foreign investment in Canada article for Deloitte
edited by Leon Altman
April 16, 2010

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Bringing down the barriers to international investment in Canadian private companies

 

Canada�s tax laws have historically imposed daunting barriers to foreign (non-Canadian) investment in Canadian-based private corporations. Foreign� investors interested in Canadian companies have had to maneuver around a gauntlet of administrative impediments. �For instance, under section 116 of the tax code, purchasers of "taxable Canadian property" have to withhold and remit 25% of their gross proceeds to the Canada Revenue Agency (CRA). Even though CRA has historically collected very little revenue from this regulation, its application has cast a chill on prospective investors.

 

 

Canadian law does provide a way around this withholding requirement. Under section 116 this withholding may be reduced (even eliminated) if the purchaser obtains a certificate from the CRA demonstrating that the gain realized by the non-resident is less than the gross proceeds, or the gain is exempt from tax under an income tax treaty.�

 

Unfortunately, the CRA has historically been unable to issue certificates on a timely basis; requests for certificates would typically take several months to process.� �As a result even �purchasers of private companies entitled to a reduction of the withholding would typically set aside the gross withholding amounts in escrow for several months, negatively impacting their IRR.

 

Perhaps an even bigger barrier �was the further requirement that non-resident vendors file a Canadian income tax return to report the disposition and assert their entitlement to claim treaty benefits.� This flies in the face of many fund limited partnership agreements which impose an obligation on the GP to ensure that investment activities do not give rise to tax filing obligations in other jurisdictions.� In addition, the triggering of such filing obligations could prove troubling from an investor relations perspective.

 

Those funds interested in investing in Canadian businesses historically invested through an intermediary or holding company.� However, the cost of establishing and maintaining such structures was sometimes uneconomical or was sufficiently burdensome so as to discourage investment in Canada.� A 2007 survey by Deloitte and Canada�s Venture Capital & Private Equity Association of over 500 venture capital firms found that 40% of U.S. respondents and 28% of global respondents cited Canada�s unfavourable tax environment as a key reason for not investing in Canadian private companies.

 

Sweeping change

On March 4, 2010, the government of Canada proposed to change its tax legislation to remove this barrier to international investment in Canada. It is is one of the most significant changes to capital gains taxation in recent years.� Although these proposals are frequently described as changes to �section 116,� they are actually much broader.� The government proposes to amend the definition of taxable Canadian property to exclude securities of Canadian private companies (other than those that derive their value principally from real property).� The proposed amendment would eliminate entirely the need for withholding under section 116 as well as the requirement of the vendor to file Canadian income tax returns to report the disposition.

 

The enactment of these proposals should have a dramatic impact on cross-border investment by venture capital and private equity firms.

 

Making fundraising easier for Canadian funds
The fundraising environment in Canada had become increasingly challenging (even before the financial crisis of 2007) because many of Canada�s largest LPs had developed their own deal teams and were placing greater emphasis on investing directly rather than through funds.� Ontario Teachers� Pension Plan Board, Ontario Municipal Employees Retirement System (OMERS) and Canada Pension Plan Investment Board (CPPIB) have all established direct investment capabilities and announced reductions to their fund investment programs.� Accordingly, Canadian GPs have increased their reliance on non-Canadian sources of capital.� With the proposed change, non-Canadian investors, including non-Canadian fund-of-funds, should be able to invest directly in funds managed by Canadian GPs without the need for intermediaries or holding companies.

 

Investors Welcome

By eliminating significant impediments to international investment, the proposed amendments should make it easier for non-residents to invest in quality Canadian private companies. By creating a more hospitable environment, Canada is no longer building barriers but instead putting out a welcome mat to international investors.