC investors then invest in this Delaware corporation rather than in its Canadian subsidiary. If this reorganization is not done adroitly, serious consequences can ensue. For example, these Canadian subsidiaries and existing Canadian shareholders may lose major Canadian tax benefits, while existing labor-sponsored and other government-funded Canadian venture investors may inadvertently become ineligible investors.
Canada also excludes U.S. limited liability companies (LLCs) from the treaty’s exemption from double taxation. Because many U.S. venture firms include LLCs as partners, as a practical matter those firms cannot invest in Canada at all. It can be extremely embarrassing and painful for an unwitting U.S. VC general partner to later have to explain to an existing LLC investor why it will be double-taxed in Canada and the U.S. on its share of gain from the sale of a Canadian portfolio company. This has happened, and it can quickly lead to troubling questions when indemnification is sought by the angry LLC. Some VCs may consider avoiding this LLC problem by using a wholly owned Luxembourg or Barbados subsidiary to make the Canadian investment, but only after a careful assessment of its legality under Canada’s anti-avoidance tax rules.
All of these worrisome Canadian cross-border rules apply not only to U.S. VCs investing in Canadian emerging companies, but also to other U.S. private equity groups, as well as to U.S. institutional investors when investing in Canadian venture capital and other private equity firms.
Tax reform on tap?
Despite the challenges of investing in Canada, its emerging technology companies are just too attractive and too close to home to ignore. There are currently significant discussions underway in Canada about changing the country’s onerous tax laws around foreign investments, but no predictions can be made as to when or if positive reforms will come. Until that happens, there are creative ways to take advantage of the many opportunities that Canada has to offer the U.S. venture capital industry.
The key is to recognize that U.S. VCs should never invest directly in a Canadian corporate entity and there is no straight line to the closing. However, with experienced advisors you can implement the right workaround. Completing your deal may take more time and effort than you expected, but if you know where the landmines are and how to avoid them, there is a goldmine of opportunity waiting to be found in Canada.
Stephen A. Hurwitz is a partner in the law firm of Choate Hall & Stewart LLP, Boston. He focuses on Canada-U.S. cross-border transactions involving U.S. and Canadian venture capital and private equity firms and technology companies. He was chairman and co-founder of Testa, Hurwitz & Thibeault LLP. He recently co-authored Financing Canadian Innovation: Why Canada Should End Roadblocks to Foreign Private Equity (available at www.cdhowe.org), which discusses these and other Canadian cross-border tax problems and offers specific legislative solutions. He can be reached at Hurwitz@choate.com.