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Starting A High Tech Company - Canada Or The U.S.? Certain Financial and Tax Considerations


An explosion in the number of high tech companies in North America in the 1990s has created an enormous number of opportunities for entrepreneurs in the emerging technologies that will be shaped and developed in the 21st century. The continued development of these emerging technologies will have a profound affect on all our lives and on our planet. The exciting new technologies that will change all of our lives (hopefully for the better) in the 21st century can be categorized as follows:

  • Internet related technologies;
  • Computer software & hardware development;
  • Biotechnologies, genetics and genome research;
  • New drugs and medicines, medical research and health sciences;
  • Environmental and "pollution control" technologies;
  • Engineering and design;
  • New materials sciences;
  • Nuclear fusion research;
  • New energies, new fuels, fuel cells and alternative energies;
  • Weather and meteorological research;
  • Telecommunications, data transmission and related technologies;
  • Agricultural and food sciences;
  • Manufacturing and industrial technologies;
  • New satellite launch systems, space and astronomical sciences; and
  • Other unknown technologies that will no doubt emerge from continued R&D.

Governments and government agencies will no doubt play a big role in the research and development of some of these technologies but the private sector will probably play a greater role in developing those technologies that will more easily lead to a commercial product or service. Commercialization of new technologies is the domain of the high tech company. Most high tech companies begin as private enterprises and then "go public" in order to raise more capital. It is the stocks of these new public high tech companies that have created a great deal of interest in recent months.

The tumultuous rise and fall of high tech stocks over the past few months on North American and World markets present new opportunities and new dangers for the general investing public. For the most part only a small percentage of the investing public actually has a detailed understanding of each new technology and even less understanding of whether further development of these technologies will indeed result in viable products or services. The increasingly complex world of high finance, trade, taxation and business methodologies adds to the already difficult and complicated road for entrepreneurs seeking to start a new high tech company. In general, experience has shown that successful entrepreneurs were the ones who were left to do what they knew best, and that is to begin with an idea, invention or new technology and take it to market. In the process a new technology is developed, exploited and sometimes used in combination with other new and existing technologies to create never before thought of products and services. Perhaps the combination of two or more technologies may lead to a new branch of science or knowledge. Hard work, perseverance and risk taking seem to be the common characteristics of successful entrepreneurs. After all, Thomas Edison said it best when asked to what he attributed his many successes, he said and I paraphrase: "99% perspiration and 1% inspiration".

In this article, I will briefly discuss some important financial and tax considerations for entrepreneurs in deciding how to start a high tech company and where to locate it - Canada or the U.S. There are key differences between the two countries, such as regulatory and taxation laws, business conditions, availability of financial capital and financing, market size, consumer needs and attitudes, etc. These key differences will finally determine where the new high tech company should be located and whether in the end it will succeed or fail.

Some of the issues that have to be considered in a startup situation are as follows:

  • Type of company - (Corporation, Proprietorship, Partnership, LLC, etc.);
  • Location of company - (Where in Canada or the U.S.);
  • Business and regulatory environment - (Corporate and other laws, business conditions);
  • Taxation - (Business, Personal, Social Security, Sales and Excise, etc.);
  • Business and strategic planning;
  • Access to markets and capital;
  • Financing the venture - (Banks, Venture capital, Private, Govt. loans and grants, etc.);
  • Research and development - (Technologies, product, processes, marketing, etc.);
  • Human resources - (attracting, motivating, compensating and keeping skilled workers);
  • Management - (Through all phases Planning, Startup, R&D, Production, Marketing);
  • Sales and Marketing of product and services;
  • Production and manufacturing; and
  • Selling, customer service and follow-up.

This article will concentrate on certain financial and taxations considerations only, which may or may not be the most important issues in deciding whether to start the company in Canada or the U.S.

Financial and business considerations

How to finance a startup enterprise is probably the most important aspect an entrepreneur has to deal with at the very beginning. Without adequate financing the high tech company is doomed to failure. Financing allows the company to invest in research and development, acquire the equipment it needs, hire the staff it requires and operate for months and perhaps years without much revenue, let alone profits, in order to create new products and services. Business taxation at this point in a start up company's life is probably the last thing the entrepreneur has in mind. In order for a company to be liable for business tax, it must be profitable. Typically, a start up high tech may not realize profits for many years. Even when it realizes profits years down the line, it will probably have a large pool of net operating losses carried forward that it can utilize in profitable years to reduce or eliminate corporate income tax.

The U.S. appears to have a much friendlier environment to raise money for start up high tech companies as compared to Canada. First of all, the U.S. is more than ten times the size of Canada in terms of the size of the economy. The U.S. population is about 8 times that of Canada's. In fact Canada has fallen behind the U.S. over the last ten years in GDP per capita, standard of living and productivity. The recession of the early 90s was deeper and lasted longer in Canada than in the U.S. The remarkable growth of the U.S. economy over the last 10 years has been driven largely by a rapid rise in productivity, which was and still is being fuelled by new technologies. This rapid rise in productivity has even dampened inflationary pressures to produce an unprecedented long lasting high growth and low inflationary environment. Canada is catching up slowly but the process will still take a long time, perhaps Canada will never catch up.

Experience has shown that Canadian banks and other lending institutions have been much more conservative than those in the U.S. Risk taking seems to come more easily to the American, perhaps because the rewards are greater and easier to achieve in part due to the size of its economy and the size of its institutions and corporations. Another aspect is attitude. Canadians seem to be more financially conservative and perhaps act a little more slowly in taking risk than their American cousins. However, due to their highly integrated and interdependent economies, the Canadian economy over the past few years has been boosted by the high growth American economy.

It appears to be easier to raise money from banks, venture capitalists and private lenders in the U.S. than in Canada. It is for this reason alone that many Canadian entrepreneurs have chose to start their high tech company in the U.S. rather than in Canada. Taxation levels were not an issue. There appears to be no choice but for Canadian banks and other lenders to emulate their U.S. counterparts in this area if Canada is to realize high growth and high productivity. The venture capital situation in Canada has improved substantially over the last two years, partly due to a booming economy, but there seem to be many more willing lenders in the U.S. and an entrepreneur will probably have an easier time raising money in the U.S.

The size of the U.S. economy as compared to that of Canada's makes it easier for entrepreneurs to sell their new products and services and this is another attractive feature that has swayed some entrepreneurs to locate in the U.S. Both Canada and the U.S. are highly regulated economies but it appears that it is easier to bring certain products to market in the U.S. than in Canada. For instance, some new drugs have made it to market faster in the U.S. than in Canada after approval is given by the regulatory authorities. For other products and services it may be easier to bring it to market in Canada than in the U.S. Accordingly, depending on the product or service, the market conditions and the regulatory environment for that particular product or service may be better in Canada.

It appears that both Canada and the U.S. have a shortage of highly skilled workers, and in certain key industries the shortage appears to be more acute in the U.S. Again due the size of its economy, institutions and corporations, it is easier for the U.S. to attract highly skilled workers from around the world. American corporations usually can afford to pay higher salaries, provide them with a larger pool of money and resources to conduct R&D and also offer a lower personal tax environment to boost. This has caused what some have called the "brain drain" from Canada into the U.S. over the past 10 years. Highly educated and skilled professionals and workers have left Canada and moved to the U.S., for a variety of reasons such as more opportunities, higher salaries, availability of capital and resources, etc. Large American corporations actively recruit graduates from top Canadian Universities, offering them much higher starting salaries and benefits. Canada is a good source of many skilled professionals, workers and entrepreneurs. Canada has a long and highly acclaimed history for innovation and invention. Many technologies, products and services were first invented and initially developed in Canada by Canadians but to the great loss of Canada these inventors and innovators moved to the U.S. and took know-how and intellectual properties with them. Many have been quite successful and actually brought new products and services to market. Some entrepreneurs have by-passed this route and have chosen to set up shop in the U.S. from the very start.

Certain taxation considerations

It is widely known that Canada is a high tax country as compared to the U.S. Again the relative size of the economies has a lot to do with it. Canada is also a bilingual country (English and French) and new products and services have to be eventually available in both languages. This adds to the cost of bringing the product or service to market. Here is an example of the differences in personal income tax rates for residents of Ontario, Canada and New York State (a relatively high tax State), assuming a single taxpayer using 1999 tax rates (combined Federal and Provincial/State):

TaxableAverage Personal Income Tax Rates
IncomeOntario, CanadaNew York StateDifference
$50,00025.9%22.8%3.1%
$100,00036.3%32.6%3.7%
$150,00040.4%35.0%5.4%
$200,00042.5%37.0%5.5%
$250,00043.8%38.2%5.6%
Highest Marginal Tax Rate48.7%46.4%2.3%

Ontario is not the highest taxed province, in fact there are several other provinces with higher tax rates and still the tax rates in Ontario is higher than the tax rates in New York State. Although the highest marginal personal tax rates in New York State is not much lower than that in Ontario, the key difference is that the highest marginal tax rate in Ontario starts at taxable income of about C$65,000 while the highest marginal tax rate in New York State starts at taxable income of about US$288,000. This results in higher average tax rates for high-income earners in Canada as compared to those in the U.S.

However, after adding social security taxes, City taxes and other local taxes in the U.S., etc it appears that the average tax burden is higher in New York State when compared to that in Ontario at the lower income levels, being below $100,000. The real difference is when income levels are higher than $100,000. At these levels a larger portion of income is taxed at the highest marginal tax rate in Canada, thereby increasing the average tax burden on income.

Personal income tax rates are even lower in certain states that have no personal income tax, such as Florida, Texas, Nevada and Washington. Canadians moving to these states will realize a much higher after-tax take home pay. California is also a high tax state and average and marginal income tax rates are a little higher than those for New York State. In Canada, tax rates in Quebec, British Columbia, Manitoba and Newfoundland are higher than in Ontario. In fact only the provinces of Alberta, Nunavut and the Yukon and North West Territories have tax rates that are lower than those in Ontario. It could be said that Ontario is one of the lower taxed provinces/territories in Canada and still the tax rates are higher than those in New York State and California at higher income levels.

The corporate income tax rates in Canada are generally comparable to those in the U.S. However, corporate income tax rates applicable to active business income earned by a Canadian Controlled Private Corporation (CCPC) in Ontario is very low on the first C$240,000 of profits. For example, a New York State company with taxable income of US$240,000 will be taxed at the average rate of about 41% (Federal + State) while a similar company in Ontario with taxable income of C$240,000 will be taxed at an average rate of about 20.5% (Federal + Provincial). The highest marginal Federal + State corporate income tax rate in New York State is about 44% while the highest marginal Federal + Provincial corporate income tax rate in Ontario is also about 44% in the year 2000. In addition, corporate income tax rates are dropping in Canada.

The Federal corporate income tax rates in the U.S. appear to increase at a rapid rate when taxable income is between $50,000 and $335,000 but above that the rates do not rise very rapidly. In Canada, Federal and Provincial income tax rates are only low for CCPCs earning active business income and also for other corporations engaged in manufacturing and processing but for other types of corporate income (i.e. investment income, etc.) the tax rates are high starting with the first dollar of profits.

The Canadian income tax system is integrated so that in theory, income earned and taxed in a corporation and the retained earnings paid to its shareholder as a dividend should result in the same total tax as income earned directly by an individual. There is no such concept in the U.S. and in fact corporate taxes can be quite high for personal service and personal holding companies in the U.S.

The Canadian corporate income tax system also offers rich tax credits to corporations carrying on scientific research and experimental development (SRED) activities in Canada. This is quite attractive to high tech companies carrying on SRED activities, especially if the company is Canadian controlled and private. These tax credits (offered by both the Federal and several provincial governments) provide a good source for financing SRED activities in Canada. However, there are certain limits and certain criteria that have to be met in order to be eligible for these credits. A lower corporate income tax environment in Canada is certainly helpful but higher personal income taxes are a hindrance to attracting and keeping highly skilled workers. Human and capital resources play a much more important part in the ultimate success of a high tech company and tax considerations are not as important, at least at the start up stage.

Providing stock options to employees of high tech companies has been one way these companies have attracted, motivated and kept their employees throughout the early non-profitable years. Once the technology has been developed to a point where it is viable to take the company public, these stock options have provided these lucky employees with a tremendous windfall. Many have sold the stocks they acquired by way of options in the open market at very high prices and realized large capital gains. Stock option benefits are taxed as regular employment income in both Canada and the U.S. However, if certain conditions are met, only 3/4 of stock option benefits are taxable in Canada. This may be reduced to 2/3 to keep in line with recent changes to the taxability of capital gains, see discussion below. Recently announced changes to Canada's taxation laws will also provide a deferral of up to C$100,000 a year of the stock option benefit until such time as when the stock is actually sold rather than being taxable at the time the options are exercised. .

Capital gains are still taxed at very high rates in Canada. Up until the end of February 2000, the highest marginal income tax rate on capital gains was about 38%, whereby 3/4 of capital gains was taxable. This highest marginal tax rate has now been reduced to about 32% by lowering the taxable portion of capital gains from 3/4 to 2/3 and the Ontario government plans to reduce the provincial tax on capital gains even further over the next few years so that eventually only 50% of capital gains will be taxable in Ontario. In the U.S., long-term capital gains are taxed at the maximum rate of only 20%. Many economists in Canada have argued that Canada also needs to reduce the tax burden on capital gains in order to encourage greater risk taking and entrepreneurship. However, Canada does have a $500,000 lifetime capital gains exemption on capital gains realized by Canadian residents upon the sale of shares of certain CCPCs, farm corporations and farmland. This capital gains exemption has been a great bonus for small business owners in Canada.

There are several other differences in the tax systems in Canada versus those in the U.S. For instance, Canada has a federal Value-Added Tax (VAT) called the Goods and Services tax (GST). In some provinces this federal GST has been integrated with the provincial sales tax and this is called the Harmonized Sales Tax (HST). Another key difference is that in the U.S. spouses can file a joint income tax return but separate Federal and State and sometimes City returns need to be filed, while in Canada each person has to file his or her own income tax return but a combined Federal and provincial income tax return can be filed in every province and territory, except Quebec. There are many other differences in the taxations systems of each country; however a detailed discussion of these numerous differences in the tax systems of both countries is beyond the scope of this article.

Conclusion

Past experience has shown that lower income tax rates and rich tax credits are not the most important considerations for entrepreneurs thinking of starting a high tech company. Financing, business and market considerations, availability of human and capital resources, the regulatory environment, etc. may be more important. Some entrepreneurs may find Canada more attractive than the U.S. in starting a particular high tech company but it appears that for the most part the U.S. appears to be the hot bed for cultivating these high tech companies.


This is a joint page of Chang and Boos and McCarney, Greenwood, LLP. The article was provided courtesy of Mr. Roy Ohm, C.A., C.P.A.

McCarney Greenwood, LLP
Chartered Accountants
900 - 10 Bay Street
Toronto, Ontario
M5J 2R8
Attention: Mr. Roy Ohm, C.A., C.P.A. (Illinois)
Tel: (416) 362-0515, Extension 358
Fax: (416) 362-0539

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