Tax incentives should be directed to specific SME investments determined by individual investors.

For Canada’s economy to grow and create jobs, it is vital that small and medium-sized enterprises (SMEs) have access to the equity capital needed to seize business opportunities quickly.

It is generally recognized that it is difficult to attract the risk capital needed to start up an enterprise, expand operations and acquire companies — steps that, in turn, help to secure and build markets, talent and revenue. It’s a chronic problem that plagues established small and mid-sized businesses, as well as business start-ups. Without access to equity capital, new businesses cannot get off the ground, and existing businesses cannot expand or may be acquired by bigger firms. In the technology sector, acquisition often means being bought by a U.S. enterprise, resulting in economic loss to Canada.

New and emerging small businesses rely mainly on informal financing sources, primarily individuals, including networks of “angel investors,” ranging from family and friends to more organized investor networks associated with formal business incubators, often attached to universities and colleges.

In the last three years, the estimated dollar value of financing in public and private markets for listed small businesses has fallen by half, to just over $1 billion a year. Equity financing for private small companies through the venture capital markets has increased steadily in this recent three-year period but is still averaging just over $2 billion a year. The domestic venture capital funds are an important, albeit relatively modest, source of equity capital for small business, reaching overall annual funding of about $1 billion a year, slightly less than U.S. venture capital investments in the Canadian market.

While there is general agreement that Canada suffers from a chronic shortage of equity capital for both business start-ups and emerging small businesses, there is little consensus on the right policy mechanisms to assist these businesses overcome the capital shortage.

Government steps in

The federal government committed $400 million through the Venture Capital Action Plan (VCAP) to match and attract private sector funding. Four funds of funds (FOFs) were established under the plan, responsible for securing investors. These FOFs provided capital to 19 individual venture capital funds, which, in turn, invested in nearly 100 Canadian companies.

The Auditor General of Canada (in its 2016 Spring Report) expressed concern about the selection process and the criteria used to evaluate FOF managers. The government stated that it reserved the right to make changes to the selection process and to select any firm that it preferred. This had a negative impact on fairness, openness and transparency. The Auditor General also criticized the high management fees that ultimately reduced investors’ return on investment and significantly limited the amount of capital available to entrepreneurs.

Another tool used by the government to facilitate access to capital for small and medium-sized businesses is the labour-sponsored venture capital corporation (LSVCC) tax credit. An LSVCC is a specially created mutual fund. The fund managers invest in eligible SMEs. Individual taxpayers can claim a 15 percent federal tax credit for share purchases of provincially registered LSVCCs, to a maximum of $5,000 in each year. The evidence indicates labour-sponsored funds have a history of poor performance and carry steep management fees.

With both the Venture Capital Action Plan and the LSVCCs, it is the fund managers who seek out small and medium-sized businesses in which to invest, not individual Canadians. A more effective approach to stimulate investment in small business would be for the government to provide incentives to individual investors to encourage them to invest directly in eligible small enterprises. Through such a broadly structured incentive, the marketplace effectively decides on the appropriate investment.

Focus on eligible investments, not funds

One option is for the federal government to provide tax breaks to investors who buy shares of eligible start-up businesses and small, private (unlisted) companies. The UK has two highly successful programs structured along these lines (see below).

Tax breaks could also be extended for the purchase of shares of eligible listed SMEs. This would ignite renewed interest from market participants in small public companies listed on the TSX Venture Exchange. Stock exchanges provide access to the deeper capital pools needed for growing mid-sized businesses, a particular need for this country. They also provide an effective exit strategy for private equity firms, venture capital and angel investors, allowing them to take a company public through an initial public offering.

Policy proposals

The Investment Industry Association of Canada has put forward a range of recommendations over the past several years as part of the pre-budget consultation process:

  • A lower capital gains tax rate for qualified investments in the shares of small business. Eligible companies would include small private companies (Canadian-controlled private corporations) and small public companies listed on a recognized stock exchange, up to a defined revenue or asset threshold.
  • A tax-free roll-over provision for the disposition or sale of assets reinvested in qualified small business equity shares. This would, in effect, unlock significant amounts of capital tied up in low-return investments and would encourage investors to take advantage of opportunities offered by small-cap companies with faster growth potential. The proceeds not subject to capital gains tax could be capped at a maximum amount.
  • Introducing equivalents of the UK Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS). The EIS provides a 30 percent personal tax credit for the purchase of shares of eligible companies with gross assets of less than £15 million and no more than 250 full-time employees. The SEIS provides a 50 percent tax credit for the purchase of shares of eligible companies with assets up to £200,000 and fewer than 25 employees. The shares must be held for at least three years or tax relief will be withdrawn. Eligible shares held for more than three years are also exempt from capital gains tax. The EIS and SEIS programs have been effective. The EIS, operational for over 20 years, is partly responsible for the UK having the largest small business sector among the countries in the EU.
  • An increase in the annual contribution amount to tax-free savings accounts (TFSAs), conditional on the additional investment being made in the shares of eligible small businesses. The TFSA throughout its seven-year existence has proven an effective savings vehicle for Canadians of all income levels, as individuals seize the opportunity to save through the instrument and shelter returns from personal tax. Since 2009, approximately $34 billion annually, on average, has been contributed to TFSA accounts (some $240 billion in total). A proportion of TFSA savings have been invested in the speculative shares of small business. The TFSA annual contribution limit was reduced from $10,000 to $5,500 for 2016. In 2016, the annual limit of $5,500 brings the cumulative total amount of contribution room to $46,500.

The goal of capital markets is to bring together people who need capital with those who wish to invest it. We need to put our best minds together to find creative solutions that will enable small Canadian businesses to achieve their desired objectives and their full potential.

Photo: hanayama / Shutterstock.com

 


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