Liberals’ proposed tax changes will hurt tech startups, investors warn

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Canadian technology financiers are warning that the federal government's controversial proposals on small-business taxation will threaten its innovation agenda by choking off capital for high-growth startups.

That conclusion is drawn from two surveys of investor groups that provide much of the early stage financing to Canadian startups – angel investors and venture-capital firms. The surveys were sent to government as part of its consultation process, which closed last week.

The message has reached its intended audience. Finance Minister Bill Morneau told the Senate last Tuesday: "I think we will need to both make sure that we're not having any unintended consequences for venture capitalists, for angel investors, and carefully evaluate what people are saying to make sure that we're not actually getting comments that aren't entirely valid."

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"Clearly there are some unintended consequences here that I think the government is trying to figure out how to fix," said Mike Woollatt, CEO of the Canadian Venture Capital and Private Equity Association (CVCA).

The association represents 260 institutions and thousands of individuals, many of whom back startups.

"We are optimistic … because the minister specifically highlights venture capital and has talked about our association and others' submissions specifically. I think they do not want to have a big impact there. … we're working with them and maybe there's some ring-fence that helps ensure they don't derail a lot of the innovation funding."

Mr. Morneau has said his proposals are aimed at getting more of the "dead money" that's locked away on corporate balance sheets put to work to grow the economy. But Mike Andrade, CEO of startup Morgan Solar, said the government's proposals could exacerbate the very problem they are trying to solve, by reducing the pool of money that investors can inject into job-creating startups due to an increase in taxes.

"The tax policy is very much a blunt instrument. … The unintended consequences end up that you catch a lot of companies that you don't want to catch and you tar a lot of companies that you don't want to tar with the same brush as someone who's just trying to avoid taxes and not trying to create a real business," Mr. Andrade said.

Angel investors – typically tech entrepreneurs and wealthy individuals – are often the first outside backers to buttress startups. Despite the inherent risks of backing young firms, angel investing has been on the rise: Members of the 3,300-member National Angel Capital Organization (NACO) invested $157-million in 2016, up from $91-million in 2014.

But a NACO survey of members submitted to Mr. Morneau found that three out of four respondents would cut their investment in startups, and nearly two-thirds would decrease investment "significantly." The reason: Proposed changes would increase taxation of so-called "passive investment income" that angels invest through their private corporations. The changes would reduce available funds while decreasing returns and increasing risks for investors.

"Without the incentive of appropriate returns, we believe that angel investors will be less inclined to make these often lengthy and high-risk investments," NACO CEO Yuri Navarro and chairman Ian Bandeen said in a letter to Mr. Morneau. The government's proposed tax changes to income splitting and income "sprinkling" would further curtail available funds for angel investments for more than six out of 10 surveyed, NACO found.

Allen Lau, CEO of Wattpad, one of Toronto's most successful startups, warned that his days as an angel could end if the changes proceed. He and his wife, Eva, have backed close to 20 startups through their private holding company, but, "If this tax proposal goes ahead, I would reconsider whether I should be angel investing or not. I'm not sure I'd be able to afford that, and I'm sure a lot of the angel investors would share the same feeling."

Meanwhile, a CVCA survey found that 94 per cent of its members, who typically follow angels in backing startups, believe the changes will negatively impact the ability of venture-capital funds to raise money to invest in startups – since much of their capital comes from private corporations that would be hit by the proposals. Close to 60 per cent of those surveyed said the changes would result in their firms cutting investment levels by 20 per cent or more. "These changes would severely limit the potential upside and serve to make this asset class much less attractive, if not avoidable entirely for potential investors [and] have a significant detrimental impact on the very fundraising the government is attempting to assist," the CVCA wrote to Mr. Morneau.

The government has faced stiff criticism to the draft legislation from doctors, farmers, lawyers, small-business lobby groups and others. The proposals would also restrict the ability of business owners to "sprinkle" income to family members who are not directly involved in the business as a way of paying less tax. It would also restrict conversion of dividends into lower-taxed capital gains. The government has promised to release updated proposals within weeks.

The criticism from tech leaders hits at a sensitive spot for a Liberal government that has embraced the innovation sector. One of the government's first policy flip-flops came with its decision not to increase taxation of stock options – a 2015 election promise – after tech leaders warned that it would limit their ability to attract employees. The government has since announced showpiece programs to support the sector, including a $950-million "superclusters" initiative, a $400-million program to bolster venture-capital investing and funding for cleantech and artificial-intelligence organizations.

But Canadian tech leaders warn that with the continued draw of the giant U.S. technology sector – which heavily recruits from Canadian engineering schools such as University of Waterloo and whose financiers routinely pressure promising Canadian startups to relocate – any measures that weaken Canada's competitiveness will lead money and talent to leave.

With a report from Bill Curry