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In the first of three short articles to be published over the coming weeks on the topic of Summer Updates for VCT Fund Managers, Roger Blears examines some particular considerations VCT fund managers operating in the UK should have when pursuing investment opportunities further afield and Bill Northcote, Partner & Head, Business Law Group Shibley Righton LLP, Toronto, Ontario adds some comments on VCs investing in Canada.
And US PE and other global investors are now here and willing to pay a premium for companies they regard as currently undervalued.
Yet, all fund managers compete globally.
Venture Capital Trust (“VCT”) fund managers in the UK are separately setting their sights on investing abroad, and Australia and Canada appear to offer interesting opportunities.
Some points to consider for those that do.
To qualify for VCT investment, an Australian, Canadian or other overseas Topco will need to have a permanent establishment in the UK (s.286A Income Tax Act 2007) at the time the VCT invests and for all times thereafter. If the overseas investee company ever ceases to have a permanent establishment in the UK, the investment will cease to be part of a VCTs’ qualifying holdings and it can never regain that status.
The requirement must be satisfied by the overseas Topco itself. It cannot be satisfied by the fact that one of its subsidiaries will carry on activities in the UK.
Some substantial, probably all UK/Euro activity will therefore need to be run through a UK branch of the overseas Topco.
These UK activities must be more than merely preparatory or auxiliary in character. The legislation lists some examples of activities which might be considered to be preparatory or auxiliary in nature – for instance, the storage or display of goods or merchandise belonging to the Topco; the maintenance of stock owned by the Topco for storage, display or delivery; the maintenance of stock owned by the Topco for the purpose of processing by another person; purchasing goods or merchandise or collecting information on behalf of the Topco.
A UK branch or division of the Topco must satisfy this substance requirement. It cannot be satisfied by a subsidiary.
So, what substantive existing operations can immediately be transferred from a subsidiary to a UK trading division of the Topco?
But doing business abroad always has a cost to it.
A better option may be to structure a ‘flip’ so that the shareholders of the existing overseas Topco transfer their shares to a new UK parent company in exchange for a matching issue of shares in the parent company.
The VCT fund manager is then able to invest directly in the new UK parent company using its existing investment systems, processes and documentation.
Just easier. More sensible. Less risk of an HMRC challenge that the parent company does not have a permanent establishment in the UK.
If the group’s trade is technology based and it earns its revenues by the sale of licences or the receipt of royalties, then the flip will need to fit within the terms of section 306(7) Income Tax Act 2007.
This means that the new UK parent company will need to acquire the existing overseas Topco at a time when the only shares issued by the new UK parent company are subscriber shares and the consideration for the acquisition of the existing overseas Topco will need to consist wholly of the issue of the new shares in new UK parent company.
Most businesses in Canada are carried on through a partnership or a corporation. Foreign investment in Canadian businesses can be done directly through the Canadian corporation or partnership, (generally a limited partnership (“LP”)) or indirectly through a Canadian holding entity, that can also be a Canadian corporation or partnership. Generally, the main consideration in deciding how to structure a Canadian investment by a non-resident is tax.
VC Investing in Partnerships: From a tax point of view, the advantage of investing in a Canadian LP is that income is calculated at the partnership level and allocated to the partners and taxed in their hands. Consequently, non-resident partners of a Canadian LP are not subject to Canadian tax other than income from certain Canadian sources.
The disadvantage is that when income is from rents, royalties or dividends, the partnership will have to deduct and withhold on behalf of all partners, including Canadian partners. Even more onerous is the fact that one non-resident partner will make it necessary for a partnership selling “taxable Canadian property” to get a tax clearance certificate from Canadian tax authorities for each sale. Many Canadian LP’s will not accept non-resident partners, so any investment in these entities should be done through a Canadian corporation which becomes the partner.
“Taxable Canadian property” includes real property situated in Canada, property used or held in a business carried on in Canada; shares of corporations that are not listed on a designated stock exchange, and certain shares of corporations listed on a designated stock exchange.
Before investing in a Canadian LP, a non-resident should obtain legal advice on how the investment should be structured.
Canadian corporations can create and issue a wide variety of shares with customized share attributes including enhanced voting rights, cumulative or non-cumulative preferential dividends, redeemable and/or retractable shares and/or shares with a priority as to the return of capital on winding up or dissolution.
There is a category of corporation called Canadian controlled private corporations (“CCPC’s”) which have many tax advantages which are often used in early-stage corporations. A CCPC is essentially a Canadian corporation which is private (i.e., not a public corporation) and which is not controlled by non-Canadians. The principle tax advantages including a lower tax rate on corporate profits, and the ability of the owners to access a lifetime capital gains exemption (the “LCGE”) of approximately $900,000 on the sale of their shares. Any change of control will result in the loss of these benefits. Any acquisition or investment in a CCPC should be structured to take these factors into account.
In order to take advantage of the lifetime capital gains exemption, the shares of the CCPC must be disposed of or reorganized and the CCPC must have at least 50% of its assets used in an active business in Canada in the 2 years preceding the and 90% of its assets must be used in an active business in Canada.
This becomes important because of the UK requirement for a permanent establishment in the UK. The resident Canadian shareholders of a CCPC which is an investee of a UK VC will be the need to monitor the quantum of the assets in the UK permanent establishment in order to ensure that the 50% and 90% requirements are met. To the extent that these resident Canadian shareholders have already had appreciation is their shares they may wish to lock in their tax benefits by “crystallizing” their use of the LCGE.
Whether the investment will be a minority interest or total purchase, long term or short term, and whether income will be repatriated to the UK or reinvested are all factors to be considered in deciding on a suitable structure. Each case is unique.
Another significant factor is that employment in Canada by a Canadian entity is, unlike the United States, not an “at-will” employment regime. On termination an employee is generally entitled to certain minimum statutory notices or payment in lieu plus “common law” reasonable notice of termination. While the statutory minimums cannot be contracted out of the “common law” reasonable notice period can be varied or eliminated by written agreement. It is therefore generally speaking highly desirable to have the Canadian employees enter into written employment agreements as a condition of funding. Typically, non-competition covenants are difficult to enforce and must be reasonable in both geographic and temporal scope. Usually, it will be easier to enforce non-solicitation covenants.
William L. Northcote
B. A., LL.B., LL.M. (International Business Law)
Partner & Head, Business Law Group
SHIBLEY RIGHTON LLP Barristers & Solicitors
250 University Avenue, Suite 700 | Toronto, Ontario M5H 3E5
T: 416.214.5252 | F: 416.214.5452
[email protected] | www.shibleyrighton.com