Explanatory Memorandum
(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)Chapter 7 - Regulation impact statement
Background
7.1 Economic growth and job creation increasingly depend on successful innovation, meaning that the results of research and development must be effectively translated into commercial outcomes. Access to finance is a key factor in this process of innovation. While Australia is noted for its strong research capabilities, it has been less successful in attracting the necessary venture capital to commercialise this research.
7.2 Various submissions made to the Review of Business Taxation highlighted this market failure, indicating that there was a shortage of venture capital funding in Australia because the CGT regime that existed at the time acted as an impediment to the development of this market. The Review of Business Taxation accepted the argument that in order to stimulate venture capital funding from both domestic and non-resident sources it is necessary to make the CGT regime more competitive.
7.3 Many foreign tax-exempt entities, such as United States pension funds, the most dominant source of venture capital investment globally, would not invest in Australia as they are liable for tax on these investments, whereas they face no tax in their home jurisdiction or many other countries.
7.4 Compared with other countries, Australia's venture capital market is still relatively under-developed, especially for early stage investment. In terms of venture capital investment as a percentage of GDP, Australia ranked 13th out of 20 leading countries in 1999 accounting for 0.16% GDP [F1] . The Australian Bureau of Statistics conducted a survey of the activity in the Australian venture capital industry in 2000-2001. Investors had committed $5.7 billion at the end of the year, in 806 investee companies.
7.5 In order to promote the development of the Australian venture capital market to overcome the perceived shortage of venture capital funding, the Review of Business Taxation recommended a targeted CGT concession to promote foreign investment in the Australian venture capital market. To achieve this objective the Review of Business Taxation recommended an explicit income tax exemption on gains from the disposal of eligible venture capital investments for tax exempt pension funds from certain jurisdictions (or limited partnerships of such pension funds). The Review of Business Taxation noted that there would not only be a direct effect on non-resident investment in the domestic venture capital market but also an indirect effect if the presence of more experienced venture capital investors spills over into an enhanced local capacity for assessing and undertaking high risk investments.
7.6 The Government accepted the recommendations of the Review of Business Taxation and in September 1999 introduced a CGT concession targeted to non-resident investment in venture capital. This measure has had limited success with only $10.7 million of investment being made under the concession.
Policy objective
7.7 On 15 October 2001, the Government announced that it would extend venture capital tax concessions to all tax-exempt non-residents from Canada, France, Germany, Japan, the United Kingdom and the United States. By extending venture capital tax concessions, the Government aims to:
- •
- facilitate the development of the venture capital industry by increasing the level of investment; and
- •
- support patient equity capital investments in start-up and expanding businesses which would otherwise have difficulty in attracting investment.
7.8 These objectives will be achieved by:
- •
- providing flow through taxation treatment to limited partnerships that are VCLPs, AFOFs and VCMPs;
- •
- allowing an income tax exemption for profits and gains arising from the disposal or realisation of investments in eligible venture capital businesses to:
- -
- tax-exempt entities that are residents of Canada, France, Germany, Japan, the United Kingdom and the United States, whether the investment is made directly, or as limited partner in a VCLP or an AFOF;
- -
- non-resident venture capital fund of funds with flow through taxation status established and managed in Canada, France, Germany, Japan, the United Kingdom and the United States, provided the fund is a limited partner in a VCLP or an AFOF; and
- -
- taxable residents of Canada, France, Germany, Japan, the United Kingdom, the United States, Finland, Italy, the Netherlands (excluding the Netherlands Antilles), New Zealand, Norway, Sweden or Taiwan who are limited partners in a VCLP or an AFOF and hold less than 10% of the committed capital of the partnership; and
- •
- taxing the 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) as capital gains.
Implementation options
7.9 This measure could be administered by either the ATO or jointly by the ATO, the DITR and AusIndustry (PDF Board). The disadvantage of the ATO solely implementing the measure is the lack of expert knowledge about the venture capital industry. The ATO does not have the expertise to market and promote the measure. The preferred option is for joint implementation by the 2 organisations, whereby the roles undertaken by each agency are commensurate with their legislative responsibilities.
7.10 The PDF Board will administer the registration of VCLPs and AFOFs. VCMPs will not be registered. The general partner of a limited partnership seeking registration as a VCLP or an AFOF will be required to provide certain information when registering; however, it will not be necessary for the PDF Board to check the veracity of the information. The PDF Board will be responsible for providing advice to VCLPs and AFOFs to assist in their registration. Following registration, the general partner will be required to furnish quarterly and annual returns to the PDF Board. Depending upon the happening of certain events, the PDF Board may require a general partner to provide other information.
7.11 If a VCLP or an AFOF breaches a registration requirement or fails to lodge annual or quarterly returns or provide other required information, the PDF Board may revoke its registration. However, before registration is revoked the partnership will be notified of the nature of the breach and granted time to comply. The time the PDF Board will allow to remedy a breach of a requirement or obligation will depend on the nature of the requirement or obligation. For example, a VCLP or AFOF will be allowed up to 6 months to remedy a breach of a requirement relating to its investments. In all cases a general partner will be notified of any breach and granted time in which to make submissions on the matter.
7.12 Information the PDF Board collects in the course of registering and monitoring the activities of VCLPs and AFOFs will be provided to the ATO for the purposes of administering the taxation concession and will be used to report to Government on the usage of the concession.
7.13 The ATO will administer the taxation concession. VCLPs, AFOFs and VCMPs will be subject to self-assessment which places the responsibility for complying with the taxation laws on the taxpayer. The ATO will be responsible for providing advice to VCLPs, AFOFs and VCMPs to assist them to meet their taxation obligations. The ATO will undertake compliance enforcement on a risk assessment basis. This will involve targeted testing for compliance with the eligibility requirements, that is the eligibility criteria for VCLPs and AFOFs and investments. In conducting compliance enforcement, the ATO will independently verify the information provided in the registration process, on the quarterly and annual return forms, and from any other information the general partner provides to the PDF Board.
Assessment of impacts
7.14 This measure will impact on:
- •
- tax-exempt venture capital investors resident in Canada, France, Germany, Japan, the United Kingdom and the United States;
- •
- venture capital fund of funds vehicles resident in Canada, France, Germany, Japan, the United Kingdom and the United States;
- •
- taxable residents of Canada, France, Germany, Japan, Finland, the United Kingdom, the United States, Italy, the Netherlands (excluding the Netherlands Antilles), New Zealand, Norway, Sweden or Taiwan who are limited partners in a VCLP or an AFOF and hold less than 10% of the committed capital of the partnership; and
- •
- individual venture capital managers.
7.15 The measure will also impact on eligible Australian businesses seeking venture capital investments from the above mentioned investors. The investments must satisfy the following criteria for the concession:
- •
- the investment must be in an unlisted Australian company or a listed Australian company which is in the process of delisting and the delisting takes place within 12 months of the initial investment;
- •
- the investment can only be by way of shares or options. (Subject to certain limitations, a VCLP or an AFOF may make loans, including convertible notes, to the company);
- •
- an initial investment must be in a company with total assets of less than $250 million;
- •
- the investment must be in a company that is resident in Australia and, at the time the initial investment is made, have the majority of employees and assets in Australia; and
- •
- the company must not have as its primary activity: property development or land ownership, finance (to the extent that it is banking, providing capital to others, leasing, factoring, securitisation), insurance, construction or acquisition of infrastructure facilities, or making investments.
7.16 The measure will impact on individual venture capital managers who receive their share of the carried interest through a general partner of a VCLP or an AFOF that is a limited partnership. The effect of treating VCMPs as ordinary partnerships for taxation purposes and recharacterising the carried interest as a capital gain is that individual managers may be entitled access to the CGT discount on the carried interest.
7.17 The Government will also be affected by this measure, in particular the ATO, DITR and Invest Australia.
7.18 By jointly administering the measure, the specialist skills of the ATO and DITR will be utilised. The PDF Board has skills and knowledge relevant to industry and the promotion of venture capital investment; while the ATO has taxation law expertise and experience with compliance activities.
7.19 Joint administration will enable certain administrative functions to be carried out more effectively than if one organisation had sole responsibility. These administrative functions include:
- •
- monitoring and reporting to Government on the impact and effectiveness of the concession;
- •
- monitoring and enforcing compliance; and
- •
- providing advice to investors and businesses.
7.20 Joint administration ensures a balance between the objectives of encouraging venture capital investment and maintaining the integrity of the concession.
7.21 The ATO will incur additional administrative costs of $600,000 per annum in the first year of operation of the measure, with an increase to $760,000 per annum in later years to support projected compliance activity in relation to established funds.
7.22 The DITR will incur additional administrative costs of an average of $435,000 per annum.
7.23 The new measure will involve compliance costs for VCLPs and AFOFs arising from the requirement to register with the PDF Board and to report on a quarterly and annual basis. The PDF Board may require additional information from time to time.
7.24 This reporting will require the maintenance of records of entities' investment portfolios and also details of partnership membership.
7.25 These requirements are central to the operation of the measure in that they will provide the information necessary for the ongoing monitoring of the concession and also provide the material required by the PDF Board to report to Government.
7.26 The nature of the measure is such that the compliance costs are minimal in terms of the potential overall tax benefits arising to investors.
7.27 There will be no impact on compliance costs for small business.
7.28 This measure has a cost to revenue of $21 million in 2003-2004, $25 million in 2004-2005 and $30 million in 2005-2006.
7.29 This measure will have an impact on the Australian economy by increasing the level of investment in the Australian venture capital market by non-residents. It will result in greater competition. It will also increase access to overseas expertise for start-up and expanding companies by providing VCLPs, AFOFs and VCMPs with flow-through tax treatment in accordance with internationally recognised best practice for venture capital.
Consultation
7.30 The Australian Venture Capital Association Limited and some venture capital investors have been consulted in the development of this measure, and the development and drafting of the legislation.
7.31 Consultations have taken place at both the Ministerial and the departmental levels with Australian Venture Capital Association Limited on the development of the measure and the drafting of the legislation.
7.32 Consultation with industry will continue during the implementation process.
Conclusion and recommended option
7.33 This measure will be jointly implemented and administered by the ATO and DITR because of the specialist skills held by these organisations. These skills will provide flexibility in delivering the product while ensuring the integrity of the measure is maintained.