All posts by Rob Farrow

About Rob Farrow

accountant, entrepreneur, former chef, occasional artist, angel investor, business advisor, corporate tax specialist

Taxing Online Purchases and Sales

These days tax jurisdictions are struggling to deal with online transactions. In British Columbia we are subject to both Federal GST and BC PST. If the jurisdictions themselves are struggling, that means that small businesses may find that they are caught up in a dizzying array of complex rules for multiple jurisdictions. By and large it is likely that most small CCPCs (Canadian-controlled private corporations) are flying blind.

While government tax authorities can be saddled with complex tax laws to administer, they often aren’t adequately resourced to ensure compliance. In the case of the Federal government and the Goods & Services Tax, they hire people straight out of school with no accounting training or experience. Even the supervisors typically learn on the job without the benefit of the discipline that comes from having to justify their time to clients and actually collect fees in a competitive environment.

For their part smaller CPA firms focus on basic compliance for both PST and GST. Unlike the tax authorities, CPAs in practice do work in a competitive environment.

Their clients won’t thank them for doing a “deep dive’ into PST and / or GST issues and uncovering additional tax liabilities. Particularly when they charge more than competing firms that don’t bother.

PLACE OF SUPPLY RULES for GST

While I’m not a sales tax (aka “indirect tax”) specialist, I had to bring in a specialist when one of my clients had a bit of a home run in the first month of a new product launch. The issue surrounded the “place of supply rules” for GST. While the issue is too complex to discuss here, we needed to establish where their online customers resided and whether or not they were GST registrants.

If we were unable to document that, the tax authority would have been in a position to assess 15% GST on all online sales. This, in spite of the fact that 95% or more of the customers were non-residents and shouldn’t have been subject to GST. Luckily the specialist was able to keep us out of that minefield.

SELF-ASSESSING PST for ONLINE PURCHASES

For startups (and anyone else for that matter) purchasing online services from other jurisdictions, there is a requirement to self-assess PST on the taxable portion of those services. Most of us simply pay for online services as billed. We don’t question whether the vendor properly excluded BC PST from the invoice.

However consider that most SAAS (software as a service) companies are located in other jurisdictions and know even less about BC PST regulations than we do here. If the service is taxable – and some are – our local startup would be required to self-assess and remit tax on the purchase.

Currently GOOGLE is billing me $12.50 a month for 3 users of email services. I must confess that I am not convinced that these services aren’t subject to PST. However I’m not being charged and haven’t done a deep dive into local PST legislation to determine whether I should self-assess. Since the PST for a year would only be about $10.50, I felt that it didn’t warrant the research time.

If the exposure is fairly small, it may be practical to simply wait for the Ministry to assess. In its wisdom the government’s new PST legislation doesn’t allow for the taxation of transactions that occur more than four years before they were eventually identified by the director (Section 200 of the Provincial Sales Tax Act).

Unless of course the omission was significant and intentional.

SELF-ASSESSING PST on FOREIGN LEGAL FEES

There is also some risk that legal fees in the US relating to investments by a venture capital firm may actually be subject to BC PST. Since we’re not in that position yet, we haven’t looked too closely at the legislation.

TAX ISSUES IN SELLING TO FOREIGN JURISDICTIONS

While I’m not a US or cross-border tax specialist, I have been told that companies selling into California for instance, may be exposed to income taxes in the State of California, at some level of penetration. While Canada has tax treaties with most countries that Canadians export to, it should be noted that these typically cover federal income tax only. States and provinces may have other filing and tax requirements.

Clearly companies that deal routinely across borders should seek advice from CPAs with relevant experience.

How Good is Business Advice?

CASE STUDY #1 – RECENT MBA

A few years ago I watched as a young colleague with an MBA took it upon himself to advise the proprietor of a crepe stand about operations and business strategy – in exchange for a free crepe.  As a trained journeyman chef I was amused by the exchange.

My MBA colleague had no idea how long it would take – and how expensive it would be – to train someone to make crepes, unsupervised. It was clear to me that my colleague’s advice was vastly overpriced.

CASE STUDY #2 – ENTREPRENEUR IN RESIDENCE

A few years ago I served on an advisory panel for early stage companies at Innovation Island on Vancouver Island.

One of the participants seemed to be struggling with too much advice. The presenter had stopped working “in the business” in favour of working “on the business”. When I heard that I couldn’t help thinking that an advisor had lifted that line verbatim from an introductory management consulting textbook.

In the past year or so the company had successfully sold their services to at least 3 large government organizations – which isn’t trivial for a small startup on northern Vancouver Island.

Just a note here. Successful entrepreneurs don’t usually work for goverrnment incubators. It is most often failed entrepreneurs looking for a regular pay cheque – and maybe a pension – who work with incubators. Most successful entrepreneurs keep working in their own businesses, become investors – or simply retire.

CASE STUDY #3 – IP LAWYER

Many years ago I read an opinion piece by an intellectual property lawyer. He recommended that a startup developing IP should keep it close to the chest until they secured investment. He didn’t like the idea of using the IP in services in order to prove out the technology. Maybe that works for an IP lawyer who gets paid when the IP is protected – but it sounds like bad advice to me. How does a startup know whether their IP is worth protecting until they established that it’s useful?

How do you know that a minimum viable product is viable unless a customer has tried it out?

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If you’re getting advice, you really have to consider the source. Remember above all, that there is no one size fits all answer to your question. Your business, jurisdiction and personal circumstances are unique.

CPAs who have provided tax, accounting and structuring advice for years, understand this implicitly. Our challenge is to get our clients to ask us first….

 

The Evolution of the Business Plan

Management science used to tell us that we needed to plan carefully and intelligently for any new business venture, document our assumptions clearly – and then execute.
As a professional accountant I’ve always been leery of projections – or as we like to refer to them “FOFI” (i.e. future-oriented financial information). The thing is, accountants built their reputation for honesty on the accurate reporting of historical information. What’s more we’re pretty good at that.

Steve Blank – the well-respected academic and entrepreneur out of California said it very eloquently:

No business plan survives first contact with customers

 

The thing about projections is that, especially in the case of a new business, they’re almost always wrong. For a startup trying to commercialize a new technology in a new market space, projections are almost always wildly over-optimistic.

In fact most investors in early stage companies discount projections heavily – or more likely just ignore them.

Some years ago I watched a video put out by Sequoia Capital. In it Jim Goetz (the founder) said essentially that you may be wasting your time writing a 120 page business plan – since the projections are almost always wrong…

If you like what you’ve heard here is a link to the complete Youtube video…

But in spite of the fact that they are inaccurate – and most experienced investors discount or ignore them – sometimes my clients still need to prepare them. So what is the answer?

From my perspective at least, the answer is STRATPAD™.

Originally developed for the iPad – StratPad is a web-based business planning tool that most entrepreneurs can learn to use in the course of a one day workshop. Which means it costs lest than having your CPA or your management consultant write it for you – and more important, keeps the entrepreneur at the centre of the process. Since is a business plan is really a living document, management needs to keep it up-to-date, or at least re-visit it on a regular basis. If you outsource your business plan that means you always have to outsource your plan….

And you’ll never own it!

 

Asset Sale vs Share Sale

Technology companies – in fact most small businesses – often have difficulty taking advantage of the recently enriched lifetime capital gains deduction. When first introduced the capital gains deduction was targeted the first $500,000 of capital gains on family farms and qualified small business corporation shares (“QSBCs”). Since then the lifetime capital gains limit has been increased to $806,800 for QSBCs and $1 million for family farms.

However it is always difficult for sellers to sell shares. Buyers prefer to buy assets for 2 reasons:

  1. The cost of shares is not deductible by the buyer against income – while most assets are at least partially deductible
  2. Shares of small business corporations are much more complex beasts to acquire and may include undisclosed  liabilities or other “surprises” that buyers are understandably nervous about acquiring

Buyers and their legal representatives will typically discount the purchase price if the vendor insists on selling shares. In some cases buyers simply won’t consider acquiring shares.

Many small, private corporations have at least a few skeletons in their closets. Closely-held companies often operate a little too close to the line and sophisticated buyers will often engage professionals to uncover at least some of these.

As a former senior manager with PwC LLP in Vancouver I was seconded to a due diligence team looking at the potential acquisition of a technology company. As it happened, the target company was one of a number of companies owned by the same entrepreneur. The entrepreneur had separate accounting firms handling each of his companies.

The problem was that he never informed his accountants of the existence of the other companies. Each year he filed for refundable SR&ED tax credits with one of his companies. Presumably his accountants were unaware of the existence of these other companies, since they were not disclosed on the tax returns as “associated” corporations.

Because of the amount of taxable income of the associated group, the corporation would not have been entitled to high-rate refundable tax credits. Thus any purchaser could be on the hook for undisclosed tax liabilities – and penalties – in the millions of dollars.

Of course it isn’t only undisclosed tax liabilities that could surface after an acquisition. There could be problems with employees, former employees, customers or suppliers. With small corporations eligible for the lifetime capital gains exemption, financial statements are often merely compiled with little or no assurance from the public accountants drafting the statements.

For that reason most accounting and legal professionals will advise buyers of QSBCs to purchase assets – or to discount the purchase price and conduct significant due diligence before determining that price.

CAPITAL DIVIDENDS AS AN ALTERNATIVE STRATEGY

Technology entrepreneurs looking to sell their companies should understand that the value of their companies is most often determined by the value of their IP.

Selling intellectual property developed by a technology company now results in a capital gain. With capital gains, only 1/2 of the gain is taxable. The remaining un-taxed half  can be distributed tax-free to shareholders via an amount paid out of the capital dividend account (“CDA”).

So rather than selling shares – typically at a discount – the entrepreneur keeps the company and sells the IP within the company. So the sale price is higher, the sale is only partially taxable and may even be shielded by non-capital losses, SR&ED ITCs or SR&ED expenditure pools within the company. When the proceeds are distributed, the company can elect to pay dividends from the CDA account.

While this works well for technology companies that have IP, it can also work for any corporation selling goodwill as well. Usually buyers will attempt to structure their purchase so that proceeds are allocated more to tangible assets which can be depreciated more quickly. This may result in fully taxable “recaptured” depreciation.

For entrepreneurs that have done this before, be aware that the rules around gains on the sale of what used to be “eligible capital property” have changed in the last few years. Clearly each company’s particular circumstances will be unique. So it pays to get advice from a tax professional that you trust.

 

 

The Cost of Going (and Being) Public

Recently I spoke to one of the founders of a medical device company who was looking to go public in order to fund the development and regulatory approvals for their new products. Assuming that the company accurately projects their capital needs at $4 million I thought it would be a useful exercise to look at the impact of the decision to go public on the company’s burn rate.

To begin with I looked at a study published by PwC in 2014 –

 

According to PwC estimates:

How much can the costs of going public add up to?

Underwriter costs for an IPO – up to 10% of the proceeds.

Legal, audit and accounting costs – from $200K to $500K for a smaller offering

Marketing and road show costs ?

Miscellaneous costs (eg. printing costs, filing and transfer agent fees)?

What’s more many of these additional costs are ongoing.

 

 

Based on this analysis at least half of the cost is directly attributable to going public too early in the life of the company.  Given that this is a medical device company, the cost of foregone SR&ED refunds could easily exceed the IPO and maintenance costs.

Ideally going public should be seen as a possible exit for Series A or Series B investors instead of a strategy for raising money for a development stage company.

VCC Tax Credit Is Not “Government Assistance”

British Columbia’s Small Business Venture Capital Act provides a 30% tax credit to eligible investors in corporations involved in a “prescribed business activity” within BC. For individuals the tax credit is fully refundable and isn’t considered taxable under paragraph 12(1)(x) of the Income Tax Act:

SUBSECTION 12)(1) – INCOME INCLUSIONS

(x) Inducement, reimbursement, etc. — any particular

amount (other than a prescribed amount) received by the tax –

payer in the year, in the course of earning in come from a busi –

ness or property, from

(i) a person or partnership (in this paragraph referred to as the

“payer”) who pays the particular amount

(A) in the course of earning in come from a business or prop –

erty,

(B) in order to achieve a benefit or advantage for the payer or

for persons with whom the payer does not deal at arm’s

length, or

(C) in circumstances where it is reasonable to conclude that

the payer would not have paid the amount but for the receipt

by the payer of amounts from a payer, government, munici –

pality or public authority described in this sub paragraph or

in sub paragraph (ii), or

(ii) a government, municipality or other public authority,

where the particular amount can reasonably be considered to

have been received

(iii) as an inducement, whether as a grant, subsidy, forgivable

loan, deduction from tax, allowance or any other form of in –

ducement, or

(iv) as a refund, reimbursement, contribution or allowance or

as assistance, whether as a grant, subsidy, forgivable loan, de –

duction from tax, allowance or any other form of assistance, in

respect of

(A) an amount included in, or deducted as, the cost of prop –

erty, or

(B) an outlay or expense,

to the extent that the particular amount

(v) was not otherwise included in computing the taxpayer’s in –

come, or deducted in computing, for the purposes of this Act,

any balance of undeducted outlays, expenses or other

amounts, for the year or a preceding taxation year,

(v.1) is not an amount received by the tax payer in respect of a

restrictive covenant, as de fined by sub sec tion 56.4(1), that was

in cluded, under subsection 56.4(2), in computing the income

of a person related to the taxpayer,

(vi) except as provided by subsection 127(11.1), (11.5) or

(11.6), does not reduce, for the purpose of an assessment made

or that may be made under this Act, the cost or capital cost of

the property or the amount of the outlay or expense, as the case

may be,

(vii) does not reduce, under subsection (2.2) or 13(7.4) or

paragraph 53(2)(s), the cost or capital cost of the property or

the amount of the outlay or expense, as the case may be, and

(viii) may not reasonably be considered to be a payment made

in respect of the acquisition by the payer or the public author –

ity of an interest in the taxpayer, an interest in, or for civil law a

right in, the taxpayer’s business or an interest in, or for civil

law a real right in, the taxpayer’s property;

The key wording here is:

(other than a prescribed amount)

VCC tax credits are prescribed by Regulation 7300 of the Income Tax Act to be “prescribed amounts” for the purposes of paragraph 12(1)(x). Not only do recipients not have to include the tax credit in income, they don’t have to reduce the Adjusted Cost Base of the underlying shares after receiving the tax credit (Regulation 6700)

This is a good deal for investors – to extent that investments in such companies can ever be considered “good” for investors. It also means that friends and family can invest in eligible shares and obtain a full deduction for the share when transferring to a self-directed RRSP.

Self-Employed Contractor or Employee?

Whether you are an individual looking for a broader range of tax deductions than employees are ordinarily entitled to, or an employer looking for a more flexible working arrangement with your “employees”, you need to understand the rules around employment.

The employer-employee relationships is dealt with by a number of different legislative regimes. These include:

  1. The Income Tax Act (Canada)
  2. The Canada Pension Plan
  3. The Employment Insurance Act
  4. The BC Employment Standards Act

It is important to understand that simply wanting to qualify for enhanced tax deductions as an independent contractor isn’t enough. Similarly employers can’t avoid the obligations of an employer merely by stating that a person providing services is self-employed.

Tax authorities – as well as other regulators – will look to the specifics of the relationship itself and make their own determination. This is true whether or not both parties intended to avoid the characterization of the relationship as an employment contract.

If you wish to establish a relationship that isn’t an employer-employee relationship, you should understand the position of the CRA with respect to this issue.

The CRA publication:

Employee or Self-Employed?

RC4110(E) Rev. 14

explains how this issue is perceived by both the CRA and the courts.

It is possible for the employer and the employee/contractor to contract out of the employee relationship, but it must be done thoughtfully and should be in writing. Regardless of whether or not the contract is in writing, the terms must clearly avoid the appearance of a “master-servant relationship”, or the courts (and the CRA) will look through the contract and assess accordingly.

If an employer pressures an employee to agree to a position as an independent contractor, the government may side with the employee if the self-employed contractor seeks employment insurance and severance when he or she is dismissed.

In a situation like this the employer could be required to pay severance and be subject to an assessment for a shortfall in CPP and EI withholdings.

The website TaxTips.ca has a decent explanation of many of the issues: TaxTips.ca

If an “employee” forms a corporation to provide services to his or her employer,  the corporation may be considered as a Personal Services Business – which would have significant implications. These are potentially more onerous than what an individual would face if he is deemed to be an employee without the complication of a corporation.

The case of Walter Pielasa and his wife, Susan (758997 Alberta Ltd. v. The Queen – 2004 TCC 755) illustrates some of the problems that an “incorporated employee” can face if his corporation is found to be a personal services business.

IMPLICATIONS TO A CORPORATION OF CLASSIFICATION AS A ‘PERSONAL SERVICES BUSINESS’

LIMITS TO ALLOWABLE DEDUCTIONS

Paragraph 18(1)(p) of the Income Tax Act restricts the deduction of expenses of a personal services business of a corporation to the following allowable deductions:

  1. the salary, wages or other remuneration paid in the year to an incorporated employee of the corporation
  2. the cost of any benefit or allowance provided to an incorporated employee
  3. any amount expended in connection with the selling of property or the negotiating of contracts by the corporation, as long as the amount would have been deductible if it had been expended by the incorporated employee under a contract of employment that required the employee to pay the amount, and
  4. legal expenses incurred by the corporation in collecting amounts owing to it on account of services rendered

The above amounts are only deductible by a personal services business if they would be deductible by a business other than a personal services business.

LOSS OF THE SMALL BUSINESS DEDUCTION

A personal services business is not eligible for the small business deduction, and thus pays tax at full corporate tax rates.

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While these outcomes would significant for any incorporated employee and could be devastating to employers, there are other potentially significant disadvantages in those cases where the employer is successful in structuring contracts to meet the definition of ‘independent contractor’. I’ll discuss these in a future post.

 

Importance of Startups in Job Creation

As a part of their “The Startup Revolution” series, the Compass Blog published “The Rise of the Startup“. It makes for fascinating reading.

In particular they point to a study by the Kauffman Foundating in 2010. That study revealed that:

over the past 28 years – startups were responsible for all net new jobs in the United States. In 21 of those 28 years, startups was the only class of business to create net new jobs.

According to their blog there are 4 key reasons for the rise of the startup:

  1. startups can be built for thousands, rather than millions of dollars
  2. emergence of new types of investors:  angels, accelerators and micro-VCs
  3. entrepreneurship developing its own management science
  4. speed of consumer adoption of new technology

Of course the Kauffman study shows that startups have been important in job creation for at least 28 years. If that’s true then those 4 factors may not explain the rise of startups, but rather how our economy is adapting to their importance.

Silicon Valley

Local Startup Sues Incubator in Dispute Over IP

Pixsel Sues Invoke Labs for Allegedly Stealing Code to Create a Competitor

This story got coverage in the main stream press today.

Perhaps it is a good thing that the local CBC station is beginning to cover the startup / high tech scene. Certainly this sector is becoming a major source of new economic activity. Before we rush to take sides, it is important that we keep things in perspective. Firms involved in incubating startups have their own economic interests. Sometimes economic self interest pushes people – and organizations are just people working together – to cross the line.

At the same time, startup companies are an important source of creativity and energy – but most fail. It is all too common for people who fail to find someone else to blame.

Unless Pixsel or Invoke Labs (both?) can successfully commercialize their IP and create wealth and economic activity locally, we may never hear of this again. In the mean time we can celebrate the fact that activity in the local startup scene is starting to get our attention.