Welcome to a BetaKit weekly series designed to help startups and entrepreneurs. Each week, investors Roger Chabra and Katherine Hague tackle the tough questions facing founders today. Have a question you would like answered? Tweet them with the #askaninvestor hashtag, or email them here.
This week on Ask An Investor, we answer a question on where should founders incorporate their company legally.
To provide a comprehensive answer, I’ve called upon Chad Bayne, partner at law firm Osler, Hoskin &; Harcourt. Chad and I have worked on many companies together over the past decade. He is a veteran of the startup ecosystem, represents many promising startups across North America, and has been involved in countless situations from incorporation, to financing, to exit and everything in-between.
I asked Chad a series of questions on the topic of company incorporation. Here’s what he had to say.
What major things should companies think about and keep in mind when they are deciding where to incorporate their company?
When forming a company, the two primary considerations are the location of the founders, and the location of the team.
What are the pros and cons of incorporating in the popular regions that you recommend (e.g. Delaware)
Canada:
Pros:
- Permits the company’s registered office to be in any Canadian province or territory.
- Name of the company is protected across Canada.
- Industry Canada permits electronic filing. (Certain Canadian jurisdictions, such as Ontario, still require physical copies submitted in person in duplicate.)
- No annual filing fees.
Cons:
- The company requires 25% of the directors to be resident Canadian directors. (Some jurisdictions in Canada, such as British Columbia, Quebec, New Brunswick, Nova Scotia, and Yukon do not have these requirements.)
- Because the name is protected across Canada, it is often more difficult to secure a name for the company.
Delaware:
Pros:
- The most common jurisdiction in the US for incorporation – almost all of the material corporate law related jurisprudence comes out of Delaware courts.
- All US VC investors and their counsel are familiar with Delaware, so it presents little friction for investment.
- No state tax payable so long as the company does not have a permanent establishment in the state of Delaware.
Cons:
- Annual franchise tax payable on authorized capital.
Are there specific considerations for Canada-based entrepreneurs? what about US-based entrepreneurs?
For Canada-based entrepreneurs, there are significant tax benefits that result from having a Canadian-controlled private corporation (essentially, a Canadian corporation either incorporated federally, provincially, or territorially) that is not controlled according to law, or in fact by non-Canadian resident shareholders or public companies.
These tax benefits include:
1. Access to the enhanced (i.e. refundable) scientific research and experimental development (SR&ED) tax credit regime
2. Canada-based entrepreneurs have the ability to access their lifetime capital gains exemption on the sale of shares of a qualified small business corporation (the first $800,000+ of capital gains on the same of such shares are tax-free)
3. Enhanced tax treatment for options granted to Canadian-resident employees (including a deferral of the tax payable on the employment benefit resulting from the exercise of such options until the ultimate sale of the underlying shares). In addition, there are certain additional tax savings that may be achieved upon a liquidity event. As a result, it is generally not as tax efficient for Canada-based entrepreneurs to hold shares of a US corporation.
For US-based entrepreneurs, it makes the most sense to incorporate in the US.
For a company with Canada and US-based entrepreneurs, you would typically lean to the country where the founders holding the greater ownership of the company are located.
As companies mature out of early-stage, are there additional considerations or strategies to look at around company incorporation?
US investors may resist investing in a Canadian corporation and push to invest in a Delaware corporation due to:
Sophisticated legal counsel with significant cross-border experience (both from a corporate and tax perspective) is in the best position to discuss and weigh the different options with the entrepreneurs.
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1. Lack of familiarity with Canadian law, and the general familiarity with Delaware law. Generally, if an investor has never invested in a Canadian company before, there will be significant friction to do so.
2. Certain US tax rules that are only applicable to foreign holdings, such as passive foreign investment company and controlled foreign corporation.
3. In the case of institutional VC funds, limitations on the ability to invest outside of the United States that are codified in the funds’ limited partnership agreements (which is more common if the fund has received funding from the US government).
If necessary, a Canadian corporation can be reorganized to have a Delaware parent corporation; however, this will likely result in a significant tax or legal cost to implement. That being said, many US top-tier VC firms, including Insight, Accel, Sequoia, Kleiner Perkins, Caufield &a Byers, Bessemer, Battery, and Union Square Ventures have invested directly into Canadian corporations.
Due to complex US inversion rules and recent changes, it is much more difficult to reorganize a Delaware corporation to have a Canadian parent corporation.
Who should advise entrepreneurs on this topic (e.g. lawyer, accountant, personal tax planner etc.)? what do you need to keep in mind to select the right advisor?
Sophisticated legal counsel with significant cross-border experience (both from a corporate and tax perspective) is in the best position to discuss and weigh the different options with the entrepreneurs.
Any other advice for early-stage entrepreneurs on this topic?
Seek advice before deciding where to incorporate.
Also, incorporating your company in Canada or the US will not limit your ability to expand operations to the other jurisdiction through the formation a wholly-owned subsidiary in the other jurisdiction.
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