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:
-
all tax exempt non-residents from Canada,
France, Germany, Japan, the United Kingdom or the United States of America;
-
non-resident venture capital funds of funds
established and managed in Canada, France, Germany, Japan, the United Kingdom
or the United States of America; and
-
taxable non-residents, which are resident in
Canada, Finland, France, Germany, Italy, Japan, the Netherlands, New Zealand,
Norway, Sweden, Taiwan, the United Kingdom or the United States of America,
holding less than 10% of the equity in a venture capital limited partnership.[12]
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:
-
the investor is a VCLP, an AFOF or an eligible
venture capital investor registered under the Venture Capital Act 2002;
-
the holding company was formed specifically as a
vehicle for reinvestment; and
-
within 6 months, the holding company uses the
money from the eligible investment to make an eligible venture capital
investment in another company, which meets the requirements of subsections
118-425(2) through 118-425(7).
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:
-
a range of definitional changes about what forms
of relationship will result in two entities being considered 'connected
entities' for the purpose of the bill;
-
changes to the date at which the eligibility
test is applied, where shares are acquired on the conversion of convertible
notes;
-
the notional place of residence of a venture
capital management partnership will now be the place of its central management
and control;
-
interest derived by non-resident partners in
VCLPs or AFOFs will be subject to withholding tax, not tax at marginal rates on
net income;
-
investee companies which move offshore will be
able to have as their auditor a person appropriately registered in their
country of residence; and
-
the Tax Commissioner will be able to disclose
information to the Pooled Development Fund Board in order to assist the board
to administer venture capital laws.
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