Canadian vs. US Incorporation – the Canadian Startup Dilemma
Canadian technology companies often want or need to attract investment from foreign and, in particular, US investors. While US capital is often welcome, the interests of US investors are sometimes in conflict with the interests of Canadian founders and employees. These competing interests can make the decision of whether to incorporate in Canada or the United States a difficult one, as many investors prefer, and in some cases insist, that the corporation be incorporated under U.S law. While there is often great pressure to get started with an incorporation when forming a new business, founders must carefully weigh the pros and cons of Canadian versus US incorporation, as it is difficult and costly to change course after the original incorporation.
(i) Advantages of Canadian incorporation
In the late 1990s and early 2000s, US venture capital funds dramatically stepped up their investments in Canadian portfolio companies. In those days, many US VCs invested directly into Canadian-incorporated companies. Through the early 2000s, it became apparent that the US VCs would encounter Canadian income tax issues when trying to exit from their Canadian investments. The most serious problems arose from the requirement that a non-Canadian resident obtain a section 116 certificate on the sale of shares of a Canadian company or face a 25% withholding tax. A section 116 certificate is required whenever a purchaser acquires property that is taxable Canadian property (TCP) from a non-resident of Canada. Until 2010, shares of all private Canadian companies were TCP. Delays in obtaining section 116 certificates, and onerous reporting requirements, turned many US VCs away from direct investments in Canadian companies. When these problems became apparent, many of the most promising Canadian startups either incorporated in the US in the first instance, or were reorganized as US companies to attract US VC funding.
After an intense campaign by the innovation sector, in 2010 the section 116 problem was solved through legislative amendments to the Income Tax Act (Canada) (the ITA). Amendments to the ITA passed effective March 4, 2010, changed the definition of TCP. The new definition excludes shares of corporations that do not, at any time during the 60-month period prior to the time of determination, derive more that 50 percent of their value from real or immovable property in Canada, Canadian resource property, timber resource property, or options or interests in respect of the foregoing. The effect of this change is that purchasers no longer need to withhold 25 percent of the purchase price on acquisition of shares of most privately-held Canadian companies from sellers resident in the US, and it obviates the need for sellers to apply for a section 116 certificate before the full purchase price may be received.
Today, most US VCs are once again comfortable investing directly into Canadian companies. This is good news for Canadian startups, as founders and the companies can continue to enjoy the many tax benefits that come with Canadian incorporation. Some of the pros and cons of Canadian incorporation are discussed below. The central question in whether Canadian incorporation makes sense is whether the company will be a Canadian-controlled private corporation (CCPC).
A. What is a CCPC?
A CCPC is a Canadian-incorporated, private corporation that is, throughout the year, not controlled, directly or indirectly, by one or more non-residents of Canada or public corporations (or any combination thereof). For this purpose, control has two aspects: first, it means more than 50 percent of the voting rights required to elect a majority of the Board of Directors (called legal or de jure control); second, it means factual or de facto control – any direct or indirect influence that, if exercised, would result in control in fact of the corporation, whether through a shareholders agreement, option to purchase shares, convertible debt or other means.
There is no bright-line test for what constitutes de facto control of a CCPC. Provided that it is founded by Canadian resident individuals, a typical startup company incorporated in Canada would qualify as a CCPC. To the extent that it can then secure venture capital or other equity financing from Canadian sources, that company can continue to be a CCPC well past the startup stage.
B. CCPC advantages
There are numerous advantages to a Canadian corporation maintaining its CCPC status.
I. Company advantages
The Canadian federal government promotes jobs and investment in Canada with investment tax credits (ITCs) under the Scientific Research and Experimental Development (SR&ED) Program. ITCs can be used to reduce tax otherwise payable by the corporation or may, in certain circumstances, be refundable to the corporation where the corporation is not taxable. SR&ED ITC rates are currently 35 percent for qualifying CCPCs and 15percent for other corporations. The 35% rate applies to the first CA$3 million of qualified SR&ED expenditures incurred in a year and is refundable. SR&ED expenditures in excess of the CA$3 million expenditure limit will earn ITCs at the reduced rate of 20 percent.
Once a CCPC is earning income from active business, it is eligible for the small business income tax rate, which provides that the first CA$500,000 of active business income will be taxed at a lower rate of federal tax.
II. Founder advantages
One of the most important advantages to the founders of a CCPC is the one-time CA$800,000 lifetime capital gains exemption. When a Canadian shareholder disposes of certain qualifying shares, the shareholder will realize a capital gain to the extent that the proceeds of disposition of the shares exceed the adjusted cost base of such shares plus any reasonable costs of disposition. Where the disposition is of qualifying shares, the first CA$800,000 (or where the exemption has been previously used by the individual, the unused portion of the CA$800,000 exemption) of capital gains realized by an individual on the sale of shares of a CCPC will not be subject to income tax, so long as the shares were held by the taxpayer for at least 24 months. This is a significant tax benefit for first-generation entrepreneurs who have not used up the exemption. Splitting founder shares with a spouse or family trust can result in even greater tax savings. The CA$800,000 lifetime capital gains exemption is available only for sales of certain qualifying shares of CCPCs, and therefore not available for the sale of shares of US-incorporated companies.
Other tax incentives exist to encourage reinvestment by successful entrepreneurs. A capital gain realized from the sale of shares of an eligible small business corporation (which must, among other things, be a CCPC at the date of the sale) may be deferred to the extent that the proceeds are reinvested in shares of another eligible small business corporation, subject to restrictions on the carrying value of the assets of both CCPCs, both before and after the respective shares were issued. This reinvestment can be made in the year of disposition or within 120 days after the end of that year. Unlike the US capital gains reinvestment scheme, this deferral is available only to individuals (who will typically be angel investors or second-generation entrepreneurs) and cannot be passed through professional investment corporations, trusts or partnerships. To qualify for the deferral, the shares of both CCPCs must have been issued by the corporation to the individual, and therefore shares acquired by purchase, rather than from treasury, will not qualify.
III. Employee advantages
For many early-stage technology companies, stock option plans are a key tool for recruiting and retaining key executives and employees. Canadian employees are savvy in assessing the value of equity incentives. Not only is option price and percentage ownership important, a stock option plan should also be tax effective. This is where a CCPC has two clear advantages.
First, as a general rule, an employee who is granted a stock option at an exercise price of $X and who exercises the option when the shares are worth a higher amount $Y, must include in income an amount equal to $Y-$X (subject to a 50% deduction in certain cases – see below). However, on the exercise of an employee stock option granted by a CCPC, tax is generally deferred until the option-holder disposes of the underlying shares.
The second benefit applicable only to employee stock options of a CCPC is a 50% deduction on a gain realized from the sale of underlying shares, so long as at least two years have elapsed from the date of exercise. A similar 50% deduction is available in respect of shares of a non-CCPC, but is subject to additional conditions, including a requirement that the exercise price of the option must be not less than the fair market value of the underlying shares at the date of the grant. This means that non-CCPCs–including all US-incorporated companies–cannot grant cheap or below fair market value stock options to Canadian employees while maintaining the tax effectiveness of the stock option plan. Moreover, shares of companies which are not publicly traded are notoriously difficult to value. If an option grant must be at fair market value to secure the tax deduction, boards of directors are advised to be conservative in determining the fair market value of underlying shares, or risk depriving employees of the tax benefit. Where a company has both US and Canadian employees, this means that the option pricing may end up being driven by Canadian income tax considerations.
C. What if the company cannot qualify as a CCPC?
Clearly, if a company will be majority-owned by Canadians and can otherwise qualify as a CCPC, there are strong arguments to incorporate in Canada to secure CCPC status. If, however, founders are non-residents of Canada, or an early source of investment is from non-Canadian resident or public company investors, it is possible that the company will not be able to meet the CCPC ownership requirements, or will cease to be a CCPC shortly after incorporation. Still, in addition to the CCPC advantages outlined above, there are reasons to consider Canadian incorporation.
I. Eligible investors
First, certain pools of capital are available only to Canadian-incorporated companies. As may be expected given its mandate, Business Development Bank of Canada is restricted from investing in companies incorporated outside Canada.
II. Lower costs
Another potential advantage to incorporating in Canada is lower legal and accounting costs. In many respects, US-incorporated companies operating primarily in Canada must comply with a dual regulatory regime that requires guidance from both US and Canadian advisers. Unless carefully managed, this can slow the pace of decision making and result in headaches for management. For cash-strapped startup companies without immediate aspirations of recruiting or seeking investment south of the border, it can be difficult to justify the expense and hassle of incorporating in the United States.
(ii) Additional advantages of Canadian incorporation
Federal and provincial governments have gone to great lengths to make Canadian corporations statutes internationally competitive. As a result, in terms of corporate governance, Canadian-incorporated companies operate fairly efficiently on a day-to-day basis. However, depending on a company’s long-term business plan and investors’ potential exit scenarios, there are a number of factors that may weigh in favour of US incorporation. Some difficulties that can be avoided by incorporating in the US only tend to arise when a company is sold. Again, the problem is navigating Canadian income tax laws.
A. Merger & acquisition transactions
Many successful Canadian companies are acquired by complementary businesses or competitors in the US In the technology sector, acquisition transactions are structured often as stock deals or cash-and-stock deals, in which some or all of the purchase price for shares of the target is stock of the acquiring company. Share-for-share deals do not present a problem where shares of a US-incorporated target are sold to a US purchaser, as a tax-deferral for Canadian shareholders is available under the ITA in respect of the sale. This means that selling shareholders will generally not be taxed until the shares acquired on the exchange are sold. Roll-over treatment, however, is not available for share-for-share deals in which shares of a Canadian-incorporated target are sold in return for shares of a US purchaser. This means that tax on any gain realized on the sale will be payable by Canadian shareholders in the year of the take-over, unless the special steps discussed below are taken. This creates problems if, for example, there is no public market for the shares of the US purchaser, or the shares cannot be traded as a result of resale restrictions, or if the acquirer is itself at an early stage of growth and disposing of the shares to cover tax liability is an unattractive option. As a result, if the target in a cross-border share-for-share deal is incorporated in Canada, Canadian shareholders of the target can end up with a significant tax liability for which they have no immediate means to pay.
Typically, this problem has been avoided by structuring acquisitions of Canadian companies as exchangeable share deals, in which the stock portion of the purchase price is paid by issuing shares of a newly-incorporated Canadian subsidiary of the US purchaser, shares of which are directly or indirectly exchangeable for shares of the US purchaser. This results in tax-deferred treatment for Canadian resident shareholders on the sale of the Canadian target until the selling shareholder exchanges the shares of the Canadian subsidiary for stock of the purchasing US company. Indeed, this structure is common enough that some large public companies have listed tracking shares on the Toronto Stock Exchange to facilitate acquisitions of Canadian-incorporated companies. Compared to a garden-variety share-for-share exchange transaction, however, an exchangeable share transaction can be costly, time-consuming and complex. In addition, not every US acquirer is familiar with exchangeable share deals, and the prospect of having to jump through extra hoops may discourage a purchaser from pursuing a marginal transaction.
If an exit transaction is structured as an asset sale, another issue that arises when a Canadian corporation is used is that under Canadian income tax law, in the event of a dividend payment or deemed dividend on the repurchase of shares by the Company in the course of distributing proceeds to the shareholders of the Company from an asset sale, any dividend or deemed dividend payable by a Canadian company to a non-resident shareholder will be subject to a withholding tax of 25 percent (reduced to between 5-15 percent under the Canada-US Tax Treaty).
Occasionally M&A exits involve a buy-back by the target of its shares. A deemed dividend can arise with a repurchase of shares to the extent the repurchase amount exceeds the share’s paid-up capital (the amount originally paid to the company to issue the share). This tax may not apply if the company is a US corporation.
B. Special tax considerations for US investors
Certain amendments to the Canada-US Tax Treaty which came into force in 2008 provide for the reversal of a long-standing position taken by the Canada Revenue Agency (CRA) on the applicability of treaty benefits to flow-through entities like a US LLC. Formerly, the Canada-US Tax Treaty contained no provisions which required the CRA to recognize the flow-through status of a limited liability company (LLC) incorporated in the US Because the US resident members of the LLC, and not the LLC itself, were taxed directly on their income and gains under US tax law, the CRA took the position that the LLC was not resident in the US for Treaty purposes.
This status meant a US LLC did not qualify for the limits on the rate of Canadian withholding tax on payments of dividends, interest and royalties, or the exemption from Canadian tax on capital gains realized on certain types of treaty-protected property (which may include shares of a Canadian corporation that do not derive their value principally from Canadian real property). One effect in particular was that the sale by the LLC of shares of a Canadian company led to a tax on the gain in Canada levied on the LLC as a corporation, and a tax on the gain in the US on individual residents required to include the gain. This made investment in Canadian-incorporated private companies less attractive, even though an LLC is not itself taxed under US tax law, and even if an individual member of the LLC resident in the US may qualify for favourable tax treatment under the treaty.
Pursuant to 2008 amendments, if a US resident derives an amount of income, profit or gain from an entity (other than an entity resident in Canada), and the tax treatment of the amount in the US is the same as if the amount were derived directly by the investor, that amount is considered to be derived directly by the US resident for treaty purposes. As US residents are typically afforded favourable tax treatment for treaty purposes, the amendments in effect eliminate many of the undesirable treaty consequences of investing in a Canadian-incorporated private company through a US LLC.
C. Corporate considerations
From a company perspective (but not necessarily from a minority shareholder perspective), there are certain inherent advantages to incorporating in the State of Delaware. The Delaware General Corporation Law is generally more permissive and less protective of minority shareholder rights compared to the Canada Business Corporations Act (CBCA) and Canadian provincial corporation statutes. For example, Canadian corporations must conduct shareholder business either by unanimous written resolution (i.e., a resolution signed by each and every shareholder permitted to vote) or by an annual or special meeting of the shareholders. For Delaware corporations, shareholder approvals can be obtained by the written consent of the majority of shareholders. At first blush this may seem like a relatively minor difference. However, financing transactions – which generally require some form of shareholder approval – are much easier to co-ordinate if management does not have to track down each and every shareholder to sign written resolutions (which can be difficult or impossible to obtain if, for example, there are disgruntled or departed founders who continue to hold shares), or hold a shareholders’ meeting which may entail delivering a notice, preparing information circulars and the like.
US investors are also sometimes surprised that under Canadian corporation statutes, class voting rights and dissent and appraisal rights are available in a broad array of circumstances compared to Delaware corporations. In addition, in Canada the availability of a broad oppression remedy colours many disputes. These additional remedies should be weighed against the generally less litigious environment in Canada.
Canadian incorporated companies are generally required under their governing statutes to report in Canadian GAAP, which today means ASPE (Accounting Standards for Private Enterprises).
A further consideration if a company will have US investors represented on the Board is director residency requirements under the CBCA and some provincial corporation statutes. Under the CBCA, 25 percent of directors (or at least one director, in companies having fewer than four directors) must be resident Canadians. It should be noted, however, that the corporate legislation of some Canadian provinces, such as British Columbia, New Brunswick and Nova Scotia, do not have director residency requirements.
(iii) Weighing the options
Based on the discussion above, the interests of Canadian founders and US investors can be in opposition when it comes to deciding whether to incorporate in Canada or the United States. On balance, for businesses intending to operate primarily in Canada, we tend to recommend Canadian incorporation when one or more of the following factors are in play:
- The company will be majority-owned by Canadians so as to qualify as a CCPC. This consideration is paramount if most of the founders and key employees are Canadian residents, or if the company wishes to rely on refundable SR&ED tax credits to fund its startup operations.
- The company anticipates that it can fund its operations and execute its business plan without having to seek significant amounts of venture capital from US or other non-Canadian sources.
- The company is a smaller, more speculative venture that cannot afford the extra expense of US incorporation.
US incorporation may be advantageous under the following circumstances:
- The founder group and prospective investors are primarily non-residents, such that the company would not otherwise qualify as a CCPC.
- The anticipated exit for the company is acquisition by a US entity that will occur in the near term.
- As it matures, the company anticipates shifting the bulk of its operations to the US.
In most cases, it is relatively easy to make an informed decision regarding jurisdiction of incorporation. Conflicts can arise, however, where a company would otherwise be a CCPC, but the initial investor group includes US investors who understand the risks of, and are opposed to, investing in a Canadian-incorporated entity. In this situation, the incorporation decision will be a factor of the relative bargaining strength of the Canadian founder group and US investors. If the stakeholders ultimately decide on US incorporation, and the company would otherwise be a CCPC, it may be possible to establish a cloned Canadian company, the ownership of which mirrors the shareholder group of the US company. The Canadian company will then be a CCPC, and will be eligible for refundable SR&ED tax credits at the enhanced rate for SR&ED activities it carries on and lower taxes on the first CA$500,000 of active business income. However, the Canadian company cannot be controlled de jure or de facto by non-qualifying shareholders. If the parent is US-incorporated, however, there may be no practical way to recapture the CA$800,000 lifetime capital gains exemption and the stock option deferral that would ordinarily be applicable to CCPCs. A further consideration is the extra accounting and legal costs entailed in issuing equity to the shareholder group at both the separate US and Canadian levels (although in our experience these costs are more than offset by the tax benefits).
(iv) Reorganizing a Canadian company to the US
If a corporation is incorporated in Canada and it is later decided to move to the United States, it is possible to export a Canadian company to Delaware or another US jurisdiction. Generally, an export (or continuance) will not result in shareholders being deemed to have disposed of their shares, resulting in a capital gain. The corporation will have a deemed taxation year immediately before the emigration and will be deemed to have disposed of its property for proceeds equal to the fair market value, and in addition will be liable to pay tax equal to 25 percent of the excess of the fair market value of its assets over the total of the paid-up capital of its shares and any outstanding debts, at the time it ceases its Canadian residency. This can be avoided if the corporation adopts an exchangeable share structure. Implementing an exchangeable share structure, however, will typically be more expensive.
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