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Canada's venture capital is really shelter capital

The Canadian government has taken a number of steps that will encourage investors to commit to the country's venture capital funds. But, as Mark Schwartz of Piper Marbury Rudnick & Wolfe LLP argues, recent tax reforms have not gone far enough.

The steps that Canadian governments have taken to cut taxes and reduce debt levels are only the first of many needed for Canada to return to an economically competitive situation with the United States, its primary trading partner.

The issue is not just long-term capital gains or the capital gains rollover allowance, areas where some now claim that Canada has a comparative advantage over the United States. The issue is taxation generally, which remains horrendous in Canada, and tax shelters specifically, which past tax cuts did not even address.

In the 2001 index of economic freedom published by the Heritage Foundation and The Wall Street Journal, Canada's income and corporate tax ranking was a five on a scale of one to five - the worst possible score, and, to the best of my knowledge, the only OECD country to obtain a five in this category.

Recently, the conference board of Canada stated that, in every measure of the tax burden, Canadian companies have been bearing a greater tax load. ‘Canada's corporate tax burden — even under recent tax cuts by the liberal government - is uncompetitive with the United States and is putting the country at risk in a globally competitive environment.' It explained.

The problems for nascent Canadian businesses also require the overall tax situation to improve significantly. Take the perverse economic consequences created by the existence of certain tax avoidance schemes, such as the tax credits associated with labour sponsored venture funds, or LSVFs. These credits distort the incentives for investing because the investor's primary concern shifts from whether the company will be profitable to whether the investment will be a profitable tax shelter. As a result, fully 40 per cent of Canada's VC industry is in the form of LSVFs.

Yet their defenders justify their existence for two primary reasons. They point to the risks associated with VC funding, and to the government's belief that markets tend to under price risky investments due to a dearth of information about their likelihood of success. While these may be valid concerns, having government share in the risk as a passive investor is a wholly inappropriate solution. All this does is create a form of moral hazard: investors take excessive risks because they are not forced to bear the full brunt of their decisions, resulting in inappropriately allocated resources.

It is precisely because of the speculative nature of the VC industry that such investing is normally restricted to a group of specialised professionals with access to an enormous amount of market information. Yet, the Canadian government, in its zeal to mandate growth to its VC industry without providing a commensurate amount of fiscal sanity, has nevertheless sought to expand the pool of VC investors to all comers.

Tragically, the LSVFs have become so attractive from a tax shelter perspective that Canadian venture funds spend more time touting the potential tax savings than they do the LSVFs' portfolio of emerging growth companies. The first lines of a recent advertisement for a popular fund read as follows: ‘Investors in working ventures receive a 15 per cent federal tax credit on the first $5,000 invested each year and a matching 15 per cent provincial tax credit ... completely in addition to your regular RRSP tax deduction ... |T]he total out-of-pocket cost of a $5,000 investment in working ventures can be as low as $985.'
 
One would have had to read clear through to the next paragraph to learn anything about the fund's investments, or its historical return on investment. Such an economic and fiscal policy makes no sense if the desire is to increase national productivity, and promote the best and most innovative entrepreneurial ideas.

Some claim that the Canadian economy is somehow structurally superior to that of the United States for having avoided the dot-com fiasco, and that this superiority is somehow reflected in the overall Canadian standard of living.

Countries prosper when their citizens experiment, whether with dot-coms, biotechnology or otherwise. That is how discoveries are made, that is how Microsoft, Intel and the like were created and became industry leaders. Without government permitting such risk-taking, a country is unlikely to find economic supremacy in any area of business. Hence, productivity, employment and standards of living will suffer. The fact that almost 50 per cent of Canadian venture capital is directly or indirectly government sponsored (nine per cent of the VC industry is direct government funding, and 40 per cent LSVFs) indicates the extent to which the Canadian government is willing to let its citizens experiment at their own risk: not very much.

To paraphrase the noted Canadian economist Reuven Brenner, an economy is better off with failed private experiments than with government-financed experiments, because the private sector makes investors and their recipients far more accountable, correcting mistakes faster. Unlike government, the private sector does not sustain obvious failures with further subsidies, simply for reasons of political expediency. Furthermore, government does not finance the better entrepreneurs or technologists. Rather, it tends to finance those who are better connected politically.

To assess the Canadian standard of living, one need look no further than the value of Canada's currency compared to the standard of value around the world - the US dollar. The Canadian currency has lost one-third of its value during the past 25 years, meaning that what Canada as a whole can purchase in terms of global output (compared to what the United States can purchase) has diminished by a third. This kind of success a country can do without.

Copyright © 2001 Piper Marbury Rudnick & Wolfe LLC

Mark I. Schwartz is a venture capital and technology attorney who represents Canadian and US venture funds and emerging growth companies at the Washington, DC office of Piper Marbury Rudnick & Wolfe LLP. He can be contacted at mark.schwartz@piperrudnick.com

Piper Marbury Rudnick & Wolfe LLP has more than 800 lawyers and operates out of offices in Chicago, Washington, Baltimore, New York, Tampa, Philadelphia, Dallas, Reston, Edison and Los Angeles. The firm's practice is focused on business and technology, real estate and litigation. For more information please visit www.piperrudnick.com