House of Representatives

Tax Laws Amendment (2007 Measures No. 2) Bill 2007

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello MP)

Chapter 8 - Venture capital

Outline of chapter

8.1 Schedule 8 to this Bill amends the venture capital regime by:

·
relaxing the eligibility requirements for concessional taxation treatment for foreign residents investing in venture capital limited partnerships (VCLPs) and Australian venture capital funds of funds (AFOFs); and
·
providing taxation concessions for Australian residents and foreign residents investing in early stage venture capital activities through a new investment vehicle called an early stage venture capital limited partnership (ESVCLP).

8.2 Amendments are made to close the pooled development fund (PDF) scheme to new applications as a result of the introduction of the ESVCLP investment vehicle.

8.3 A technical amendment is also made to the regime in relation to the conditional registration of VCLPs and AFOFs.

Context of amendments

8.4 In the 2006-07 Budget, the Government announced a package of measures aimed at increasing activity in the venture capital sector (Treasurer's Press Release No. 37 of 9 May 2006). This measure addresses key findings of the Review of Venture Capital Industry and demonstrates the Government's ongoing support for Australia's venture capital sector.

8.5 The venture capital regime was introduced in 2002 to provide an incentive for foreign investors from specified countries to invest in the Australian venture capital industry, to develop the Australian industry and to provide a source of equity capital for relatively high risk and expanding businesses which find it difficult to attract investment through normal commercial mechanisms.

8.6 The Venture Capital Act 2002 (VC Act) provides for the registration, administration and regulation of limited partnerships under the venture capital regime. Taxation concessions are provided under the Income Tax Assessment Act 1997 (ITAA 1997) and the Income Tax Assessment Act 1936 (ITAA 1936).

8.7 Eligible foreign resident partners in VCLPs or AFOFs are exempt from tax on their share of the profit or gain made on the limited partnership's disposal of an eligible venture capital investment. The limited partnership is treated as an ordinary partnership rather than as a corporate limited partnership. The concessional taxation treatment is provided by Subdivision 118-F (capital gains tax (CGT) exemption for venture capital investment) of the ITAA 1997, sections 51-54 and 51-55 (exemption for gains or profits) of the ITAA 1997 and section 94D (treatment as ordinary partnerships) of the ITAA 1936.

Summary of new law

8.8 This measure enhances the existing venture capital regime by:

·
relaxing the eligibility requirements for concessional taxation treatment for foreign residents investing in VCLPs and AFOFs by:
·
allowing eligible venture capital investments to be acquisitions of units in units trusts and convertible notes, that are equity interests, in companies and unit trusts;
·
allowing some investments (up to 20 per cent of committed capital) to be in companies and unit trusts that are not located in Australia;
·
allowing limited partners to be residents of any foreign country and general partners and VCLPs to be resident of, or established in, countries with which Australia has a double tax agreement in force;
·
allowing auditors to be appointed at the end of the financial year in which an investment is made; and
·
reducing the minimum partnership capital required for registration as a limited partnership under the VC Act to $10 million; and
·
providing taxation concessions for Australian residents and foreign residents investing in early stage venture capital activities through a new investment vehicle called an ESVCLP with the following features:

-
the committed capital of the ESVCLP cannot exceed $100 million;
-
an investment by an ESVCLP in any one entity cannot exceed 30 per cent of the ESVCLP's committed capital;
-
the size of the investee entity immediately before the investment is made by the ESVCLP must not exceed $50 million;
-
the ESVCLP must not continue to hold investments in an entity once the size of the entity exceeds $250 million;
-
the ESVCLP must have an investment plan approved by the Venture Capital Registration Board (VCR Board);
-
the ESVCLP must report to the VCR Board on the implementation of its approved investment plan; and
-
the VCR Board will publish the reports and make them publicly available.

Comparison of key features of new law and current law

New law Current law
Relaxing eligibility requirements
Allowing investments to be made through the acquisition of convertible notes, that are equity interests, and investments in unit trusts. Investments must be acquisitions of shares or options in companies.
Allowing some investments to be made in companies and unit trusts that are not located in Australia. The investee company must be an Australian resident and be located in Australia for at least 12 months after the first investment is made by the investor.
Allowing limited partners to be residents of any foreign country and general partners and VCLPs to be residents of, or established in, countries with which Australia has a double tax agreement in force. Limited partners, general partners and VCLPs must be residents of, or established in, certain specified foreign countries.
Allowing auditors to be appointed at the end of the financial year in which an investment is made. An auditor is required on an ongoing basis including at the time of making an investment.
Reducing the minimum committed capital required for registration as a limited partnership to $10 million. The minimum committed capital required for registration as a limited partnership is $20 million.
Providing taxation concessions for ESVCLPs
Establishing registration and reporting requirements for the new ESVCLP investment vehicle. No equivalent.
Treating ESVCLPs as ordinary partnerships, or 'flow-through' vehicles, for tax purposes. Limited partnerships are generally taxed as companies under Australian tax law.
Exempting all the partners of an ESVCLP from tax on their share of the income and gains derived from eligible early stage venture capital investments. No equivalent.
Closure of PDF regime
Closing the PDF regime to new applications. The scheme will continue to operate for PDFs registered at the closure date of the scheme. Eligible investment companies formed in Australia may be registered as PDFs. PDFs may make eligible investments in Australian resident companies and receive concessional taxation treatment on certain income.
Technical amendment
Ensuring that partners in conditionally registered VCLPs and AFOFs that become fully registered are entitled to the tax exemption on any income or gains derived from eligible investments made while conditionally registered. This treatment will also apply to ESVCLPs. Partners in VCLPs and AFOFs are not entitled to tax concessions in relation to investments made while the partnership was conditionally registered.

Detailed explanation of new law

Part 1 - Relaxing eligibility requirements

8.9 The venture capital regime was introduced in 2002 to provide an incentive for foreign investors from certain countries to invest in the Australian venture capital industry, to develop the Australian industry and to provide a source of equity capital for relatively high risk and expanding businesses which found it difficult to attract investment through normal commercial mechanisms.

8.10 This measure relaxes the eligibility requirements for the venture capital regime, without changing its intrinsic nature, by:

·
allowing eligible venture capital investments to be acquisitions of units in unit trusts and convertible notes, that are equity interests, in companies and unit trusts;
·
allowing some investments (up to 20 per cent of committed capital) to be in companies and unit trusts that are not located in Australia;
·
allowing limited partners to be residents of any foreign country and general partners and VCLPs to be resident of, or established in, any country with which Australia has a double tax agreement in force;
·
allowing auditors to be appointed at the end of the financial year in which an investment is made; and
·
reducing the minimum partnership capital required for registration as a limited partnership under the VC Act to $10 million.

Investments in convertible notes and unit trusts Convertible notes that are equity interests

8.11 Certain venture capital investments qualify for concessional taxation treatment under Subdivision 118-F of the ITAA 1997. Section 118-425 of the ITAA 1997 defines an 'eligible venture capital investment' to be, broadly, an investment in a company or a holding company that is at risk and has been made through the acquisition of shares or options. Amendments are made to Subdivision 118-F of the ITAA 1997 to allow eligible investments to be made through the acquisition of convertible notes, that are equity interests, and to allow investments to be made in unit trusts.

8.12 Section 118-425 of the ITAA 1997 is amended to extend the definition of 'eligible venture capital investment' in a company to include an acquisition of convertible notes, that are equity interests, issued by the company [Schedule 8, items 27 to 29 and 34, paragraph 118 - 425(1)(b) and subparagraphs 118 - 425(1)(b)(ii) and (iii) and subsection 118 - 425(9) of the ITAA 1997] . Debt interests continue to be excluded from eligible venture capital investments because they do not satisfy the requirement for the investment to be at risk (paragraph 118-425(1)(a) and section 118-430 of the ITAA 1997). Division 974 of the ITAA 1997 sets out the tests for determining whether an interest is a debt interest or an equity interest for tax purposes.

8.13 Amendments are also made to extend the definition of eligible venture capital investment to include the acquisition of convertible notes, that are equity interests, in holding companies. [Schedule 8, items 38 and 40, paragraph 118 - 425(11)(a) and subparagraphs 118 - 425(11)(c)(i) and (ia)]

8.14 As a result of allowing eligible investments to include the acquisition of convertible notes that are equity interests, consequential amendments are made to Subdivision 118-F of the ITAA 1997 to include references to convertible notes. [Schedule 8, items 15, 17, 24 to 27, 38 and 40, subsection 118 - 410(4) (heading), subsection 118 - 415(3) (heading), subsection 118 - 425(9), paragraph 118 - 425(11)(a), subparagraph 118 - 425(11)(c)(i) and subsection 118 - 425(15A)]

Unit trusts

8.15 Section 118-427 is inserted in Subdivision 118-F to allow venture capital investments to be acquisitions of units in unit trusts [Schedule 8, item 44, section 118 - 427 of the ITAA 1997] . For an investment in a unit trust to be an eligible venture capital investment, certain requirements must be met. The requirements are comparable to those applying to investments in companies but changes have been made to reflect the terminology and concepts for unit trusts. The requirements are:

·
the investment must be either an acquisition of units in the unit trust, an acquisition of options or an acquisition of convertible notes, that are equity interests, issued by or on behalf of the unit trust [Schedule 8, item 44, paragraph 118 - 427(1)(b) of the ITAA 1997] ;
·
the investment must be at risk; that is, there can be no arrangement, agreement or similar undertaking to guarantee the value of the units or any distributions or entitlements to income or capital from the unit trust [Schedule 8, items 44 to 46, paragraph 118 - 427(1)(a), paragraphs 118 - 430(a) and (b) of the ITAA 1997] ;
·
the total amount of the partnership interest in the unit trust, together with its interests in any connected entities of the unit trust, cannot exceed 30 per cent of the partnership's committed capital (as defined in subsection 995-1(1) and section 118-445 of the ITAA 1997) [Schedule 8, item 44, paragraph 118 - 427(1)(d) and subsection 118 - 427(2) of the ITAA 1997] ;
·
immediately prior to the making of the investment, the unit trust must not exceed the permitted entity value (defined in section 118-440 of the ITAA 1997) of either $250 million in the case of investments made by VCLPs or $50 million for investments made by ESVCLPs (see below for an explanation of ESVCLPs) [Schedule 8, items 44, 52 and 131 to 138, paragraph 118 - 427(1)(c), subsection 118 - 427(7), subsection 118 - 440(1) (note), subsection 118 - 440(1), subsections 118 - 440(3) and (5), paragraphs 118 - 440(5)(a) and (b), paragraphs 118 - 440(7)(a) and (c), subsections 118 - 440(8) and (9) of the ITAA 1997] ;
·
at the time the investment is made, the unit trust must not be listed on a stock exchange in Australia or a foreign country or, if it is listed, it must cease to be listed within 12 months of the investment being made [Schedule 8, item 44, paragraph 118 - 427(1)(c) and subsection 118 - 427(8) of the ITAA 1997] ;
·
at the time the investment is made:

-
the unit trust must have its location in Australia; that is, the unit trust must carry on business in Australia and either have its central management and control in Australia or have more than 50 per cent of the beneficial interests in the trust income or property held by Australian residents; and
-
if it is the entity's first investment in the unit trust, the unit trust must also have more than 50 per cent of its employees and assets located in Australia for 12 months after the investment is made, unless a shorter time is specified under section 25-5 of the VC Act,
however, if the value of the investment at the time it is made and the value of all other investments owned by the entity at that time does not exceed 20 per cent of the entity's committed capital, the unit trust is treated as satisfying this location in Australia requirements [Schedule 8, item 44, paragraph 118 - 427(1)(c), subsections 118 - 427(3) and (13) of the ITAA 1997] ;

·
the predominant activity of the unit trust cannot be:

-
property development or land ownership;
-
finance, to the extent that it is banking, providing capital to others, leasing, factoring or securitisation;
-
insurance;
-
construction and/or acquisition of infrastructure facilities; and
-
investments deriving income from interest, rents, dividends, royalties or lease payments;

[Schedule 8, item 44, paragraph 118 - 427(1)(c) and subsections 118 - 427(4) and (14) of the ITAA 1997]
·
the unit trust must have a registered auditor at the end of the income year in which the investment is made and at all times thereafter [Schedule 8, item 44, paragraph 118 - 427(1)(c) and subsection 118 - 427(6) of the ITAA 1997] ;
·
the unit trust must not invest any part of the investment in another entity unless the other entity is connected with the trustee of the unit trust and satisfies the requirements applying to the unit trust; however, deposits made with authorised deposit-taking institutions are allowed [Schedule 8, item 44, paragraph 118 - 427(1)(c) and subsection 118 - 427(5) of the ITAA 1997] ; and
·
if units are acquired in exchange for all of the units in a unit trust that satisfies the requirements of an eligible investment, the replacement units will be treated as an eligible investment even if the requirements are not met by that unit trust [Schedule 8, item 44, subsection 118 - 427(9) of the ITAA 1997] .

8.16 Section 118-427 applies to consolidated and consolidatable groups where a unit trust is able to choose or has chosen to be the head company under section 713-130 of the ITAA 1997. This provision also applies to unit trusts that are not corporate unit trusts and public trading trusts as if they were those types of trusts. [Schedule 8, item 44, subsection 118 - 427(12) of the ITAA 1997]

8.17 As a result of allowing investments to be made in unit trusts, consequential amendments are made to Subdivision 118-F of the ITAA 1997. [Schedule 8, items 1, 6, 16, 18, 26, 39, 41, 42 and 47 to 53, section 118 - 400, subsections 118 - 405(4) to (7), subsections 118 - 410(5) and (6), subsections 118 - 415(4) to (6), section 118 - 425 (heading), paragraph 118 - 435(2)(b), paragraph 118 - 425(11)(b), subparagraph 118 - 425(11)(c)(iii), paragraph 118 - 425(11)(d), paragraphs 118 - 435(1)(b) to (d), paragraphs 118 - 435(2)(c) and (d), subsection 118 - 440(1) (note) and subsection 995 - 1(1) (definition of 'eligible venture capital investment') of the ITAA 1997]

8.18 Amendments are also made to the VC Act to extend its operation to include investments made in units in unit trusts. [Schedule 8, items 56 to 84, paragraph 9 - 1(1)(e), subparagraphs 9 - 1(1)(e)(ii) and (iii), paragraph 9 - 1(1)(f), subparagraphs 9 - 5(1)(d)(ii) to (iv), paragraph 9 - 5(1)(e), paragraph 9 - 10(1)(aa), paragraph 15 - 1(ga), paragraph 15 - 1(gb), paragraphs 15 - 10(c), to (f), paragraph 21 - 5(3)(d), paragraph 21 - 5(3)(f), paragraph 21 - 20(1)(g), paragraph 21 - 20(1)(h), paragraph 21 - 20(1)(j), paragraph 21 - 20(1)(k), paragraph 21 - 20(1)(l), section 25 - 1, section 25 - 1 (note), subsections 25 - 5(1A) and (2), subsections 25 - 10(1A) and (2), subsections 25 - 15(1A) and (2) of the VC Act]

Location in Australia

8.19 The requirement that investee entities must be located within Australia for an investment to be an eligible venture capital investment is being relaxed. The current requirement in subsection 118-425(2) of the ITAA 1997 provides that at the time the investment is made:

·
the company must be an Australian resident; and
·
if it is the entity's first investment in the company, the company must also have more than 50 per cent of its employees and assets located in Australia for 12 months after the investment is made, unless a shorter time is specified under section 25-5 of the VC Act.

8.20 An amendment is made to allow no more than 20 per cent of the entity's committed capital to be made in investee entities that do not comply with this requirement. Where the sum of the value of the investment at the time it is made and the value of all other investments owned by the entity at that time does not exceed 20 per cent of the entity's committed capital, the investment may be made in an entity that does not satisfy the location in Australia requirement. [Schedule 8, items 30 and 43, subsection 118 - 425(2) and subsection 118 - 425(12A) of the ITAA 1997]

8.21 The value of an investment is the value shown in the last audited accounts of the entity or in a statement prepared in accordance with accounting standards. [Schedule 8, items 35 to 37, subsection 118 - 425(10) (heading) and subsection 118 - 425(10) of the ITAA 1997]

Residency requirements

8.22 Changes are being made to the residency requirements for limited partners, general partners and VCLPs as a result of the reforms to the CGT treatment of foreign residents. The CGT changes have removed the incidence of Australian CGT on most assets held by foreign residents. Therefore, the restriction of the venture capital concessions to certain foreign residents is being relaxed.

8.23 The restriction on the country of residence of limited partners is being removed to allow a wider range of non-residents to invest in the Australian venture capital industry. Section 118-420 of the ITAA 1997 defines an 'eligible venture capital partner' to be, broadly, a tax-exempt foreign resident, a foreign venture capital fund of funds or a taxable foreign resident whose share of the partnership's committed capital is not more than 10 per cent. Currently, tax-exempt foreign residents and foreign venture capital funds of funds must be either residents of, or established in, Canada, France, Germany, Japan, the United Kingdom or the United States of America. Taxable foreign residents must be residents of Canada, Finland, France, Germany, Italy, Japan, the Netherlands, New Zealand, Norway, Sweden, Taiwan, the United Kingdom or the United States of America. Amendments are made to section 118-420 to allow limited partners to be resident of any foreign country. [Schedule 8, items 19 to 25, paragraph 118 - 420(1)(c), paragraph 118 - 420(3)(b), paragraphs 118 - 420(4)(a) and (b), paragraphs 118 - 420(5)(b) and (c) and subsection 118 - 420(6)]

8.24 Amendments are also made to relax the residency requirements for general partners and VCLPs. Currently, VCLPs must be established in Australia, Canada, France, Germany, Japan, the United Kingdom or the United States of America and general partners must be residents of one of those countries (section 9-1 of the VC Act). These requirements are being relaxed and extended to VCLPs and general partners resident in, or established in, any country with which Australia has a double tax agreement in force. [Schedule 8, item 54, paragraph 9 - 1(1)(a) of the VC Act]

Appointment of auditors

8.25 Subsection 118-425(5) requires that an investee company must have a registered auditor at the time the investment is made. This requirement is being amended to allow the appointment of a registered auditor to be made at any time during the income year in which the investment is made. If the company does not have a registered auditor at the end of the year in which the investment is made, and at all times thereafter, the investment will not be an eligible venture capital investment and will not be eligible for concessional tax treatment under Subdivision 118-F. [Schedule 8, items 31 to 33, subsection 118 - 425(5), paragraphs 118 - 425(5)(a) and (b) and subsection 118 - 425(5) (note) of the ITAA 1997]

8.26 Consistent with this requirement, an investee unit trust must have a registered auditor appointed at the end of the income year in which the investment is made and at all times thereafter. [Schedule 8, item 44, subsection 118 - 427(6) of the ITAA 1997]

Minimum partnership capital

8.27 One of the registration requirements for a limited partnership under section 9-1 of the VC Act is that a minimum amount of partnership committed capital is required. The minimum amount of committed capital is being reduced from $20 million to $10 million to assist fund raising for investments, in particular, by small funds. [Schedule 8, item 55, paragraph 9 - 1(1)(d) of the VC Act]

Part 2 - Providing taxation concessions for early stage venture capital limited partnerships

8.28 The venture capital regime is being enhanced by the introduction of a new limited partnership investment vehicle. The new investment vehicle is an early stage limited capital partnership, or ESVCLP, and is designed to encourage investments in start-up enterprises with a view to commercialisation of the activity. The introduction of the ESVCLP will stimulate activity in the venture capital sector and enhance the development of skills and the formation of capital.

8.29 The new investment vehicle is replacing the PDF corporate structure with a more relevant and internationally recognised limited partnership structure. As a result, the PDF scheme is being closed to new applications but will continue to operate for registered PDFs.

8.30 Registration, regulation and administration of ESVCLPs is to be provided under the VC Act. The functions of the PDF Board are being extended to include the new investment vehicle. As a result, the name of the PDF Board is being changed to the VCR Board.

8.31 The structure of the ESVCLP scheme is similar to that for VCLPs, with additional requirements to ensure the integrity of the regime. ESVCLPs will be treated as flow-through vehicles for tax purposes and resident and foreign partners will be exempt from income tax on all income or gains derived from eligible investments made through the vehicle.

8.32 To ensure that investments made by ESVCLPs are targeted at early stage activities, the new regime has the following distinguishing features:

·
the committed capital of the ESVCLP cannot exceed $100 million;
·
an investment by an ESVCLP in any one entity cannot exceed 30 per cent of the ESVCLP's committed capital;
·
the size of the investee entity immediately before the investment is made by the ESVCLP must not exceed $50 million;
·
the ESVCLP must not continue to hold investments in an entity once the size of the entity exceeds $250 million;
·
the ESVCLP must have an investment plan approved by the VCR Board;
·
the ESVCLP must report to the VCR Board on the implementation of its approved investment plan; and
·
the VCR Board will publish the reports and make them publicly available.

8.33 The explanation of the new law has the following structure:

·
the concessional tax treatment for ESVCLPs:

-
eligible venture capital investments held by ESVCLPs;
-
flow-through treatment;
-
treatment of capital gains and losses;
-
income exemption;
-
treatment of losses; and
-
treatment of carried interests; and

·
the regulation of ESVCLPs:

-
registration requirements;
-
application for registration;
-
obligations while registered;
-
revocation of registration;
-
determinations by the Board; and
-
review of decisions.

Concessional tax treatment for ESVCLPs

8.34 A limited partnership is an ESVCLP if its registration as an ESVCLP is in force under Part 2 of the VC Act. [Schedule 8, items 119, 149 and 150, subsection 118 - 407(4) and subsection 995 - 1(1) (definitions of 'early stage venture capital limited' and 'ESVCLP') of the ITAA 1997] Eligible venture capital investments held by ESVCLPs

8.35 Sections 118-425 and 118-427 of the ITAA 1997 define the meaning of eligible venture capital investments in companies and unit trusts respectively. These definitions are relevant for investments made by ESVCLPs as well as VCLPs and AFOFs. There is a variation in these requirements for ESVCLPs relating to the permitted entity value of the investee entity immediately before the investment is made.

8.36 The permitted entity value of an investee entity is defined in section 118-440 of the ITAA 1997 as the sum of the value of the entity's assets and the value of the assets of any entity connected with the entity (with an adjustment to ensure that assets are not double-counted to both the entity and connected entities). ESVCLPs can only invest in entities with a permitted entity value of $50 million or less immediately before the investment is made. [Schedule 8, items 131 to 138, subsections 118 - 440(1 ), ( 3) and (5), paragraphs 118 - 440(5)(a) and (b), paragraphs 118 - 440(7)(a) and (c), subsections 118 - 440(8) and (9) of the ITAA 1997]

8.37 Section 118-428 of the ITAA contains 'additional investment requirements' that must be satisfied by ESVCLPs. The requirements relate to listing on a stock exchange of an investee entity and the purchase of pre-owned investments by ESVCLPs. A definition is inserted in subsection 995-1(1) of the ITAA 1997. [Schedule 8, item 145, subsection 995 - 1(1) (definition of 'additional investment' requirement for ESVCLPs)]

8.38 If, at the time of making an investment in an entity, the ESVCLP does not already own an investment in the entity, the entity cannot be listed on an Australian or foreign stock exchange. However, if the ESVCLP already owns an investment in the entity, the entity may be listed on an Australian or foreign stock exchange. [Schedule 8, item 130, paragraph 118 - 428(1)(a) of the ITAA 1997]

8.39 A pre-owned investment can only be acquired in an entity by an ESVCLP if:

·
either:

-
the ESVCLP already owns an investment in the entity; or
-
the ESVCLP will be making investments that are not pre-owned investments at the same time; and

·
the sum of the value of the pre-owned investment at the time of investment and the value of all other pre-owned investments that the ESVCLP owns does not exceed 20 per cent of the partnership's committed capital.

[Schedule 8, items 130 and 154, paragraphs 118 - 428(1)(b) and (c) and subsection 995 - 1(1) (definition of 'pre - owned') of the ITAA 1997]

8.40 A pre - owned investment is defined as an investment that was issued or allotted to an entity other than the ESVCLP. An investment will be a pre-owned investment if the ESVCLP acquires it on a secondary market. [Schedule 8, item 130, subsection 118 - 428(2) of the ITAA 1997]

8.41 The value of an investment is the value recorded in the audited accounts or in a statement prepared in accordance with accounting standards. [Schedule 8, item 130, subsection 118 - 428(3) of the ITAA 1997]

Flow - through tax treatment

8.42 An ESVCLP is taxed as an ordinary partnership rather than as a corporate limited partnership under Division 5A of Part III of the ITAA 1936. Division 5A taxes certain limited partnerships as companies. Section 94D of the ITAA 1936 defines a 'corporate limited partnership' and is amended to exclude ESVCLPs from the definition. This amendment ensures that ESVCLPs are taxed as flow-through vehicles under Division 5 of Part III of the ITAA 1936; that is, the partners are taxed on their share of the net income of the partnership according to their own tax status. [Schedule 8, items 89 to 94, subsection 94D(2), subsection 94D(2) (notes 1 to 3), paragraph 94D(3)(a) and subparagraph 94D(3)(a)(ia) of the ITAA 1936]

8.43 Under Division 5 of Part III of the ITAA 1936, each partner is assessable on its share of the partnership net income and is allowed a deduction for its share of a partnership loss. Unlike partners in an ordinary partnership, limited partners are only liable for the debts of the limited partnership to the extent of their investment in the partnership. Therefore, amendments are made to Division 5 to limit the amount of loss that is deductible to a limited partner of an ESVCLP to the extent of their financial exposure. This is consistent with the treatment for limited partners of VCLPs and AFOFs. [Schedule 8, item 88, paragraphs 92(2AA)(b) and 92A(1)(b) of the ITAA 1936] Capital gains and losses

8.44 Under section 118-407 of the ITAA 1997, a partner's share of a capital gain or loss from an ESVCLP that arises in relation to eligible venture capital investments is exempt from income tax if the following conditions are met:

·
the partner is a partner in a limited partnership [Schedule 8, item 119, paragraph 118 - 407(1)(a) of the ITAA 1997] ;
·
if the partner is a general partner, the general partner is either an Australian resident or a resident of a country with which Australia has a double tax agreement in force [Schedule 8, item 119, subsection 118 - 407(2) of the ITAA 1997] ;
·
the CGT event arises in relation to an eligible venture capital investment made by the partnership and the additional investment requirements have been met [Schedule 8, item 119, paragraph 118 - 407(1)(b) of the ITAA 1997] ;
·
the partnership was unconditionally registered (as defined in subsection 995-1(1) of the ITAA 1997) as an ESVCLP when the investment was made [Schedule 8, item 119, paragraph 118 - 407(1)(c) of the ITAA 1997] ; and
·
at the time of the CGT event, the ESVCLP:

-
was unconditionally registered;
-
satisfied the registration requirements of section 9-3 of the VC Act, other than the investment registration requirements but including the divestiture registration requirement; and
-
owned the investment and had owned the investment for at least 12 months [Schedule 8, item 119, paragraph 118 - 407(1)(d) of the ITAA 1997] .

8.45 When a general partner is:

·
not an Australian resident; and
·
a company or a limited partnership,

the place of residence of the general partner is where the general partner has its central management and control. [Schedule 8, item 119, subsection 118 - 407(3) of the ITAA 1997]

8.46 A partnership is treated as having met the divestiture registration requirement if, having failed to meet the requirement at the start of an income year, it meets the requirement within six months of that time (or a longer period as extended under subsection 17-3(3) of the VC Act). [Schedule 8, item 119, subsection 118 - 407(5) of the ITAA 1997]

8.47 A definition of the 'divestiture registration requirement' is included in subsection 995-1(1) of the ITAA 1997 to have the meaning given by subsection 9-3(3) of the VC Act (see paragraph 8.60). [Schedule 8, item 148, definition of 'divesture registration requirement' in subsection 995 - 1(1) of the ITAA 1997]

Income

8.48 An income tax exemption is also provided for an entity's share of any income derived from eligible venture capital investments, for example dividends and a share of a capital gain to which a unitholder is entitled, if the following conditions are met:

·
the entity is a partner in a limited partnership [Schedule 8, item 105, paragraph 51 - 52(1)(a) of the ITAA 1997] ;
·
if the entity is a general partner, the general partner is either an Australian resident or a resident of a country with which Australia has a double tax agreement in force [Schedule 8, item 105, subsection 51 - 52(3) of the ITAA 1997] ;
·
the partnership made the investment and was unconditionally registered as an ESVCLP when it made the investment [Schedule 8, item 105, paragraphs 51 - 52(1)(b) and (d) of the ITAA 1997] ;
·
the investment met the additional investment requirements [Schedule 8, item 105, paragraph 51 - 52(1)(c) of the ITAA 1997] ; and
·
the partnership was unconditionally registered as an ESVCLP and owned the investment when the income was derived [Schedule 8, item 105, paragraph 51 - 52(1)(e) and subsection 51 - 52(5) of the ITAA 1997] .

8.49 When a general partner is:

·
a foreign resident; and
·
a company or a limited partnership,

the place of residence of the general partner is where the general partner has its central management and control. [Schedule 8, item 105, subsection 51 - 52(4) of the ITAA 1997]

8.50 Section 51-54 of the ITAA 1997 provides an income tax exemption for any gains or profits arising from the disposal of eligible venture capital investments for partners in VCLPs and AFOFs. Amendments are made to extend this exemption to partners in ESVCLPs. [Schedule 8, items 106 to 109, subsection 51 - 54(1) (heading), paragraphs 51 - 54(1)(a) and (b) and subparagraph 51 - 54(2)(a)(ii) of the ITAA 1997]

Losses

8.51 A partner's share of a loss arising from the disposal of an eligible venture capital investment by a VCLP or AFOF is not deductible under section 26-68 of the ITAA 1997. Amendments are made to extend this restriction to losses made by ESVCLPs on the disposal of eligible venture capital investments. [Schedule 8, items 100 to 103, subsection 26 - 68(1) (heading), paragraphs 26 - 68(1)(a) and (b) and subparagraph 26 - 68(2)(a)(ii) of the ITAA 1997]

8.52 Subdivision 195-B of the ITAA 1997 quarantines losses incurred by a limited partnership prior to it becoming a VCLP or an AFOF. If the limited partnership ceases to be a VCLP or an AFOF, any tax loss quarantined can then be recouped. Amendments are made to extend the application of Subdivision 195-B to ESVCLPs. This means that any loss incurred by the limited partnership prior to becoming an ESVCLP cannot be utilised while it is an ESVCLP. [Schedule 8, items 139 to 144, section 195 - 60, section 195 - 65 (heading), section 195 - 65, section 195 - 70 (heading) and section 195 - 70 of the ITAA 1997]

Carried interests

8.53 A venture capital general partner's share of the gains made by a VCLP or AFOF on the sale of the eligible venture capital investments, the carried interest, is taxed as a capital gain under section 104-255 of the ITAA 1997. The general partner makes a gain at the time an entitlement to receive a payment arises (CGT event K9). Amendments are made to section 104-255 to extend the treatment to general partners of ESVCLPs. Carried interests are specifically excluded from the income exemption provided by section 51-52. [Schedule 8, items 105, 110 to 115, subsection 51 - 52(6), subsections 104 - 255(1 ), ( 4) and (5), paragraphs 104 - 255(6)(a) and (b), paragraph 116 - 30(5)(a) and subsection 118 - 21(1) of the ITAA 1997]

8.54 A consequential amendment is made to the definition of 'carried interest' in subsection 995-1(1) of the ITAA 1997 to extend its application to ESVCLPs. [Schedule 8, item 147, subsection 995 - 1(1) (paragraph (a) of the definition of 'carried interest') of the ITAA 1997]

Consequential amendments

8.55 A number of consequential amendments are made to the ITAA 1936 and the ITAA 1997 as a result of the introduction of the ESVCLP in the venture capital regime. [Schedule 8, items 86, 87 and 95, subsection 6(1), subsections 18A(1) and (2) and subparagraph 128B(3)(h)(ii) of the ITAA 1936; items 96 to 99, 104, 116, 120 to 129, 151 to 153, 155 and 156, subsection 4 - 10(2) (note 2), subsection 9 - 5(2) (note 2), section 11 - 15 (item in the table dealing with foreign investment) and section 11 - 15, section 36 - 25, section 118 - 400, subsection 118 - 410(1) (heading), paragraphs 118 - 410(1)(b) and (f), subparagraph 118 - 410(1)(f)(iv), paragraphs 118 - 410(2)(b) and (d), paragraphs 118 - 420(4)(c) and (5)(d), paragraphs 118 - 425(8)(b) and (11)(a), subsection 995 - 1(1) (after paragraph (a) of the definition of 'investment registration requirement'), subsection 995 - 1(1) (paragraph (b) of the definition of 'limited partnership'), and subsection 995 - 1(1) (definition of 'unconditionally registered') of the ITAA 1997]

The regulation of ESVCLPs

8.56 The VCR Board can register limited partnerships as ESVCLPs when the registration requirements of Division 9 of the VC Act are met. [Schedule 8, items 169 and 170, section 7 - 1 of the VC Act]

Registration requirements

8.57 The registration requirements of an ESVCLP are listed in section 9-3 of the VC Act and can be categorised as general registration requirements, investment registration requirements and the divestiture registration requirement. All requirements must be met.

8.58 The general registration requirements are contained in paragraphs 9-3(1)(a) to (d) of the VC Act:

·
the limited partnership was established under a law of Australia or a country with which Australia has a double tax agreement in force [Schedule 8, item 171, paragraph 9 - 3(1)(a) of the VC Act] ;
·
all of the general partners of the partnership are residents of either Australia or one of the countries with which Australia has a double tax agreement in force [Schedule 8, item 171, paragraph 9 - 3(1)(b) of the VC Act] ;
·
the partnership agreement provides that the partnership is to remain in existence for at least five years but not more than 15 years [Schedule 8, item 171, paragraph 9 - 3(1)(c) of the VC Act] ; and
·
the committed capital of the partnership must be at least $10 million but cannot exceed $100 million [Schedule 8, item 171, paragraph 9 - 3(1)(d) of the VC Act] .

8.59 The investment registration requirements are contained in paragraphs 9-3(1)(e) to (h), (j) and (k) [Schedule 8, item 171, subsection 9 - 3(2) of the VC Act] :

·
the committed capital of any partner, together with associates (as defined in subsection 995-1(1) of the ITAA 1997), cannot exceed 30 per cent of the total committed capital of the partnership, unless:

-
the partner is an approved deposit-taking institution;
-
a life insurance company;
-
a public authority carrying on life insurance business;
-
a widely-held complying superannuation fund; or
-
the VCR Board otherwise approves;

[Schedule 8, item 171, paragraph 9 - 3(1)(e), subsections 9 - 3(4) and (5) of the VC Act] ;
·
all of the partnership's investments are eligible venture capital investments or would have been eligible venture capital investments had the investee company or unit trust met the location in Australia and the permitted entity value requirements of the ITAA 1997 [Schedule 8, item 171, paragraph 9 - 3(1)(f) of the VC Act] ;
·
each investment complies with the partnership's approved investment plan and the partnership acts in accordance with that plan [Schedule 8, item 171, paragraphs 9 - 3(1)(g) and (h) of the VC Act] ;
·
the partnership does not carry on any activities which are not related to making eligible venture capital investments [Schedule 8, item 171, paragraph 9 - 3(1)(j) of the VC Act] ; and
·
the only debt interests held by the partnership are permitted loans [Schedule 8, item 171, paragraph 9 - 3(1)(k) of the VC Act] .

8.60 The 'divestiture registration requirement' is contained in paragraph 9-3(1)(i) of the VC Act [Schedule 8, item 171, subsection 9 - 3(3) of the VC Act] :

·
the partnership must not hold an investment if, at the end of the preceding income year, the sum of the total values of the assets of the investee entity and the assets of any connected entity of the investee exceed $250 million [Schedule 8, item 171, paragraph 9 - 3(1)(i) and subsection 9 - 3(6) of the VC Act] .

Application for registration

8.61 The requirements for making a registration application that apply to VCLPs and AFOFs are contained in Division 11 of the VC Act. These requirements are extended to apply to ESVCLPs. [Schedule 8, items 175 and 176, subsection 11 - 1(1) and paragraph 11 - 1(2)(ja) of the VC Act]

Registration

8.62 The VCR Board must register a limited partnership as an ESVCLP if:

·
the application meets the requirements of section 11-1 of the VC Act;
·
any additional information requested by the VCR Board under section 11-10 has been provided;
·
the general partner has advised that the ESVCLP has sufficient funds to commence its investment programme; and
·
the VCR Board is satisfied that:

-
the partnership's investment plan is appropriate; and
-
the partnership is able to implement the investment plan given the skills and resources to which it has access.

[Schedule 8, item 177, subsection 13 - 1(1A) of the VC Act]

8.63 The VCR Board is not required to register a limited partnership as an ESVCLP if the registration requirements have not been met or a previous registration has been revoked under Division 17 of the VC Act. [Schedule 8, item 177, paragraphs 13 - 1(1A)(g) and (h) of the VC Act]

8.64 The VCR Board must notify the general partner as to whether registration has been granted and, if not granted, the reasons for the decision. [Schedule 8, item 178, subsections 13 - 1(3) and (4) of the VC Act]

8.65 The VCR Board cannot register a limited partnership as:

·
both as a VCLP and an ESVCLP;
·
both as an ESVCLP and an AFOF;
·
both as a VCLP and an AFOF; or
·
as a VCLP, as an ESVCLP and as an AFOF.

[Schedule 8, item 179, subsection 13 - 1(5) of the VC Act]

8.66 Section 13-5 of the VC Act provides that the VCR Board may conditionally register a VCLP or an AFOF if the application requirements have not been met. Conditional registration is extended to ESVCLPs in the same circumstances. [Schedule 8, items 180, 181 and 182, subsections 13 - 5(1A) and (3) of the VC Act]

8.67 Section 13-10 of the VC Act provides when registration is in force. Consequential amendments are made to extend its application to ESVCLPs. [Schedule 8, items 181 to 183, subsections 13 - 10(1) and (2) and subsection 13 - 10(3) of the VC Act]

8.68 An approved investment plan for an ESVCLP is defined as:

·
the investment plan referred to in the notice from the VCR Board advising the general partner that registration as an ESVCLP has been approved; or
·
a replacement plan that is approved by the VCR Board.

8.69 An investment plan may be replaced if a general partner makes a request in writing to the VCR Board stating the reasons for replacement of the original plan. If the VCR Board is satisfied that the replacement plan is appropriate, it must grant the request for replacement and notify the general partner of the decision. If it is not satisfied as to the appropriateness of the replacement plan, it must refuse the request and advise the general partner of its reasons for the decision. [Schedule 8, item 184, section 13 - 15 of the VC Act]

8.70 When determining under paragraph 13-1(1A)(c) whether an investment plan, or a replacement plan, is appropriate, the VCR Board must take into account the extent to which the limited partnership and its investments focus on early stage venture capital. In making this determination, the VCR Board may consider:

·
the stages of development of the investee entities;
·
the cash flow levels of the investee entities;
·
the levels of technology of the investee entities;
·
the proportion of intellectual property to total assets of the investee entities;
·
the levels of risk and return of the investee entities;
·
the amount of tangible assets and collateral of the investee entities against which borrowings may be secured;
·
the legislative requirements for an ESVCLP to make and hold investments;
·
whether the committed capital requirements of an ESVCLP are being circumvented; and
·
any additional matters specified in guidelines issued by the VCR Board.

[Schedule 8, item 184, subsection 13 - 20(1) of the VC Act]

8.71 The VCR Board may issue guidelines, which are legislative instruments, specifying additional matters to be taken into account when deciding whether investment plans are appropriate. [Schedule 8, item 184, subsection 13 - 20(2) of the VC Act]

8.72 It should be noted that these factors are indicative only and the VCR Board is not limited to these matters when deciding the appropriateness of an investment plan. [Schedule 8, item 184, subsection 13 - 20(3) of the VC Act]

Obligations while registered

8.73 The obligations imposed on VCLPs and AFOFs by Division 15 of the VC Act in relation to quarterly and annual returns are extended to ESVCLPs. [Schedule 8, items 185 to 187, section 15 - 1, paragraph 15 - 1(fa) and section 15 - 10 of the VC Act]

8.74 An additional requirement is imposed on ESVCLPs to supply an annual report to the VCR Board within three months of the end of the financial year. The report must provide information on the implementation of the approved investment plan, including descriptions of investments made and disposed of during the financial year. The report is to be in a form or format specified by the VCR Board in guidelines issued by legislative instrument. The VCR Board will publish the reports, and may do so in its annual report to the Minister for Industry, Tourism and Resources which is tabled in Parliament. [Schedule 8, item 188, section 15 - 17 of the VC Act]

Revocation of registration

8.75 The circumstances in which the VCR Board may revoke registrations under Division 17 of the VC Act are extended to ESVCLPs. If the VCR Board is of the view that an ESVCLP does not meet the registration requirements, the general partner must be notified that registration will be revoked unless the requirements are met. [Schedule 8, items 189 to 191 and 193 to 199, paragraph 17 - 1(1)(a), subsections 17 - 1(1) and (5), paragraph 17 - 5(1)(ab), subsections 17 - 5(1) and (6), subsection 17 - 10(1), subparagraph 17 - 10(1)(e)(i), section 17 - 15 and subsections 17 - 25(1) and 25 - 5(1) of the VC Act]

8.76 In addition, registrations may be revoked for ESVCLPs when the divestiture registration requirement is not met. When an ESVCLP does not meet the divestiture registration requirement at the end of an income year and does not meet the requirement within six months of the end of the income year, the VCR Board must revoke the registration. However, a general partner may apply for an extension of time, of up to three months, in which to meet the requirement when there are circumstances justifying an extension. The VCR Board may issue guidelines by legislative instrument about the matters to be considered in granting extensions of time. [Schedule 8, item 192, section 17 - 3 of the VC Act]

Determinations by the VCR Board

8.77 Division 25 of the VC Act allows the VCR Board to make determinations in relation to investments by VCLPs and AFOFs. These provisions are to apply to ESVCLPs. [Schedule 8, items 200 and 201, subsections 25 - 10(1) and 25 - 15(1) of the VC Act]

Review of decisions

8.78 Division 29 of the VC Act provides that decisions made by the VCR Board in relation to VCLPs and AFOFs are reviewable. Amendments are made to extend these provisions to ESVCLPs. [Schedule 8, items 202 to 204, paragraphs 29 - 1(aa ), ( b) and (c) of the VC Act]

Consequential amendments

8.79 Consequential amendments are made to the VC Act to include references to ESVCLPs. [Schedule 8, items 166, 167, 168, 172, 173 and 174, section 3 - 5 (heading), paragraph 3 - 5(a), Part 2 (heading), subparagraph 9 - 5(1)(d)(i) and (ii) and paragraph 9 - 5(1)(e) of the VC Act]

Venture Capital Registration Board

8.80 As a consequence of the introduction of the new venture capital investment vehicle, the functions of the PDF Registration Board are being extended to include the registration and monitoring of ESVCLPs. [Schedule 8, items 157 to 165, subsection 4(1), paragraph 6(3)(a), paragraph 6(3)(ab), paragraph 72(1)(c), paragraph 72(1)(ca), paragraph 73(1)(c), paragraph 73(1)(ca), paragraph 74(2)(c) and paragraph 74(2)(ca) of the Pooled Development Funds Act 1992 (PDF Act)]

8.81 The expanded functions have resulted in the name of the PDF Registration Board being changed to the VCR Board. [Schedule 8, items 215, 216 and 217, subsection 4(1) (definition of 'Board'), Part 2 (heading) and section 5 of the PDF Act]

8.82 Consequential amendments are made to replace references to the PDF Registration Board in the ITAA 1997 and the VC Act with references to the VCR Board. [Schedule 8, items 206 to 214, paragraph 118 - 425(2)(b), subsection 118 - 425(2), subsection 118 - 425(3) (note 3), subsection 118 - 425(14) (heading), subsection 118 - 425(14), subsection 995 - 1(1) (definition of 'form approved' by the PDF Board), and subsection 995 - 1(1) (definition of 'PDF Board') of the ITAA 1997, items 218 to 347, subsection 1 - 15(2), section 3 - 1 (note), paragraph 3 - 5(c), section 3 - 15 (heading), section 3 - 15, section 3 - 20, section 7 - 1, paragraph 9 - 10(1)(b), subsections 9 - 10(2) and (3), subsection 11 - 1(1), paragraph 11 - 1(2)(l), subsection 11 - 5(1), section 11 - 10, subsections 11 - 15(1) to (4), subsection 113 - 1(1), paragraph 113 - 1(1)(d), subsection 13 - 1(2), paragraph 13 - 1(2)(d), subsection 13 - 1(3), subsection 13 - 1(4), subsections 13 - 5(1) and (2), section 15 - 1, paragraph 15 - 1(h), subsection 15 - 5(1), section 15 - 10, section 15 - 15 and section 15 - 20, subsections 17 - 1(1) and (2), paragraphs 17 - 1(3)(a) to (c), subsection 17 - 1(5), subsection 17 - 5(1), paragraph 17 - 5(2)(a), paragraph 17 - 5(2)(c), subsection 17 - 5(3), subsections 17 - 5(4) and (6), section 17 - 10 (heading), subsection 17 - 10(1), subsection 17 - 10(2), paragraph 17 - 10(2)(a), section 17 - 15, section 17 - 20, subsections 17 - 25(1) and (2), section 21 - 1, subsections 21 - 5(1 ), ( 2) and (4), subsections 21 - 5(4) to (6), subsections 21 - 10(1) to (4), subsection 21 - 20(1), section 21 - 25 (heading), subsections 21 - 25(1) to (3), paragraph 21 - 25(3)(a), subsections 21 - 30(1) and (2), Part 4 (heading), Division 25 (heading), section 25 - 1, section 25 - 5 (heading), subsections 25 - 5(1) to (6), section 25 - 10 (heading ), subsections 25 - 10(1) to (6), subsection 25 - 15 (heading), subsection 25 - 15(1) to (5), subsection 25 - 25(5) and (6), section 29 - 1, subsections 29 - 5(1) and (2), subsections 29 - 10(1) and (2), subsections 29 - 10(4) to (6), paragraph 29 - 10(6)(b), subsection 29 - 10(8), paragraph 29 - 10(8)(a), subsections 29 - 15(1) and subsections 33 - 1(1 ), ( 2) and (3), section 33 - 5 (heading), section 33 - 5, paragraphs 33 - 5(a ), ( c) and (d) of the VC Act.]

Closure of the PDF regime

8.83 The PDF regime is closed to new applications for registrations as a PDF from the date of Royal Assent of this Bill. [Schedule 8, items 348 and 349, subsection 4(1) at the end of the definition of 'registration applications' and subsection 11(4A) of the PDF Act]

Technical amendment

Conditional registration

8.84 Amendments are made to ensure that eligible partners in conditionally registered VCLPs and AFOFs that become fully registered are entitled to a tax exemption on the profits and gains derived from investments made while the partnership was conditionally registered.

8.85 Section 13-5 of the VC Act provides that the VCR Board may conditionally register a partnership as a VCLP or an AFOF if the partnership does not meet all the information requirements for full registration. Once full registration has been granted, the date of effect of the registration is backdated (section 13-10 of the VC Act):

·
for the purposes of the tax concessions provided under the ITAA 1997, the registration is taken to have come into force on the day on which conditional registration was granted; and
·
for the purposes of the VC Act and the ITAA 1936, registration is taken to have come into force on either:

-
the day on which the partnership was established if the partnership has only carried on activities relating to being registered as a VCLP or an AFOF; or
-
the day on which conditional registration was granted in all other cases.

[Schedule 8, item 350, section 118 - 400 (note) of the ITAA 1997; items 352 and 353, section 7 - 1 (note) and subsection 13 - 10(2) of the VC Act]

8.86 The definition of 'unconditionally registered' in subsection 995-1(1) of the ITAA 1997 is amended to reflect the amendments to subsection 13-10(2) of the VC Act. [Schedule 8, item 351, subsection 995 - 1(1) definition of 'unconditionally registered']

8.87 ESVCLPs will also be subject to this treatment. [Schedule 8, items 181 to 183, subsections 13 - 10(1) and (2), subparagraph 13 - 10(2)(a) and subsection 13 - 10(3) of the VC Act]

Application and transitional provisions

8.88 The amendments to relax eligibility requirements (described in Part 1 above) apply to assessments for the 2007-08 income year and all later years. [Schedule 8, item 85]

8.89 The amendments made to introduce an ESVCLP apply to assessments for 2007-08 income year and later years. [Schedule 8, item 205]

REGULATION IMPACT STATEMENT

Background

8.90 The introduction of an ESVCLP and enhancement of the operation of the existing VCLP regime is part of an integrated package announced in the 2006-07 Budget (Treasurer's Press Release No. 37 of 9 May 2006) that was aimed at increasing activity in the venture capital sector of the private equity market.

8.91 The venture capital market in Australia currently has approximately 15 VCLPs (which reported $1,767 million in capital commitments) and approximately 15 PDFs (which have raised more than $896 million and invested more than $750 million in 546 companies up until June 2006) that are registered under current Australian Government programmes. Investors in the venture capital market include sophisticated individuals with high risk profiles and some superannuation funds that are willing to allocate some funds to riskier investments. Businesses looking for start-up or expansion capital seek venture capital interests.

8.92 The Australian Bureau of Statistics (ABS) publication Venture Capital and Later Stage Private Equity 2005-06 (ABS Cat. No. 5678.0) states that there was a growth in funds committed to venture capital and later stage private equity investment vehicles during 2005-06 where, by 30 June 2006, investors had $10.9 billion committed to investment vehicles, a 9 per cent increase on the previous year. It should be noted that this data is an aggregate of venture capital and later stage private equity investment as the ABS does not distinguish between the two. The industry association (AVCAL) also fails to distinguish between the two and is considered to represent the interests of private equity. No meaningful data is available on ESVCLPs from the ABS.

8.93 The number of businesses that will be affected by the proposal will be the number of venture capital funds that choose to register as ESVCLPs, which is unable to be quantified. This proposal will benefit companies that are seeking to commercialise products through increasing the pool of equity capital, stimulating the venture capital sector, and increasing competition in the venture capital sector, which should lower the cost of capital for small businesses.

8.94 As part of this package, the Government is also committing $200 million for a further round of funding of the Innovation Investment Fund programme. This programme provides Government funds alongside funds from private investors to encourage the development of new companies, particularly those with a technology focus. The continuation of the Innovation Investment Fund programme will also increase the number of fund managers with experience and expertise in the venture capital sector.

8.95 This measure is the Government's response to key findings of a review of the venture capital industry to assess the impact of recent Government reforms and the contribution of the industry to the national economy. This review was conducted by an expert group made up of persons with relevant economic and investment experience and expertise. The Minister for Industry, Tourism and Resources announced the review in a Press Release dated 10 May 2005. The Government decided not to release the expert group's Report and has not made any public announcement of the recommendations made in the report.

8.96 The Australian Government introduced the venture capital regime from 1 July 2002 and amended the regime in June 2004. The current regime is jointly regulated by the Department of Industry, Tourism and Resources and the Australian Taxation Office (ATO). The current venture capital regime makes Australia a more attractive market for investment. The Government conducted the review to allow it to comprehensively assess a number of calls from industry to make Australia an even more attractive investment destination.

Policy objective

8.97 The ESVCLP regime will provide an investment vehicle targeted at ESVCLPs providing flow-through tax treatment and a complete tax exemption for income, both revenue and capital, received by its domestic and foreign partners. The regime will progressively replace the PDF programme which provides tax concessions to investors carrying on eligible activities in eligible small and medium sized entities.

8.98 The aim of providing a tax concession to investors in ESVCLPs is to encourage venture capital investment in early stage start-up and expanding businesses with high growth potential. The flow-through limited partnership structure of an ESVCLP is more effective and relevant than the corporate structure of the PDF programme and is the internationally recognised, structure for venture capital investment. The Government previously accepted that this is the preferred, internationally recognised, structure for venture capital investment when the venture capital regime was introduced in 2002.

8.99 The aim of the changes to the VCLP regime is to encourage its use by removing unnecessary regulation and reducing its complexity without changing its intrinsic nature. Relaxing these restrictions should make Australia more competitive in attracting foreign investment in venture capital by:

·
removing a range of restrictions, including allowing investment in unit trusts and convertible notes as well as shares and options;
·
relaxing the requirement that 50 per cent of assets and employees must be in Australia for 12 months after making the investment; and
·
removing restrictions on the country of residence of limited partners.

8.100 The removal of restrictions will only apply for VCLPs with no additional reporting obligations to the PDF Board, which will be renamed the VCR Board. The amendment providing for ESVCLPs will have additional reporting requirements to the VCR Board. This is greater than VCLPs as it will provide significant tax benefits over the VCLP. It is not feasible to assess whether the reduction in regulation for VCLPs will outweigh the increase in reporting for ESVCLPs as they are two different investment vehicles and are not comparable.

Implementation options

Introduction of an ESVCLP

8.101 A partner in an ESVCLP will be exempt from tax on income and capital gains made on investments in entities that satisfy eligibility requirements. A tax exemption rewards profitable activities and is an incentive to select investments likely to be profitable. An alternative approach would be to grant an immediate tax deduction for investments in eligible entities. A tax concession in the form of an immediate tax benefit can be detrimental to the policy objective of a measure as, often, investors will invest merely to obtain the front end incentives. This approach is not effective in attracting investors to asset classes such as venture capital which require patient capital [1] .

8.102 The structure of the ESVCLP regime is similar to that of the existing VCLP regime in that it will be a flow-through vehicle for tax purposes. However, unlike a VCLP, the ESVCLP regime:

·
provides tax-exempt returns on investments to both resident and foreign partners (investors). Only certain foreign partners in a VCLP are exempt from tax on investment returns;
·
restricts eligible investments to companies whose total asset value is not more than $50 million (the limit is $250 million for a VCLP); and
·
requires disposal of an investment if the total asset value of a company or unit trust in which the investment is made increases to more than $250 million (no similar requirement in the VCLP regime).

8.103 The ESVCLP regime restricts the asset value of an eligible investee entity to $50 million as the regime will progressively replace the existing PDF programme which also has a $50 million asset value.

8.104 Where a disposal of an investment is required, it must be done within six months from the start of the income year. The VCR Board will monitor and enforce this requirement and where this requirement is not met, the VCR Board will revoke the ESVCLP's registration.

8.105 The establishment of the VCLP regime in 2002 was aimed at providing an investment vehicle for Australia that was consistent with other internationally well recognised and utilised limited partnership structures. Without such a vehicle, international capital will be discouraged from investing in any level of the Australian venture capital/private equity market. The relaxation of restrictions for VCLPs will remove unnecessary regulation and red-tape and produce an outcome that is more attuned to the way the venture capital industry operates. The availability of an internationally recognised limited partnership investment that is not overly regulated is aimed at increasing Australia's competitiveness in attracting foreign investment over and above our competitors'.

8.106 This measure is aimed at increasing levels of investment in the venture capital sector, and whilst exact quantitative data is unavailable, it is estimated that this measure will attract up to 20 per cent additional foreign and domestic investment.

8.107 Unlike VCLPs, applicants for registration as an ESVCLP will be required to submit an investment plan for approval by the VCR Board as part of the application. The VCR Board will assess these plans against specified criteria to determine whether there is an appropriate emphasis on investment in early stage venture capital. These criteria are designed to distinguish investments in businesses that are starting up, or in the early stages of expansion, from other types of investment. The VCR Board can publish guidelines (as a legislative instrument) on how it will apply the criteria.

8.108 An ESVCLP will be able to submit an amendment to a plan or a completely revised investment plan for the approval of the VCR Board. The VCR Board will assess the replacement plan against the same criteria as those used for assessing all investment plans.

8.109 ESVCLPs will be required to lodge annual and quarterly reports which will contain the same information VCLPs are currently required to provide. In addition, ESVCLPs will be required to report, on an annual basis, their performance against their investment plan, including investments and divestments. This requirement will not lead to an additional compliance cost as the reporting will generally be information that a venture capital fund prepares as part of their quarterly reporting to their investors. Typically, a venture capital fund would value its investment each quarter when reporting to its investors. In the case of an ESVCLP, it would only be required to obtain valuations on its investee entities once a year, and this information can be sourced from the audited accounts of the investee entity. The VCR Board will report in its annual report on the progress of ESVCLPs in implementing their investment plans.

8.110 The ESVCLP may incur minimal additional costs in addressing the compliance cost aspect of reporting. However, as the information required for ESVCLPs is information that it would collect in the normal running of its business (the same as VCLPs), it is expected that a venture capital fund that chooses to operate as an ESVCLP would be able to meet the reporting requirements of an ESVCLP at little or no additional cost over those related to a VCLP.

Changes to the VCLP regime

8.111 The VCLP regime provides the following tax incentives:

·
a tax exemption for certain foreign investors on the profits and gains made by a VCLP on equity investments in Australian resident companies whose assets are not more than $250 million;
·
VCLPs, AFOFs and venture capital management partnerships are treated as flow-through vehicles for taxation purposes. That is, each partner is taxed on its share of income, losses and profits according to the partner's tax status; and
·
a 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) is treated as a capital gain for taxation purposes.

8.112 The VC Act contains the administrative structure and regulatory requirements for the operation of the regime. These requirements include a registration process for VCLPs and AFOFs. The PDF Board, established by the PDF Act administers these requirements. (The name of the Board is being changed to the VCR Board to reflect its other functions as, over time, PDFs will cease to exist.)

8.113 General partners of VCLPs and AFOFs are required to furnish annual and quarterly returns to the VCR Board to enable the VCR Board to monitor their compliance with investment requirements.

8.114 The operation of the VCLP regime is to be enhanced by removing or relaxing unnecessary restrictions. These changes:

·
remove restrictions on the country of residence of limited partners;
·
reduce the required minimum committed capital from $20 million to $10 million;
·
allow investment in unit trusts and convertible notes as well as shares and options;
·
allow the appointment of auditors to investee entities to occur at the end of the financial year in which the investment is made; and
·
allow up to 20 per cent of a VCLP's committed capital to be invested in companies and unit trusts that do not satisfy the residency requirements.

8.115 The changes mean that some existing partners in a VCLP or AFOF who are residents of a foreign country that did not qualify for the tax exemption will be eligible for the exemption. This is expected to increase foreign investment in the Australian venture capital market. The residency requirements of investee entities are being relaxed to allow some investment in foreign entities which will further expand investment options.

8.116 Reducing the minimum partnership capital requirement and allowing investment in investee entities that have not yet appointed an auditor will increase the range of limited partnerships and entities eligible to participate in the regime. These changes also have administrative advantages.

8.117 Expanding the type of eligible investment a VCLP can make from shares and options in companies to include convertible notes and units in unit trusts, will give fund managers a wider range of investment choices. Fund managers will be able to adopt a wider range of strategies to increase their expertise and manage a higher degree of risk should they so desire.

Assessment of impacts

Impact group identification

8.118 This measure will impact on:

·
small and medium businesses seeking capital injections to finance the future activities of relatively high risk and expanding businesses;
·
Australian resident investors - they will be tax-exempt on income and profits and capital gains made by ESVCLPs in which they are partners;
·
fund managers of ESVCLPs - they will be entitled to the carried interest tax concession which will be exempt from tax; and
·
fund managers of VCLPs - they will have more investment choices.

Introduction of an ESVCLP

8.119 Small and medium businesses seeking capital injections to finance the future activities of relatively high risk and expanding businesses should find it easier to obtain capital.

8.120 Australian resident investors should be attracted to participate as they will be tax-exempt on income and profits and capital gains made by ESVCLPs in which they are partners.

8.121 The impact on foreign investors is expected to be minimal as they are not subject to Australian tax on their capital gains.

8.122 Fund managers will be required to report to the VCR Board on implementation of investment plans, including investments and divestments. These reports will be published in the VCR Board's annual report which is publicly available.

Changes to the VCLP regime

8.123 Existing limited partners in a VCLP or AFOF who are residents of a foreign country that did not qualify for the tax exemption will be eligible for the exemption. Removing this restriction should increase foreign investment in the Australian venture capital industry.

8.124 The range of limited partnerships eligible for registration as VCLPs will be expanded as the required level of committed capital has been reduced from $20 million to $10 million. This reduction in size should attract more fund managers to the VCLP regime.

Analysis of costs / benefits

Compliance costs

8.125 The overall compliance cost impact of the proposal will result in a small increase for implementation and ongoing compliance costs. The impact is expected to mainly affect a small number of small and medium enterprise clients. The impact upon tax agents and other intermediaries was considered to be minimal. The overall compliance cost impact of the proposal will result in an approximate $25,000 impact for implementation costs and a $5,000 impact for ongoing compliance costs. This impacts upon the entire industry and, given the size of committed capital, these impacts are relatively small.

8.126 There will be compliance costs for resident taxpayers seeking to take advantage of the tax exemption on income and capital gains made by an ESVCLP. However, the tax benefits that will accrue to resident partners on their returns from investments in an ESVCLP should compensate for this increase.

8.127 A small increase in compliance costs may also arise for venture capital fund managers (general partners typically structured as limited partnerships) owing to the need to acquaint themselves with ESVCLPs and the changes to VCLPs. However, these costs should be low as the ESVCLP regime is similar to the VCLP regime in most aspects and the approved investment plan requirement is similar to that currently required for the registration of a PDF. A venture capital manager's share of the gains made by a VCLP on the sale of eligible venture capital investments is called the 'carried interest'. The carried interest is treated as a capital gain which provides a tax benefit for fund managers.

Administration costs

8.128 Overall, it is anticipated that there will be minimal administrative impact on the ATO and the Department of Industry, Tourism and Resources.

8.129 As a result of this measure, the ATO may incur some minimal initial costs in making changes to its material and educating its staff, particularly about the tax exemption for resident investors in an ESVCLP. It may also incur minimal costs in providing advice to taxpayers, including through public and private rulings.

8.130 The ATO may also incur minimal additional costs in its compliance activity to ensure that resident taxpayers and fund managers are complying with the requirements of the ESVCLP regime. However, the ATO will be able to draw on its experience with the VCLP regime.

8.131 The Department of Industry, Tourism and Resources will also incur minimal initial costs in setting up the registration process for ESVCLPs, educating its staff and providing advice to fund managers. There may be a small increase in the cost of administering the VCLP regime because smaller funds will now qualify for registration and more foreign investors will qualify for the tax exemption. As with the ATO, the Department of Industry, Tourism and Resources will be able to draw on its experiences in dealing with the VCLP regime.

Government revenue

8.132 This measure will have these revenue implications:

2007 - 08 2008 - 09 2009 - 10 2010 - 11
- -$2m -$7m -$16m

Economic benefits

8.133 The Australian venture capital market plays a significant role in providing patient equity capital to start-up and expanding businesses. These amendments will stimulate activity across the venture capital sector and address the principal finding of the Government's venture capital review that the venture capital sector in Australia is underdeveloped.

8.134 A vibrant venture capital sector is important for the effective commercialisation of Australia's research and development activity and in stimulating technical innovation. It is therefore an important component of future economic growth.

8.135 These amendments should encourage domestic and foreign investment in ESVCLPs and VCLPs with the result that finance is more readily available and cheaper for relatively high risk and expanding businesses seeking to finance their innovative activities.

8.136 The amendments are an incentive for professional fund managers in other sectors to become involved in venture capital investment and for new venture capital managers to gain experience and expertise. The changes will also allow fund managers to undertake more diverse investments and spread risk.

8.137 Investors in ESVCLPs will benefit from higher returns on investments as returns will be fully tax-exempt. The ESVCLP investment vehicle replaces the PDF which was subject to tax (at concessional rates) although investors were exempt from tax.

8.138 The changes to the VCLP regime will benefit foreign limited partners who are residents of countries that were not previously eligible for the tax exemption. These limited partners will be exempt from tax on their share of profits on eligible investments made by the VCLP.

Consultation

8.139 In conducting the review, the expert group received submissions from interested parties and met with a wide range of industry stakeholders. As noted in the background, the Government decided not to release the expert group's Report and has not made any public announcement of the recommendations made in the report. It is therefore not possible to outline the views of industry.

8.140 This measure is the Government's response to key findings of the review of the venture capital industry. This measure is supported by industry as it represents industry submissions made to the review.

8.141 Targeted confidential consultation with interested parties was undertaken on the development and drafting of the legislation. This included the PDF Board, the Australian Venture Capital and Private Equity Association and the ATO.

Conclusion and recommended option

8.142 A tax exemption on income and capital gains made on investments in start-up and expanding businesses is an effective mechanism for increasing activity in the venture capital sector. It attracts patient investors aiming at identifying businesses engaged in innovative activities which are likely to have a successful outcome.

8.143 Establishing a specific vehicle for investment in start-up and expanding businesses is an incentive for more fund managers to participate in the venture capital industry. Similarly, reducing the minimum size of a VCLP is also an opportunity for fund managers to acquire experience and expertise in the venture capital industry.

8.144 Relaxing the existing restrictions on the foreign investors in VCLPs that qualify for the tax exemption and the kinds of investments that are eligible for the concession should increase foreign investment in venture capital to the benefit of the Australian economy.

8.145 While access to the benefits of these amendments will necessarily result in some increase in compliance costs for investors seeking to take advantage of the tax incentives, these small costs will be outweighed by the tax benefits.

8.146 Treasury and the ATO will monitor this taxation measure, as part of the taxation system, on an ongoing basis.


View full documentView full documentBack to top