Canada drops tax in hopes of achieving VC gold

A recent change in Canadian tax law looks to have positive implications for U.S. venture investment in the country, although some would like to see Canada go even further.

Last week, the Canadian government announced it will scrap Section 116, a law that withholds 25% of the returns from the sale of a Canadian company backed by a U.S.-based venture firm until each investor proved they were a foreign citizen. This process reportedly sometimes delayed the official sale many months, or years in some cases. There is no U.S. law similarly hampering Canadian VCs.

The change will make it vastly more economic for U.S. investors to back Canadian outfits, says attorney Stephen Hurwitz, who focuses on cross-border transactions between the United State and Canada for the Boston law firm Choate Hall & Stewart.

Though Canada and the United States have a treaty stating 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, “in practice, [the process] was much different,” Hurwitz says,

“When a Canadian VC invested in a U.S. company and sold it, that person was immediately free to take his money back to Canada. No red tape, [no] tax filings,” Hurwitz says. “American venture firms have meanwhile been forced to prove that each of their LPs is U.S.-based before receiving the full proceeds of a sale.”

Sometimes, “[the LPs] would also [even] have to provide tax returns,” says Hurwitz, who adds that he knows of “one case where a U.S.-based VC firm had to file 900 signatures for a single exit.”

To get around the rule, VCs have either been avoiding the country altogether, or in certain must-have situations, relocated the Canadian companies and incorporated them in Delaware at great cost.

“We’ve done six deals in Canada—all companies that were turned into Delaware corporations,” says Charles Lax, managing general partner of GrandBanks Capital in Wellesley, Mass.

Unfortunately, he says, the added cost in legal fees to do each deal has been “between $250,000 and $400,000 for the first round of financing.”

GrandBanks has participated in two Series A deals in Canada: Database software maker xkoto, which is now based in Waltham, Mass., and First Coverage, which is still based in Toronto, Ontario. Yet GrandBanks might have done more early stage investing if the fees required to circumvent Section 116 hadn’t been so onerous, Lax suggests.

According to a 2007 survey by Deloitte and Canada’s Venture Capital & Private Equity Association of 528 VCs worldwide, 40% of U.S. respondents pointed to Canada’s tax laws as a key reason they weren’t funding Canadian startups.

Still, while the change in Canada’s tax code should greatly help Canadian technology companies of all stages to attract U.S. investment, not everyone thinks it does enough, including Lax.

While he calls the development “great” and one that will “vastly improve the cash flow velocity” into Canada, he says the “issue we’re going to end up having still is that we don’t have full tax transparency on transactions.”

The problem is that unlike in the United States, where one company can acquire another in a tax-free stock transaction, in Canada, when a company is acquired, even in a stock transaction, the “exchangeable event” is sometimes still considered a liquidity event. This is an issue that may continue to give U.S. investors, particularly those interested in roll-ups, pause.

“Canada doesn’t have same data that our state and federal governments provide U.S. tax authorities, which gives them a pretty good handle on transactions and some degree of comfort that they are getting their share,” Lax says. As a result, “they’re afraid they’ll lose opportunities to collect tax.”

It’s “crap,” but it’s a “bigger problem for Canadian” than U.S. investors, he says.

Mark McQueen, president and CEO of Toronto, Ontario-based Wellington Financial, says that he doesn’t think the elimination of the law would change much, as most U.S. VC firms are shying away from early stage deals.

“The last 48 months has taught them to look at ‘later stage deals,’ whatever that might mean to an individual firm,” McQueen said in a blog post titled “Let’s not declare victory just yet.”

“It’s definitely not a trend which is going to save Canada’s early stage tech sector,” McQueen says.

Jon Cook of Reuters contributed to this report.