Australia: Venture Capital and Non-Portfolio Dividends: More Changes

A. Venture Capital

Taxation Laws Amendment (2004 Measures No.3) Act No.105 of 2004 has made amendments to the changes made in 2002 to taxation of venture capital investments in Australia. (Please click on 'Next Page' link at the bottom of this page to view an earlier article on this subject.)

The 2002 amendments resulted in certain venture capital limited partnerships being treated as partnerships and not companies for Australian income tax purposes. In general Limited partnerships are taxed as companies, which means the limited partnership will be taxed at the entity level in Australia before the profits are distributed to the non-resident partners.

The changes in 2002 introduced the above tax treatment to 3 types of limited partnerships: Venture capital limited partnership ("VCLP"), Australian Venture capital fund of funds ("AFOF") and Venture capital management partnership ("VCMP").

The following changes were introduced in 2002:

• The 3 types of partnerships were taxed on "flow through". The partners would be liable and not the partnership itself. In normal circumstances, limited partnerships would be taxed as companies, making limited partnerships liable to tax before distribution to the partners;
• Specified non-resident limited partners in VCLPs and AFOFs were exempt from Australian income tax on the profits or gains on "eligible venture capital investments";
• The "carried interest" of a general partner of a VCLP, AFOF or VCMP will be taxed as capital gains;
• Specified non-resident investors were also entitled to the above concessions, in respect of eligible venture capital investments.

Capital gains tax relief was made available also to non-resident eligible venture capital investors resident in Canada, France, Germany, Japan, the United Kingdom and the United States, who are exempt from tax in their country of residence.

Eligible venture capital investments were defined when the 2002 changes were made.

If the investee company’s primary activity was any of the following, the investment in it would not be eligible:

• Property development or land ownership;
• Finance ( to the extent it is banking, providing capital to others, leasing, factoring and securitisation);
• Insurance;
• Certain construction activities;
• Making investment to derive interest, rent, dividends, royalties or lease payments.

The above restrictions applicable to the investee company meant that investment in the holding company of the venture capital entity cannot be an eligible investment.

The current amendments relaxed the rules relating to investments into holding companies thus allowing those investments to be treated as eligible investments, provided certain conditions are satisfied.

In order to qualify for the eligible investment status the investee company must satisfy at least 2 of the following requirements:

1. more than 75% of the company’s assets (determined by value) must be used primarily in activities that are not ineligible activities;
2. more than 75% of the company’s employees must be engaged primarily in activities that are not ineligible activities;
3. more than 75% of the company’s total assessable income, exempt income and non-assessable non-exempt income must come from activities that are not ineligible activities

Different rules apply depending on whether the holding company is a new or an existing company. The primary activity prohibition have been repealed.

The consolidation regime in Australia adopts the single entity approach, according to which the head company of the group is considered as carrying on the several businesses of the members in the group.

The single entity approach to consolidated groups and the new predominant activity test outlined above will allow investments in head company of an existing group to qualify as eligible investments in most cases.

If the investment is made in a holding company that is formed for the purpose of making eligible investments, the following requirements must be satisfied by the new holding company.

(1) Within 6 months of the investment being made in it, the holding company must use the money:

• To acquire shares or options in the other company, including meeting any incidental costs of making that investment, such as legal and stamp duties and company registration costs;
• To pay administrative expenses associated with the investment in the other company, for example costs relating to engaging employees; or
• To provide loans to the other company; and

(2) The company in which the new holding company invests meets the requirements to be an eligible venture capital investment within those 6 months and at the end of the period. (Paragraph 1.14 of the Explanatory Memorandum)

A new section has been added dealing with investing in a non-resident company that wholly owns another company which satisfies the requirements to be an eligible venture capital investment. In this case the non-resident company will also be considered as an eligible venture capital investment. The non-resident company must be a resident of Canada, France, Germany, Japan, the United Kingdom, the United States of America or any other foreign country prescribed by the Regulations.

Under the 2002 changes, if a non-resident limited partner in VCLP or AFOF was considered as having a permanent establishment in Australia then interest derived from VCLP or AFOF were taxable in Australia at the marginal rate of tax applicable to the non-resident person. The amendments make the interest income subject to withholding tax only. The withholding tax will be subject to any limitation in the relevant double tax agreement.

In recent times, Australia has been rolling out significant amendments in international taxation.

The New International Tax Arrangements (Participation Exemption and Other Measures) Act 2004 amends the Income Tax Assessment Act 1936 to make non-portfolio dividends not liable to tax in Australia. The Act came into force in late June 2004.

The following conditions must be satisfied for any dividend to be a non-portfolio dividend:

1. the company receiving the dividend must have at least 10 percent voting interest in the distributing company;
2. the receiving company must be the beneficial owner of the shares in respect of which the dividend is paid;
3. the shareholder must hold the required voting interest at the time the dividend is paid;
4. there should not be any arrangement under which the voting rights of the shareholder could be affected.

The exemption extends even to controlled foreign companies deriving non-portfolio dividends, thus excluding non portfolio dividends from the income that is attributed to resident shareholders in such foreign companies and therefore reducing the amount of attribution of income to Australian shareholders of CFCs.

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.