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Tax laws creating crisis in Canada’s venture capital industry by posing barrier to badly needed global funding

Deloitte survey of over 500 global venture capitalists underscores need to fix

Toronto, December 5, 2007 — Although Canada remains one of the top three targets for increased U.S. venture capital (VC) investment globally, a global VC survey reveals that 40% of U.S. respondents and 28% of global respondents cite Canada’s unfavourable tax environment as a key reason for not investing in Canadian companies. This level of concern is five times higher than for any other country in the survey and reflects the current investment crisis within Canada’s venture capital industry.

The Global trends in venture capital 2007 survey is sponsored by Deloitte, in cooperation with the Canadian Venture Capital Association (CVCA) and numerous other VC associations internationally. Specifically, the survey measures the degree to which 528 VCs from around the world are expanding their investment strategies, and was conducted in the Americas, Asia Pacific, Europe, the Middle East and Africa.

Fixing Canada’s “broken VC ecosystem” a priority of government and industry
“The outlook for the Canadian venture capital industry is bleak given its ecosystem is broken and there is no immediate solution at hand. The Canadian government and the domestic VC community must join forces to bring the industry back from the brink of collapse,” says John Ruffolo, National Leader,   Technology, Media & Telecommunications Industry Group, Deloitte. “Although remedies exist at each investment stage, the country must act quickly to remove major tax barriers preventing critically needed international flows of investment capital from crossing our borders.”

According to Ruffolo, the results of the global VC survey should trigger alarm bells throughout the industry and government. “If not fixed in the near term, the Canadian VC ecosystem — made up of successive and sequential stages of capital investment from early seed financing through initial public offerings — will collapse. We need the government’s help to pull the industry out of this crisis,” he says.

"Deloitte's groundbreaking study confirms what many U.S. and global venture capitalists have long known ― that Canada may have the most unfavourable tax environment for foreign VC investment in the industrialized world,” explained Stephen Hurwitz, partner in the Boston-based law firm of Choate Hall & Stewart and renowned Canada-U.S. cross-border tax issues advocate. “This impediment to the inflow of foreign investment is leading to the continuing demise of Canada’s VC ecosystem and is preventing its technology industry from achieving its full potential both domestically and globally. The resulting damage to Canada's most precious asset ― innovation ― is incalculable. Until the Canadian government puts an end to the unnecessary paperwork required by 'Section 116' of its cross-border tax law, more and more foreign VCs will continue to take their money elsewhere, which will result in the loss of future jobs and tax revenue," he concluded.

The Canadian government typically invests up to $9 billion a year in research and development. However, without a healthy VC ecosystem that is able to convert the ideas and research produced from this substantial investment into real products that create revenues, jobs and taxes, much of this investment will be wasted.

As evidence, in a five-year comparison, venture capital investment in Canadian operating companies in the third quarter of 2007 ($517 million) is almost 21% lower than in the third quarter of 2002 ($653 million). In addition, almost a third (31%) fewer Canadian operating companies (147) were funded by venture capital firms in the third quarter of 2007 compared to the third quarter of 2002 (215). As of the end of September 2007, new capital commitments by venture firms into Canadian operating companies totalled $852 million, down 72% from the $3.087 billion committed during all of 2002. Further, over five years, the total amount of capital raised by Canadian venture capital firms has decreased at an alarming rate from $3.087 billion (2002) to $1.973 billion (2003) to $1.779 billion (2004) to $2.21 billion (2005) to $1.635 billion (2006) to a year-to-date total of only $852 million (2007).

Tax barriers preventing foreign investment in Canada 

  • Withholding and Section 116 Certificate process — The overwhelming majority of foreign VCs are not subject to Canadian tax when they sell an investment, but face a delay of many months to work through the Section 116 tax clearance process until funds can freely flow to them. Many foreign VCs are structured such that each of the investors in the VC — sometimes hundreds or even thousands — is subject to this clearance process as if they held the investment directly. This delay results in lower returns and frequently causes direct financial loss to investors. Canadians who invest in the United States, the United Kingdom and other major global markets do not face such taxes or delays from red tape.
  • Requirement to file Canadian tax returns by foreigners who don’t owe taxes creates hundreds of pages of unnecessary paperwork — Canada continues to impose tax filing requirements in circumstances where no taxes are payable by these investors. When a foreign VC sells an investment, they must file a Canadian tax return even if they do not owe any taxes. Each of the investors in some of these foreign VCs may also need to comply with these filing requirements, which can result in literally hundreds of pages of documents that are required for signature and processing for a single sale. This tax return filing issue can also apply to certain Canadian public companies. 
  • Barriers to liquidity also affect Canadian investors — It is also critical to defer the taxes incurred by Canadian investors when a Canadian company they have invested in is sold to a foreign company, and when no cash proceeds are paid to the investor. Current Canadian cross-border merger tax rules limit foreign capital flows for Canadians and require the use of cumbersome exchangeable share structures. This not only discourages foreign investors from participating in these structures, but also encourages Canadian companies to relocate their businesses outside of Canada. Once again, Canada is unique in this distinction.  

The Canadian government has taken a few small steps but needs to start taking strides 
The recent decision to recognize U.S. limited liability corporations (LLCs) as flow-through entities and eliminate non-resident withholding tax on interest payments under the Protocol to the Canada-U.S. tax treaty was very welcome. Given that the LLC structure is a common form of corporate organization among U.S.-based private equity firms, U.S. resident investors will no longer incur Canadian taxes from the disposition of their Canadian investments. However, it is important to note that the treaty is not yet effective and it is unclear when it might take effect.

Other solutions are needed to fix the industry’s broken ecosystem 
The government of Canada can remove the tax barriers preventing the flow of direct foreign VC investment into the country, and it can also play a critical role in reviving the Canadian domestic VC ecosystem. At the seed and early stage financing rounds, both federal and provincial governments could provide incentive tax credits, flow-through tax deductions, and/or reduced capital gains taxes for investors. At the first round of institutional VC funding, the federal and provincial governments could also improve retail venture capital programs, particularly for provinces where such programs have been curtailed (e.g., Ontario) or do not currently exist (e.g., Alberta). And, at the latter round of institutional VC funding, the government can play a pivotal role as a source of capital for these VCs.

Less than half of Canadian VCs investing globally
Only 44% of Canadian VCs currently invest abroad — and some of that is through investing in Canadian companies with significant foreign operations. Those Canadian VCs who do invest globally do so with varying intensity: 19% have 26-50% of their capital invested outside Canada, but 44% have less than 10% of their capital invested internationally.

There are a number of techniques that VCs use to manage the sometimes difficult process of investing abroad. Three quarters (75%) of Canadian VCs will only invest alongside another VC who has a local presence, 58% sometimes do so through strategic alliances with foreign-based firms, and half (50%) are requiring their investment partners to travel more to manage their investments. More than three quarters (78%) of Canadian VCs plan to increase their international investment activities over the next five years.

When Canadian VCs invest internationally, they tend to invest close to home and in markets they understand, including the United States (52%), the United Kingdom and Ireland (10%) and Latin America (10%). When compared to their U.S. counterparts, Canadian VCs want to increase their global investments at a faster rate (78%) than both global (58%) and U.S. VCs (54%), but are being cautious about the number of investments they make, with three quarters limiting their investments to under five investments: 67% at one to two companies and 9% at three to five.

Canada is a relatively low priority for U.S. VC expansion
Behind China (34%) and India (24%), Canada is attracting the attention of just 11% of U.S. VCs as a primary country for expansion. In addition to the historical reasons why Canada is attractive to U.S. VCs ― primarily geographic proximity and political/economic stability ― respondents also cited lower costs, lower regulatory compliance and lower legal costs than the United States. Further, Canada did not elicit many of the negative perceptions associated with the United States, such as the cost of complying with corporate governance and the United States’ litigation environment. Canada also fared well when compared to other countries’ weak intellectual property laws and too-lax regulation (primarily China and India).

"This report clearly demonstrates the importance of global capital markets to the Canadian venture capital community," commented Rick Nathan, President of the Canada’s Venture Capital and Private Equity Association (CVCA) and a Managing Director of Kensington Capital Partners. "We welcome foreign investment in this sector, however, as the supply of domestic venture capital across Canada continues to decline, we must work harder to build up a stronger base of Canadian venture capital funds.”

About the Deloitte and CVCA Global Trends in Venture Capital 2007 Survey
The Global Trends in Venture Capital 2007 Survey was sponsored by Deloitte in cooperation with the Canadian Venture Capital Association and numerous other VC associations around the world. It surveyed venture capitalists in the Americas, Europe and the Middle East, and Asia Pacific. Deloitte received 528 responses from general partners with assets under management ranging from less than US$100 million to greater than US$1 billion. The survey was conducted in the second quarter of 2007. Of the total number of respondents, 54% were based in the Americas, 31% in Europe, 13% in Asia Pacific and 2% in the Middle East. Of U.S. firms, 86% were VC firms, while 14% were exclusively private equity firms. Of non-U.S. firms, 64% were VC firms, and 36% were private equity firms.

About Deloitte 
Deloitte, one of Canada’s leading professional services firms, provides audit, tax, consulting, and financial advisory services through more than 7,600 people in 56 offices. Deloitte operates in Québec as Samson Bélair/Deloitte & Touche s.e.n.c.r.l. The firm is dedicated to helping its clients and its people excel. Deloitte is the Canadian member firm of Deloitte Touche Tohmatsu. Deloitte refers to one or more of Deloitte Touche Tohmatsu, a Swiss Verein, its member firms, and their respective subsidiaries and affiliates. As a Swiss Verein (association), neither Deloitte Touche Tohmatsu nor any of its member firms have any liability for each other’s acts or omissions. Each of the member firms is a separate and independent legal entity operating under the names “Deloitte,” “Deloitte & Touche,” “Deloitte Touche Tohmatsu,” or other related names. Services are provided by the member firms or their subsidiaries and not by the Deloitte Touche Tohmatsu Verein.

About the CVCA 
The CVCA - Canada’s Venture Capital & Private Equity Association, was founded in 1974 and is the sole national representative of Canada’s venture capital and private equity industry. Its over 1,200 members are firms and organizations that manage the majority of Canada’s pools of capital designated to be committed to venture capital and private equity investments. CVCA’s members actively collaborate to increase the flow of capital into the industry and expand the range of profitable investment opportunities. This is accomplished by the CVCA undertaking a wide variety of initiatives, ranging from developing comprehensive performance and valuation statistics to promoting the industry’s interests with governments and regulatory agencies.

Contacts

Name:
Andrea Lekushoff
Company:
Broad Reach Communications
Job Title:
President
Phone:
416-435-2569
Email
alekushoff@broadreachcommunications.com