Bills Digest No. 78 2002-03
Taxation Laws Amendment (Venture Capital) Bill
2002
WARNING:
This Digest was prepared for debate. It reflects the legislation as
introduced and does not canvass subsequent amendments. This Digest
does not have any official legal status. Other sources should be
consulted to determine the subsequent official status of the
Bill.
CONTENTS
Passage History
Purpose
Background
Main Provisions
Concluding Comments
Endnotes
Contact Officer & Copyright Details
Passage History
Venture Capital Bill
2002
Taxation Laws Amendment
(Venture Capital) Bill 2002
Date Introduced:
14 November 2002
House: House of Representatives
Portfolio: Treasury
Commencement:
1 July 2002
Purpose
The Taxation Laws
Amendment (Venture Capital) Bill 2002 (the TLA(VC) Bill) amends the
Income Tax Assessment Act 1936 (ITAA 1936) and the
Income Tax Assessment Act 1997 (ITAA 1997) to extend the
scope of the existing tax exemption for venture capital investment
to registered Venture Capital Limited Partnerships (VCLPs) and
Australian Venture Capital Funds of Funds (AFOFs). The measures
also propose to tax the venture capital manager s share of gains
made by a VCLP or an AFOF on the sale of eligible venture capital
investments (the carried interest) as a capital gain instead of as
income.
The Venture Capital Bill 2002 (the VC Bill)
provides the administrative measures for the registration and
revocation of registration of VCLPs and AFOFs.
The Bills give effect to the Government s
November 2001 Election commitment to improve incentives for foreign
investment in the venture capital sector.
Recognising that access to venture capital is a
critical factor in facilitating the growth of Australian companies,
the Prime Minister foreshadowed during the 2001 election campaign
that the Government would review taxation arrangements for venture
capital investment:
One of the more pressing issues facing business
leaders is how to operate and expand their companies in an
increasingly competitive global environment. My Government remains
firmly of the view that Australian companies can successfully
compete on the global stage while remaining based in Australia. But
to achieve this, we need internationally competitive taxes and
taxation systems.
If re-elected, the Coalition Government will, as
a matter of priority, examine whether features of the current
taxation arrangements adversely affect the capacity of business to
remain in Australia. This will be done in consultation with key
stake holders and industry representatives.
Particular attention will be paid to whether
Australia s international tax regime acts as an impediment to:
-
- Australian companies attracting domestic and foreign
equity;
-
- Australian companies expanding offshore; and/or
-
- holding companies and conduit holdings being located in
Australia.
In an increasingly competitive global
environment, reducing taxes on equity flows will significantly
enhance the ability of companies to manage their capital base.
The Government intends to extend the previously
announced exemption for capital gains on venture capital
investments by providing venture capital limited partnerships with
flow through taxation treatment.
These changes, which will apply from 1 July
2002, stem from the Government s commitment in Backing Australia s
Ability to ensure that venture capital investment is encouraged.
(1)
At the time the cost to Government of the
proposed new tax incentives was estimated at $60 million over three
years beginning in 2003 04. This initial estimate was revised in
the Explanatory Memorandum to the Bills and is now put at $76
million over three years.(2)
Overview of legislation
The key features of the new legislation are:
-
- venture capital limited partnerships will be able to access
flow-through taxation treatment allowing the income, profits, gains
and losses of the partnerships to flow through to partners
-
- the current Capital Gains Tax (CGT) exemption provided to
certain foreign pensions funds on profits or gains from the sale of
investments in eligible venture capital investments will be
extended to a wider pool of foreign investors
-
- general partners of limited partnerships must apply to the
Pooled Development Funds (PDF) Registration Board to qualify for
tax exemption, and
-
- a venture capital manager s 'carried interest' or entitlement
to a distribution from a limited partnership will be taxed as a
capital gain, rather than as income.
As noted in the Minister s Second Reading
Speech, limited partnership structures are the investment vehicle
of choice in overseas venture capital markets:
The measures recognise that venture capital
limited partnerships with flow through taxation treatment are the
preferred investment vehicles internationally and that countries
competing with Australia for capital offer exemption from taxation
on gains from the sale of those investments.
Taxing the carried interest of venture capital
managers as capital is also consistent with the international tax
treatment of those gains. An internationally consistent tax
treatment is critical in attracting highly skilled international
venture capital managers to Australia. Such managers will
contribute to the expertise and competitiveness of Australia s
venture capital industry which, in turn, will attract venture
capital funds by offshore investors.
These measures will therefore bring Australia
into line with what is currently recognised as best practice within
the international market. As a result, it is anticipated that there
will be a strong increase in venture capital by non-residents over
the medium term and that these measure will lay the foundation for
greater participation by experienced venture capital funds managers
in the Australian venture capital market.
According to the Australian Venture Capital
Journal (AVCJ), total capital in the Australian venture capital
sector rose $1.05 billion from $8.2 billion to $9.3 billion in 2001
02 (see graph below).(3)
The $9.3 billion comprises $7.01 billion with
fund managers and listed companies, and $2.34 billion with firms
that are private, government or local offices of offshore
groups.
The AVCJ 10th Annual Venture Capital
Survey shows that the sector has grown 126 per cent in the ten
years since 1992 93, when investments totalled $4.1 billion.
However, the 13 per cent increase in total
investments in 2001 02 and the 7 per cent rise in 2000 01 represent
a much slower rate of growth compared to the record 44 per cent
increase in 1999 2000 during the information technology boom.
Source: Australian Venture
Capital Journal
The survey also shows that despite 126 per cent
growth in the sector over the last decade, the level of privately
managed capital has remained the same, being $2.38 billion in 1992
93 and $2.34 billion in 2001 02.
While the sector has more capital and more
investments than before, exits are a constant feature of the sector
s activities.
During 2001 02, the sector exited from 82
investments. Of these, 41 or 50 per cent were at a profit, 38 or 46
per cent were at a loss, and three broke even. In 2000 01, there
were 62 exits, of which 34 or 55 per cent were at a profit, 25 or
40 per cent were at a loss and five broke even.
Although Australia has been insulated from the
economic downturn affecting other developed economies, venture
capital funding is an area that suffered as a result of the loss of
investor confidence in global equity markets after the
technology-bust.(4)
In 2001 02, $894.7 million was raised in venture
capital, compared to $1.27 billion in 2000 01 and $1.75 billion in
1999 00. The $894.7 million was raised by 18 firms, down from 34
firms each in 2000 01 and 1999 00.
According to the AVCJ, the decline in venture
capital funding over previous years "shows a smaller number of
managers raising large amounts, a shorter tail of managers small
amounts, and very few first funds by new managers". Another factor
is the role of institutional investors:
The reluctance of super funds and other institutions to invest
in private equity since the tech bust highlights that institutions
and professional investor[s] are not immune from herd investing.
Happy to commit while the market was rising and the bubble
building, many now lack the stomach for countercyclical investing
just when venture capital history shows that periods of low
business valuations ultimately provide the best vintage years and
superior returns.(5)
Source: Australian Venture Capital
Journal
Despite the current slow market conditions,
there are good prospects for continued growth in the sector. The
Australian Venture Capital Association estimates, based on an
economic analysis by Econtech, that the imminent limited
partnerships and tax changes will attract an additional $1 billion
in foreign capital over the next five years.(6)
By extending the current CGT exemption, the
venture capital sector should experience an increase in funds
flowing into the sector from foreign tax-exempt entities, including
overseas superannuation funds, and from tax paying entities. The
only drawback is that the exemption applies to a restricted list of
countries, although the Government has indicated it will consider
adding other appropriate countries as required.
The new provisions in respect of the carried
interest paid to investment managers, which will be treated as
capital gain rather than income, will make it easier to attract US
or UK expertise in managing funds in Australia. Venture capitalists
will be taxed at 24.25 per cent, the same as in the US.
The registration procedures for limited
partnerships and the ongoing reporting obligations will result in
higher running costs for venture capital funds that qualify for tax
exemption. While the registration and reporting processes ensure
the integrity of the measures, in time the ongoing obligations may
become a cost burden for some small funds.
Part 2 of the VC Bill 2002
provides for the registration of two types of limited partnerships
by the PDF Board established under the Pooled Development Funds
Act 1992 (PDF Act 1992).
Proposed section 9-1 sets out
the requirements for the registration of a limited partnership by
the PDF Board. A VCLP may be registered if:
-
- it is established in Australia, Canada, France, Germany, Japan,
the United Kingdom, United States or any other country prescribed
by regulations
-
- all the general partners are resident in one of the above
mentioned countries
-
- the partnership agreement specifies that the partnership will
remain in existence for at least 5 years but no more than 15
years
-
- the committed capital of the partnership is at least $20
million
-
- its only investments are eligible venture capital investments,
and
-
- every debt interest that the partnership owns is a permitted
loan.
A limited partnership may be registered by the
PDF Board as an AFOF under proposed section 9-5
if:
-
- it is established under a State or Territory law in
Australia
-
- all the general partners are Australian residents
-
- its partnership agreement specifies that the partnership will
remain in existence for at least 5 years and not more than 20
years, and
-
- its only investments are in a VCLP or eligible venture capital
investments in a company in which a VCLP (in which the AFOF is a
partner) already holds an investment.
The following proposed definitions inserted into
section 995-1 of the ITAA 1997 apply:
-
- A general partner means a partner of a limited partnership
whose liability in relation to the partnership is not limited.
(Item 16 of Schedule 1 of the
TLA(VC) Bill), and
-
- A limited partner means a partner of a limited partnership
whose liability in relation to the partnership is limited
(Item 18 of Schedule 1 of the
TLA(VC) Bill)).
The above definitions will also be inserted into
subsection 6(1) of the ITAA 1936 by Items 2 and
3 of Schedule 2 of the TLA(VC)
Bill.
Limited partnership means a partnership where
the liability of at least one of the partners is limited. This
definition of limited partnership in section 94B of the ITAA 1936
will be inserted into subsection 6(1) of the ITAA 1936 by
Item 4 of Schedule 2 of the
TLA(VC) Bill.
It must be noted that in a limited partnership
it is the general partner that is responsible for the day to day
operation of the partnership. For this reason proposed
section 13-1 of the VC Bill requires a general partner of
a VCLP and an AFOF to apply for registration.
A venture capital management partnership (VCMP)
as defined in proposed subsection 94(3) to be
inserted into the ITAA 1936 by Item 16 of
Schedule 2 to the TLA(VC) Bill is a limited
partnership that:
-
- is a general partner of either or both of the following:
-
- One or more VCLPs;
- One or more AFOFs; and
-
- only carries on activities that are related to being such a
general partner.
Proposed subsection 94(3) also
provides that a limited partnership ceases to be a VCMP if it
ceases to meet the requirements in paragraphs (a) and (b).
Under the existing law, limited partnerships are
taxed as if they were companies under Division 5A of the ITAA 1936
and are referred to as corporate limited partnerships. Item
16 of Schedule 2 of the TLA(VC) Bill
amends section 94D by inserting proposed subsection
94(2) to provide that a VCLP, an AFOF or a VCMP cannot be
a corporate limited partnership. In consequence, VCLPs, AFOFs and
VCMPs will be treated as ordinary partnerships for taxation
purposes. This amendment will permit the flow through of profits,
gains and losses to the partners of VCLPS, AFOFs and VCMPs.
Loss limitation rules will limit the deduction
allowable to limited partners for partnership losses to the extent
of the partner s exposure to the loss. This is calculated under
proposed subsection 92(2AA) of the ITAA 1936 to be
inserted by Item 13 of Schedule 2
of the TLA(VC) Bill by deducting from the capital contributed by
the limited partner of the following amounts:
-
- the amount of contributed capital the partnership has repaid to
the partner
-
- the total of all deductions allowed to the partner for
partnership losses incurred in previous income years, and
-
- the amount of any debt of the partner that is secured by the
partner s interest in the VCLP or the AFOF.
The Explanatory Memorandum to the VC Bill and
the TLA(VC) Bill states that the loss limitation rules are
necessary to protect the integrity of the measure as without this
limitation limited partners would be able to claim deductions for
losses to which they were not exposed to. It adds that similar
limitation on loss claims are to be found in other jurisdictions
including Canada, New Zealand, the UK and the US.(7)
As in the case of capital gains made on the sale
of assets held by an ordinary partnership, capital gains made on
assets held by a VCLP, an AFOF or a VCMP will be taxable to a
partner according to the partner s tax status. Thus individuals who
are partners in a VCMP will qualify for the CGT discount on the
carried interest if they satisfy the other requirements of the
discount.
Proposed Subdivision 195-B to
be inserted into the ITAA 1997 by item 23 of
Schedule 2 of TLA(VC) contains rules about the
income tax treatment of limited partnerships that become or cease
to be VCLPs, AFOFs or VCMPs. Thus tax losses cannot be transferred
to a VCLP, an AFOF or a VCMP under proposed section
195-65. Previous tax losses can be deducted after ceasing
to be a VCLP, an AFOF or a VCMP under proposed section
195-70. The Commissioner may make determinations how to
take account of limited partnerships having income years of less
than 12 months when they become or cease to be VCLPs, AFOFs and
VCMPs.
The current CGT exemption to certain overseas
pension funds on the profit or gain from the sale of investments in
eligible venture capital investments, will be extended by
proposed Subdivision 118-F to be inserted by
Item 6 of Schedule 1 to the
TLA(VC) Bill to partners in the VCLP or AFOF which are:
-
- tax-exempt entities (including pension funds, endowment funds
and foundations) from Canada, France, Germany, Japan, the UK, the
USA or any other country prescribed in the regulations. These
investors may hold up to 100 per cent of the committed capital of
the VCLP or AFOF
-
- foreign venture capital funds of funds established in Canada,
France, Germany, Japan, the UK or the USA. These funds of funds may
hold up to 30 per cent of the committed capital of the VCLP or
AFOF
-
- taxable entities from Canada, France, Germany, Japan, the UK or
the USA, holding less than 10 per cent of the committed capital of
the VCLP or the AFOF, and
-
- an entity (taxable or otherwise) from Finland, Italy, the
Netherlands, New Zealand, Norway, Sweden, Taiwan and which holds
less than 10 per cent of the committed capital of the VCLP or
AFOF.
The investment must have been held by the VCLP
or AFOF for at least 12 months to qualify for the tax
exemption.
To qualify for the tax exemption, the investment
in either shares or options must be an eligible venture capital
investment and the investment must be at risk (that is, investors
must bear the risk of owning the shares or options themselves) as
required in proposed paragraph 118-425(1)(a) to be
inserted by Item 6 of Schedule 1. of the TLA(VC)
Bill.
Proposed sections 118-425 to
118-445 to be inserted by Item 6 of
the TLA(VC) Bill sets out the requirements for an eligible
venture capital investment and these cover listing, size, auditor,
primary activity and residency requirements. Broadly the company
seeking the capital must:
-
- be an unlisted Australian company, or a listed Australian
company that will be delisted within 12 months of the date of the
investment (proposed paragraph 118-425(7)(a) and
(b)
-
- have assets not exceeding $250 million at the time of the
investment (proposed subsection 118-425(6) and
proposed section 118-440)
-
- have a registered company auditor (proposed subsection
118-425(5)), and
-
- not have any of the following as its primary activity:
-
- property development
-
- finance to the extent that it is banking, providing capital to
others, leasing, factoring or securitisation;
-
- insurance
-
- construction or the acquisition of infrastructure activities,
and
-
- investments that generate interest, rents, dividend, royalties
or lease payments (proposed subsection
118-425(3)).
Additionally under proposed subsection
118-425(2), if the investment is first made in the
investee company, for 12 months following the investment, that
company must:
-
- have more than 50 per cent of their employees in Australia,
and
-
- retain more than 50 per cent of its assets in Australia.
A carried interest is a partner s entitlement to
a distribution from a VCLP, an AFOF or a VCMP which is contingent
on profits being made for the limited partners of the VCLP or
AFOF.
The meaning of carried interest is provided in
proposed section 104-255 to be inserted into the
ITAA 1997 by item 5 of Schedule 3
of the TLA(VC) Bill. A carried interest can be held by a general
partner of a VCLP or an AFOF under proposed subsection
104-255(4) and by a limited partner under proposed
subsection 104-255(5) to be inserted by Item
5 of Schedule 3 of the TLA(VC) Bill.
When a venture capital manager becomes entitled
to receive a payment of carried interest it becomes liable to CGT.
The carried interest is not ordinary income of the venture capital
manager. At the same time a deduction is not allowable to a VCLP,
an AFOF or a VCMP for a carried interest payment. These outcomes
are achieved by amendments to sections 10-5, 12-5 of the ITAA 1997
and by proposed section 118-20 of the ITAA 1997 by
Items 2, 3 and 13 respectively of
Schedule 3 of the TLA(VC) Bill.
A carried interest entitlement can be a discount
capital gain if the partnership agreement under which it arises was
entered into at least 12 months before the payment of carried
interest.
To qualify for the exemption, a limited
partnership must apply to the PDF Registration Board for
registration as a VCLP or AFOF under proposed Part
2 of the VC Bill.
The application must be in writing or lodged
electronically and must include information in relation to the
general partner, the fund, the limited partner investors and the
fund s broad investment plans. The PDF Board must decide the
application within 60 days of the application being lodged,
although it has discretion to extend the period by up to 60
days.
It is the duty of the PDF Board to register
VCLPs or AFOFs and to monitor their activities for compliance with
the new legislation. Once a limited partnership is registered, the
general partner must lodge quarterly and annual returns with the
PDF Board, and any further information requested by the Board.
The Bills implement a key election commitment by
providing new venture capital incentives for foreign
investment.
The removal of tax impediments may allow
Australian companies seeking venture capital funding to source
funds from the hitherto elusive overseas venture capital
markets.
-
- Prime Minister, Press Release, Securing Australia s
Prosperity, 15 October 2001.
- Explanatory Memorandum, p. 4.
- See Australian Venture Capital Journal, 10th
Annual AVCJ Venture Capital Survey 2002, October 2002, No.
114, pp 6 19.
- See 'Venture capital drying up', The Australian, 1
October 2002.
- Australian Venture Capital Journal, 10th Annual
AVCJ Venture Capital Survey 2002, October 2002, No. 114, p.
12. See also "Venture capital funds a drag on super returns",
Australian Financial Review, 26 June 2002.
- See 'The golden chance', Business Review Weekly, June
6 12, 2002, p. 55.
- Explanatory Memorandum, paragraph 2.19, p. 19.
Michael Priestley and Bernard Pulle
9 December 2002
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ISSN 1328-8091
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