Outcry Over Section 116 Clearance Certificates: Legitimate Barrier for Foreign Investment Firms or Convenient Scapegoat?

Posted on December 11, 2009


New York, October 12, 2009 – Just 17 venture capital funds raised $1.6 billion in the third quarter of 2009, according to Thomson Reuters and the National Venture Capital Association (NVCA). This level represents the smallest number of venture funds raising money in a single quarter since the third quarter of 1994 when 17 funds were also raised and the lowest level of dollars committed since the first quarter of 2003 when $938 million was raised.

Source: Thomson Reuters and National Venture Capital Association News Release (October 12th, 2009)

In preparing for the December 14th PI Window on Business Segment titled “Foreign and Domestic Venture Capital Investment: Opportunity Versus Choice” in which I will be interviewing U.S. high tech entrepreneur and investment expert Brad Feld regarding the key factors that influence VC investment decisions, I re-read my research material.

This of course included reviewing the CATA video in which the association’s president John Reid interviews lawyer and Chair of the law firm Fraser Milner Casgrain LLP’s Technology Group, Thomas A. Houston.

What was interesting about the video, which CATA has made available for download, is that upon initial viewing Houston cites a number of interesting statistics including the fact that the Q3 capital investment level was at a 14 year low, with the Province of Ontario experiencing an 87 percent drop compared to the same period a year earlier.

Houston went on to state that foreign investments in Canada were off the previous year’s pace by 24 percent and, according to a report by Deloitte’s, Canada is ranked as one of the most unfavorable countries in terms of “welcoming” foreign investors.

While there are several reasons for the drop, which we will get into momentarily, the video and corresponding CATA press release assigned the blame for the decline exclusively on the Sector 116 clearance certificate requirements.  Specifically, that the “Section 116″ clearance certificate” is required for every investor in a US venture fund.”  The fact that many funds have “dozens or even hundreds of investors,” according to the CATA release means that a “single stock deal can literally require hundreds of applications and hundreds of signatures.”

Referencing one such case in which a US venture capital firm required “almost 900 signatures” in connection with a single transaction, it is not a stretch to imagine that out of touch bureaucratic process is the single most important obstacle to Canadian firms receiving much needed capital from US-based investors.  But is this really the case or, are there other factors that have been overlooked in terms of the admittedly sharp decline in foreign investment such as the continuing fallout from what the National Venture Capital Association (NVCA) referred to as the “wake of the past year’s financial crisis?”

After all, and as cited in the opening paragraph from today’s post, the Reuters/NVCA October 12th News Release indicated that “venture capital fund raising activity” in the U.S. “registered the second consecutive quarterly decline in the third quarter of 2009.”  This according to statistics represents the “smallest number of venture funds raising money in a single quarter since the third quarter of 1994.”  Correct me if I am wrong, but I do not believe that the US has a Section 116 clearance certificate requirement.

I am of course not suggesting that the clearance certificate issue is not a contributing factor in what is a significantly larger issue.  Having to fill out the required tax forms to collect our company’s fees for speaking engagements in the States or face the mandatory withholding tax is not something that I enjoy doing.  But putting the aggravation aside, it has not deterred me from continuing to accept invitations to speak in the US.  This is where the creditability of the CATA message is somewhat diminished.

As is often the case, we tend to over-simplify a complex issue by picking a convenient target that can be readily if not accurately hung in effigy.  We heard this in my interview with Stockwell Day regarding the Buy American policy which as it turns out had less to do with actual economic reasons and more to do with Congresses concerns surrounding public opinion during the dark days of the financial crisis.

The over simplification viewpoint is further fueled by the fact that neither CATA nor Mr. Houston took the time to explain why the Section 116 clearance certificate was incorporated into the tax act in the first place.  Nor did they bother to explain what if any consequence in terms of the broader picture a “simple amendment of the tax act” would have from a big picture perspective.   Even if the desired amendment was in fact made to the Canadian Tax Act, there is no guarantee that the floodgates of foreign capital investment would suddenly open in a wave of needed funding.  Once again, refer to the Reuters/NVCA News Release.

While Reid makes reference in the video to the availability of corresponding white papers and other documentation supporting their position, one would think that even a general estimate of the dollar amount of lost investment as a result of Section116 would have been provided instead of the “900 signature” example.  If I am not mistaken, the reference to the firm having had to obtain 900 signatures would seem to suggest that despite the “onerous” condition they still went ahead with the investment.

This is one of the main reasons why I am very much looking forward to Monday’s interview with the US-based Feld, whose 20 years as an early stage investor and entrepreneur will likely shed the needed (and balanced) light on this issue.

As is likely the case with anyone who has been following this story, I am more interested in the questions that haven’t been asked and answered versus what is understandably the somewhat biased views of an association whose membership is in a sector that is desperate for cash.

Remember to use the On-Demand Player below to tune in to the live December 14th interview with Brad Feld.

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