Top players in the labour-sponsored investment fund business say the proposed removal of the 15% Ontario tax credit for eligible LSIF investments in the province after March 2006 is unlikely to damage the industry significantly.

They contend that LSIFs are better equipped to weather a tax credit withdrawal than they were in 1996, when a five percentage point cut in the federal credit caused national sales to plummet.

“Even without a 15% [Ontario] tax credit, there’s still a [LSIF] market. [The impact] won’t be as large [as in 1996],” says David Ferguson, managing general partner of VenGrowth Private Equity Partners Inc. of Toronto. VenGrowth has more than $1 billion in AUM.

Ontario’s 15% provincial tax credit matches the 15% federal tax credit on a $5,000 maximum annual contribution to an Ontario-based LSIF.

LSIFs took a major hit in 1996, when Ottawa reduced its tax credit from 20% to 15% and extended the minimum investment holding period to eight years from five years. Sales crashed by 74% and didn’t regain their pre-1996 investment level of $757 million until 2001, Ferguson says.

David Levi, president and CEO of GrowthWorks Ltd. , a Vancouver-based venture capital management company with $800 million in LSIF assets under management, agrees with Ferguson that the industry is more mature now, and that Ontario’s withdrawal from the program won’t be as devastating.

Despite the decision announced Aug. 29, Ferguson and Levi suggest financial advisors need not be concerned that the tax credit will be eliminated in one fell swoop on March 1, 2006. Neither expects a worst-case scenario in which funds close down and redeem fund units prior to their eight-year holding requirement, thereby forcing investors to repay tax credits.

Business as usual

“When we talked to some financial advisors, the vast, vast majority have been [saying it’s] business as usual,” says Ferguson. He says some advisors have been put off by the uncertainty, while others see the 2005 tax year as “a last time buying opportunity” and may double up on Ontario-eligible LSIFs. “The investment companies are not
concerned.”

Levi says the bigger labour-sponsored funds can stand on their merits without the provincial tax credit and the smaller, more vulnerable Ontario-based funds may be bought up by the larger funds, in a long-overdue industry consolidation that will see two or three dominant funds left standing. Growthworks recently acquired two smaller funds and is currently in discussions with others, Levi says.

An industry consolidation would benefit investors, who would see lower management expense ratios and enhanced fund performance, Levi says. LSIF MERs range from 5.5%-12.26%, according to Morningstar Canada data.

In any event, Levi and Ferguson expect Ontario to tread lightly and proceed slowly with its plans, beginning after March. The province may make a series of staggered cuts to the tax credit or eligible contribution maximums, rather than cutting all LSIF sponsorship dead with a single blow, suggest those who are closely monitoring the situation.

“What’s unclear at this point [is that] the government says the LSIF tax credit will be phased out no earlier than the end of this RRSP season,” says Ferguson. He says the phrasing in no way locks the government into eliminating the tax credit completely on that date or even beginning a phased-in tax cut right away. Levi suggests the ambiguous wording leaves open the possibility that Ontario may phase the credit out gradually, rather than eliminate it on March 1. A finance ministry spokesman would not comment on speculation.

Nonetheless, Levi says, the province has been responsive to concerns expressed in recent weeks by labour-sponsored funds, the venture capital industry in general and sectors that will be hardest-hit by legislative changes that would diminish the pool of venture capital funding in Ontario.

The move was hinted at during the last Ontario budget when the government — stung by the high-profile folding of several small new funds — announced a moratorium on the registration of new LSIFs. At the same time, the province relaxed regulations to allow the funds to invest up to 25% of their capital pool in publicly-traded companies, and made it easier for funds to merge.

Industry consultation

In his August announcement, Finance Minister Greg Sorbara said: “To assist with an orderly exit, we will consult with the LSIF industry on rules that will help fund managers manage their portfolios, while ensuring that government spending is directed to priority areas.” And, he pointed out: “Investors continue to have the option to invest in labour sponsored investment funds. Our proposal would simply end the added Ontario incentive.”

@page_break@Every other province in Canada offers a LSIF tax credit. In December, Newfoundland and Labrador became the last jurisdiction in Canada to pass legislation allowing LSIFs in the province, although Quebec is also reviewing its program. Some believe that Quebec’s decision about whether to keep its program will be a litmus test of the federal government’s own future commitment to its 15% tax credit for LSIF investments, although many doubt Ottawa will do away with the program it founded in 1988.

Since 1991, when Ontario began matching the federal government’s tax credit, the province has paid out more than $600 million in the program. There are 46 registered LSIFs and almost $3 billion in AUM in Ontario.

According to the Association of Labour-Sponsored Investment Funds, $289 million was invested in LSIFs across Canada, during the first half of 2005 (most of them registered in Ontario), vs $596 million in all of 2004 and $535 million in 2003. In the past decade, LSIFs have invested some $2.7 billion in more than 550 Ontario companies, ALSIF says.

The LSIF industry has had a tough year. The scandal at Winnipeg-based Crocus Investment Fund has created reluctance in some investors to buy into LSIFS, a survey shows. And the last federal budget dealt a blow by removing the 30% foreign-content limit on RRSPs. One of the selling features of LSIFs had been that Ottawa would extend an investor’s foreign-content limit by $3 for every $1 held in a LSIF, up to a maximum of 50%. IE