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Canadian Venture Capital Activity: An Analysis of Trends and Gaps (1996–2002)

Appendix E: Summary of Recent Tax Measures and Outstanding Tax Issues

Government plays an important role in creating the framework to enhance the financial resources needed for a dynamic VC sector. The federal government has acknowledged this in its recent strategy laid out in "Achieving Excellence" and with the introduction, in the 2000, 2001 and 2003 federal budgets, of several measures aimed at supporting VC investments in Canada. Following is a summary of the key measures, their description and impacts on the VC industry, and the status of their implementation.

1. Summary of Recent Tax Measures and Changes

Changes

Description

Status

October 2000

Tax cuts to encourage entrepreneurship and innovation

To secure a more prosperous future for Canadians, the government is taking steps to promote entrepreneurship and make Canada more internationally competitive.
Corporate tax reductions — The 28 percent general corporate tax rate was reduced to 21 percent by 2004, starting with a one-point reduction on January 1, 2001. Further two-point cuts will take effect in each of the following three years.
Capital gains inclusion rate — Previously reduced to two thirds from three quarters as of February 28, 2000, it was further reduced to one half as of October 18, 2000.
Tax rollover of capital gains — Tax-free rollovers were expanded and made available to more businesses. The size of eligible investment was increased to $2 million from $500 000 and the size of small businesses eligible for the rollover will be increased to $50 million from $10 million. This measure was expanded as of October18, 2000.
The government has also announced a measure to defer the income inclusion of benefits from employee stock options as of February 28, 2000.

All effective.

Budget 2001

Amendments to the definition of Qualified Limited Partnership (QLP)

For tax-exempted investors like pension funds, limited partnerships that do not qualify as QLP are considered foreign property for the purposes of the income tax rules.
Elimination of the 30 percent ownership restrictions for QLPs — Limited partnership may be a QLP even though a limited partner, either alone or as part of a non-arm's-length group, has more than 30 percent ownership interest in the partnership. Any limited partner or group that holds more than 30 percent interest in a QLP will be treated as owning a proportionate interest of each property owned by the QLP, including any foreign property. For example, if the assets are Canadian, they will be treated as Canadian, in contrast to the past rule, which deemed them to be foreign. An ownership interest of 30 percent or less in a QLP will remain exempt from treatment as foreign property.

To be implemented through amendment to Income Tax Regulations, which have been published in Canada Gazette in May 2003. Further changes were announced in budget 2003 (see below).

Amendment to section 115.2 of the Income Tax Act, which pertains to business income, to make it easier for non-residents who invest through partnerships to retain Canadian investment managers and advisors.

Before the announcement of the measure, a partnership was a "qualified non-resident" only if none of its members were resident in Canada. Thus, a partnership that has some non-resident members could not rely upon the assurance that section 115.2 provides.
Section 115.2 was modified to apply to partnerships and their members, and to enable the non-resident members of a partnership to avail themselves of the assurance provided by the section. First, the definition "qualified non-resident" was changed so that it will no longer include a partnership, but will instead apply separately to each partner. Second, the rule will be changed to provide that a "qualified non-resident" is not considered to carry on business in Canada solely because a Canadian resident provides investment management and administration services to the non-resident or to a partnership of which the non-resident is a member. It should be noted that this assurance extends only to the non-resident partners: a partner who is resident in Canada is not a "qualified non-resident" and cannot benefit from section 115.2.

Implemented through Bill C-49 — "An Act to implement certain provisions of the budget tabled in Parliament on December 10, 2001," which received Royal Assent on March 27, 2002.

Budget 2003

Changes to QLP rules

In response to industry concerns, the budget proposes the following changes to the QLP rules:
- The requirement that QLP units be identical will be relaxed to accommodate differences in units that do not impact on the share or nature of the partnership's income or loss allocated among limited partners. With this change, matters such as variations in voting rights, the right to participate in investment advisory committees and co-investment rights will not be taken into account in determining whether the units of a QLP are identical.
- The manner in which the foreign property limit is applied to QLPs will be changed to more closely reflect the manner in which the limit is applied to mutual fund trusts. This means that a QLP unit will generally not be treated as foreign property during a calendar year, provided the QLP satisfied the foreign property limit throughout the previous calendar year. This change will prevent a QLP from permanently losing its status as a QLP solely because its foreign property holdings exceeded the 30 percent limit at some point in the past.
- The QLP rules will be modified to provide that a partnership does not lose its QLP status solely because of a temporary fluctuation in the general partner's share of the partnership's income as a result of the limited partners having priority in the ordering of distributions.
- The investment limitations on a QLP will be relaxed to allow a QLP to invest, as a limited partner, in units of other QLPs. However, for the purpose of applying the foreign property limit to the investing QLP, the units of the other QLP will be treated as foreign property of the investing QLP in the same proportion as the foreign property held by the other QLP.

These measures will apply for the 2003 and subsequent taxation years.

Draft regulations to be published in Canada Gazette Part I in summer-fall 2003.

Phasing out of federal capital tax

Threshold for small business tax rate increased to $300 000

Tax-free rollover of small business capital gains enhanced

Elimination of federal capital tax on large corporations over a period of five years and increase the threshold at which it begins to apply from $10 000 000 to $50 000 000 in 2004.

Increase to $300 000 from $200 000, in increments of $25 000, starting in 2003, the annual amount of active business income of a small business corporation that is eligible for the special 12 percent federal corporate income tax rate.

Expand the capital gains rollover for eligible small business by eliminating the original investment limit and the reinvestment limit and by allowing an eligible reinvestment to be made in the year of disposition of the original investment shares or within 120 days after the year.

Implemented through Bill C-28 — "An Act to implement certain provisions of the budget tabled in Parliament on February 18, 2003," which received Royal Assent on June 19, 2003.

2. Summary of Outstanding Tax Issues^{Footnote a}

Proposed Changes

Description/Rationale

Status

Modification to the qualification requirements for a Qualified Limited Partnership (QLP)

The definition of QLP should be amended in order to remove its current restrictive technical aspects and to permit a typical Canadian VC or private equity fund to constitute a QLP. In such a typical fund:
- there is only one class of limited partnership interests, although these interests may be treated differently in limited situations;
- the general partner (GP) is entitled to a "carried interest" (often 20 percent), which is a participation in the profits of the fund provided to the GP in light of its contributions to the fund;
- the fund invests in shares and debt of Canadian and non-Canadian firms although occasionally the fund may invest in mutual funds, trust units or other partnership interests or an existing investment of the fund may be exchanged for mutual funds, trust units or partnership interests; and
- the fund acquires and disposes of its assets in a commercially desirable order and manner, such that, at any time, the foreign property held by the fund may represent more than 30 percent of the cost amount of all property held by the fund.
This proposed modification would allow a typical Canadian VC or private equity fund to qualify as a QLP, permitting the fund to benefit from QLP rules (see above changes made to QLP definition and rules). This would likely increase the participation of Canadian venture capitalists and equity funds in the VC market.

Most of these concerns have been addressed in the 2003 budget. Draft regulations are expected to be published in the Canada Gazette in summer-fall 2003.

Revision to withholding taxes on interest and dividends paid to non-residents

Withholding tax provisions should be revised to make it cheaper and easier for Canadian companies to access U.S. and other foreign capital. The amendment should provide an exemption (or reduction) from withholding tax on interest paid by a resident of Canada to a non-resident person with whom the debtor is dealing at arm's length on portfolio investments.
Part XIII of the Income Tax Act should also be amended to add a provision which would enable the general partner of a partnership to elect in prescribed form to act as agent in connection with compliance with withholding tax obligations under part XIII. Notice of the election would be provided to any person who would otherwise make a payment to the partnership which otherwise would be subject to withholding under part XIII. Payments could be made to such partnerships without any requirement to withhold tax under part XIII.
The general partner would be responsible for remitting to the CCRA the withholding tax applicable to the portion of the payment attributable to the interests of the non-resident partners in the partnership. The general partner would be liable for failure to withhold and remit the required withholding tax in the same manner as an agent under subsection 215(3) of the Act.

Discussions are being conducted between Finance Canada and the VC industry.

Revision to rollover for cross-border mergers

Canadian tax laws impose a cash tax obligation on Canadian investors who receive no cash, only high-risk illiquid shares in private companies in cross-border merger transactions. The rationale to change this is that cash taxes should not be payable prior to the time when cash proceeds are received by the taxpayer.
In the October 2000 Economic Statement and Budget Update, the government undertook to consult with interested parties on a tax deferral provision that specifically addressed tax-deferred cross-border share-for-share exchanges. At the same time, the government noted that a basic requirement for such a mechanism is that it protect Canada's tax base.
This would encourage Canadian entrepreneurs to establish their new businesses as Canadian incorporated companies and thus keep the capital market activity to Canadian lawyers, accountants and investment bankers. Overall, this would reinforce Canada's financial industry.

A draft of legislative proposals will be released in the near future for public review and comment.

Revisions to associated company rule

The Income Tax Act contains the concept of "associated corporations," which are burdensome for both corporations and venture capitalists because they cause corporations to be regarded as associated if they have accessed capital from the same VC source.
Furthermore, these associated corporations must share a single $200 000 small business deduction. The association can increase a corporation's liability to pay large corporations' capital tax and reduce its ability to access SR&ED tax credits.
The CVCA is proposing to add a definition of VC to subsection 256(1) of the Act so that investments made by a "Canadian Venture Capitalist" in corporations would be ignored for purposes of the association rules. Following is the proposed definition of "Canadian Venture Capitalist":
1. an enterprise or related group of enterprises whose principal business is investing in the securities of SMEs;
2. has funds in excess of $10 million under management or committed for investment;
3. is managed by full-time employees whose activities, powers and compensation are governed by contract;
4. has specific investment objectives, restrictions and strategies set out in its substantiating documents;
5. acts as a fiduciary in terms of predominantly managing funds owned by parties other than its managers, or alternatively;
6. has been designated a VC Corporation by a Canadian Securities Commission or is an LSVCC under the Income Tax Act.
This change would ensure that corporations that are associated only because they have accessed capital from the same VC source will not be penalized for tax purposes. This would provide Canadian firms with access to capital on a more cost-effective basis, from both domestic and foreign sources.