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Many Canadian private companies in the start up phase of their business operations need access to additional capital to fund expansion. The ability to obtain bank or other conventional sources of financing can be limited or very expensive. In such situations it is very common for the company to seek additional funds by issuing shares through private placements.
Investors are increasingly viewing share investments in private companies as an attractive alternative or in addition to investments in publicly traded stock and money market securities given the recent poor performance of the markets.
A number of factors must be weighed in deciding whether to purchase private company shares within an RRSP.
Generally the investor, together with any related persons, cannot hold 10% or more of any class of shares issued by the private company.
The company must meet a number of conditions in order for its shares to qualify to be held within a RRSP.
A private company that exclusively operates an active business in Canada with no foreign operations will likely meet the asset test. A company can go offside of the asset test in situations where it expands into other countries either through branch offices/plants or foreign subsidiaries.
Until recently the asset test only had to be met at the time the private company shares were acquired by the RRSP. Last year new penalty provisions were introduced that require the asset test be met at all times the shares are held within the RRSP. If the asset test is not met a 50% penalty tax based on the value of the private company shares held within the RRSP may arise. The penalty may be refunded upon disposition of the offending shares. Private company shares held within a RRSP prior to March 2011 that are now offside of the new asset test will not be subject to the penalty tax provided steps are taken by December 31, 2021 to remove the shares from the RRSP.
An investor, as a practical matter, is unable to control the operations of a company that he/she has bought shares in. Under the old asset test, a company could start off by meeting the test and over time expand into foreign operations. The fact that the company ceased to meet the asset test would not negatively impact the investor who had bought shares within their RRSP. The shares would continue to qualify to be held within the RRSP and no penalties would apply. Under the new requirement that the company meet the asset test continuously it is conceivable that the 50% penalty tax could inadvertently apply to the investor if the company is not continuously monitoring the asset test. Given the illiquid nature of investments in private companies it is also not necessarily feasible to dispose of the shares in the private company in order to mitigate any exposure the penalty tax if the company is expected to fall offside of the asset test.
By implementing changes to the timing of the asset test, the Department of Finance has introduced another element of risk to investing in private company shares through a RRSP that people need to consider.
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