Growth startups have one thing in common: they need injections of cash to drive that growth. Without money, startups may be able to grow, just not as fast. So, if rapid growth is the goal, and investment helps them get there, how do we get as much cash to as many startups as possible?
The answer from all four Atlantic provinces is using equity or small business investor tax credits (in this article I'll use “ETC” for simplicity) to make investing cheaper. ETCs allow investors to reduce their taxes. The result is that it can cost 70 cents or less to invest a dollar – a pretty neat trick.
The rules are governed by legislation in each province. In this article, we look at the similarities between the provinces (New Brunswick, Nova Scotia, P.E.I., and Newfoundland and Labrador), identify significant differences, and point out some important considerations.
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To keep it simple, we’ll stick to ETCs for individual investors; we won't talk about community development corporations (which are an extension of the ETC framework in some provinces) or companies and trusts as investors.
What is it?
In theory, the process of applying for ETCs is relatively straightforward (you’d have to ask your lawyer or accountant about how hard it is for real).
It starts with a company looking to raise a round of funding, knowing that it will be able to raise more money, more easily if it can give investors an ETC. By reducing the investor’s taxes, the company effectively gives the investor a discount on its shares.
Let’s look at an example, Brickify Inc. wants to raise $100,000 from an angel investor, Susan. Without ETCs, Susan pays $100,000, hoping that in a few years she will get a lot more money back.
If, instead, Susan could get a 35% ETC, she would pay Brickify $100,000 for its shares, but reduce the tax she pays by $35,000. The net effect is that Susan pays $65,000 for shares worth $100,000 – increasing her potential return and decreasing her risk.
So, an eligible company can, theoretically, use ETCs to raise money at a higher valuation from local investors.
The process looks like this:
1. Brickify goes out and gets investors like Susan to subscribe for shares (essentially an expression of interest);
2. Once the investors are lined up, Brickify applies for certification (the process is a bit different in each province)
3. With certification approved, the round closes
4. Within a month after closing Brickify applies for certification and ETCs for each of its investors;
5. Susan, and the other qualifying investors get tax credits;
6. Everyone is happy.
The application is different in each province but generally, the company needs:
• Articles of incorporation (or equivalent documents, depending on the province);
• Amount of money to be raised;
• List of investors;
• Financial statements;
• Investment plan outlining how the money will be used.
Deduction
The deduction is the part most people care about and focus on; this is the amount that investors are allowed to subtract from their taxes.
The allowable deductions by province are:
• New Brunswick: 50% (max. investment of $250,000, min. of $1,000);
• P.EI.: 35%;
• Nova Scotia: 35%;
• Newfoundland: 20% to 35% (depending on where you are).
On their face, these deductions are great, but it's important to know that there are limits in some provinces regarding how much you can actually deduct in a year.
Nova Scotia restricts investors to deducting a maximum of $17,500 annually, and in P.E.I., the maximum is only $7,000. This can lead to misunderstandings. For example, in Nova Scotia, for an investment of $100,000 the credit should be $35,000 for the year. But instead, the investor can only deduct $17,500 in that year, and then has to carry over the rest of the credit (essentially claim it in another year).
In Newfoundland, the maximum credit in a year is $50,000, significantly better than in Nova Scotia and P.E.I. But, in Newfoundland any applications can be denied if the total of all credits will exceed $1 million. This is a pretty high bar, but you wouldn’t want to be the investor whose claim is denied after investing in a company and expecting to get a tax credit.
In New Brunswick, the maximum is $125,000, a recent change that, with the 50% deduction, provides a significant incentive for investors there.
It is important to understand the restrictions that come with the initial deduction because they can play a significant role in how much money an investor saves.
Eligible company
In all provinces, a company must be "eligible" to apply for a certificate. Below are the most common requirements for eligibility.
In all provinces, an eligible company must have assets and revenue below a certain threshold:
• Newfoundland: Assets less than $20 million;
• New Brunswick: Assets less than $40 million;
• Nova Scotia: Assets and revenue less than $25 million;
• PEI: Assets or revenues less than $3 million.
In all provinces except Newfoundland, a certain proportion of wages and salaries must be paid to employees who are resident in that province:
• New Brunswick: 75% (or 50% if more than half of revenue comes from outside the province);
• Nova Scotia: 25%;
• PEI: 75%.
There is a requirement that the company is an active business in the sense that it should be doing something with the money. The company can't just reinvest or lend out the money to others. Also, some services are barred from certification (e.g. lawyers, accountants, etc.).
Finally, and unsurprisingly, the company must stay in the province. This doesn't mean it can't do business outside the province, just that the registered office has to stay within the province.
Holding periods
Investors are required to hold their shares for a few years after buying them. The investor may not sell the shares back to the company or sell or transfer them to anyone else.
The required number of years are:
• Newfoundland: 5 years
• New Brunswick: 4 years
• Nova Scotia: 5 years
• P.E.I.: 5 years
Discretion
The legislation governing ETCs gives the provinces a lot of discretion over whether or not to authorize a particular certificate and whether to revoke it later.
For example, in all provinces, certification may be revoked if the company is "conducting its business or affairs in a manner that is contrary to the spirit and intent of this Act and the regulations." This gives the province wide authority to revoke a certificate.
The intent of ETCs is to facilitate investment in small businesses and stimulate growth; the intention is not to give people a tax loophole. In fact, there is a clause in all four pieces of legislation that says if it looks like you are doing the investment as a tax shelter, it will be denied.
Disclaimer from a law student
I wrote this article as a review of the rules in each province, not as an instruction manual for how things work. What's written here is a simplification of what the rules say and whenever the law is simplified there are likely to be misinterpretations.
Use this as a guide to educate yourself on how ETCs in each province are similar and different, not as a guide to actually applying for and using ETCs.
Get the Cheat Sheet
There is also a simple, 2-page, infographic cheat sheet that condenses the basic information for each province and how the application process works.
Get it here.
Eric Feunekes is working towards a joint Law and MBA degree at University of New Brunswick and will use them to pursue a career in law, finance, technology, and work with start-ups. To read more of his work, visit www.ericfeunekes.com.
