Held back by outdated LP rules
The Trump administration’s recent proposals for tax reform called for reducing the corporate tax rate to 15 per cent, including for pass- through businesses that are “small to medium size.”
The availability in the U. S. of multiple types of passthrough business structures represents an i mportant difference between the Canadian and U. S. tax systems. In addition to general and limited partnerships (which we also have in Canada), the U. S. also permits a business to be operated as a pass- through in corporate form, but without the risk of liability to their owners. Specifically, U. S. limited liability companies (LLCs) and “S” corporations both flow the tax results of business operations to their owners, wit hout compromising their owners’ limited liability. There is no corporate equivalent to the LLC or “S” corporation in Canada and, absent significant tax and corporate- law reform, entities like these will not be available to Canadians any time soon.
The ability of pre- reve nue, pre- profi t , passthrough corporations to f l ow t ax l osses to t heir owners is a significant competitive advantage for Americans which materially enhances early- stage fundraising, particularly for technology startups.
Currently, the only Can- adian business vehicle ( outside of the resource sector) that offers both passthrough tax treatment and limited liability is the limited partnership ( LP). However, the limited liability of a partner in a LP is forfeited if he takes part in the control of the business. This is typically fine for passive investors, but it poses a serious problem for founders and active investors of a startup business that is formed as a LP.
As a result, few Canadian businesses use the LP struc- ture, despite the possibility of tax benefits. If a LP structure was more attractive, operating losses from the business could be passed on to investors to be offset against income from other sources ( or carried forward or backward to other tax years), thereby effectively reducing the cash cost of their investment. It is reasonable to assume that this would increase the availability of early-stage capital.
The rule that causes an active limited partner to lose his or her limited liability is an anachronism based on an outdated concern. The theory behind this rule is that it is necessary to protect third parties dealing with a LP from being duped by the principals of the business i nto believing they were dealing with a general partnership, in which case they would have full recourse against the partners. Today, it is generally expected when dealing with a business of any kind that creditors will have recourse against the assets of the business and not personally against the owners.
This rule alone disadvantages our startups compared to the Americans, both with respect to the cost and the availability of risk capital. The pass- through of losses can reduce the actual cost of a risk capital investor by over 50 per cent, as most early- stage investors are in the higher personal incometax brackets.
The fix is easy. The Ontario Limited Partnerships Act (and limited partnership statutes of the other provinces) should be amended to eliminate the loss of limited liability for active partners. This would enable LPs to develop as a legitimate business structure for earlystage businesses and reduce the competitive advantage enjoyed by our U. S. neighbours.
Even if this solution is implemented, companies that carry on business in more than one province must take care because the protection afforded to active partners would only be effective in those provinces that have changed their limited partnership rules. If the change is made only in Ontario, for example, the LP would be advised to convert to corporate form before extending its operations beyond Ontario.
A further limitation of a LP structure is that SR& ED tax incentives, which many early- stage businesses rely on as a lifeline, are often not available to LPs. Thus, there may be a trade- off between the prospects for investment capital and access to SR&ED funding.
This innovation economy is globally competitive. Canada has abundant, skilled human resources in science and technology, a strong entrepreneurial culture and robust capital markets, but commentators regularly bemoan our underperformance i n commercializing innovations. Much of the blame falls on the challenges in accessing adequate risk capital. This small change could make a big difference.
REQUIRING AN ACTIVE PARTNER TO LOSE LIMITED LIABILITY IS AN ANACHRONISM THAT HANDICAPS OUR STARTUPS COMPARED TO THE U.S.