U.S. investors are increasingly aware of the risks – including potential adverse tax consequences – of investing in entities organized outside of the United States. In many cases, Canadian and U.S. legal advisors have responded by recommending that Canadian start-ups incorporate in the U.S. Sometimes, U.S. incorporation is the right decision for both the company and its investors.
However, there is no "one size fits all" answer. This article explores some of the advantages and disadvantages of incorporating in Canada and/or investing in Canadian corporations. (Note that most U.S. businesses with operations in Canada will incorporate a Canadian subsidiary for the purpose of conducting operations in Canada; similarly, most Canadian corporations operating in the U.S. will have a Delaware subsidiary. This article deals with the jurisdiction of incorporation decision for the parent corporation.)
Advantages of Incorporating in Canada
A "Canadian-controlled private corporation" (CCPC) is a private corporation which is not controlled, directly or indirectly, by non-residents or public corporations (or any combination of non-residents and public corporations). "Control" is not merely a question of voting control or ownership of a majority interest in the corporation - it is a matter of actual influence on the day-to-day management of the corporation, whether through share ownership, protective provisions in the company's articles or a shareholders agreement, an option to purchase shares or other means. A CCPC must be incorporated in Canada. The best reason to incorporate in Canada is to secure the numerous benefits of CCPC status, if the company could otherwise qualify as a CCPC. These benefits, which are summarized below, are well known to Canadian tax and legal advisors.
1. Capital Gains Deduction
Only shares of a CCPC can qualify as "qualified small business corporation shares" (QSBC shares). The first Cdn.$500,000 of capital gains earned by an individual (other than a trust) on the sale of QSBC shares will not be subject to income tax. This can be a significant benefit for Canadian founding shareholders, especially if share splitting with a spouse or other individual is used as a tax planning strategy. Note that this is a "lifetime" exemption, and if already fully used, will not be available for the sale of QSBC shares.
2. Reinvestment Opportunities
In February 2000, the Canadian federal government introduced a tax deferral of capital gains for proceeds of up to Cdn.$2,000,000 resulting from the sale of shares of an eligible small business corporation (which must be a CCPC on the date of the sale), if the proceeds are reinvested in another CCPC. The deferral is subject to certain restrictions on the carrying value of the assets of the second CCPC both before and after the transaction. Unlike the corresponding U.S. capital gains reinvestment scheme, the deferral is only available to individuals and cannot be "passed through" professional investment corporations, trusts or partnerships.
3. Tax Deferral on Exercise of Stock Options for Canadian Employees
As a general rule, an amount equal to the "in-the-money" value of employee stock options will be included in the income of a Canadian employee in the year of exercise and reported on his or her T4. However, on the exercise of an option of a corporation that is a CCPC on the date of grant, tax is deferred until the taxation year in which the employee disposes of the underlying shares. There is also a deferral available for shares of a corporation which is not a CCPC - however, the deferral is limited (to an annual maximum of Cdn.$100,000 based on the fair market value of the underlying shares on the date the option was granted) and is only available for shares listed on a prescribed stock exchange. If no deferral is available, a Canadian employee who exercises a stock option and fails to dispose of the underlying shares in the same taxation year will not have realized cash proceeds to cover the resulting tax liability.
4. Tax Deduction on Gain from Optioned Shares
Where an employee stock option benefit is included in the income of a Canadian employee, the Income Tax Act (Canada) (the "ITA") provides for two separate fifty percent deductions (if available, either deduction, but not both, may be claimed):
As a bottom line, CCPCs can exercise greater flexibility in structuring equity incentive plans (such as the ability to grant "cheap" or below-fair market value options) without depriving Canadian employees of an important tax deduction.
5. Investment Tax Credits
Investment tax credits (ITCs) under the Scientific Research and Experimental Development (SR&ED) program lower the cost of SR&ED performed in Canada. Generally, SR&ED expenditures are fully deductible or may be carried forward indefinitely. lTCs under the SR&ED program are available to both CCPCs and non CCPCs. However, CCPCs are eligible for special treatment. If a corporation is a CCPC through the year with Cdn.$200,000 or less of taxable income in the previous year, it can receive an ITC equal to thirty-five percent of certain qualified SR&ED expenditures subject to an expenditure limit of Cdn.$2,000,000. For CCPCs, this is a refundable claim - meaning that to the extent that the corporation does not otherwise have to pay tax, it may be entitled to a full refund on qualified current expenditures, and a forty percent refund on qualified capital expenditures. For non-CCPCs, the ITC rate is twenty percent for both current and capital expenditures and claims are not refundable (that is, the corporation can only apply the claim against tax otherwise payable). The refundability feature available only to CCPCs can be an important source of cash flow for early-stage companies, potentially providing months of additional runway before seed or venture capital funds are exhausted.
6. Business Deductions
CCPCs earning income from an active business carried on in Canada are eligible for the small business deduction, which lowers the federal tax rate on the first Cdn.$200,000 of active business income to approximately thirteen percent (about nine percent less than the general corporate rate). Before anticipated reductions to the general corporate rate take effect, CCPCs also have the benefit of a somewhat lower rate of federal tax on active business income between Cdn.$200,000 and Cdn.$300,000.
7. Deduction of ABILs
An individual who lends money to a CCPC (whether in the form of convertible or non-convertible debt) is permitted to deduct an allowable business investment loss if the debt is ultimately written off. This can be a benefit to bridge or angel investors who prefer to invest in a debt vehicle.
Canadian Companies that are not CCPCs
Even if a company cannot qualify as a CCPC, there are still reasons to consider incorporating in Canada:
1. Access to Capital
Certain large pools of capital are only available to companies incorporated in Canada. Business Development Bank of Canada (BDC) and Ontario labour-sponsored venture capital corporations are only permitted to invest in entities organized under Canadian laws. While it is possible for some restricted investment funds to invest indirectly in a U.S. incorporated entity (for instance, by purchasing exchangeable shares of a Canadian subsidiary), this results in a complicated capital structure and extra expense to both the company and the investor. The investor at the Canadian subsidiary level may also encounter tax problems if the company is acquired by a U.S. purchaser (see "No Roll-over Treatment for Canadian Shareholders" below).
2. Eligibility for RRSPs
Shares of a private Canadian corporation can be "qualified investments" for the purpose of certain deferred income plans including registered retirement savings plans. Unlisted shares of a U.S. corporation cannot be "qualified investments". This means that shareholders of eligible private Canadian corporations can allocate shares to a RRSP or similar plan, where the investment can grow on a tax-sheltered basis. Employees can also use funds held in a RRSP to purchase an equity interest in an eligible private Canadian corporation through an employee share purchase plan.
3. Lower Legal and Accounting Costs
U.S. incorporated companies operating primarily in Canada must comply with two separate tax and securities regulatory regimes. This means that companies must regularly consult both U.S. and Canadian legal advisors and accountants. As a result, Canadian businesses which incorporate in the U.S. often have significantly higher expenses for day-to-day professional services.
Next week, the authors review the main disadvantages of incorporating in Canada including taxation concerns, no roll-over treatment for Canadian shareholders and other topics that might dissuade private equity investors.
About The Authors
Tom Houston, Partner, FMC (profile)
Tom Houston is managing partner of the Ottawa office of Fraser Milner Casgrain LLP. Tom leads one of the largest venture capital and private equities groups in Ottawa, Canada's technology capital and most active VC market. Tom has been recognized as a leading practitioner in the LEXPERT(TM) Legal Directory in the areas of "Computer and I.T. Law", "Corporate Finance and Securities" and "Technology". Tom's e-mail address is email@example.com.
Andrea Johnson, Associate, FMC (profile)
Andrea Johnson is an associate with the Ottawa office of Fraser Milner Casgrain LLP. Andrea's practice focuses on company and investor side representation in cross-border venture capital and private equities transactions. Andrea has worked on many of Canada's largest venture capital deals. Andrea's e-mail address is firstname.lastname@example.org.
FMC is one of Canada's leading business law firms, with over 550 lawyers in Toronto, Montreal, Ottawa, Edmonton, Calgary and Vancouver and a representative office in New York.
This article is reproduced with permission of Fraser Milner Casgrain LLP. For more information about Fraser Milner Casgrain LLP, please visit the firm's web site at www.fmc-law.com.
© 2002 Fraser Milner Casgrain LLP. All rights reserved.