Explanatory Memorandum
(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)Chapter 3 - Venture capital exemption
Outline of Chapter
3.1 Schedule 3 to this Bill inserts Subdivision 118-G into the ITAA 1997 and Part 7A into the PDFA 1992. It allows certain non-resident, tax exempt pension funds exemption from tax on gains made on the disposal of their Australian venture capital investments.
3.2 The exemption is available to tax exempt foreign pension funds from specified jurisdictions on the disposal of eligible venture capital investments, owned for at least 12 months, that have an element of risk.
Context of Reform
3.3 There is a shortage of venture capital funding in Australia and the current CGT regime is an impediment to the development of this market. As Australia competes with other jurisdictions for foreign venture capital investment, it is necessary to have a competitive tax regime to attract the highly mobile capital of non-resident investors. Australia's tax treatment of capital gains on venture capital investments is seen as being relatively harsh in comparison with that of other countries competing for these investments.
3.4 A significant issue for foreign investors is that they may receive no credits, or only limited credits, for Australian tax because they are tax exempt in their country of residence or generally subject to lower rates of tax.
3.5 To stimulate venture capital funding, it is necessary to make the CGT regime more competitive by targeting CGT relief for such investments.
Summary of new law
3.6 The new law will provide venture capital entities, such as United States pension funds, with an exemption from tax on the disposal of venture capital equity in resident investment vehicles in Australia.
3.7 To qualify for the exemption the venture capital entity must:
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- not be a resident of Australia;
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- be a foreign superannuation fund;
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- be a resident of a specified jurisdiction;
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- be exempt from tax in that jurisdiction;
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- be registered under Part 7A of the PDFA 1992; and
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- make an eligible investment.
3.8 The normal residency rules apply to a venture capital entity. A venture capital entity cannot be a dual resident with Australia but can have dual residency of 2 non-Australian specified jurisdictions.
3.9 The specified jurisdictions are Canada, France, Germany, Japan, the United Kingdom and the United States of America. The list of specified jurisdictions may be added to by regulation with the date of effect stipulated in the regulation. The countries selected need to satisfy the criterion that they exempt only bona fide retirement pension funds.
3.10 An entity is exempt from tax in its country of residence if it is effectively not liable to income tax in that country.
3.11 An eligible investment must be:
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- in a resident investment vehicle;
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- by way of venture capital equity;
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- held at risk; and
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- held for at least 12 months.
3.12 A resident investment vehicle is a company or fixed trust that:
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- is an Australian resident;
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- does not have total assets exceeding $50 million at the time of the new investment (including the new investment); and
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- does not have property development or ownership in land as its primary activity.
3.13 Venture capital equity is a share in a company or unit or other fixed interest in a trust.
3.14 The venture capital entity must be registered with the PDF Board under the PDFA 1992. It must also lodge an annual return with the PDF Board.
Comparison of key features of new law and current law
3.15 There is no current law that provides venture capital entities with an exemption from tax on the disposal of venture capital equity.
Detailed explanation of new law
3.16 If a venture capital entity makes a profit or gain from the disposal of venture capital equity in a resident investment vehicle, owned for at least 12 months, that profit or gain is not taken into account for calculating taxable income. Correspondingly, a loss is also disregarded. The same treatment is given to a gain, profit or loss made by a limited partnership which is on revenue account. [ITAA 1997, sections 26-70 and 51-55, subsection 118-505(1)]
3.17 The entity must be registered under Part 7A of the PDFA 1992 at the time the venture capital equity is disposed of or a CGT event happens to the equity. [Subsection 118-505(2)]
Example 3.1
On 15 November 2000 Tokyo Municipal Workers Pension Fund (TMWPF) acquires 5 million $1 ordinary shares in Australia Innovations Pty Ltd, a resident investment vehicle. TMWPF is registered by the PDF Board as a venture capital entity.
On 20 May 2002 TMWPF sells these shares for $8 million. The $3million gain on the sale of the shares is exempt from Australian income tax, providing TMWPF is still registered as a venture capital entity.
What is a venture capital entity?
3.18 A venture capital entity is a foreign superannuation fund that is:
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- not a resident of Australia;
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- a resident of a specified eligible jurisdiction:
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- Canada;
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- France;
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- Germany;
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- Japan;
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- the United Kingdom; or
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- the United States of America; and
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- exempt from tax on its income in that jurisdiction.
[Subsections 995-1(1) and 118-515(1)]
3.19 A venture capital entity which is a partner in a partnership of venture capital entities is eligible for the exemption if the venture capital equity in a resident investment vehicle is provided through the partnership. [Paragraph 118-515(2)(a)]
Example 3.2
On 1 May 2001 the Miami City Employees Pension Fund (MCEPF) acquired 1 million $10 ordinary shares in Great Inventions Australia Ltd (GIAL), a resident investment vehicle. MCEPF is also a partner in a partnership with 5 other tax exempt United States pension funds. Through this partnership $12 million is subscribed for ordinary shares in GIAL, each partner contributing $2 million for this investment.
When MCEPF sells any of its ordinary shares in GIAL, it applies subsection 118-515(1) to determine if it is a venture capital entity. When MCEPF sells its interest in any of the ordinary shares in GIAL, it applies subsection 118-515(2) to determine whether it is a venture capital entity.
3.20 If the partnership is a 'limited partnership', the concession is available to the partners providing:
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- all the partners, other than the general partner or managing partner, are venture capital entities; and
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- the general or managing partner's interests in the partnership is less than 10% of the value of the total assets of the partnership.
[Paragraph 118-515(2)(b)]
3.21 A 'limited partnership' has the meaning given in section 94B of the ITAA 1936. [Subsection 995-1(1)]
3.22 Where the investment in a resident investment vehicle is made through a partnership, it is not necessary that all the partners be residents of the same jurisdiction. It is sufficient that the partners are residents of any of the specified eligible jurisdictions.
Example 3.3
The partners in the Bahamas Venture Capital Partnership are 3 United States tax exempt pension funds, 2 Canadian tax exempt pension funds and one Japanese tax exempt pension fund. If all 6 partners are venture capital entities in their own right, new venture capital equity, acquired through the partnership is eligible for the venture capital exemption.
If one of the partners is a New Zealand pension fund, the other 5partners would not be eligible for the exemption for the equity acquired through the partnership. New Zealand is not a listed jurisdiction. However, if the 5 non-New Zealand partners separately acquire venture capital equity in a resident investment vehicle, and register with the PDF Board, they are each eligible for the exemption for these investments.
3.23 The venture capital entity must be a non-resident throughout the period commencing just before it acquires the venture capital equity in the resident investment vehicle and ending at the time all or part of the equity is disposed of. No apportionment of the exemption is available for venture capital entities which are non-residents for a part of the period. [Paragraph 118-515(1)(a)]
3.24 The fact that a venture capital entity has a permanent establishment in Australia will not prevent it being eligible for the exemption.
Eligible non-resident countries
3.25 Eligibility for the exemption requires the venture capital entity to demonstrate that it is a resident of Canada, France, Germany, Japan, the United Kingdom or the United States of America. [Subparagraphs 118-515(1)(d)(i) to (vi)]
3.26 These jurisdictions have been chosen because they have:
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- potential to be significant sources of venture capital investment; and
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- pension funds which are exempt from tax.
3.27 Other countries which exempt only bona fide retirement pension funds may be added by regulation to the list of eligible jurisdictions. [Subparagraph 118-515(1)(d)(vii)]
3.28 The tax exempt status required of a venture capital entity means the entity's income is exempt, or is effectively exempt, from taxation in the country in which it is resident. [Paragraph 118- 515(1)(e)]
3.29 An entity is effectively exempt from taxation if:
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- a law of that country;
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- a decree, proclamation, instrument or direction (however described) issued by a competent authority in that country; or
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- an administrative arrangement in that country;
has the effect that tax is not paid on the income.
3.30 A venture capital entity must be a foreign superannuation fund throughout the period commencing just before it acquires the venture capital equity in the resident investment vehicle and ending at the time all or part of the equity is disposed of.
3.31 The entity is a foreign superannuation fund at a time if:
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- it is an indefinitely continuing fund, which is a provident, benefit, superannuation or retirement fund;
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- it is established in a foreign country;
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- it was established in that country for the benefit of individuals who are not residents of Australia or of a Territory; and
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- its central management and control is carried on outside Australia by entities which are not Australian residents or residents of a Territory.
[Subsection 118-520(1)]
3.32 A fund is not a foreign superannuation fund if an amount paid to the fund is an allowable deduction or qualifies for a tax offset. [Subsection 118-520(2)]
What is a resident investment vehicle?
3.33 A resident investment vehicle is an entity in which a venture capital entity acquires venture capital equity that is eligible for the exemption. [Subsection 995-1(1)]
3.34 The resident investment vehicle must be either a company or a trust which is resident only in Australia. [Subsection 118-510(1)]
3.35 A trust cannot be a resident investment vehicle unless the beneficiaries have 'fixed entitlements' to all of the income and capital of the trust. [Subsection 118-510(2)]
3.36 A beneficiary of a trust has a fixed entitlement to a share of the income or capital of the trust in the circumstances as set out in section 272-5 of Schedule 2F of ITAA 1936 [F15] . [Subsection 995-1(1)]
3.37 The resident investment vehicle must satisfy a $50 million value of assets test. The test is applied just before the venture capital entity acquires venture capital equity in the resident investment vehicle. The sum of following amounts must not exceed $50 million:
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- the total value of the assets of the resident investment vehicle;
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- the total value of the assets of any company or trust connected with [F16] the resident investment vehicle; and
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- the amount of the venture capital equity the venture capital entity proposes to acquire in the resident investment vehicle.
[Paragraph 118-510(1)(a)]
3.38 The total value of the assets is ascertained from the last audited accounts of the company or trust prepared for Corporations Law purposes for a period ending less than 18 months before the acquisition time. If such accounts are not prepared, a statement audited by the company's or trust's auditor and showing that value at a time not longer than 12 months before the acquisition time could be used. [Subsection 118-510(3)]
3.39 The company or trust must not have as its primary activity or main business, property development or land ownership. [Paragraph 118-510(1)(b)]
Example 3.4
Millennium Solar Ltd (MSL), a resident investment vehicle, is engaged in the development and marketing of solar power appliances. During the 2000-2001 income year MSL sold its business premises and acquired new premises, making a $50,000 gain. MSL also leased excess car parking spaces in its new premises.
These land ownership transactions are considered only incidental to MSL's primary activity or main business and would not affect MSL's status as a resident investment vehicle. Other property development and land ownership activities by MSL in previous or future years could impact on this status.
Meaning of venture capital equity
3.40 The venture capital exemption is only available to a venture capital entity that disposes of venture capital equity it acquired in a resident investment vehicle.
3.41 Venture capital equity is a share in a company or an interest in a trust issued or allotted to a venture capital entity on or after the date of Royal Assent of this Bill. [Subsection 118-525(1) and item 18]
3.42 The venture capital entity must bear the risk of owning the share or interest. The venture capital entity must have no arrangement, either before or after the share or interest is issued or allotted, as to:
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- maintaining the value of the share or interest;
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- the amount of earnings made from owning it; or
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- protection from all of the commercial loss of owning it.
[Paragraph 118-525(1)(c)]
3.43 In certain circumstances a share or interest in a resident investment vehicle will not be treated as being venture capital equity. If any of the following events happen and they are connected to the issue or allotment of a share or interest to a venture capital entity, or to some other arrangement between the entities concerned, the share or interest is not venture capital equity where:
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- a share or interest in that vehicle acquired by another entity before that issue or allotment is cancelled or redeemed;
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- there is a return of capital in that vehicle that was acquired before that issue or allotment; or
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- value is shifted out of a share or interest in that vehicle acquired before that issue or allotment.
[Subsection 118-525(2)]
Example 3.5
The Chicago Pension Fund, a venture capital entity, has owned onemillion ordinary shares in Bright Ideas Ltd, a resident investment vehicle, since 1995. These shares are ineligible for the venture capital exemption.
On 1 August 2000, Bright Ideas buys back these one million shares and issues 500,000 ordinary shares to the Chicago Pension Fund. The new ordinary shares are not venture capital equity and are ineligible for the venture capital exemption.
Pooled Development Fund Registration Board
3.44 A no0n-resident tax exempt venture capitalist seeking to benefit from the venture capital exemption must be registered as a venture capital entity with the PDF Board. [ITAA 1997, subsection 118-505(2)]
3.45 The current PDFA 1992 does not cover the registration and administration of venture capital entities.
3.46 The PDFA 1992 is being amended to authorise the PDF Board to register venture capital entities, receive annual returns by these entities and, in limited situations, revoke the registration.
3.47 An entity seeking venture capital tax concessions must apply for registration with the PDF Board [PDFA 1992, subsection 52A(1)] . The entity must apply for registration within 30 days after the venture capital entity makes its first investment in venture capital equity [subsection 52A(2)] .
3.48 An entity need only register once, that being at the time it acquires or proposes to acquire its first venture capital equity in a resident investment vehicle. The focus of the registration is the venture capital entity itself, rather than resident investment vehicle. If the investment is made through a partnership, each venture capital entity that is a member of the partnership, must be registered.
3.49 The application must contain the following information:
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- the country in which the entity is a resident;
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- details of the entity's tax exempt status in that country;
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- details of the entity's status as a foreign superannuation fund;
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- the address of the entity's registered office;
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- the name and address of the resident investment vehicle in which the entity has acquired or proposes to acquire venture capital equity and the industry in which the resident investment vehicle operates;
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- the amount of the venture capital equity acquired or proposed to be acquired in the resident investment vehicle and the date on which it was or will be acquired;
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- the total value of the assets of the resident investment vehicle, immediately before the venture capital equity was or will be acquired;
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- details of investments, other than venture capital equity, that the entity holds in the resident investment vehicle; and
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- if the entity is a general partner or managing partner of a limited partnership referred to in subparagraph 118-515(2)(b)(ii) of the ITAA 1997, details of the partner's interests in the assets of that partnership.
[Subsection 52A(3)]
3.50 The PDF Board may require the applicant to provide additional information and documents in support of the information provided in the application. If the PDF Board is satisfied that the applicant has provided the required information it must register the applicant as a venture capital entity [subsection 52A(4)] . The PDF Board must notify the applicant of its registration within 45 days of the application being lodged [subsection 52A(5)] . The PDF Board must decide an application for registration within 45 days after receiving it. The PDF Board has the authority to extend the period in which it decides the application [section 52B] .
3.51 A registered venture capital entity must lodge an annual return with the PDF Board. This return must be lodged within 3 months of the end of the financial year (30 June).
3.52 The annual return must contain the following information:
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- the country in which the entity is a resident;
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- details of the entity's tax exempt status in that country;
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- details of the entity's status as a foreign superannuation fund;
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- details of:
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- venture capital equity in resident investment vehicles acquired by the entity during the year;
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- venture capital equity in resident investment vehicles disposed of by the entity during that year; and
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- venture capital equity in resident investment vehicles held by the entity at the end of that year;
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- the industries in which those resident investment vehicles operate; and
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- if the entity is a general partner or managing partner of a limited partnership referred to in subparagraph 118-515(2)(b)(ii) of the ITAA 1997, details of the partner's interests in the total assets of that partnership.
[Section 52C]
3.53 The PDF Board has the power to revoke the registration of an eligible venture capital entity if it fails to lodge an annual return or lodges an incomplete annual return. [Subsection 52D(1)]
3.54 If the PDF Board intends to revoke an entity's registration it must advise the entity of this intention in order to give the entity the opportunity to address the grounds on which the PDF Board's intention is based. The PDF Board must consider any submission made by the entity before proceeding to revoke its registration. [Subsections 52D(2) and (3)]
Application and transitional provisions
3.55 The amendments to Divisions 26 and 51 and Subdivision 118-G of the ITAA 1997 and the PDFA 1992 apply to the issue or allotment of venture capital equity in a resident investment vehicle on or after the day this Bill receives Royal Assent. [Item 18]
Consequential amendments
3.56 An amendment is made to section 11-15 to ITAA 1997 to include a gain or profit from the realisation of venture capital gains in the list of ordinary and statutory income which is exempt only if it is deemed by certain entities. [Item 1]
3.57 Amendments are made to the PDFA 1992 to facilitate the administration of venture capital entities. The PDF Board's decision to refuse to register or revoke the registration of a venture capital entity is added to the definition of reviewable decision [item 5] . Amendments to subsection 4(1) apply to include definitions of 'venture capital equity', 'resident investment vehicle' and 'venture capital entity' [items 6 to 8)] . The PDF Board's responsibility for registering venture capital entities is added to the list of the PDF Board's functions [item 9] .
3.58 The PDF Board is also authorised to seek additional information and documents for the purposes of applying the PDFA 1992 [item 10] . Venture capital entities will be liable to penalties for providing false or misleading information or documents in connection with either an application for registration or an annual return [items 11 and 12] . The PDF Board is provided with powers to delegate certain functions and powers [items 14 to16] . The PDF Board is required to include information relating to venture capital entities in its annual report to the Minister [item 17] .