Canada Posed To Scrap Impediment to U.S. Investment

On the week that peHUB launched in November 2007, venture capitalist Charley Lax wrote the following:

Meaningless paperwork is destroying Canada’s venture capital industry, and if our northern neighbor ever wants significant US venture capital to flow north, they’ll listen when I tell them to eliminate Section 116 certificates immediately.

Well, nothing happened “immediately,” but Canada last week signaled that Section 116 is headed to the scrapheap. What follows is are some questions about Section 116 for Stephen Hurwitz, an attorney who focuses on cross-border transactions between the U.S. and Canada:

What is Section 116?

It’s a rule that’s been around for more than a decade. It works, or rather worked, as follows:

Canada and the U.S. have a treaty that says when a U.S. venture capitalist invests in a Canadian company and later sells shares, it only has to pay taxes once, in the home country. And vice versa. The way it worked in practice, though, was very different.

When a Canadian VC invested in a U.S. company and sold it, he was immediately free to take his money back to Canada. No red tape, tax filings, etc. But when the U.S. VC sold his stake in a Canadian company, the Canadian government demanded that it prove every one of its investors was from the U.S. And, until the U.S. VC could prove it, the Canadian government would hold 25% of the proceeds in escrow. All LPs — and even their LPs, in the case of funds-of-funds — had to file an application proving residency. Sometimes they’d also have to provide tax returns.

All of this was managed by 45 different offices in Canada, none of which had uniform processes or requirements. Sometimes it took six to eight months — or even a year or two — for a U.S. VC to get their money back. I know of one case where a U.S. VC had to file 900 signatures for a single exit.

Moreover, if the exit was in stock instead of cash, U.S. VCs sometimes lost millions as the value of that escrowed stock declined.

2. But there has been U.S. VC investment in Canadian companies. How did that work?

They often adopted legal acrobatics to avoid the Canadian government. Sometimes you’d take a Canadian company, relocate it and turn it into a Delaware corporation. But that could cost up to $400,000 in legal fees, with flow charts like spaghetti.

Too complex, too expensive and too time consuming. The result is that a number of U.S. VCs just said they weren’t investing in Canada.

Ok, so what happened last week?

Well, in Canada, it was estimated that the cost of enforcing this rule was exceeding the amount of taxes collected. So, on March 4, the Harper government said it was ending Section 116, as part of its budget. There are some exclusions for real estate, timber and minerals, but that’s not what most VCs are investing in.

Going forward, it will be as easy for a U.S. VC to invest in a Canadian tech company as it has been for a Canadian investor to invest in a U.S. tech company.

You and others have spent years lobbying for this change. If there is no legislative objection to Harper’s move — which there doesn’t appear to be — why did it take so long?

That’s a very good question. In talking with the civil service in prior years, their view was their job was to protect Canadian taxpayers from possible unintended consequences. What has happened now really just involved an act of political will by the government, to say: “Wait a minute, this doesn’t work.” 

Do you believe U.S. VCs who stopped investing in Canadian companies will take a second look?

They definately will take a second look. What will happen is you’ll have one U.S. VC call another and tell them about this great company they just found.

My understanding is that is de facto being treated as if it’s a done deal, and the only thing that could change it would be if the Harper government fell under budget pressure, but there’s no sign of that happening. The budget was submitted on March 5, and it says that change to Section 116 applies to sales of Canadian shares beginning March 5.