The Australian Parliament passed 2 major pieces of legislation in mid December dealing with the exemption of capital gains tax ("CGT") in the case of disposal of non-resident venture capital equity investments in Australia. The laws were:
- Venture Capital Act 2002; and
- Taxation Laws Amendment (Venture Capital) Act 2002
The former Act includes rules relating to registration of certain non-resident venture capital entities in order to access CGT exemption and the latter amends the Income Tax Assessment Act 1997 by the introduction of a new subdivision 118F titled " Venture Capital Investment" containing the provisions relating to CGT exemption.
According to the existing subdivision 118G, the capital gains and losses of superannuation funds resident in Canada, France, Germany, Japan, the united Kingdom and the United States are disregarded for Australian tax purposes . This subdivision applies only to superannuation funds and only if their income is exempt from taxation in the country of their residence.
In contrast, the new subdivision 118 F is broader and exempts CGT liability of nonresident partners of specified partnerships and also introduces registration and compliance obligations.
Taxation of non-residents and CGT in Australia
In normal circumstances, non-residents will be liable for CGT if there is capital gain when an asset acquired after 20 September 1985 having the "necessary connection with Australia", is disposed.
In general, investments made in Australia would have the "necessary connection with Australia" and therefore would trigger CGT liability.
Only a few of Australia’s double tax agreements deal with CGT, which applies only with respect to assets acquired after 20 September 1985.
Venture capital partnerships
The new subdivision refers to 3 partnerships in the scheme of CGT exemption:
1. Venture Capital Limited Partnership ("VCLP")
Part 2 of the Venture Capital Act 2002 provides for the registration of VCLP’s. The main requirement is that the limited partnership must be established in Australia, Canada, France, Germany, Japan, the United Kingdom or the United States of America and all the general partners of it must be resident in any of the above countries.
The partnership is required to exist for not less than 5 years and not more than 15 years.
All investments of the partnership must be eligible venture capital investments and the total committed capital should be at least $ 20 Million..
2. Australian venture capital fund of funds ("AFOF")
The partnership must be established in Australia and have only Australian residents as general partners. There are no minimum capital requirements as in VCLP’s. However, the partnership is required to exist for not less than 5 years and not more than 20 years.
Eligible investments by AFOF’s can either be an investment in a VCLP, in a company in which a VCLP, of which the AFOF is a partner owns one or more eligible venture capital investments.
Both VCLP’s and AFOF’s cannot lend unless the loans are permitted loans.
As in the case of VCLP's, registration is under Part 2 of the Venture capital Act 2002.
3. Venture Capital Management Partnership (VCMP")
This limited partnership is itself a general partner of VCLP's or can only engage in activities that are reserved for general partners in limited partnerships ( management of the partnership).
Although VCLP’s, AFOF’s and VCMP’s are all limited partnerships they will be taxed as ordinary partnership with flow through tax treatment for the partners. In normal circumstances limited partnerships are taxed as companies.
The exemption from CGT applies to the following partners of VCLP’s and AFOF’s on disposal of eligible venture capital equity investments:
- Residents of Canada, France, Germany, Japan, the United Kingdom and the United States exempt from Australian tax;
- Residents of Canada, Finland, France, Germany, Italy, Japan, the Netherlands( excluding the Netherlands Antilles), New Zealand, Norway, Sweden, Taiwan, the United Kingdom and the United States taxable in Australia , holding less than 10% of the committed capital of a VCLP or AFOF;
- Venture Capital funds of funds established and managed in Canada, France, Germany, Japan, the United Kingdom and the United States. The fund must not hold more than 30% of the committed capital of a VCLP or AFOF.
In addition, eligible venture capital investors (not being partners in VCLP’s or AFOF’s) can also access the CGT exemption. They are the residents of Canada, France, Germany, Japan, the United Kingdom and the United States exempt from Australian tax , directly investing in eligible venture capital investments and registered according to Part 3 of the Venture Capital Act 2002
Among other obligations, the registered entities will be required to provide information to the Pooled Development Fund ("PDF") Board and in annual returns indicating the amount invested and distributions made.
Committed capital of a partner in a partnership is the sum of the amounts that the partner may, under the partnership agreement, become obliged to contribute to the partnership. It is irrelevant whether the partner has in fact contributed the amount, the amounts contributed are subsequently returned to the partner or the contribution gave rise to equity or debt interests in the partnership.
Eligibility of venture capital investments will be decided by the PDF board under the Venture Capital Act 2002.
Eligible Venture capital investment
Investments can only be in companies and must be at risk.
"At risk’ investments are limited to acquisition of shares or options to acquire shares in Australian resident companies
An investment is "at risk" if the entity that owns the investment has no arrangement as to the maintenance of the value of the shares or any earnings or other return that might be made from the shares.
The primary activity of the investee company must not be property development or land ownership, finance (to the extent it is banking, providing capital to others, leasing, factoring and securitisation), insurance, certain construction activities and making investment to derive interest, rent, dividends, royalties or lease payments.
Activities of the investee company that are ancillary or incidental to any activity will be taken as forming a part of that activity.
More than 50% of the people engaged by the investee company must perform their services primarily in Australia and more than 50% of the assets of the company must be situated in Australia.
The permitted entity value of the company cannot exceed $ 250 Million immediately before the investment is made. The permitted entity value is the sum of the total value of the company’s assets and the value of the assets of other entities connected with the company (like group companies).
Venture Capital Managers
Venture capital managers are general partners of VCLP’s and AFOF's or limited partners of VCMP’s that are general partners of VCLP’s and AFOF’s. Eligible investments are held by VCLP's or AFOF's. The managers are entitled to a "carried interest" in the proceeds from the sale of the investments of VCLP's or AFOF's. Carried interest is not the entitlement to receive management or similar fees from the partnerships. It is not attributable to the equity interest in the partnerships. Therefore the partnership profits accruing to the manager because of it being a partner does not form part of the carried interest.
Carried interest arises when an eligible investment is disposed and proceeds are recovered in excess of the amounts payable to the partners. The excess is payable to the venture capital manager. This payment will amount to an incentive to the manager for successfully managing the investments of the partnership.
The amendments treat the carried interest of the manager as capital gains and not as income. Further, the payment to the manager will not be considered as income of the partnership, thus lessening the taxable income of the partnership for Australian income tax purposes.
Carried interest arises when the manager becomes entitled to it (probably under the partnership agreement) and not when it is actually paid to the manager.
There are 3 specific adjustments under the Act that are applicable to the capital gains arising as carried interest.
- The apportionment rule -If the payment received includes an amount that is attributable to another CGT event or some other amount due, then the capital proceeds can be adjusted (manager’s share of the profits attributable to its equity interest in the partnership)
- The non-receipt Rule- This will be applicable if the entitlement is unlikely to be paid due to events happening after the entitlement arose (insolvency of the partnership)
- The repaid Rule-This rule will be available if the manager is required to repay the carried interest (carried interest paid on the basis of profit made but subsequently the partnership makes losses)
This is only a brief account on venture capital incentives. Any prospective investor is best advised to undertake a very close examination of the relevant provisions before making any decision .
The Government has promised to add further names of countries to those already listed, residents of which will be entitled to claim the CGT exemption.
The hopes of the government in attracting foreign venture capital to Australia are reflected in the words of the Minister for Revenue and Assistant Treasurer referring to the changes:
"The measures will unlock the potential for more rapid growth of Australia’s venture capital market, particularly through the increased support of tax-exempt foreign investors and thereby promote expansion of the venture capital industry."
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.