House of Representatives

Explanatory Memorandum

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

Chapter 4 Venture capital managers

Outline of chapter

4.1 This chapter explains the taxation treatment of a venture capital manager's share of the gains made by a VCLP or an AFOF on the sale of eligible venture capital investments. The venture capital manager's share of these gains, known as the carried interest, is taxed as a capital gain.

Context of amendments

4.2 The expansion of the venture capital industry is a critical element in realising the innovation potential in Backing Australia's Ability . Venture capital managers inject hands-on expertise to increase significantly the success and growth of investee companies. Active management of these companies distinguishes the venture capital industry from the passive funds management industry. Treating the carried interest of venture capital managers as a capital gain is consistent with the way that interest is taxed in the United Kingdom and the United States. It should encourage leading international venture capital managers to locate in Australia and facilitate the development of the venture capital industry.

Summary of new law

4.3 An individual venture capital manager's entitlement to a payment of carried interest is a new CGT event, CGT event K9. The manager makes a capital gain at the time an entitlement to receive a payment arises. The capital gain is a discount capital gain if the carried interest arises under a partnership agreement that was entered into at least 12 months before the CGT event happened and the other requirements for the discount are met.

Detailed explanation of new law

What is the carried interest

4.4 A carried interest is a partner's entitlement to a distribution from a VCLP, an AFOF or a VCMP that is contingent on profits being attained for the limited partners of the VCLP or AFOF. A carried interest can be held by:

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a general partner of a VCLP or an AFOF; or

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a limited partner of a VCMP that is a general partner of a VCLP or AFOF.

These partners are referred to as 'venture capital managers' throughout this explanatory memorandum. [Schedule 3, items 5 and 16 of the TLA(VC) Bill; subsections 104-255(4) and (5) and subsection 995-1(1)]

4.5 The carried interest does not include any entitlement the partner may have to a management or similar fee from the VCLP, AFOF or VCMP. [Schedule 3, item 5 of the TLA(VC) Bill; paragraph 104-255(6)(a)]

4.6 A general partner may acquire an equity interest in a VCLP or AFOF by undertaking to commit capital to the partnership. The carried interest does not include any interest of the general partner that is attributable to that equity interest. [Schedule 3, item 5 of the TLA(VC) Bill; paragraph 104-255(6)(b)]

Taxation of the carried interest

4.7 When a venture capital manager becomes entitled to receive a payment of carried interest CGT event K9 happens and the manager makes a capital gain. This entitlement may be held directly, when the manager is the general partner in a VCLP or an AFOF or a limited partner in a VCMP, or indirectly, when the manager holds the interest in the VCLP, AFOF or VCMP through a trust or similar flow-through entity.

4.8 When the level of profits specified in the partnership agreement have been attained for the limited partners of a VCLP or AFOF and the venture capital managers become entitled to a payment of carried interest, the event that creates the entitlement in the sale of an eligible venture capital investment by a VCLP or an AFOF. As a VCLP or an AFOF is a partnership, any capital gains or losses made on the partnership's CGT assets are made by the partners individually and each partner's entitlement is calculated according to the relevant partnership agreement (section 106-5). The effect of the carried interest entitlements being treated as capital gains made by venture capital managers is that these amounts are not taken into account in calculating the net income of the VCLP or AFOF under section 92 of the ITAA 1936. [Schedule 3, items 4 and 5 of the TLA(VC) Bill; section 104-5 and subsection 104-255(1)]

4.9 The time at which the CGT event happens is the time the venture capital manager becomes entitled to receive the payment. Typically, the entitlement will arise at the same time as the VCLP or AFOF sells the eligible venture capital investment and allocates the proceeds according to the partner's interests in the partnership.

4.10 If a manager holds an interest as a limited partner in a VCMP through a trust, the trust would become entitled to the payment at the time the VCMP allocates the capital gain made by the VCLP or AFOF. If the individual venture capital manager is presently entitled to a share of the net income of the trust, the capital gains character of the carried interest included in a distribution flows to the manager and the time of the event is the time the trust became entitled to the payment of carried interest. [Schedule 3, item 5 of the TLA(VC) Bill; subsection 104-255(2)]

4.11 The amount of the capital gain is the amount the manager is entitled to receive or the market value of any property received in lieu of payment. A venture capital manager cannot make a capital loss on a carried interest. [Schedule 3, item 5 of the TLA(VC) Bill; subsection 104-255(3)]

4.12 The term 'payment' in relation to 'entitled to receive a payment of carried interest' includes:

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a payment that is attributable to the carried interest;

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giving property to satisfy a carried interest; or

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giving property to satisfy an entitlement that is attributable to a carried interest, such as an entitlement arising from an indirect interest in a general partner of a VCLP or AFOF or in a limited partner of a VCLP.

[Schedule 3, item 5 and 17 of the TLA(VC) Bill; subsections 104-255(7) and 995-1(1)]

Carried interest taxed as a capital gain

4.13 Where an amount is both a capital gain and income, the amount is generally taxed as income (section 118-20). However, an entitlement to receive a payment of carried interest that is CGT event K9 is taxed as a capital gain. The carried interest is not ordinary income of the venture capital manager and is statutory income only to the extent that it is a capital gain. Likewise, a deduction is not allowable to a VCLP, an AFOF or a VCMP for a carried interest payment.

4.14 To achieve this outcome the following provisions of the income tax law that could apply to treat a payment of carried interest as income, will not apply:

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the ordinary income and deduction provisions of the income tax law (sections 6-5 and 8-1 of the ITAA 1997);

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provisions relating to profit-making undertakings or plans (sections 15-15 and 25-40 of the ITAA 1997 and sections 25A and 52 of the ITAA 1936); and

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the statutory income provisions (section 6-10 of the ITAA 1997) except section 102-5 of the ITAA 1997 which includes net capital gains in assessable income.

[Schedule 3, items 2, 3 and 13 of the TLA(VC) Bill; sections 10-5, 12-5 and 118-21]

Discount capital gains

4.15 In working out whether a capital gain is a discount capital gain the cost base of the CGT asset is required to be taken into account (sections 115-5 and 115-20). A cost base cannot be taken into account in working out the capital gain made from CGT event K9 in relation to a carried interest because a carried interest does not have a cost base. The requirement to take the cost base into account does not apply when calculating the capital gain arising from a carried interest. [Schedule 3, items 6 and 7 of the TLA(VC) Bill; section 110-10 and subsection 115-20(3)]

4.16 For a capital gain to be a discount capital gain the CGT event must happen to a CGT asset that was acquired at least 12 months previously. This requirement does not apply to a carried interest entitlement that is CGT event K9. A carried interest entitlement can be a discount capital gain if the partnership agreement under which it arises was entered into at least 12 months before the CGT event. [Schedule 3, item 8 of the TLA(VC) Bill; subsection 115-25(2A)]

Capital proceeds

4.17 In working out a capital gain from a CGT event the capital proceeds are taken into account. The capital proceeds are the total of the amount received or the market value of any property received in respect of the event (section 116-20). In certain circumstances, such as if there are no capital proceeds or the proceeds cannot be valued, the person is taken to have received the market value of the CGT asset that is the subject of the event (subsection 116-30(1)). Some CGT events are expressly excluded from being subject to this rule (subsection 116-30(3)).

4.18 Special rules setting out the capital proceeds for certain CGT events are set out in section 116-20(2). The capital proceeds for CGT event K9, entitlement to receive a payment of a carried interest, is specified to be the amount of the payment to the extent that it is a payment of carried interest. [Schedule 3, items 9 and 10 of the TLA(VC) Bill; subsection 116-20(2)]

4.19 There are 5 modifications that can be made to the general rules about capital proceeds for particular CGT events (section 116-10). The CGT events for which the general rules have been modified are set out in section 116-25. Modifications 2, 3 and 4, the apportionment rule, the non-receipt rule and the repaid rule, apply to CGT event K9. [Schedule 3, item 11 of the TLA(VC) Bill; section 116-25]

4.20 The apportionment rule (section 116-40 - modification 2) will be relevant if a payment received includes an amount that is attributable to another CGT event or some other amount due. For example, a venture capital manager may receive a payment that includes the manager's share of a distribution from an equity interest the VCMP holds in the VCLP and a payment of carried interest.

4.21 The non-receipt rule (section 116-45 - modification 3) will be relevant if an entitlement to a carried interest that arose in a particular year was unlikely to be paid because of events occurring after that time. For example, a carried interest entitlement may not be paid because the VCLP became insolvent.

4.22 The repaid rule (section 116-50 - modification 4) will be relevant if a venture capital manager is required to repay an amount of carried interest paid in an earlier income year. For example, a VCLP may incur losses on its venture capital investments in later years and be required to repay carried interest entitlements that were paid on the basis of profits made in earlier years.

Ceasing to be entitled to a carried interest

4.23 If a venture capital manager ceases to be entitled to receive a payment of carried interest from a VCLP, AFOF or VCMP, CGT events A1 or C2 may apply. The market value substitution rule (modification 1) can apply to these CGT events. Broadly stated, the market value substitution rule replaces a taxpayer's actual capital proceeds, if any, with the market value of the asset that is no longer owned if:

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no capital proceeds are received; or

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the capital proceeds received in a non-arm's length transaction are either less or more than the asset's value.

4.24 If the venture capital manager does not receive any capital proceeds on ceasing to be entitled to a carried interest, the manager will not be treated as having received capital proceeds equal to the market value of the interest. [Schedule 3, item 12 of the TLA(VC) Bill; subsection 116-30(5)]

Non-resident managers

4.25 The carried interest entitlement of a venture capital manager that is a non-resident of Australia for taxation purposes is a capital gain if the capital proceeds are regarded as being derived from an Australian source. The capital proceeds will be regarded as having an Australian source if they would have had an Australian source if the receipt was ordinary income of the recipient. [Schedule 3, item 15 of the TLA(VC) Bill; subsection 136-15(3)]

Fringe benefits

4.26 An individual venture capital manager may become entitled to a carried interest in circumstances related to their employment. The carried interest payment is expressly excluded from being a 'fringe benefit' within the definition in section 136 of the FBTAA 1986 where:

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the manager becomes entitled to receive a payment of a carried interest; or

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the manager is granted or acquires a carried interest or an entitlement to a carried interest.

[Schedule 3, item 1 of the TLA(VC) Bill; paragraphs 136(1)(ma) and (mb) of the FBTAA 1936]