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Strengthening Venture Capital in Canada

September 2003

Why venture capital matters

Capital markets are essential to an efficient, dynamic economy. Venture capital, in particular, plays a key part in the success of smaller, start-up companies in the most innovative and promising business sectors.

What makes venture capital markets so important for Canada?

• While large established Canadian corporations can access world markets, the vast majority of Canadian private companies aren’t large enough to tap into U.S. and other world markets.

• Bank lending is not necessarily well suited to the financing of early-stage entrepreneurs in sectors such as the high-tech industry.

• Because venture capital investors tend to seek local opportunities, or work with investment companies with which they are familiar, innovative Canadian ideas must have a well-developed, Canadian venture capital industry to become commercially successful.

How Canada is doing

Throughout its history Canada has relied on strong capital markets as the foundation of its economic growth.

• Canada is home to the seventh-largest exchange in the world by market capitalization, the Toronto Stock Exchange, and one of the few countries to have both an equities exchange and a derivatives exchange.

• The size of our bond market is $1.2 trillion, and trading activity in 2002 exceeded $4 trillion. Relative to gross domestic product, our bond market is smaller than the U.S. market but comparable in size to those of the United Kingdom and France. In an environment of government surpluses, our corporate bond market has grown impressively since the mid-1990s.

• Venture capital fundraising in Canada grew strongly during the second half of the 1990s and, compared to other countries, has weathered recent market downturns relatively well, but:

• Total per-capita Canadian venture capital investment averaged only about one-half of U.S. investment over the last three years; and

• Canadian pension funds have been a much less important source of venture capital than their U.S. counterparts since the early 1980s—over the period 1998-2002, pension funds accounted for an average of about 20 per cent of venture capital funding in Canada compared with nearly 50 per cent in the U.S.

What Canada is doing

Over the past few years Canada has set a clear course to make venture capital investing more attractive, stimulate entrepreneurship and create an advantage for investment in Canada. The initiatives taken include:

Creating a more competitive corporate tax system

• Reduced corporate income taxes—We are reducing the general corporate income tax rate from 28 per cent in 2000 to 21 per cent in 2004; it is 23 per cent in 2003.

• Elimination of the federal capital tax—Budget 2003 eliminated the federal capital tax over five years and, for medium-sized corporations (those with less than $50 million in capital), completely eliminates the capital tax as early as 2004.

With the cuts implemented to date, the average (federal and provincial) corporate tax rate in Canada, including capital taxes, is now below the average U.S. rate. The Canadian tax advantage will rise to more than 6 percentage points by 2008.

• Reduced taxes on small and medium-sized businesses—To help small businesses keep more of their earnings, a reduced income tax rate of 12 per cent applies on the first $200,000 of qualifying active business income. Budget 2003 increased this amount to $300,000 phased in over four years.

Promoting venture capital investment and entrepreneurship

• Reduced capital gains taxes—To create a tax system more favourable to investment and innovation, the October 2000 Economic Statement and Budget Update lowered the capital gains inclusion rate to one-half. The top capital gains tax rate in Canada is 50 per cent of the top marginal tax rate (federal plus provincial)—an average rate of 22.7 per cent for Canada, ranging from 19.5 per cent in Alberta to 24.3 per cent in Newfoundland and Labrador. Canada’s low corporate income tax rates and the 50-per-cent capital gains inclusion rate ensure that business income, retained in a corporation and realised by investors as capital gains, is taxed at competitive rates in Canada.

• Expansion of tax-free capital gains rollovers for small business investors—In the 2000 Budget, the government allowed investors to defer the taxation of capital gains on small business shares, up to certain limits, if they reinvest the proceeds of disposition in other small businesses.

• Budget 2003 significantly expanded this measure by eliminating the limits on eligible investment amounts and by extending the allowable reinvestment period.

• Encouraging pension fund participation in venture capital investments—Budget 2001 and Budget 2003 included tax measures that removed impediments to pension fund investments in venture capital markets through limited partnerships, a vehicle that pension funds prefer for such investments.

• Targeted venture capital pools—The Business Development Bank of Canada and Farm Credit Canada have established targeted venture capital operations, together estimated at $310 million by March 2003, to increase financing of knowledge-based and export-oriented businesses.

Investing in Research Excellence

The ideas and discoveries generated in universities, colleges, research hospitals and other research institutions, and innovative private sector firms are a key input to the creation of innovative products, services and technologies. The federal government’s funding commitments in successive budgets will increase spending in support of research excellence and the commercialization of research discoveries by close to $13 billion over the period 1998 to 2005.

Investments include:

• $3.7 billion in the Canada Foundation for Innovation to support the modernization of research infrastructure at universities and colleges, research hospitals and other non-profit research institutions;

• $375 million through Genome Canada to develop and implement a national genomics strategy; and

• $1.5 billion invested in a number of initiatives such as SchoolNet, the Community Access Program, broadband, and Government-on-Line that are helping to maintain Canada’s position as one of the most connected nations in the world.

Additional support for knowledge and innovation includes:

• An additional $680 million annually through the Federal Granting Councils (the Canadian Institutes of Health Research, the Natural Sciences and Engineering Research Council, and the Social Sciences and Humanities Research Council) raising their combined budgets to $1.5 billion in 2003-04;

• $170 million annually through the National Research Council (NRC), including $60 million per year for the Industrial Research Assistance Program that assists small and medium-sized businesses to develop and use new technologies, and support for the NRC’s national system of innovation centres;

• $190 million annually for Technology Partnerships Canada to invest with companies in research, development and innovation;

• $225 million annually to support the indirect costs of research at universities and other institutions;

• $300 million annually to create and sustain 2,000 Canada Research Chairs to help universities attract and retain world-class researchers in areas such as the natural sciences, engineering and health; and

• $105 million annually to create and sustain 4,000 Canada Graduate Scholarships (2,000 master’s and 2,000 doctoral scholarships) at Canadian universities.