Implications of the government’s tax changes on the technology sector

The government’s proposed tax law changes could have significant negative impacts to the very sector the government is going to great lengths to support. In its March 2017 budget, the government set aside hundreds of millions of dollars to encourage innovation stating “the future success of all Canadians relies on it.”

Yet, this past July, the government released the “Tax Planning Using Private Corporations” consultation paper, proposing significant changes to how these companies are used in tax planning. Feedback on the tax changes has been fast and fierce, with the tech sector in particular voicing its concerns about how these changes will impact them.

Here’s a high-level overview of each of the proposed changes announced in July:

  1. Income splitting with family members to reduce the overall family tax burden. Also called income sprinkling, this is generally achieved by having income that would otherwise be earned by an individual who is taxed at high marginal personal tax rates being moved to family members who are taxed at lower marginal rates. The changes broaden the current rules to limit this.
  2. Passive investment portfolios owned by private corporations. Today, any business profits of a company are taxed at corporate rates which are significantly lower than the top personal marginal tax rates, providing a significant tax deferral if these after-tax profits are then invested in passive investments in the company.
  3. Strategies that convert regular or dividend income into capital gains. The proposed changes, which have now been withdrawn, were designed to prevent tax planning that allows corporate surplus to be extracted from companies as a capital gain rather than as a taxable dividend.

Guardian angels

Think of many of the great technology companies around today and you know they all started very small. Their stories are similar: someone had a great idea and convinced enough family and friends to believe in them and invest their own time and money. The good ones succeeded and turned to the next level of investors, angels. From there, the most successful turned to venture capitalists to fund their growth.

Angel investors are successful entrepreneurs who invest profits from their business in new ventures launched by other entrepreneurs. Their numbers are vast enough to have its own organization, the federally registered not-for-profit National Angel Capital Organization (NACO) that has 3,300 members and more than 45 Angel member groups.

NACO responded to the proposed changes with a formal submission to the government explaining the important role of angel investors in Canada’s technology ecosystem, stating that angels help build successful businesses to the point where their revenues and growth make them attractive to venture capitalists and other funding sources. According to NACO, Angels are the early capital that feeds the pipeline for venture capital firms and the early-stage public markets.

The tax changes, says NACO, whether focused on income splitting, passive investing in private companies or strategies involving the extraction of corporate surplus, will reduce capital of  businesses that invest in start-ups. Angel investing is not for the faint of heart, with a good percentage of startups failing in the first year. Without the incentive of appropriate returns, NACO argues that Angel investors won’t be willing – or will be unable to – make these often extensive and high-risk investments.

The story is the same for venture capitalists. The Canadian Venture Capital and Private Equity Association (CVCA) sees itself as an advocate on behalf of the venture capital and private equity industry to ensure sound public policy that encourages a favourable environment for investment.

The CVCA’s response to the government outlined the impact the changes would have on funding innovation in Canada and highlighted the fact that the industry and government must work together to get tax reform that will not put up roadblocks to innovation.

A good offense is the best defense

The government stopped receiving consultation briefings on the changes at the beginning October. The good news is the initial feedback about angel investors and venture capitalists was heard loud and clear with the government stating these two groups would not face “unintended consequences.” It has already updated its July proposal to set a $50,000 annual threshold for passive investment income to which the proposed tax changes will not apply, although whether that’s high enough is still up for debate. In addition they have eliminated the proposed changes targeting strategies that allowed for the removal of corporate surplus as capital gains, rather than as taxable dividends.

As well, the government is also considering the appropriate scope of measures as they relate to passive investment income, specifically whether capital gains realized on the sale of shares of a private corporation engaged in an active business might be excluded from the new rules.

For help with the current and future rules and advice and support on how the proposed changes will impact the tech sector, please speak to your BDO advisor.

Harry Chana
Partner, International Tax

Paul Walker
Senior Manager, Tax

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