Private Equity in Canada: Disadvantages

Tom Houston and Andrea Johnson, Fraser Milner Casgrain LLP

Disadvantages of Incorporating in Canada

Again, tax considerations on both sides of the border weigh heavily in the decision to incorporate in the U.S. rather than Canada. Note that most of the factors weighing against Canadian incorporation only become important at the time of a merger or acquisition or other liquidity event.

1. No Roll-over Treatment for Canadian Shareholders.

A common exit for many successful Canadian businesses, particularly in the technology sector, is a purchase by a U.S. acquirer. However, Canadian shareholders do not receive a roll-over in the event of a purchase of shares of a Canadian corporation in which the purchase price is stock of a U.S. acquirer. As a result, tax will be payable by Canadian shareholders on the gain in the value of their shares in the year of the sale, rather than the year in which they dispose of the stock received on the acquisition. In all-stock or cash-and-stock deals in which shares of the U.S. acquirer are not immediately freely tradeable, this means that the Canadian shareholders will likely not have sufficient cash proceeds (or any cash proceeds) from the sale to cover the resulting tax liability. This issue is particularly serious for Canadian selling shareholders of Canadian corporations if there is no public market for the shares of the U.S. acquirer, or if the shares received on the acquisition are subject to resale restrictions. This problem can be addressed by the U.S. acquirer issuing exchangeable shares of a Canadian subsidiary, which are directly or indirectly exchangeable for shares of the U.S. parent, to Canadian shareholders of the target company. Most Canada/U.S. cross-border practitioners are now familiar with this type of exchangeable share transaction. However, compared to a conventional acquisition, an exchangeable share structure is costly and time-consuming. Exchangeable share structures also create their own securities and tax problems, and at the end of the day Canadian shareholders who receive exchangeable shares may not have the same degree of liquidity as their U.S. counterparts. The CCRA is aware of this issue, and in the most recent federal budget the government signaled that it was prepared to introduce roll-over treatment for share-for-share take-over bids by U.S. acquirers of unlisted Canadian corporations. Nonetheless, until new roll-over legislation is actually introduced, if an acquisition by a U.S. entity is anticipated, founders may be advised in the first instance to incorporate in the U.S., since roll-over treatment is available for Canadian shareholders of a U.S. corporation acquired by a U.S. entity.

2. Withholding Tax on Proceeds of Disposition of Non-Residents

In an acquisition of shares of a Canadian corporation which are not publicly traded, twenty-five percent of the proceeds of disposition payable to a non-resident seller must be withheld by the purchaser to cover the potential tax liability of the seller. The purchaser is relieved of this obligation if the non-resident seller obtains a clearance certificate (otherwise known as a Section 116 certificate) from the CCRA. A clearance certificate is readily obtainable from the CCRA if the non-resident seller prepays Canadian tax (or provides acceptable security) on the capital gain arising from the sale transaction. A clearance certificate should also be available where the sale of shares is exempt from capital gains tax in Canada pursuant to the Canada-U.S. Income Tax Convention (the "Treaty"). However, if a clearance certificate is requested based on a Treaty exemption, there are often delays while the CCRA reviews relevant tax information to confirm that a Treaty exemption is in fact available. If a clearance certificate is not obtained within a month of the closing of the transaction, the proceeds withheld by the purchaser must be remitted to CCRA. However, in some districts, there can be a delay of up to twelve weeks before requests for clearance certificates are processed. If proceeds are shares of a publicly-traded acquirer, non-resident sellers will be exposed to fluctuations in the equity markets during the waiting period. Note as well that in the case of non-resident sellers structured as limited partnerships, the CCRA may require detailed tax information regarding the limited partners in order to determine if a Treaty exemption is available. In our experience, this has caused administrative problems and privacy concerns for non-resident investors.

3. No Flow-Through Status for LLCs

The benefits of the Treaty are not available to limited liability companies (LLCs) by virtue of their flow-through status for U.S. tax purposes. As a result, any gain (or loss) from the sale of shares of a Canadian corporation will he fully taxable in Canada and will not be flowed through to shareholders of the LLC. This means that it is generally not viable for LLCs to invest directly in Canadian corporations, although an indirect investment through a Barbados holding structure is a possibility (provided that the LLC is willing to establish such a structure, usually at its own expense).

4. Tax on Dividends and Deemed Dividends

A Canadian corporation will also have withholding and remittance obligations with respect to dividends and deemed dividends payable to non-resident shareholders. A deemed dividend may arise on the redemption or other repurchase of shares by a Canadian corporation to the extent that the proceeds to the shareholder exceed the paid up capital of the redeemed shares. The withholding rate applicable to dividends and deemed dividends is either five or fifteen percent, depending on the payor's percentage ownership of the corporation.

5. U.S. Tax Issues

The discussion above touches on selected issues arising under Canadian tax legislation and treaties which impact U.S. investors investing in Canadian companies.

There are also several provisions of U.S. tax law that may result in unfavourable U.S. tax treatment of a disposition by a U.S. shareholder of an interest in a Canadian corporation. If the Canadian corporation is treated as a controlled foreign corporation, passive foreign investment company, or a foreign investment company, gain recognized by a U.S. shareholder in a taxable sale may be taxed as ordinary income. Moreover, the U.S. will tax many dispositions of foreign shares by U.S. shareholders in transactions that would qualify for non-recognition as a tax-free reorganization had the U.S. shareholder disposed of U.S. stock. For example, transactions that involve the merger of a Canadian corporation into a U.S. corporation will be taxable to the Canadian corporation's U.S. shareholders even though the merger would have been tax-free for two U.S. corporations. As a further example, an asset sale by a Canadian corporation to a U.S. corporation in exchange for stock, that normally would be treated as a tax-free reorganization under U.S. tax law, will generally trigger taxable income for U.S. shareholders who own ten percent or more of the Canadian corporation's shares to the extent of their share of the Canadian corporation's earnings and profits. In this situation, a tax-free result can be achieved if, instead of acquiring the Canadian corporation's assets, the U.S. corporation acquires shares in the Canadian corporation by issuing its voting stock in exchange. In any event, care will be required in structuring a U.S. shareholder's disposition of shares of a Canadian corporation.

6. Optics/Prestige

There are also intangible qualities attached to U.S. incorporation for Canadian-based companies, including a "prestige" element and creating a greater comfort level in U.S. and some foreign public and private equity markets. Ultimately, this can translate to a higher valuation (or avoid a discount) for the company on an IPO or M&A transaction.

Deciding Where to Incorporate

In general, Canadian incorporation may be preferable in the following situations:

  • the controlling shareholder group is such that the company would be able to qualify as a CCPC;
  • the company anticipates that it can fund its operations and execute on its business plan without having to seek venture capital from U.S. sources;
  • BDC or a labour-sponsored fund will be a lead investor at an early stage; and/or
  • the company is a smaller venture that cannot afford the extra expense of U.S incorporation.

On the other hand, U.S. incorporation may be preferable if:

  • the company will be controlled by non-residents and/or public companies such that the company would not otherwise qualify as a CCPC;
  • a principal lead investor is a U.S. LLC or a U.S. LLP;
  • the anticipated exit for the company is an acquisition by a U.S. purchaser; and/or
  • as the company matures, it anticipates shifting its operations south of the border.

U.S. tax issues which are not particular to investments in Canadian corporations may also impact the decision if a U.S. investor is involved.

For many early-stage Canadian technology companies, the jurisdiction of incorporation decision will be a factor of the relative bargaining strength of the Canadian founders (who will generally prefer Canadian incorporation) and prospective U.S. investors (who tend to prefer U.S. incorporation).

If a company would otherwise be a CCPC but for U.S. incorporation, it may wish to establish a "sister" Canadian company that will qualify as a CCPC for the purpose of obtaining refundable SR&ED credits at the enhanced rate. As a final note, it is possible to reconstitute a Canadian corporation in the U.S. Generally, an export results in shareholders being deemed to have disposed of their shares, typically resulting in a capital gain. The deemed disposition can be avoided if the corporation adopts a share exchange structure. The difficulty of tax issues in both Canada and the U.S. means that U.S. reconstitutions are rarely undertaken.

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

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

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.

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