The trouble with Canada

Canadian VCs complain that cross-border tax laws are responsible for the dismal state of the local venture capital industry.

In December, consulting firm Deloitte released a survey of more than 500 venture capital investors showing that 40 percent of US respondents and 28 percent of global respondents listed Canada's cross-border tax laws as a major reason to avoid investing in Canadian early stage companies.

Specifically, the respondents cited Section 116 of Canada's cross-border tax law as a major deterrent. This section allows foreign entities to avoid taxation on the sale of investments, but only after they complete a lengthy filing process to prove residency in another country. The process can take up to eight months, during which time the Canadian government holds 25 percent of the gross profits of the sale in escrow. The law impacts foreign limited partners who want to invest in a Canadian VC fund, as well as foreign investors who want to make a direct investment into a Canadian company.

?The country must act quickly to remove major tax barriers preventing critically needed international flows of investment capital from crossing our borders,? Deloitte's John Ruffolo said in a statement. ?If not fixed in the near term, the Canadian VC ecosystem? will collapse.?

There is no denying that Canadian VC is haunted by a funding shortfall. As the Deloitte report points out, over the past five years venture capital fundraising by Canadian firms has declined from around $3 billion in 2002 to around $900 million in 2007.

Rick Nathan, president of the Canadian Venture Capital and Private Equity Association and managing director at Kensington Capital Partners, describes the industry's woes as the result of a sort of vicious cycle.

Most Canadian venture players went into business in the 1990s, and were hit hard by the telecom and tech crashes soon after, he says. Without the benefit of a long pre-crash track record of success to lure investors back, unlike many US venture firms who were hit equally hard, they found themselves deserted by local institutional investors. Lacking funds, many Canadian VCs are often unable to adequately capitalize their portfolio companies, which in turn leads to poor returns on their investments. Poor returns ensure that the institutional investors continue to stay away.

Stephen Hurwitz, a partner in Boston law firm Choate Hall & Stewart who works on Canada-US cross-border tax issues, says the laws are the main problem, ?hindering hundreds of millions of dollars of much needed capital from coming into Canada.?

?Canada has all the technology and talent needed to be successful ,? Hurwitz says.

And yet, although Canada's gross domestic product is roughly 10 percent of total GDP in North America, Canadian technology companies are receiving less than 5 percent of all venture capital dollars invested in North America, and Canadian venture capital firms are receiving about 3 percent of all funds invested in venture firms in North America. The result, Hurwitz says, is that Canadian companies and venture firms ?have one arm tied behind their backs.?

Howard Riback, chief financial officer of Canadian VC Ventures West, agrees that the impact of Section 116 is substantial. If the provision were eliminated, he says, Canadian VCs might be able to fill the funding gap by bringing in more US syndicate partners for deals. But the burdensome filing requirements keep US VCs away.

Some market participants feel the focus on Canadian tax overstates the burden of Section 116. David Adderley, chief operating officer of Ottawa-based Celtic House, disagrees that cross-border tax laws are the main problem.

?To foist the issues that Canadian venture capital has, which are many, on the tax regime is a false assertion,? Adderley says. ?All jurisdictions have their fair share of issues whether tax or otherwise. If you're investing in Germany you worry about the labor laws; in the US you have Sarbanes-Oxley.?

?The country must act quickly to remove major tax barriers preventing critically needed international flows of investment capital from crossing our borders.

If not fixed in the near term, the Canadian VC ecosystem?will collapse.?

There are plenty of ways to structure an investment or a limited partnership to avoid the Section 116 certification process, he says, and if the opportunity is good enough a foreign partner will work around it. One such method is an exchangeable share program, whereby an investor reorganizes a Canadian company as a Delaware holding company with a Canadian subsidiary. Private equity funds can also register in a country such as Barbados or Luxembourg that has a tax treaty with Canada, and then submit just one application for a Section 116 clearance certificate, rather than submit separate applications for each limited partner as a fund registered in Canada would.

But Hurwitz points out that legal fees for those structures often run to $500,000, a significant amount for an investment of a few million dollars. Riback adds that foreign investors simply don't want to bother investing in Canada when there are so many opportunities in other places like India, China and Israel, whose tax laws have far less red tape.

?It's a huge amount of work trying to work around these inappropriate tax laws, and it's very cumbersome,? he says. ?It's a very negative start to the long process of building a company.?

The CVCA and other industry groups have made numerous presentations to the Canadian government detailing why Section 116 should be changed or eliminated. But Hurwitz says to date he has seen no evidence of the political will to change the requirements.

Last March, the government did announce amendments to the US-Canada tax treaty in particular that granted US limited liability companies exemption from Canadian taxes. No changes were made to the Section 116 certificate filing process at that time. But Canada's finance minister Jim Flaherty did not dismiss the idea of revisiting the issue in the future.

?It is two sides of the same coin,? Flaherty told The Wall Street Journal at the time. ?I expect that we'll do more in the future on that.?

Studies like the Deloitte report have helped to increase political awareness of the issue, Nathan said.

?In the past six to twelve months we've seen a significant amount of serious attention paid to the issue,? Nathan said. ?We are working aggressively with revenue authorities, and I do think we're making some important progress.?