Academic journal article University of Toronto Faculty of Law Review

The Influence of Taxation on Capital Structure in Venture Capital Investments in Canada and the United States

Academic journal article University of Toronto Faculty of Law Review

The Influence of Taxation on Capital Structure in Venture Capital Investments in Canada and the United States

Article excerpt


Broadly speaking, venture capital refers to the pooling of private capital for investment in early-stage companies with a high potential for capital growth. One of the most important choices in venture capital contracting is the method of financing to be used. Evidence has shown that the preferred methods of financing change depending on the country of the investment. In particular, empirical studies show that, in the U.S., convertible preferred shares are used in the vast majority of venture capital investments, while in Canada a wider range of structures are used.

American academics have argued that, by investing via convertible preferred shares, venture capitalists investing in U.S. portfolio companies can reduce the tax burden on employee stock compensation, providing a benefit that can be shared between both parties. Portfolio companies can receive such a tax benefit by valuing the convertible preferred shares at an artificially high level compared to the common shares used as employee compensation. The argument is that lax enforcement by the IRS of these artificial valuations lowers the effective tax burden on employee stock compensation and has resulted in convertible preferred shares being the financing vehicle of choice.

This paper compares the tax regimes of Canada and the U.S. as related to capital structure choices and concludes that taxation may provide an explanation for why venture capitalists investing in Canada choose to invest using a wider range of vehicles. First, in relation to stock-based employee compensation, it concludes that while it is uncertain as to how the CRA or Canadian courts would react to a U.S.-style low valuation of common shares compared to convertible preferred shares, even if such a valuation would be acceptable, the tax incentives to pursue such a strategy in Canada are not as strong. Second, because there are other Canada-specific provisions where tax incentives (or disincentives) may militate against convertible preferred shares, venture capitalists investing in Canada may choose different capital structures to take advantage of those incentives (or avoid the disincentives). The paper closes by laying the groundwork for further research and analysis by questioning whether a tax-neutral legislative regime would be preferable to systems such as the U.S., and to a lesser extent Canada, which provide incentives to choose a particular capital structure.


Le capital de risque designe la mise en commun de capital prive aux fins d'investissement dans des societes en premier developpement avec un fort potentiel de croissance du capital. La methode de financement s'avere une des decisions les plus importantes s'attachant aux engagements contractuels lies au capital de risque. Les recherches demontrent que les methodes de financement privilegiees different selon le pays ou se font les investissements. Plus specifiquement, les etudes empiriques revelent que les actions privilegiees convertibles sont utilisees dans la grande majorite des investissements de capital risque aux Etats-Unis, alors qu' au Canada une gamme plus etendue de structures est utilisee. Les universitaires americains maintiennent qu'en investissant au moyen d'actions privilegiees convertibles, les societes de portefeuille americaines peuvent reduire le fardeau fiscal impose au regime de remuneration a base d'actions des employes, creant ainsi un profit pouvant se partager entre les deux parties. Les societes de portefeuille recoivent un avantage fiscal en evaluant les actions privilegiees convertibles a un niveau artificiel eleve comparativement aux actions ordinaires de remuneration des employes. L'argument est que le laxisme de l'I.R.S. par rapport aux evaluations artificiellement elevees reduit le fardeau fiscal de la remuneration a base d'actions des employes et contribue au choix des actions privilegiees convertibles comme mecanisme de financement privilegie. …

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