Wednesday, July 18, 2007

Nearshoring Private Equity: The Next Great Opportunity For Canada

A continued source of frustration for Canadian startups is our inability to access US private equity. Ontario's Premier even recently visited Silicon Valley to try and tout the advantages of investing here. One of my US colleagues, who spent time with Mr. Eves, points out that he needn't have bothered: if Canada really wants to attract US private equity, my friend says, it should do nothing.

Congress, he says, is doing a solid job trying to drive US private equity overseas on its own. Congressional hearings began last week on proposed tax law reforms which, if passed, will effectively double the tax that private equity fund managers pay.

This reform has been on the table for a while, but as an election year approaches, momentum has swelled. As part of an election platform, this kind of tax reform makes for a compelling story: managers of private equity or tax funds receive most of their compensation as capital gains on their investments (the "carried interest"), which are taxed at 15%; the reforms would tax carried interests at the same rate as ordinary income. Hedge fund managers should be taxed at the same rate as policemen, candidates are telling the electorate.

Leading Democratic candidates are on record as supporting this amendment, and the belief is that the legislation will inevitably pass when the next President is elected. According to some colleagues, it will be challenging for funds to find another loophole to work around it.

So where does that leave Canada? With a potentially huge opportunity to entice private equity and hedge funds to move their operations here. Think of us as a startup facing an incumbent(the US) in competition for private equity customers. Our tax regime would be far more favourable and isn't likely to change in the near term: carried interest income in Canada simply isn't a significant part of the tax base. Making investments in the US from Canada is a straightforward affair under current tax treaty rules. Plus, Toronto is a financial service centre, a travel hub, and a terrific centre; switching costs appear low. As long as we do nothing to change our tax regime, we have a chance to add high income earning professionals and their funds to our tax base.

Canada as a tax haven? In this case it's possible, and a potentially huge opportunity. City of Toronto, start your business development engines.

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