Bills Digest no. 117 2015–16
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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.
Dr Nitin Gupta
Economics Section
4 May 2016
Contents
Purpose
of the Bill
Structure of the Bill
Background
Committee consideration
Policy position of non-government parties/independents
Position of major interest groups
Financial implications
Statement of Compatibility with Human Rights
Key issues and provisions
Concluding comments
Date introduced: 16
March 2016
House: House of
Representatives
Portfolio: Treasury
Commencement: Schedule
1 and most of Schedule 2 of the Bill will commence on the later of 1 July 2016
or Royal Assent. The commencement of Items 73 and 75 of Schedule 2 is dependent
on the passage of the Tax
Laws Amendment (New Tax System for Managed Investment Trusts) Bill 2015.
Links: The links to the Bill,
its Explanatory Memorandum and second reading speech can be found on the
Bill’s home page, or through the Australian
Parliament website.
When Bills have been passed and have received Royal Assent, they
become Acts, which can be found at the Federal
Register of Legislation website.
All hyperlinks in this Bills Digest are correct as at
May 2016.
Purpose of the Bill
The Tax Laws Amendment (Tax Incentives for Innovation)
Bill 2016 (the Bill) seeks to:
- amend
the Income Tax Assessment Act 1997 (ITAA 1997) to promote
investment in Australian start-ups and early stage innovating companies
- amend
the Venture Capital Act 2002 and the ITAA 1997 to improve the
attractiveness of venture capital[1] regimes for investors.
Structure
of the Bill
The Bill has two Schedules. Schedule 1 seeks to amend the ITAA
1997 to encourage new investment in Australian early stage innovation
companies with high growth potential by providing investors, who invest in such
companies, with a tax offset[2] and a capital gains tax exemption for their investments. These amendments form
part of the Tax Incentives for Early Stage Investors measure.
Schedule 1 also creates a new requirement for early stage
innovation companies to report information about their investors to the
Australian Taxation Office, so that the eligibility of investors for tax
offsets and capital gains exemptions can be determined.
Schedule 2 to this Bill amends the early stage venture
capital limited partnership (ESVCLP)[3] and venture capital limited partnership (VCLP)[4] regimes within the Venture Capital Act and ITAA 1997 to improve access to venture capital investment and make the regimes more
attractive to investors.
The amendments provide an additional
tax incentive for limited partners in new ESVCLPs, relax restrictions on ESVCLP
investments and fund size and clarify the legal framework for venture capital
investment in Australia.
Background
The Bill seeks to implement measures announced by the
Government in the National
Innovation and Science Agenda on 7 December 2015.[5] The measures were included in the Mid-Year Economic and Fiscal Outlook 2015‑16,
released on 15 December 2015.[6]
According to the Minister’s second reading speech, the
measures included in the Bill ‘will help to encourage innovation, risk taking and
an entrepreneurial culture in Australia’. [7] Furthermore, the ‘Bill delivers upon two commitments: providing concessional
tax treatment to investment in innovative, high-growth start-ups; and reforms
to the arrangements for Venture Capital Limited Partnerships to improve access
to capital, and make the regime more user-friendly and more internationally
competitive’.[8]
The Australian Government currently provides a series of
tax concessions to companies to facilitate innovative activities through the Research
and Development (R&D) tax incentive, Early Stage Venture Capital Limited
Partnership (ESVCLP) and Venture Capital Limited Partnerships (VCLP). However,
venture capital funds typically target companies that are more advanced in
their innovation activities and are expected to attract needed capital. Early
stage innovators face more acute financial constraints, which are not
adequately addressed by the current framework, and the Bill seeks to alleviate
these.[9]
These proposed changes are intended to encourage and
support innovation, risk‑taking, and an entrepreneurial culture in
Australia.[10]
Committee
consideration
The Bill has not been referred to Committee for
consideration.
The Senate Committee for the Selection of Bills in its
meeting on 16 March 2016 deferred its consideration of the Bill to its next
meeting.[11]
Senate Standing Committee for the
Scrutiny of Bills
The Senate Standing Committee for the Scrutiny of Bills
considered the Bill but had no comment on it.[12]
Policy
position of non-government parties/independents
Labor has been supportive of the Bill, and of the specific
provisions in it. Its main rationale for supporting the Bill is to improve the
environment for angel investors[13] and venture capital firms.[14]
On 3 May 2016, Senator McKim, on behalf of the Australian
Greens, tabled amendments to the Bill.[15] These amendments provide for alternative criteria for eligibility to register
as an Early Stage Innovation Company (ESIC). The Bill provides that a company
must pass a number of tests in order to qualify as an ESIC (see proposed
section 360-40 of the ITAA 1997, at item 1 of Schedule 1).
One of these tests is the ‘principles-based’ test, under which the company must
demonstrate that it is focused on developing its innovation for
commercialisation and that it has the potential for high growth, can address a broader
than local market and has competitive advantages.[16] The amendments proposed by the Greens would ensure a company is able to meet
the ‘principles‑based’ part of the ESIC test where it is has ‘an economic, social, cultural or environmental mission that is
consistent with a public or community benefit’ and ‘reinvests the majority of
the profit it makes to fulfil that mission’.[17]
Senator McKim explained that the proposed amendment
addresses a perceived gap in the Bill:
The gap that we would seek to fill is around
social enterprises. It is important that people understand that there is a
movement developing in Australia around social enterprises—that is, a company
that has not only an economic mission but a social, cultural or environmental
mission consistent with a public or community benefit. We think that those
companies should also have the opportunity to attract further investment by the
way and the means that the bill proposes for companies that have an economic
aim.[18]
Position of
major interest groups
On 14 February 2016, the Treasury released a discussion
paper Tax incentives for early stage investors to assist in the design
of concessional tax treatment for investors through a non-refundable tax offset
and a capital gains tax (CGT) exemption on investments that meet certain
eligibility criteria.[19] At the time of writing, Treasury had not published submissions to the
discussion paper, but some organisations have made them available on their own
websites.[20] These submissions provide some guide to the views of major interest groups on
the provisions of the Bill.
The Australian Venture Capital Association, in its submission
to the discussion paper, considered, amongst other things, that the proposed
eligibility criteria for an eligible innovation company (which are the same in
the Bill as in the discussion paper[21])
‘will, in practice prove to be extremely limiting as many start-ups will fail
in at least one, if not all, of these criteria at the time of the initial
investment’.[22]
In its submission to the Treasury consultation paper,
Research Australia, which is an alliance of 160 members and supporters
advocating for health and medical research in Australia, was ‘generally
supportive’ of the investor and capital gains tax concessions.[23] Research Australia noted:
[The proposal] is an important measure to improve Australia’s
capacity to innovate, and has significant potential to increase both economic
benefits and health outcomes derived from Australia’s significant investment in
health and medical research.24]
A number of groups, including the Australian Venture
Capital Association (AVCAL) and start up financiers BlueChilli and OneVentures,
are reported as supporting urgent action on start-up incentives prior to an
election to avoid an ‘investor strike’ and a ‘chilling’ impact on the market.[25]
Financial
implications
According to the Explanatory Memorandum, the Bill has the
following financial impact on the Budget (see tables 1 and 2):[26]
Table 1: Schedule 1:
2015-16 |
2016-17 |
2017-18 |
2018-19 |
2019-20 |
Nil |
Nil |
-$65m |
-$65m |
-$65m |
Source: Explanatory
Memorandum, Tax Laws Amendment (Tax Incentive for Innovation) Bill 2016, p.
3.
Table 2: Schedule 2:
2015-16 |
2016-17 |
2017-18 |
2018-19 |
2019-20 |
Nil |
Nil |
Unquantifiable |
Unquantifiable |
Unquantifiable |
Source: Explanatory
Memorandum, Tax Laws Amendment (Tax Incentive for Innovation) Bill 2016, p.
4.
Schedule 1 also has an estimated compliance cost of $1.25
million per year. This cost has been fully offset within the Treasury portfolio.[27] Schedule 2 imposes minor transitional and ongoing operational costs on venture
capital investors and their advisers.[28]
Statement of Compatibility with Human Rights
As required under Part 3 of the Human Rights
(Parliamentary Scrutiny) Act 2011 (Cth), the Government has assessed the
Bill’s compatibility with the human rights and freedoms recognised or declared
in the international instruments listed in section 3 of that Act.
The Government considers that the Bill is compatible.[29] The Government considers that Schedule 1 of the Bill engages, but is compatible
with, the right to privacy contained in Article 17 of the International Covenant
on Civil and Political Rights (ICCPR).[30][31]
Key issues
and provisions
Schedule 1: Tax incentives for
early stage investors (TIFESI)
Schedule 1 to the Bill deals with tax incentives for early
stage investors (TIFESI). The TIFESI provisions seek to fill an important gap
between the initial (pre-concept) stage of a firm’s lifecycle, where financing
typically happens through self-funding, family and friends, and government
support and tax incentives for innovating firms (like the R&D tax offset);
and the commercialisation stage where firms have grown to a point where they
can approach venture capital firms for further, more extensive financing.
This intermediate stage, commonly known as the ‘valley of
death’, is particularly risky for firms which need to establish the
proof-of-concept and the profit-potential of their innovation. This is the
stage where most start-up companies fail because of their vulnerability to cash-flow
volatility.[32]
Investors will not be able to access the incentives until
they enter into investing arrangements with qualifying early stage innovating
firms, and this is verified by the firms themselves to the Australian Taxation
Office (ATO).
The amendments in Schedule 1 insert new Division 360 ‘Early
stage investors in innovation companies’ into the ITAA 1997.[33] New Division 360 contains one subdivision, Subdivision 360-A ‘Tax
incentives for early stage investors in innovation companies’. This new
Subdivision sets out the circumstances in which an investor would qualify for
tax offsets and exemptions from capital gains tax requirements by acquiring
shares in qualifying companies.[34] This is significant because existing tax incentives do not specifically target
investments in early stage innovating companies.
Investors who invest in qualifying early stage innovation
companies (ESIC) will be entitled to a 20 per cent non‑refundable tax
offset (proposed subsection 360-25(1)). The qualification requirements
for an ESIC are set out at proposed section 360-40 of the ITAA 1997.
However, there are restrictions on the amounts of offsets and investment
amounts that would apply.
For investors who meet the requirements of the sophisticated
investor test at section 708 of the Corporations Act
2001, there is no limit to how much they can invest in an early stage
innovating company. However, the amount of tax offset for qualifying shares would
be capped at $200,000 (proposed subsection 360-25(2)). For retail (or
non-sophisticated) investors, proposed section 360-20 limits the
amount of money invested to $50,000 in an income year. This latter provision is
to provide some protection to retail investors.
Proposed subsection 360-15(1) sets out the criteria for
entitlement to a tax offset.
Proposed subsection 360-40(1) stipulates that in order to
be a qualifying ESIC, a firm should meet certain criteria including:
1. It has been recently incorporated or registered in the
Australian Business Register (ABR) (proposed paragraph 360‑40(1)(a))
The
company:
- must have been incorporated in Australia within the last three
income years (the latest being the current income year at the test time)
- if it has not been incorporated within the last three income
years — then it must have been registered in the ABR within the last three
income years
- if it has not been registered in the ABR within the last three
income years, then:
- it must have been incorporated in Australia within the last six
income years and
- it and any wholly-owned subsidiaries must have incurred expenses
of no more than $1,000,000 in total across all of the last three income years.
2. It had total expenses of $1 million or less in the
last income year (proposed paragraph 360‑40(1)(b))
3. It had assessable income of $200,000 or less in the
last income year (proposed paragraph 360‑40(1)(c))
4. It is not listed on a stock exchange (proposed
paragraph 360‑40(1)(d))
5. It meets the ‘innovation test’ at proposed
section 360-45 or the ‘principles test’ in proposed paragraph 360‑40(1)(e).[35] (The principles test is discussed in the ‘Policy position of non-government
parties/ independents’ section of this Digest, above).
Schedule 1 also provides for exemptions from capital gains
taxes realised on shares in qualifying ESIC that have been held for between one
and ten years (proposed section 360-50).
Schedule 2
Venture capital investment
Schedule 2 to the Bill amends the early stage venture
capital limited partnership (ESVCLP) and venture capital limited partnership
(VCLP) regimes within the Venture Capital Act 2002 and the ITAA 1997 with the aim of
attracting more venture capital investment (both local and foreign) to
Australia.[36] The tax incentives proposed in this Schedule would reduce the effective costs
associated with these investments.[37] This is important because Australia’s record in venture capital investments is
quite poor compared with other advanced countries, [38] and ensuring the future growth of Australia would require the inflow of such
investments to drive innovation outcomes.
There are several important key provisions introduced in
the Schedule 2 of the Bill. Chief amongst these is the introduction of an
additional tax offset for limited partners in ESVCLP (item 2 of Schedule 2,
proposed section 61-760 of the ITAA 1997). The offset amount is
equal to up to 10 per cent of contributions made by the partner to the ESVCLP
during an income year (proposed subsection 61‑765(1) of the ITAA
1997).
Schedule 2 also relaxes restrictions on ESVCLP fund size
and investments. It amends the Venture Capital Act to increase the
maximum fund size for ESVCLPs from $100 million to $200 million (item 6 of Schedule 2, amended subparagraph 9-3(1)(d)(ii)of the Venture
Capital Act. This would increase the upper limit of the fund size within
which the ESVCLP can register and remain as an ESVCLP.
Currently an ESVCCLP must divest its investment in an
entity once the value of the entity’s assets exceeds $250 million (paragraph
9‑3(1)(i) and subsections 9-3(3) and (6) of the Venture Capital
Act). Items 15 and 16 of Schedule 2 repeal this
requirement, but restrict tax concessions for these investments.[39]
The amendments generally apply from 1 July 2016. However,
the tax offset from investments in new ESVCLPs applies to contributions made on
or after 1 July 2016 to ESVCLPs that become unconditionally registered on or
after 7 December 2015.[40]
Concluding comments
The Bill makes specific arrangements to improve the
targeting of tax benefits to investors who make genuine investment in early
stage innovating companies with the intention that these investments will
improve the innovation and commercial outcomes in Australia. This means that
minor innovations or practices that do not represent actual innovation (such as
introducing a new product in Australia that is already being sold elsewhere)
will not be eligible for tax incentives.
The Bill also allows a broad, multi-dimensional definition
of innovation to provide maximum flexibility to firms in order to suit their
particular circumstances. It is also to be expected that companies that do
attract investments would gain access to the managerial and marketing expertise
that venture capital firms typically possess. This would be invaluable in
successful commercialisation of innovation.
However, there are two main types of constraints that
could arise for innovating companies.
First, while the Bill seeks to improve
targeting/identification of the correct type of investors (that is, those who
are investing in the right type of company in order to qualify for tax
incentives) it places the onus of reporting primarily on the innovating
companies themselves; their reporting to the ATO will help the latter to
validate the tax offset claims of the investors. This can create additional
administrative burdens on the innovating firms that are otherwise constrained
in terms of overall resources.
Second, the tax incentives are aimed at investors that
would potentially be investing in innovating companies rather than the
companies themselves. There is a ‘self-selection’ element in this framework,
where investors wanting to access the benefits would need to decide whether to invest
in eligible companies. This in turn would be conditional on their assessment of
the associated costs, benefits, risks and strategic priorities. Therefore, whatever
benefits that flow to the companies themselves would do so in a highly indirect
way. The innovating firms’ outcomes would be conditional on these decisions,
and fundamentally disconnected from the intrinsic profit potential of the
innovation itself.
Moreover, it would still place the onus on the early stage
companies to attract or appeal to investors in the first place, and may divert
scarce resources from further innovation or associated product development.
In other words, while the Bill may serve to increase the
overall pool of resources available for investing, it will not serve to improve
the targeting/matching of innovating firms with investor, nor provide direct
access to funds that facilitate innovating activity.
These constraints may undermine the intended objectives of
the Bill, that is, bridging the ‘valley of death’ described above. Venture
capital firms typically invest in firms that can demonstrate a
‘proof-of-concept’ by translating an idea into a working product, and then help
to commercialise it and ‘take it to the market’. However, getting to the
product development stage can impose significant financial constraints on the
innovating early stage firms as well. This initial funding to assist firms to ‘get
off the ground but not fly’ is important in a firm’s life cycle, and it is to
be expected that the firms would use these funds to get to a point where they
could approach venture capital firms, stock markets or banks for more
substantial equity or debt-based funding.
This remains a critical gap, which the Bill does not
address. This is probably the most important point that must be borne in mind. Moreover,
the Bill seeks to incentivise risk-taking by investors, but will not
necessarily promote risk-taking by the entrepreneurs or innovative firms
themselves.
There is evidence that inadequate access to finance is the
biggest impediment to innovation for small and medium enterprises. As shown in
the recently released Securing
Australia's Future: Australia’s Comparative Advantage, a 2012 survey by the
Australian Bureau of Statistics on constraints to innovation showed that 43 per
cent of small firms and 20 per cent of medium-sized firms identified funding as
the biggest impediment to innovation; this contrasted with only 12.5 per cent
of large firms that noted funding as a constraint.[41] However, for innovation-active firms, the constraints are even more acute.
Relative to the all-firms case, 66 per cent of innovating small firms
considered financing to be the biggest impediment to innovation. The corresponding
responses for medium and large firms were 25 per cent and 16 per cent,
respectively.[42]
Despite the fact that innovation helps to improve
productivity, competitiveness and growth, this smaller segment of the market
typically finds it extremely difficult, if not impossible, to access the
traditional sources of financing (including venture capital) that are available
to relatively more established firms or those with more demonstrable products.
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