Section 116 Hindering Venture Capital Investment In Canada

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By Shawn Lawrence

We asked a panel of lawyers from Gowlings and Cooley Godward Kronish LLP to discuss with us some of these section 116 issues. Among those that responded are Michael Herman and Robert Ford of Gowlings; and Tom Meyers, Al Browne, Charlie Cameron and Rich Sanders answering for Cooley Godward Kronish LLP.

Converting entrepreneurial ideas into commercial products and successful companies requires a steady flow of venture capital investment. Canadian high growth small and medium-sized enterprises that commercialize research depend on venture capital for growth funding.

In general, non residents of Canada for income tax purposes are liable for Canadian taxation on disposal of taxable Canadian property. Under Section 116, a non-resident that disposes of certain taxable Canadian property (TCP) must notify the Canada Revenue Agency (the “CRA thereof”), either before or after, and pay the tax or provide appropriate security in order to receive a certificate of compliance (commonly known as a “Section 116 Certificate”) from the CRA. The obligation to obtain a Section 116 Certificate is aimed at ensuring that non-residents duly pay Canadian tax in respect of gains that arise on the disposition of taxable Canadian property. Any payments or security the vendor provides are credited to the vendor’s account; the CRA makes the final settlement of tax when it assesses the vendor’s income tax return for the year. If the vendor does not comply with Section 116, the property’s purchaser deducts or withholds a specified amount (25%) from the proceeds of disposition to cover the vendor’s tax. The remittance must be made within 30 days after the end of the month in which the purchase takes place.

On the surface it may sound like a simple process with a purpose, but in talking to several experts (including people (lawyers) that benefit the most from Section 116), we heard the contrary. Many viewed 116 as meaningless paperwork, time consuming and a major reason for the lack of VC dollars that are crossing the border into Canada.

Their answers and arguments below highlight a need to lessen the tax reporting burden on non-residents, and the possibility of eliminating Section 116 altogether.

Q: Do you think Section 116 hinders foreign investment in Canada, if so, can you elaborate?

Cooley: Section 116 discourages U.S. based venture firms from making investments in Canada. And it does so in a way that does not provide any resulting benefit to Canada or its citizens. As you know, Section 116 imposes a tax on certain foreign investors who hold securities in private Canadian companies. The tax is imposed when investors sell their securities. Most venture capital firms are, however, exempt from this tax as a result of a U.S./Canadian tax treaty. The exemption runs to U.S. entities, including U.S. limited partnerships (the preferred form for U.S. venture capital firms).

Unfortunately, however, as it relates to limited partnerships, in order for a limited partnership to prove that it is entitled to the benefit of the treaty, the limited partnership must prove that all of its “partners” are U.S. persons. For this purpose, and as it relates to venture capital firms, the term partner includes not only the principals in the venture firm who make the investment decisions, but it also includes the firm’s limited partners. So, in order for U.S. venture capital firms to prove that they are entitled to the benefit of the treaty, they need to show that all of their limited partners (typically, non-profit entities, pension funds, school endowments, and other institutions) are domiciled in the U.S. Mechanically, this requires the U.S. firm to obtain written certifications from 100 or so institutions attesting to the fact that they are domiciled in the U.S. This procedural hurdle creates a huge disincentive for U.S. venture capital firms to invest directly in Canadian operating companies.

As a result of the procedural hurdles to Section 116 described above, venture firms and the law firms who represent them have concocted several structures that avoid the Section 116 problem. The most prevalent of them is the exchangeable share structure. The exchangeable share structure is implemented by having the portfolio company first “flip” into a U.S. holding company. The venture firm makes the investment in the U.S. holding company. The existing Canadian investors continue to hold shares in the Canadian entity, but they are obligated to exchange those shares for U.S. holdco shares when the portfolio company is ready to sell or exit. This structure effectively avoids the procedural Section 116 problem described above, since the VC firm invests in a U.S. entity, not a Canadian entity.

However, it has significant drawbacks and limitations, including the following: (1) it is extremely costly to implement (implementation costs are at least 3x the cost to make a straight investment without the flip); (2) it is complicated and unwieldy to maintain and administer, often resulting in additional costs over the life of the company (including additional filing fees, taxes, etc.); and (3) it has the effect of forcing Canadian-based companies to migrate to the U.S. (this can result in loss of tax credits, and other advantages available to Canadian companies). Other structures include having the VC invest through an offshore investment vehicle. However, these structures also add significant complexity and cost to the process.

Q: How has Section 116 impacted you and/or your business?

Cooley: Cooley is a nationally recognized law firm with one of the largest venture capital and life sciences practices in the United States. Cooley has represented nearly half of the companies on the NASDAQ Biotechnology and BioCentury 100 Indices and more than half of the companies on the AMEX Biotech Index. In 1958, we formed the first venture capital partnership to be organized on the West coast - Draper Gaither and Anderson (now Draper Fisher Jurvetson). We continue to represent venture capital firms in all aspects of their business, including fund formation, portfolio investments, etc.

Many of our venture capital clients are interested in making cross-border investments in Canada. Unfortunately, in my experience, Section 116 dramatically impacts - and, indeed, limits - their ability to make investments in Canadian firms and has had the effect of making small, early stage cross-border VC investments into Canada prohibitively expensive.

In many ways, the wrinkle related to Section 116 described above is good for law firms, because, among other things, it increases the planning and advisory costs associated with making a cross-border investment in Canada. However, it is decidedly bad for venture firms and their portfolio companies, because it increases the transaction costs associated with these types of investments. Importantly, these increased costs are felt most significantly by the earlier stage companies, since the investment amounts tend to be much smaller, and therefore, the transaction costs, as a percentage of the money raised are much larger.

Unfortunately, in my experience, Section 116 has had the effect of making small, early stage cross-border VC investments into Canada prohibitively expensive.

Q: Do you think changes could be made to Section 116 in order to make it beneficial to both Canadian and international companies, or do you think it should be abolished completely?

Cooley: I would suggest making changes to either streamline the exemption process or exempt cross-border VC investments entirely. U.S. based VC’s should not be disadvantaged relative to Canadian-based VC’s. That is what free trade is all about.

Q: How has Section 116 affected American venture capital investments in Canadian companies?

Gowlings: The U.S. could be a tremendous source of capital for Canadian companies (it is to some degree, but could be much more so. Canadian tax laws, specifically Section 116 create barriers to efficient cross-border investment by U.S.-based venture capital funds.

Specifically, if a U.S.-based VC fund directly invests in a Canadian operating company, on disposition it will generally be required to obtain a Section 116 certificate from CRA, file a tax return and provide certain other details regarding each of its limited partners. A Section 116 clearance certificate application is required for every investor in a U.S. venture fund, and many funds have dozens or even hundreds of investors such that a single acquisition transaction involving a Canadian private portfolio company can require hundreds of applications and hundreds of signatures for a U.S. VC and its investors. These same U.S. venture investors must obtain Canadian taxpayer ID numbers and file Canadian income tax returns; even though in virtually every case no Canadian tax is ultimately due as most foreign parties are exempt under the Convention between the U.S. and Canada with respect to Taxes on Income and on Capital (the “Treaty). In addition, some U.S.-based venture capital funds are precluded from doing so under the applicable limited partnership agreement.

Likewise the Section 116 compliance regime has been subject to considerable criticism in recent years as the length of time period for the review of transactions and the issuance of a clearance certificate by the CRA has increased. U.S. VCs can sometimes wait up to four to eight months for these certificates. Further, 25% of the gross sale proceeds must be withheld by the buyer from the outset until the Section 116 clearance certificate is granted and the proceeds then released to the U.S. venture firm. When those withheld proceeds are in the form of shares of a listed public company buyer (often used as partial or whole consideration in an acquisition transaction) the share value can lose value if during the long wait there is a decline in the public market place, which can cost investors significant losses as they are not able to liquidate the holding during the Section 116 process. As such, Canada’s existing tax regime around venture capital contrasts negatively with other countries, most notably Israel, the U.K. and the United States.

Those U.S. VCs that do invest in Canada must engage in complex legal structures, such as forming a Luxembourg or Barbados subsidiary, or using an expensive exchangeable share structure whereby the Canadian investee company is reorganized into a wholly-owned Canadian subsidiary of a newly-formed U.S. (usually Delaware) parent corporation and investing in the Delaware holding company. The legal and accounting cost of such reorganization are very high, often exceeding $300,000 for an exchangeable share transaction. By their nature, venture deals are too small in size to absorb the cost of complex structuring, the cost of which can significantly impact the potential returns.

Finally, and worst of all, the empirical evidence suggests that the 116 tax clearance process in the venture context generates virtually no tax revenue for Canada, since almost all U.S. venture firms and their investors are exempt under the treaty from paying any Canadian tax. Accordingly, this process frustrates cross-border investment for what is essentially no benefit.

Q: Do you think changes could be made to Section 116 in order to make it beneficial to both Canadian and international companies, or do you think it should be abolished completely?

Gowlings: The Canadian Federal Budget 2008 made a number of changes to the current compliance regime applicable in respect of non-residents who dispose of certain property including shares of Canadian private corporations (referred to as “taxable Canadian property”). These changes are positive, but do not completely fix the problem and will not solve the issues for foreign VC investors.

Effective for dispositions that take place in 2009 and subsequent years, Budget 2008 proposes three significant changes in an attempt to simplify the compliance process that arises for foreign investors in Canada.

First, the category of “excluded property” will be expanded to exempt from the Section 116 compliance process the disposition of a property by a non-resident that is, at the time of its disposition, a “treaty-exempt property” of the non-resident. A property will be considered a “treaty-exempt property” of a non-resident at the time of its disposition if the income or gain from the disposition of that property by the non-resident would be exempt from tax in Canada because of a tax treaty at that time and, in the case of a disposition between related persons, the purchaser sends a notice to the CRA, on or before the day that is 30 days after the acquisition of the property by the purchaser, setting out certain basic information about the non-resident seller and the transaction.

Second, the “reasonable inquiry” defence available under Section 116 to purchasers of taxable Canadian property from non-residents will be expanded. Currently the defence is only available if the purchaser, after reasonable inquiry, had no reason to believe that the seller was not resident in Canada. Budget 2008 proposes to expand this defence so that the purchaser would also be absolved from liability under Section 116 if (i) the purchaser concludes after reasonable inquiry that the non-resident seller is, under a tax treaty that Canada has with a particular country, resident in that country; (ii) the property is a property any income or gain from the disposition of which by the non-resident would be exempt from Canadian tax because of a tax treaty if the non-resident were, because of the tax treaty referred to in (i), resident in the particular country; and (iii) the purchaser sends a notice to the CRA, on or before the date that is 30 days after the acquisition of the property by the purchaser, setting out certain basic information about the non-resident seller and the transaction. It should be noted that the reasonable inquiry defence only extends to a conclusion reached by a purchaser with respect to the status of the nonresident seller as a resident of a country with which Canada has a tax treaty and does not appear to extend to a conclusion reached by a purchaser with respect to whether the terms of such tax treaty would operate to exempt any income or gain realized by a resident of that country. Accordingly, it may well be the case in many instances that a purchaser may simply be unwilling to take any risk that arises with respect to the application of a particular relieving provision that is apparently applicable and would, as a result, seek to withhold from the purchase price in order to protect itself. Therefore, as a practical matter, the most significant impact of the proposed changes to the Section 116 compliance process may only be to related party transfers and is not helpful to U.S. venture investors. In other words, if the parties are not related then the process likely won’t change - as no party will take the chance - meaning the issue remains as before for foreign VCs.

Finally, a related change proposed by Budget 2008 is to exempt certain non-residents from filing a Canadian income tax return in respect of a disposition of taxable Canadian property. Currently, a non-resident is required to file a Canadian income tax return for any taxation year in which the non-resident (or a partnership of which the non-resident is a member) disposes of taxable Canadian property. As noted above, this requirement is typically viewed by non-resident investors as an onerous feature of the Canadian tax compliance landscape, particularly in circumstances where no Canadian income tax would be payable because of, for example, the application of a tax treaty. Budget 2008 eases this burden by exempting non-residents from filing Canadian income tax returns for any taxation year in which the non-resident satisfies all of the following criteria: (i) no mainstream Canadian tax is payable by the non-resident for the taxation year (including tax on the disposition of the taxable Canadian property); (ii) the non-resident is not currently liable to pay any amount under the Act in respect of any previous taxation year (other than, generally, in respect of certain stipulated amounts for which the CRA has been provided with adequate security); and (iii) each taxable Canadian property disposed of by the non-resident in the year is either “excluded property” (which as described above, will now include “treaty-exempt property”) or a property in respect of the disposition of which the CRA has issued to the non-resident a clearance certificate under Section 116 of the Act.

While these changes are positive, they do not solve the real problem for venture investors. To really solve this problem, Canada needs to give foreign investors the same tax treatment as exists in the United States and United Kingdom: right now there is no U.S. or UK capital gains tax when a Canadian investor sells shares in a private U.S. or UK company for a gain.

This makes a great deal of sense and is consistent with a policy of attracting much needed foreign venture capital. The net effect here should be tax positive for Canada since these are new investors bringing new capital and most if not all (in particular since the LLC changes discussed below) are treaty exempt in any event. Given as stated above, that the 116 process yields little actual tax revenue despite its burdens, eliminating it for venture investors should lead to the growth of additional tax paying corporations and employees and corresponding growth in aggregate tax revenues for Canada.

Alternatively, a solution similar to the Israeli model could be implemented, which would allow a Canadian Venture Capitalist (as defined) to approach the Department of Finance and receive a formal advance ruling stating that any foreign investor investing in a Canadian Limited Partnership for venture capital purposes would be granted tax-exempt status. This can be more tightly managed than having a blanket exemption - but it results in advance certainty for the venture fund and its investors that it qualifies for the exemption. This would give the investor (and the investor’s investors) certainty up front and avoid the need for complex and expensive exchangeable share and Barbados/Luxemburg structures as noted above.

At an absolute minimum, the tax clearance certificate process could be streamlined at an administrative level so as to avoid Canadian tax withholdings and time delays in obtaining clearance. The selling foreign investor should only be required to file a claim for treaty benefits, rather than apply and obtain a 116 clearance certificate from the CRA - so the solution would be “check the box” and would avoid governmental approval and the kinds of administrative burdens inherent in the current process. Compliance with these proposed solutions could also be monitored if, shortly before or after the sale, either the seller or the purchaser were required to give the Canadian government formal written notice confirming all the factual requirements for legal compliance (similar to Investment Canada notice on an acquisition of a Canadian corporation).

For the rest of the discussion, please visit:
www.bioscienceworld.ca/section116