Written by Claire M. C. Kennedy and Darcy D. Moch

There was a change announced in the March 4, 2010, Canadian federal budget that will be quite beneficial for many private equity investors participating in the Canadian private company market.

Under Canadian law, non-residents of Canada are subject to tax on gains realized on dispositions of taxable Canadian property (TCP), which includes shares of private Canadian companies.

Under the old system, certain investors had been able to rely on treaty exemptions to not be taxed in Canada on a disposition of shares of private Canadian companies if the shares did not derive more than 50 percent of their value from real property or resource property located in Canada. However, they still had to give notice of the disposition and obtain section 116 clearance certificates before purchasers could release the entire proceeds of a purchase to the vendor. This process was time-consuming and could take as much as a year to obtain the release of all of the proceeds. As well, some investors did not qualify for treaty exemption and had to pay Canadian capital gains tax on these dispositions.

One of the announcements in the budget is a proposal to amend the TCP definition effective March 5, 2010, to exclude private company shares as TCP where no more than 50 percent of the fair market value of the shares is attributable to Canadian real estate or resource property (at the time of the sale and throughout the 60 month period preceding the sale).

This is good news in that there will no longer be a need for section 116 clearance certificates nor holdbacks on dispositions of private company shares where the shares do not derive their primary value from Canadian real estate or resource property.

Moreover, private equity investors who are not resident in treaty jurisdictions will no longer be subject to Canadian tax on any gains allocated to them that are attributable to dispositions of shares of private Canadian companies outside the resource and real estate sectors.

Although this change does not eliminate Canadian tax and the need for holdbacks and section 116 clearance certificates on dispositions of shares of resource or real estate companies, it may make the section 116 holdback and clearance process faster by removing other dispositions from the clearance certificate process. It should also be noted that there may be holding structures available, which many investors have used, to eliminate or reduce Canadian tax on the sale of resource and real estate businesses.

We see this as a tangible indication of Canada's commitment to support efficient processes for the entry into and exit from the Canadian market by foreign capital and look forward to the possibility of additional reforms in the coming years to augment what is already a very transparent foreign investment structure.