Budget 2010 – Changes to Section 116 of the Income Tax Act - Implications for Foreign Investors
By: Brent Kerr and Michael Herman

Budget 2010 –  Changes to Section 116 of the Income Tax Act - Implications for Foreign Investors 

On March 4, 2010 , Budget 2010 proposed important changes to the non-resident clearance certificate and withholding tax rules in section 116  of the Income Tax Act .  These changes should  have significant  benefits for  Canada's  life sciences   sector. 

In a nutshell

Budget 2010 announced that non-residents will no longer need to obtain clearance certificates or pay withholding tax on the sale of shares in a Canadian corporation (and certain other interests), as long as the shares do not derive their value principally from real or immovable property situated in Canada, Canadian resource property, or timber resource property.  This change will be particularly beneficial to the  life sciences  sector, which has lobbied for years to obtain relief.  It is widely thought that foreign investment in Canada has been impeded by the existing rules, which impose onerous tax and administrative requirements on non-resident investors.

Details

The changes announced  in Budget 2010  are far-reaching because they will eliminate altogether the application of section 116 withholding tax and clearance certificate requirements for shares in private Canadian corporations and certain other interests - unless the value of the shares is derived principally (more than 50%) from real property, resource property or timber resource property in Canada (or was so derived at any time within the previous 60 months).  If the proposed changes are passed into law, Canadian  life sciences corporations   will no longer be handicapped by the administrative burden of section 116 that was imposed on foreign  venture capital funds and other non-resident investors.

Foreign investors in private Canadian corporations were generally protected from Canadian tax on capital gains derived from their Canadian investments if they resided in a treaty jurisdiction.  However it was necessary for them to obtain a section 116 clearance certificate from the Canada Revenue Agency.  Pending receipt of a clearance certificate, tax had to be withheld. In 2009, changes were made to relax the requirements, but the changes didn't go far enough, so the need to withhold and obtain a clearance certificate remained a practical reality.

For foreign venture capital funds, many of whom are structured as limited partnerships or LLCs, the compliance burden was a serious bone of contention.  The compliance burden was often cited by foreign VCs as a sufficient reason to look elsewhere for investment opportunities.  The problem was not limited to  the  Canadian life sciences sector, but efforts  by life sciences companies  to raise funding  from foreign, especially US, venture capital funds  were especially hampered by the tax requirements.

As an unexpected bonus, Budget 2010 also provides tax relief for investors who reside in non-treaty jurisdictions.  By excluding certain private Canadian corporations altogether from the definition of “taxable Canadian property”, capital gains on such investments will no longer taxable in Canada in the hands of any foreign investor, even an investor who has no treaty protection. 

Many life sciences companies in Canada have faced severe cash crunches since the financial crisis began in earnest in 2008. The improvement to the investment environment which should result from the change to section 116 is not a comprehensive solution to the funding crisis life sciences companies face, but it will significantly enhance their ability to access desparately needed capital from foreign investors. 

The Budget 2010 provision addressing section 116 can be found at http://www.budget.gc.ca/2010/plan/anx5-eng.html#international.