The ability to manage cash flow is a critical element to a corporation’s success. Variations in a corporation’s cash flow can result in vulnerability to its business decisions such as pre-existing debt covenants (with banks and lenders), operating or working capital covenants, and planned investments. Typical sources of cash flow include debt, equity financing and hybrid options.
With increasing sources of private funding, equity participation is becoming common. Equity financing can impact an important source of cash flow through SR&ED tax credits. Consider a Canadian controlled private corporation (XYZ) that is seeking equity financing from new partners (either corporations or individuals with a majority ownership in a corporation other than XYZ). Furthermore, XYZ is a technology company with continuous development activities leading to product(s) with an economic benefit. XYZ has filed successfully for SR&ED tax credits in the past.
While there are several ways equity participation is feasible, below are two cases where it can impact the SR&ED tax credits in a significant manner:
- Plain vanilla majority equity stake leading to a 51% or higher ownership in XYZ;
- Minority equity stake but, nonetheless results in a controlling ownership, or in other-words, the stakeholder has a deciding say on significant business decisions involving XYZ.
Impact on SR&ED cash flow – what to look for in equity transactions?
While it is a no brainer to see the cash in-flow from the new equity participation, it can have an impact (current and long-term) on the cash in-flow from SR&ED tax credits; consider three simple scenarios:
- Deemed fiscal year end: A deemed year end is created when the majority partner takes control and the deemed year end occurs when the control is acquired. This can impact the SR&ED tax credits of the corporation and in some cases may result in the reduction of part or all of the tax credits;
- Cash flow size: The actual size of the cash flow can be impacted depending on the taxable position of the corporation held by the new equity partners. If the majority stakeholder has high taxable income, this will grind down the effective Federal rate (essentially for incomes above $500K). Independent of this, there can be changes in the expense limits, leading to an introduction of non-refundable tax credits and a reduction in the refundable portion of the tax credits for XYZ;
- Residency status: If the shareholders do not satisfy Canadian residency status (from a tax perspective) then this will impact the size of the cash flow as XYZ may no longer be a Canadian Controlled Private Corporation. This determination is independent of the taxable position of the individual equity partners/corporation.
We recommend that companies such as XYZ, and especially owner-managed technology corporations perform due diligence on the impact to their SR&ED and other tax credits, following changes in share structures from the introduction of new investors.
Please contact Josh Smith (firstname.lastname@example.org) at Welch LLP for more information on SR&ED and other tax credits.