CHAPTER 2 - SCHEDULE OF THE BILL

CHAPTER 2 - SCHEDULE OF THE BILL

Venture Capital

2.1 Venture capital is a means by which innovative, start-up companies can acquire the necessary financial backing to commercialise new technologies. As such, the maintenance of a healthy environment for venture capital is an important element of the national innovation system. Bivell outlines the purpose and characteristics of venture capital as follows:

A venture capital investment is an equity investment in a private company. Venture capitalists invest for the medium to long term, generally between three and seven years. They look for capable, committed and honest management, and a business with a strong position in its market, competitive advantages, and good prospects for growth.

A typical venture capital investment will be in the order of $0.5 million to $20 million and is for a minority or significant minority equity position. Some firms will invest outside these parameters or form a syndicate for larger deals.

[]

Venture capitalists invest for capital gain. However, a venture capital investment can have a higher level of risk for the investor than other forms of investment, for example, because it is in a private company, may have little or no security and limited liquidity. To compensate for this higher risk, venture capitalists seek to make a higher rate of return than what is offered by more secure types of investments.[3]

2.2 Like other forms of capital, venture capital is mobile. Consequently, Australian innovators and entrepreneurs compete for investment support against those in other economies. Australia's regulatory environment, and in particular its taxation system, have a substantial impact on the profitability of venture capital investments in Australia and, therefore, on access to capital for Australian entrepreneurs.

Recent policy relating to venture capital in Australia

2.3 The need for Australian entrepreneurs to have access to venture capital has been recognised in a series of industry statements in recent years. The 1997 statement More Time for Business introduced the Innovation Investment Fund (IIF), a program under which the Government has acted as a significant venture capitalist, providing funding to innovative start-up companies.

2.4 The Investing for Growth statement, later in 1997, expanded the IIF, and identified various 'key elements of an effective innovation system' including 'an internationally competitive financial and venture capital market attuned to the needs of developing high technology firms.'[4] The Investing for Growth statement identified the following challenge for policy:

Effective commercialisation of discoveries is essential if the competitiveness of Australian firms is to improve. Commercialisation efforts are often hindered by limited access to venture capital and inadequate collaboration between research institutions and business.[5]

2.5 In February 2000, the Government convened an Innovation Summit involving government and business representatives, which identified the availability of venture capital as one impediment to Australia's innovation system. The final report of the Innovation Summit Implementation Group, Innovation: Unlocking the Future, stated:

Whilst Australia's venture capital market is immature, it has grown quickly in recent years and continues to do so. However, the amount we invest in the early stage of our venture capital market is small compared to international levels.

Investment of the early stages of the venture capital market in the United States is 100 times that in Australia. Furthermore, the number of deals is greater and the deal size is, on average, ten times larger than in Australia. Without access to early stage finance, businesses have little hope of developing an initial concept, developing prototypes or forming management teams to drive innovation forward.[6]

2.6 The July 1999 report A Tax System Redesigned (the 'Ralph Report') proposed a capital gains tax exemption for venture capital projects where the receiving entity had gross assets of less than $50 million. The report stated:

The Review accepts the argument that to stimulate venture capital funding from both domestic and non-resident sources it is necessary to make the [Capital Gains Tax] regime more competitive. The Review also accepts the argument that capital from international investors would not only have a direct effect but would be a catalyst for the development of the domestic venture capital market if the presence of experienced foreign investors spills over into enhanced local capacity for assessing and undertaking high risk assessments.[7]

2.7 The Treasurer responded to the Ralph Report recommendation by committing the government to:

promoting venture capital investments in Australia by exempting capital gains earned through Pooled Development Funds by Australian superannuation funds, and exempting from capital gains tax investments in venture capital projects in Australia by non-resident tax exempt pension funds, such as US and UK pension funds.[8]

2.8 The 2001 statement Backing Australia's Ability identified taxation as a major factor affecting the ability of Australian entrepreneurs to obtain access to venture capital. One initiative under Backing Australia's Ability was:

To ensure that recent changes to the tax system will encourage venture capital investment, the Government will actively monitor the impacts of the new business tax arrangements, in particular entity taxation, on domestic and overseas investment in Australian venture capital.[9]

2.9 The 2003/04 update on the progress of Backing Australia's Ability made the following statement:

One of the key factors limiting the successful commercialisation of research outcomes is the availability of early stage investment capital. While growing, the Australian venture capital market is relatively small, especially in the pre-seed stage and early stage, when funding is difficult to acquire.[10]

2.10 Latest available figures from the Australian Bureau of Statistics suggest that growth in the Australian Venture Capital Market has in fact slowed:

The results of the third Venture Capital survey show that growth evident in 2000-01 and 2001-02 slowed during 2002-03. As at 30 June 2003, investors had $7.5b committed to venture capital investment vehicles which were either specialised venture capital funds or corporations which directly invest their venture capital. This compares with a revised $6.9b at 30 June 2002.[11]

The Venture Capital Act 2002

2.11 The Venture Capital Act 2002 built on the Ralph Review taxation reforms. It extended capital gains tax exemptions for non-resident venture capital investors who fall into the following categories:

2.12 The Venture Capital Act 2002 also provided for the registration of three specific types of partnership, the Venture Capital Limited Partnership (VCLP), the Australian Venture Capital Fund of Funds (AFOF), and the Venture Capital Management Partnership (VCMP). These partnerships are the preferred vehicle for international venture capital investments.

2.13 Prior to the passage of the Venture Capital Act 2002, these forms of corporate limited partnership would have been taxed as though they were companies. Following this legislation, VCLPs, AFOFs and VCMPs were taxed as normal partnerships (thus providing 'flow-through' taxation, where the partner is the entity taxed, rather than the partnership). Introducing the Taxation Laws Amendment (Venture Capital) Bill 2002, which was packaged with the Venture Capital Bill 2002, the Parliamentary Secretary to the Minister for Finance and Administration stated:

The measures recognise that venture capital limited partnerships with flowthrough 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.[13]

2.14 The current bill makes a number of largely technical amendments to the Venture Capital Act 2002, the Income Tax Assessment Act 1936 and the Income Tax Assessment Act 1997.

Provisions of the current bill

Venture capital investment in holding companies

2.15 Section 118-425 of the Income Tax Assessment Act 1997 sets out the meaning of an eligible venture capital investment, for tax concession purposes. Currently, the provisions of that section prevent investments in a holding company from being regarded as eligible venture capital investments, even when the investment in the holding company is made specifically for reinvestment in an eligible venture capital investment.

2.16 Subsection 118-425 (3) (e) currently states that, in order to be an eligible venture capital investment, the investee company must not have as its primary activity:

(e) making investments, whether made directly or indirectly, that are directed to deriving income in the nature of interest, rents, dividends, royalties or lease payments.

2.17 Consequently, investment in a holding company which makes a venture capital investment (with the intention of deriving income in the form of dividends) would not be an eligible venture capital investment.

2.18 In addition, subsection 118-425(4) provides that if a company is the recipient of an eligible venture capital investment, the company may not invest in another entity unless the investee is a connected entity[14] which also meets the other requirements of the section.[15] Consequently, even if investments in a holding company were held (for the purposes of subsection 118-425(3)(e)) to be eligible, the holding company would be unable to invest in unconnected entities.

2.19 The Revenue Minister has, however, noted that 'holding companies are a popular investment structure used in the venture capital industry.'[16] The current bill seeks to amend the Income Tax Assessment Act 1997 to permit investment in holding companies, under certain circumstances, to be eligible venture capital investments.

2.20 Mr Mark Goldsmith, Legal Adviser to the Australian Venture Capital Association, stated in evidence:

It is common practice in the venture capital industry, when making an investment, to essentially set up a special purpose company to acquire the venture capital company. Predominantly that is to achieve a combination of debt and equity funding. You can't achieve the debt and equity funding, really, without putting in a special purpose company.[17]

2.21 Schedule 1, Part 1, Item 11 of the current bill addresses this issue by inserting a new subsection, 118-425(11), setting out an alternative path under which an investment may be deemed to satisfy the requirements of subsections 118-425(3) and (4). Under the proposed section, an investment in a newly created holding company will be an eligible venture capital investment if:

2.22 Essentially, the section allows investment in a holding company, so long as the money invested is used to make an eligible venture capital investment within 6 months.

2.23 If the holding company is part of an existing group, an investment into that holding company may still be an eligible venture capital investment, but only if the group as a whole meets the eligibility requirements set out in the proposed new subsection (3), which appears in Schedule 1, Part 1, Item 7 of the current bill. Essentially, this means that at least 75% of the group's activities, employees, and income must relate to a course of activities which are not exempt activities such as property development, finance, insurance, construction and investment. This requirement is given effect by proposed subsection (12), which appears in Schedule 1, Part 1, Item 11 of the current bill.

2.24 Comprehending the effect of these provisions is made slightly more complicated by the fact that the ineligible activities described in the paragraph immediately above, which are currently in subsection 118-425(3), will be moved in the current bill to become subsection 118-425(13). The scope of the ineligible activities has not changed.

Investments acquiring spin-off companies

2.25 One customary strategy for companies seeking to commercialise innovative research and development is to create a new company specifically intended to undertake that commercialisation, and to spin that company off from the parent entity, using the sale of equity in the spin-off company to generate revenue to support the commercialisation process. In its current form, the Income Tax Assessment Act 1997 allows for eligible venture capital investments which purchase spin-off companies, but only where the value of the spin-off company and its parent company do not exceed $250 million, immediately before the investment.

2.26 This means, for instance, that if a corporation worth $3 billion establishes a spin-off company to commercialise a new technology, and the spin-off company is worth $40 million, investment to acquire the spin-off company would be ineligible for concessional tax treatment. If, however, that $40 million company was spun off from a parent company worth $240 million, then investment in the spin-off company could be an eligible venture capital investment.

2.27 The current bill proposes to amend the Income Tax Assessment Act 1997 so that the value of the spin-off company, not the value of its parent company, is the basis for assessing eligibility. This will be the case so long as, after the investment, there is no connection between the parent company and the spin-off company. Schedule 1, Part 1, Item 13 of the bill proposes to insert a number of additional subsections into s. 118-440 of the Act. Proposed subsection (4) gives immediate effect to this proposal:

(4) In applying paragraphs (1)(b), (5)(b) and (7)(c), ignore the total value of the assets of an entity that, immediately after the investment is made, is not connected with the target entity.

2.28 During the Committee's hearing into this legislation, officials from the Department of the Treasury clarified that this amendment does not introduce a new policy. Rather, it corrects an oversight in the original drafting, and restores the legislation to reflect the Government's original policy intentions:

I think our view was that this change basically is consistent with what was originally intended by the original provisions.[18]

2.29 In addition, Schedule 1, Part 1, Item 13 of the current bill contains provisions to prevent abuse of the provisions outlined above. For instance, they will prevent investors from making a series of incremental investments, each less than $250 million, to acquire a group (or parts of a group) piecemeal, in order to unfairly claim concessional tax treatment.

Other measures

2.30 The bill contains a range of other amendments which the Committee considers to be relatively technical and uncontroversial in nature:

Committee view

2.31 The Committee has considered the contents of the bill in detail. While this inquiry was conducted over a very short period of time, it is nevertheless the case that the Committee received no evidence opposed to the bill. The Committee therefore considers that this bill should proceed.

Recommendation 1

The Committee recommends that the Senate pass this bill.

SENATOR GEORGE BRANDIS
Chair