House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Scott Morrison MP)

Chapter 2 - Venture capital investment

Outline of chapter

2.1 Schedule 2 to the Bill amends the early stage venture capital limited partnership (ESVCLP) and venture capital limited partnership (VCLP) regimes within the Venture Capital Act 2002 (VCA 2002) and Income Tax Assessment Act 1997 (ITAA 1997) to improve access to capital and make the regimes more attractive to investors. These changes are intended to encourage innovation, risk-taking, and an entrepreneurial culture in Australia.

2.2 The amendments provide an additional tax incentive for limited partners in new ESVCLPs, relax restrictions on ESVCLP investments and fund size and clarify the legal framework for venture capital investment in Australia.

2.3 All legislative references in this Chapter are to the ITAA 1997, unless otherwise stated.

Context of amendments

Operation of existing law

2.4 Venture capital is a mechanism for financing new companies at the start-up and growth stages of commercialisation. Venture capitalists typically invest funds in such companies in return for an equity share. The funds are used to develop a company's ideas to the stage where their commercial potential is sufficient for venture capitalists to sell their equity in the company to another party.

2.5 The Government provides various tax concessions to encourage Australian venture capital investments, including the VCLP and ESVCLP programs.

2.6 The programs provide beneficial tax treatment to eligible investors, with the aim of encouraging both local and foreign investment in Australia. A second aim is to develop venture capital management skills and experience in Australia.

Venture Capital Limited Partnership

2.7 The VCLP regime was introduced in 2002 to support investment in eligible venture capital investments that would otherwise have difficulty in attracting investment through normal commercial means.

2.8 A VCLP is taxed on a 'flow-through' basis, rather than being treated as a company for tax purposes like other limited partnerships (see subsection 94D(2) of the Income Tax Assessment Act 1936 (ITAA 1936)). This results in the partners rather than the 'partnership' being taxed. One of the key benefits of the program is that certain foreign partners are exempt from income tax on capital and revenue gains from disposals of investments made by VCLPs, with corresponding losses also being disregarded (sections 51-54 and 118-405). In addition, amounts received by certain partners for their successful management of the partnership's investments ('carried interests') are taxed on capital account. This entitles them to the capital gains tax (CGT) discount where they have been a partner for over 12 months (section 118-21).

2.9 To be eligible for this treatment, a range of requirements must be satisfied. The key requirement is that the VCLP must have at least $10 million of committed capital in total from its partners (paragraph 9-1(1)(d) of the VCA 2002), whilst the total value of the assets of the entity in which the VCLP invests must not exceed $250 million at the time of the investment (subsection 118-440(9)).

Early Stage Venture Capital Limited Partnership

2.10 The ESVCLP regime was introduced in 2007 to provide additional tax concessions for early stage venture capital activities, because of concerns that the VCLP program was not adequately targeting these entities.

2.11 Like VCLPs, an ESVCLP is taxed on a 'flow through' basis (subsection 94D(2) of the ITAA 1936). However, the tax concessions are more generous than the VCLP regime as both Australian and foreign investors are exempt from income tax on capital and revenue gains from disposals of investments made by the ESVCLP. Corresponding losses are also disregarded (sections 51-54 and 118-407). Income derived from the partnership, such as from dividends, is also exempt from income tax (section 51-52).

2.12 Recognising the more generous concessions available under the ESVCLP regime, this regime requires a minimum investment of $10 million in total from its partners, but with a maximum cap of $100 million (paragraph 9-3(1)(d) of the VCA 2002). In addition, the entities the ESVCLP invests in must be valued at less than $50 million, and they must be divested once the total value of the entity's assets exceeds $250 million on the last day of the previous income year (paragraph 118-440(9)(a) and subsection 9-3(6) of the VCA 2002).

Summary of new law

2.13 Schedule 2 amends the ESVCLP and VCLP regimes within the VCA 2002 and ITAA 1997 to support further venture capital investment. The amendments generally apply from 1 July 2016. However, the tax offset is available only for qualifying contributions made to ESVCLPs that become unconditionally registered as an ESVCLP on or after 7 December 2015.

2.14 The reforms include:

•

providing non-refundable carry-forward tax offsets for limited partners in ESVCLPs, equal to up to 10 per cent of contributions made by the partner to the ESVCLP during an income year;

•

increasing the maximum fund size for ESVCLPs from $100 million to $200 million;

•

removing the requirement that an ESVCLP divest an investment in an entity once the value of the entity's assets exceeds $250 million, but restricting tax concessions for such investments; and

•

allowing entities in which a VCLP, ESVCLP or an Australian venture capital fund of funds (AFOF) has invested (the investee entity) to invest in other entities, provided that after the investment:

-

the investee entity controls the other entity; and

-

the other entity broadly satisfies the requirements to be an eligible venture capital investment (within the meaning of sections 118-425 and 118-427).

Comparison of key features of new law and current law

Detailed explanation of new law

2.15 This Schedule makes a number of changes to improve the existing tax regimes applicable to venture capital investments and provides additional tax incentives for investors in ESVCLPs.

2.16 Broadly, these amendments:

•

provide a non-refundable carry-forward tax offset for investors in new ESVCLPs;

•

relax restrictions on ESVCLP investments and fund size; and

•

make a number of reforms to simplify the tax concession framework for venture capital investment in Australia.

ESVCLP tax offset

Tax offset for ESVCLP investment

2.17 The measure introduces an additional tax incentive for limited partners in ESVCLPs, in the form of a non-refundable carry-forward tax offset. The tax offset arises when a limited partner makes contributions to an ESVCLP in an income year. [Schedule 2, item 2, subsection 61-760(1)]

2.18 The purpose of the ESVCLP tax offset is to encourage additional investment in early stage venture capital by reducing the effective cost of such investments.

2.19 The amount of the offset is equal to 10 per cent of the lesser of:

•

the partner's contributions to the ESVCLP for the income year; and

•

the partner's investment related amount (broadly the proportionate share of the investments made by the ESVCLP).

[Schedule 2, item 2, subsection 61-765(1)]

2.20 As a result the partner is entitled to the offset in relation to the amount they have contributed towards the eligible venture capital investments of the ESVCLP, subject to the timing rule on the making of such investments.

Amount of the offset - contributions

2.21 A partner's contributions are those amounts the partner provides to the ESVCLP, consistent with the definition of committed capital in section 118-445.

2.22 However, in determining the amount of the offset, contributions do not include:

•

commitments to provide money or other property at a future date;

•

contributions made by a partner to an ESVCLP that the ESVCLP is, or will in the future become, obliged to repay to the partner, or will on demand by the partner be required to repay; or

•

contributions a partner makes to an ESVCLP that, during the income year, are repaid to the partner within 12 months of the contribution being made.

[Schedule 2, item 2, subsection 61-765(2)]

2.23 Contributions made by a partner to an ESVCLP that the ESVCLP is, or will become, obliged to repay to the partner include amounts in relation to which there is an obligation to repay the partner, whether or not the obligation to make the repayment arises during the income year and whether or not it is linked to a request by the partner for repayment. Contributions that an ESVCLP is obliged to repay to a partner include repayments made at the direction of the partner for the benefit of a third party. There is no time limit on when an obligation to repay must arise for a contribution to be excluded. This means that even if there is no obligation to repay an amount for 10 years or until a particular event occurs, the amount is still not a contribution if such an obligation or a contingent obligation exists. [Schedule 2, item 2, subsection 61-765(2)]

2.24 Likewise, in some cases an ESVCLP may repay amounts without being under any obligation. If such a voluntary repayment occurs within 12 months of a contribution being made, the contribution will also be disregarded to the extent it has been refunded. [Schedule 2, item 2, subsection 61-765(2)]

Amount of the offset - investment related amount

2.25 However, the amount of the offset is also limited by the partner's investment related amount for the relevant ESVCLP.

2.26 A partner's investment related amount for an ESVCLP is the total amount the ESVCLP has spent making eligible venture capital investments over the period starting at the beginning of the relevant income year and ending two months after the end of that income year, multiplied by the partner's proportionate share of the capital of the ESVCLP at the end of the relevant income year. That is, it is in effect the partner's share of the ESVCLP's investment expenditure. [Schedule 2, item 2, subsection 61-765(3)]

2.27 As the partner's share is based on their interest at the end of the income year, if they make contributions but then cease to be a partner before the end of the income year, they will not be entitled to any offset in relation to these contributions. This simplifies the calculation of the tax offset and encourages longer term commitment by partners to ESVCLPs.

2.28 Linking the offset to the amounts contributed that are invested within two months after the end of that income year ensures that the offset is only available for actual venture capital investment, rather than creating an incentive to passively hold such contributions. It is not expected to impact adversely on ESVCLPs because they generally only call on partners for contributions shortly before an investment is made.

2.29 As outlined above, the investment related amount is determined based on the total amount the ESVCLP has spent making investments over the period. This is not limited to the amount of the eligible venture capital investments the ESVCLP has made, but also includes incidental costs of making such investments as well as any administrative costs associated with those investments. [Schedule 2, item 2, subsection 61-765(3)]

2.30 The amendments contain an integrity provision to ensure that if an eligible venture capital investment is made in the two months following the end of an income year, then it is not taken into account in determining ESVCLP tax offset entitlements in the following income year. This ensures that investments made in the first two months following the end of an income year do not potentially qualify for tax offsets in two income years. [Schedule 2, item 2, subsection 61-765(4)]

2.31 A transitional rule applies to contributions and investments made before 1 July 2016 for ESVCLPs that become unconditionally registered on or after 7 December 2015. Details of this transitional rule are set out in paragraphs 2.145 to 2.150.

Nature and priority of the offset

2.32 The amendments provide that the ESVCLP tax offset will be a carry-forward tax offset. This reduces the chance that the benefit of the offset will be lost to investors if they cannot use the offset in the income year to which the offset relates. However, consistent with other carry-forward tax offsets, the offset is not refundable. [Schedule 2, item 3, table item 32 of subsection 63-10(1)]

2.33 As a carry-forward tax offset, recipients must apply the ESVCLP tax offset after any tax offsets that cannot be refunded or carried forward, but before refundable tax offsets can be applied. This ensures that the benefits of any offsets that are not refundable or able to be carried forward are not lost or deferred. It also maximises the amount of any refundable offset that will be refunded.

2.34 Within the list of carried forward offsets, the priority of the ESVCLP tax offset is below the landcare and water tax offset, but above carry-forward offsets under the research and development tax incentive. This priority for application of the ESVCLP tax offset avoids the need for entities to distinguish between the different types of offset arising under the research and development tax incentive when determining relative priority. [Schedule 2, item 3, table item 32 of subsection 63-10(1)]

2.35 Should a taxpayer undertake a tax avoidance scheme to benefit from this offset, Part IVA may apply - see paragraph 1.125 in the other Chapter to this Explanatory Memorandum.

Members of trusts and partnerships

2.36 As flow-through entities, trusts and partnerships are generally not subject to tax in their own right and in such cases do not receive any benefit from a tax offset. Accordingly, trusts and partnerships are not typically entitled to the ESVCLP offset. [Schedule 2, item 2, paragraph 61-760(1)(b)]

2.37 Instead, these amendments provide an equivalent tax offset to the members of trusts or partnerships (a beneficiary or unit holder of a trust or a partner in a partnership - see section 960-130), who are in substance the ultimate investors, based on a determination by the partnership or trustee of the members' share of the tax offset. [Schedule 2, item 2, subsection 61-760(2)]

2.38 As a result, a member of a trust or partnership is generally entitled at the end of an income year to a non-refundable carry-forward tax offset for that income year. The amount of the offset is the product of:

•

the amount of the ESVCLP offset that would be available to the trust or partnership were it an individual (notional tax offset amount); and

•

the members' share of the offset as determined by the trustee or partnership (determined share of notional tax offset).

[Schedule 2, item 2, section 61-770]

2.39 The partnership or trustee must notify members of the partnership or trust of their determination of the share of the tax offset and provide sufficient information to allow the member to work out their share of the offset. The notice must be provided within three months of the end of the income year to which the offset relates, or such further time as the Commissioner may allow. [Schedule 2, item 2, subsection 61-770(4)]

2.40 If no determination is made then members do not have any entitlement to any tax offset. Similarly if the determination does not allocate the entire available tax offset, then members are only entitled to so much of the tax offset as has been allocated to them by the trustee. [Schedule 2, item 2, subsection 61-770(1)]

2.41 In some cases members of trusts or partnerships are entitled to a fixed proportion of any capital gain from investments, as a result of the terms and conditions under which the trust or partnership operates. For example, such a fixed entitlement exists for the holders of units in unit trusts. If a member of a trust or partnership is entitled to such a fixed proportion, the member's share of the tax offset must be determined by the trustee to be that proportion. [Schedule 2, item 2, subsection 61-770(3)]

2.42 In all other cases, the amount of the offset each member receives is at the discretion of the partnership or trustee. It is not relevant and does not limit what share of an offset a member may be determined to be entitled to, whether the trust or partnership has a capital gain or net income for a particular income year, or is in a loss position, or how any such income, capital gain or loss may have been distributed. Accordingly, it is not relevant if, for example, a trustee of a discretionary trust has distributed the income or capital of a trust in a particular way in an income year. The trustee may determine which discretionary beneficiaries are entitled to the offset on a completely different basis.

2.43 In some cases the members of a trust or partnership that is a limited partner in an ESVCLP may include another trust or partnership. In this situation the members of that other trust or partnership are generally entitled to the offset (however, see paragraphs 2.45 to 2.47 below concerning trustees). If those members are themselves trusts or partnerships, then the offset will also pass to the members of these entities in the same way, until it ultimately reaches an entity that is not a trust or partnership (subject to a trustee of a trust being liable for tax in their capacity as a trustee - see below). [Schedule 2, item 2, section 61-770]

2.44 For the avoidance of doubt, the amendments make it clear that the trustee or partnership may not determine that the members of the trust or partners of the partnership are entitled to more than the amount of the notional tax offset that would have been available to the trust or partnership. [Schedule 2, item 2, subsections 61-770(2) and (5)]

Trustees that are liable for tax

2.45 Although generally trusts are not subject to tax in their own right, in certain circumstances trustees are required to pay tax on behalf of the trust. Depending on the nature and circumstances of the trust and its beneficiaries, the trustee may be the only entity liable for tax on the net income of the trust.

2.46 Despite the general rule that the offset is available to the beneficiaries or unit holders of a trust, a trustee of a trust is entitled to a tax offset if:

•

the trust would be entitled to the ESVCLP tax offset if it was an individual;

•

the trustee has not validly determined that the beneficiaries of the trust are entitled to the whole amount of the ESVCLP tax offset; and

•

the trustee of the trust is liable or has been assessed for tax in respect of the activities of the trust (under sections 98, 99 or 99A of the ITAA 1936).

[Schedule 2, item 2, subsection 61-760(3) and sections 61-765 and 61-775]

2.47 The amount of the offset available to the trustee is the amount that would be available to the trust if it were an individual, less any tax offset amounts to which beneficiaries of the trust are entitled to that relate to the same contributions which give rise to the trustee's tax offset entitlement. As a result, the trustee will not be able to obtain the offset if all of the tax offsets available to the trust have been validly distributed to beneficiaries. [Schedule 2, item 2, section 61-775]

Example 2.1: ESVCLP tax offset natural persons as partners

Ariane becomes a limited partner in a new ESVCLP that is unconditionally registered on 2 July 2016. Ariane is one of five limited partners. Each limited partner contributes $10 million to the ESVCLP during the 2016-17 income year. Accordingly, the fund has received total contributions of $50 million.

As a limited partner in an ESVCLP, Ariane is entitled to a non-refundable carry-forward tax offset equal to up to 10 per cent of contributions made as a limited partner during the income year used for eligible venture capital investment purposes either during that income year or within two months of the end of that income year.

Ariane has a 1/5th share in the ESVCLP's investments. The total $50 million is used by the ESVCLP for making eligible venture capital investments within the required time period. The total offset for partner contributions is 10 per cent of the $50 million contribution, which is $5 million. Given that Ariane has a 1/5th share in the ESVCLP's investments, she is entitled to a $1 million tax offset for the 2016-17 income year.

During the 2017-18 income year, each of the limited partners contributes $5 million to the ESVCLP. Accordingly, the fund receives total contributions of $25 million. $5 million of this amount is not used by the ESVCLP to invest in eligible venture capital investments within two months of the end of the 2017-18 income year. Accordingly, $5 million is subtracted from the total contributions before calculating the tax offset.

The tax offset for partner contributions is 10 per cent of the $20 million, which is $2 million. Given that Ariane has a 1/5th share in the ESVCLP's investments, she is entitled to a $400,000 tax offset for the 2017-18 income year.

Example 2.2: Tax offset for ESVCLP partners that are trusts

An ESVCLP is unconditionally registered on 8 December 2015. There are four limited partners in the ESVCLP. Two of these partners are trusts (trust A and trust B) and two are natural persons. Trust A is a fixed trust with two beneficiaries, with each beneficiary entitled to 50 per cent of the income and capital gains of the trust. Trust B is a discretionary trust with three beneficiaries. The trust deed for Trust B does not contain a default beneficiary clause.

On 1 July 2016, each of the four limited partners contributes $10 million. Accordingly, the fund receives total contributions of $40 million. The total $40 million is used by the ESVCLP for making eligible venture capital investments during the 2016-17 income year.

The tax offset for partner contributions is 10 per cent of the $40 million contribution, which is $4 million. Given that each of the limited partners has a 1/4th share in the ESVCLP's investments, each partner is entitled to a tax offset of $1 million.

As trust A is a fixed trust with its two unit holders having a 50 per cent interest each, they each are entitled to a $500,000 tax offset.

The trustee for trust B does not exercise its discretion to make any of the three beneficiaries presently entitled to the trust's net income. Accordingly, the trustee is liable to pay tax on the net income of the trust estate (subsection 99A(4) of the ITAA 1936). In this situation, the trustee of trust B is entitled to the $1 million tax offset for the 2016-17 income year.

Increasing the flexibility of ESVCLPs

Increase in cap for ESVCLP committed capital

2.48 Schedule 2 amends the VCA 2002 to increase the cap on the committed capital of an ESVCLP from $100 million to $200 million. As a result, in order to become and remain registered as an ESVCLP, the committed capital of an ESVCLP must be at least $10 million, but not more than $200 million. [Schedule 2, item 6, subparagraph 9-3(1)(d)(ii) of the VCA 2002]

2.49 The committed capital of an ESVCLP is broadly defined as the total amount partners may be obliged to contribute to the partnership under the partnership agreement.

2.50 The cap limits the size of investments that can be made by an ESVCLP, both in total, as the capital available to the ESVCLP is limited, and in respect of particular investments, as an ESVCLP cannot invest more than a fixed percentage of its committed capital into a single investment. The fixed percentage is generally 30 per cent, or 20 per cent where the ESVCLP is acquiring an existing investment (see paragraphs 118-425(1)(d), 118-427(1)(d) and 118-428(1)(c)). Increasing the cap therefore allows ESVCLPs to invest more overall and also more in individual entities.

Example 2.3: Increase in the cap on ESVCLP committed capital

An ESVCLP is unconditionally registered on 1 August 2016. The ESVCLP has six partners. Each of the six partners has committed in the partnership agreement to provide $20 million to the fund. Accordingly, the committed capital of the ESVCLP is $120 million.

Under the previous fund size rules, this ESVCLP would exceed the $100 million cap for committed capital. However, the amendments increase the cap for committed capital to $200 million. Accordingly the ESVCLP is under the cap and satisfies the committed capital requirements for registration as an ESVCLP.

Alternative to ESVCLP divestiture requirement

2.51 Schedule 2 amends the registration requirements for ESVCLPs (see sections 9-3 and 9-5 of the VCA 2002) to remove the requirement that an ESVCLP must divest itself of an investment in an entity (the investee) within 6 months, once the total value of the investee's assets (including the assets of any entities it controls) exceeds $250 million at the end of an income year. This increases flexibility by allowing ESVCLPs to decide if such an investment should be divested, and if so, at what time. [Schedule 2, items 15 and 16, paragraph 9-3(1)(i) and subsections 9-3(3) and (6) of the VCA 2002]

Limiting tax concessions relating to investments

2.52 However, in place of the current divestiture threshold, the amendments impose a limit or cap on the extent to which tax concessions are available for such investments after the $250 million threshold has been exceeded by the investee.

2.53 If the total value of the assets of an entity (and any connected entities) exceeds $250 million at the end of an income year, and the entity does not dispose of the investment within six months of that income year, any capital gain arising in relation to the investment will only be partially exempt. [Schedule 2, item 13, section 118-408]

2.54 The amount of the partially exempt capital gain that is not disregarded in a later income year is:

2.55 In this formula:

•

the normal capital gain is the capital gain that would otherwise arise under the income tax law as a result of the CGT event happening excluding any disregarded capital gain that would otherwise apply under the ESVCLP tax concessions;

•

the valuation year capital gain is the capital gain that would have arisen had the same CGT event occurred in relation to the same CGT asset at the end of the day six months after the end of the income year in which the $250 million threshold was first exceeded.

[Schedule 2, item 13, subsections 118-408(2)]

2.56 As a result, if the entire investment is subsequently disposed of, the capital gain will be taxable to the extent it exceeds the capital gain that would have resulted had it been disposed of at the end of the period ending six months after the end of the income year in which the $250 million threshold was crossed (i.e. the time by which the asset would have been required to be disposed of as a result of the divestiture requirement). [Schedule 2, item 13, subsections 118-408(2) and (3)]

2.57 Similarly, if parts of an investment are sold at different times, the capital gain resulting from the disposal of each part of the investment will be taxable to the extent that the capital gain resulting from the sale of that part exceeds the capital gain that would have arisen had it been sold six months after the end of the income year in which the investee entity first exceeded the threshold.

2.58 This means that, in effect, any increase in the value of the investment or of the assets that make up the investment after that time will be subject to tax as the increase in value will be reflected in a higher capital gain that will not be disregarded.

2.59 Once an investment has become subject to the tax concession cap, the cap continues to apply, even if the value of the assets of the investee entity falls below the $250 million threshold. This also means that the cap is not reset if the value of the entity falls and rises again - the amount of any partially exempt gain that is taxable is always determined by reference to the gain that would have arisen had the event occurred six months after the end of the income year in which the threshold was first crossed. [Schedule 2, item 13, subsection 118-408(1)]

2.60 These changes only apply where an exempt capital gain would otherwise arise. Consistent with the prior law, a loss, whether revenue or capital, arising in relation to an eligible venture capital investment by an ESVCLP is disregarded (see subsections 26-68(1) and 118-407(1)). This continues to apply even where the investee entity has exceeded the $250 million threshold but the gain will only be partially exempt.

2.61 Further, currently if any income from the disposal of a venture capital asset would be disregarded were it a capital gain, it will also be exempt income (see section 51-54). The amendments modify this rule. To the extent a capital gain from the disposal would only be partially exempt, only the equivalent amount of gain or profit will be exempt income. No change is made to the current denial of deductions for a share of a loss made by an ESVCLP from the disposal of an eligible venture capital investment. [Schedule 2, item 8, subsection 51-54(1A)]

2.62 Although the availability of tax concessions for investments in an entity is curtailed once an investee's value exceeds the $250 million, this does not affect the status of investments in that entity as eligible venture capital investments. Accordingly, ESVCLPs will be able to hold and carry on activities in relation to such investments without breaching the registration requirements under section 9-3 or 9-5 of the VCA 2002.

Example 2.4: Removal of ESVCLP divestiture requirement

An unconditionally registered ESVCLP has a 10 per cent investment in Ariad, a company that is an eligible venture capital investment. The interest was acquired when the total value of Ariad was $100 million. The total value of Ariad's assets is $200 million on 30 June 2015, $260 million on 30 June 2016 and increases to $300 million on 31 December 2016.

As a result, Ariad would exceed the current divestiture threshold for the ESVCLP at the end of the 2015-16 income year. Despite Ariad exceeding this threshold on 30 June 2016, the ESVCLP has until 31 December 2016 to divest its interest in Ariad after which any future capital gains from the sale become partially assessable.

The ESVCLP decides to continue to hold the interest in Ariad after breaching the threshold but finally decides to sell the interest on 20 June 2019 when the total value of Ariad is $400 million.

The exempt gain that the ESVCLP partners would have made if the ESVCLP had disposed of its 10 percent interest in Ariad on 31 December 2016 is (10 per cent interest x ($300 million - cost base of $100 million) $20 million (valuation year capital gain). Accordingly, the amount of the capital gain on the sale of the 10 per cent stake is calculated as:

Normal capital gain - valuation year capital gain

•

normal capital gain (10 per cent interest x ($400 million - cost base of $100 million) = $30 million capital gain

•

valuation year capital gain = $20 million

i.e. $30 million (normal capital gain) - $20 million (valuation year capital gain) = $10 million capital gain is assessed to the ESVCLP partners in the 2019-20 income year.

The balance of the capital gain of $20 million is exempt for the ESVCLP partners in the 2019-20 income year.

CGT exemption for distributions of exempt venture capital gains by trusts

2.63 The income tax law provides that the CGT consequences are disregarded for a partner when an ESVCLP disposes of an eligible venture capital investment of the partnership (section 118-407). Similarly, a partner's share of any gain or profit that arises in relation to an eligible venture capital investment is exempt income (section 51-54).

2.64 However, prior to these amendments, if a partner in an ESVCLP was a trustee of a unit trust or other fixed trust, a CGT taxing point could occur when the trust distributed these proceeds to its beneficiaries. In particular, CGT event E4 would often result in the CGT cost base of the fixed interest of a beneficiary in the trust being reduced by the amount of a capital gain that the trust distributed to them. If the amount of the gain reduced the cost base of the unit or interest below zero, then the distribution would result in a corresponding capital gain (section 104-70).

2.65 These amendments modify CGT event E4 by adding amounts that are exempt or disregarded under the ESVCLP tax concessions in sections 51-54 and 118-407 to the list of amounts that are excluded when applying CGT event E4 under section 104-71. [Schedule 2, items 21 and 22, paragraphs 104-71(3)(aa), (c) and (d)]

2.66 Accordingly, CGT consequences do not arise for a beneficiary in respect of the beneficiary's share of a capital gain that is disregarded or an amount of income that is exempt in the hands of the trustee, because of ESVCLP tax concessions.

2.67 This ensures that the same CGT outcome arises for the ultimate investors in ESVCLPs regardless of whether they invest directly, through a fixed trust (including a unit trust), another partnership or a discretionary trust.

Example 2.5: Distribution of CGT exempt amount to unit holder

In November 2016 Sheldon invests $100,000 in a unit trust. The unit trust, among other investment activities, is a limited partner in an ESVCLP.

In January 2017 the ESVCLP disposes of an eligible venture capital investment that it owns at a profit. It distributes the proceeds to its partners. As the unit trust is a partner and the capital gain relates to an eligible venture capital investment, the capital gain the trust derives is disregarded.

The trustee of the unit trust distributes the gain to its unit holders. Sheldon's share is $300,000.

If CGT event E4 applied, the cost base of the units of the beneficiaries would be reduced by the amount of the distribution. Sheldon's cost base as a unit holder is $100,000. Subtraction of the $300,000 gain from the $100,000 cost base would have resulted in the units having a cost base of zero and Sheldon having a capital gain of $200,000.

However, because of the amendments, CGT event E4 does not occur as the distribution is only non-assessable because of the ESVCLP tax concessions and so is disregarded.

Accordingly, no amount is included in Sheldon's assessable income due to the distribution, he does not have a capital gain and the cost base of his units in the unit trust is unaffected.

Reforms to the tax concessions for venture capital investments

Eligible venture capital investment - investments in other entities

2.68 For an investment in an entity to qualify as an eligible venture capital investment it must satisfy a number of requirements including requirements relating to its predominant activity, location and investments.

2.69 The predominant activity requirement is contained in subsections 118-425(3) and 118-427(4). Broadly, to satisfy this requirement, more than 75 per cent of at least two of following must not relate to ineligible activities in subsections 118-425(13) and 118-427(14):

•

the entity's assets:

•

the entity's employees; or

•

the entity's income.

2.70 The location within Australia test is detailed in subsections 118-425(2) and 118-427(3). Broadly, to satisfy this requirement, if the entity is a company it must be an Australian enterprise and have more than 50 per cent of its assets and employees in Australia for a period of generally 12 months. If it is a trust it must carry on business in Australia, be either managed and controlled in Australia or most of its beneficiaries must be Australian residents and the trust must have more than 50 per cent of its assets and employees in Australia for a period of generally 12 months.

2.71 The investment requirement is detailed in subsections 118-425(4) and 118-427(5). Broadly, prior to these amendments, an entity would cease to be an eligible venture capital investment if it invested in any other entity, except an entity that it controlled and that met most of the requirements to be an eligible venture capital investment (excluding those requirements that relate to the capital of the partnership). The entity must also have not used any part of the amount invested in its capacity as a trustee of another entity.

2.72 These amendments modify the investment requirement so that an entity can invest in another entity and remain an eligible venture capital investment, provided the other entity meets certain requirements.

2.73 Specifically, an investment in an entity (the first entity) will not cease to be an eligible venture capital investment solely because the first entity (that is an entity in which a VCLP, ESVCLP or AFOF has invested) invests in another entity (the second entity), if:

•

after the investment has been made, the second entity is a connected entity of the first entity because it is controlled by the first entity; and

•

the investment in the second entity meets the requirements of subsections 118-425(3) and (5) to (7) (for an investment in a company) or subsections 118-427(4) and (6) to (8) (for an investment in a unit trust).

[Schedule 2, items 26 and 32, subsections 118-425(4) and 118-427(5)]

2.74 The existing clarification that a company or unit trust can deposit money with an authorised deposit-taking institution or a body authorised under a foreign law to carry on a banking business in a foreign country whilst remaining an eligible venture capital investment is retained. [Schedule 2, items 2 and 32, subsections 118-425(4) and 118-427(5)]

2.75 Following the investment, in determining whether an investee entity meets the predominant activity test in subsections 118-425(3) and 118-427(4), the assets, activities, employees and assessable, exempt and non-assessable non-exempt income of that entity are taken to include those of any entities that it controls. An entity controls another entity if it would control the entity in a way described by section 328-125 (concerning small business entities). [Schedule 2, items 24, 25, 30 and 31, subsections 118-425(3) and 118-427(4)]

2.76 The other elements of the predominant activity test remain the same as under the current law. To satisfy the test, 75 per cent of the assets, employees, or assessable, exempt and non-assessable non-exempt income of the entity and any controlled entities must not relate to ineligible activities in subsections 118-425(13) and 118-427(14). [Schedule 2, items 24, 25, 30 and 31, subsections 118-425(3) and 118-427(4)]

2.77 This approach means entities have more flexibility to make acquisitions, whilst still preventing entities from avoiding rules about investments made by ESVCLPs and VCLPs.

2.78 The notes to subsections 118-425(3), (4), 118-427(4) and (5) are amended to reflect the changes. [Schedule 2, items 25, 26, 31 and 32, subsections 118-425(3), (4), 118-427(4) and (5)]

2.79 The amendments do not change the existing requirement that a company or unit trust must not use any part of the amount invested in the capacity of a trustee of another entity. [Schedule 2, items 26 and 32, subsections 118-425(4A) and 118-427(5A)]

Extending Innovation Australia's discretion: eligible venture capital investment

2.80 In addition, these amendments provide for Innovation Australia to modify the operation of some of the eligible venture capital investment requirements to allow the complementary activities of a controlled entity to be disregarded for a specified period when applying the predominant activity test or the location within Australia test. [Schedule 2, items 28, 33 and 42, subsections 118-425(14B), (14C), 118-427(15A) and (15B) of the ITAA 1997 and subsections 25-15(1) and (1A) of the VCA 2002]

2.81 To allow the activities of a controlled entity to be disregarded when applying the predominant activity test to an entity for a period, Innovation Australia must be satisfied that:

•

the activities of the controlled entity are complementary to the activities of the controlling entity or other controlled entities that are not ineligible activities;

•

the principal activities of the whole group of entities are not ineligible activities; and

•

in all of the circumstances it is appropriate to disregard the activities of the controlled entity for that period.

[Schedule 2, items 28 and 33, subsections 118-425(14B) and 118-427(15A)]

2.82 This discretion is only available in limited circumstances. The principal activities of the first entity must not be ineligible activities. While the second entity may have significant ineligible activities, ineligible activities must not make up a majority of the activities of the first entity and all of its controlled entities taken together. [Schedule 2, items 28 and 33, paragraphs 118-425(14C)(b) and 118-427(15B)(b)]

2.83 Further, the activities of the controlled entity must be complementary to these principal activities. This requires Innovation Australia to be satisfied that there is not just an association between the activities, but that engaging in one of the activities assists or provides some advantage in engaging in the other. [Schedule 2, items 28 and 33, paragraphs 118-425(14C)(a) and 118-427(15B)(a)]

2.84 Finally and most importantly, Innovation Australia must consider that it is appropriate in all of the circumstances that the activities of the second entity be disregarded. As the purpose of the wider test is specifically to take account of all of the activities within an entity's control, the exercise of this discretion requires some form of special or exceptional circumstances. [Schedule 2, items 28 and 33, paragraphs 118-425(14B)(c) and 118-427(15A)(c)]

2.85 Some potential circumstances that may make it appropriate to disregard the activities of a controlled entity include if:

•

it is expected that the activities of the controlled entity would cause the entity to fail the test on a temporary basis (for example if the controlled entity has significant ineligible activities relating to assets and income that the entity intends to sell as soon as possible);

•

the controlled entity would be an eligible venture capital investment if acquired directly by the VCLP or ESVCLP;

•

the acquisition of the controlled entity would significantly increase the expected future growth of the entity or help facilitate innovation; or

•

the nature of the activities involved means that it would be impractical or involve significant cost or forgone benefits were the ineligible activity to cease.

2.86 The amendments also provide Innovation Australia with a similar discretion to determine that a controlled entity does not need to meet the location in Australia requirement. [Schedule 2, items 28 and 33, subsections 118-425(14C) and 118-427(15B)]

2.87 To determine that the location in Australia requirement does not apply to a controlled entity for a period, Innovation Australia must be satisfied that:

•

the activities of the controlled entity are complementary to activities of the controlling entity or other controlled entities; and

•

in all of the circumstances it is appropriate to disregard the activities of the controlled entity for that period.

[Schedule 2, items 28 and 33, subsections 118-425(14C) and 118-427(15B)]

2.88 The location in Australia requirement is an important part of the targeting of the ESVCLP and VCLP tax concessions. These concessions are intended to help promote investment in businesses in Australia. They are not intended to be available for investments in entities without a sufficiently clear connection with Australia. Further, ESVCLPs and VCLPs should not be able to avoid this requirement simply by making their investment through an Australian entity.

2.89 However, despite this, in special circumstances the location within Australia requirement may be too strict.

2.90 This discretion would allow Innovation Australia to in effect waive the location within Australia requirement for an investment that would otherwise satisfy venture capital investment requirements. This discretion can only be exercised if Innovation Australia is satisfied that:

•

the controlling entity is an Australian resident (or, if they are a trust, satisfy the requirements of paragraphs 118-427(3)(a) and (b) - that is, carries on business in Australia and either has its management located in Australia or the majority of the interests in the income or property of the trust are held by Australian residents); and

•

the acquisition was complementary to its existing business activities.

[Schedule 2, item 28, subsection 118-425(14C)]

2.91 Consistent with the discretion to disregard the activities of the controlled entity for the predominant activity test, Innovation Australia must also consider that it is appropriate in all of the circumstances that the activities of the second entity be disregarded. As the purpose of the wider test is specifically to take account of all of the activities within an entity's control, the exercise of this discretion requires some form of special circumstances to exist. This could include, for example, unique opportunities for rapid expansion tied to acquiring an overseas entity engaged in complementary activities.

Holding companies

2.92 These amendments also remove the holding company exception in subsection 118-425(11). [Schedule 2, items 27 and 29, subsections 118-425(11) and (16)]

2.93 The holding company exception was intended to allow entities that have a sole purpose of investing in another entity that is an eligible venture capital investment to be an eligible venture capital investment. It did so by allowing such holding companies to disregard the predominant activity and investment requirements that a holding company could not satisfy.

2.94 The changes to the investment requirements (discussed above) mean that investments in entities that have a sole purpose of investing in an eligible venture capital investment are an eligible venture capital investment. As a result, the holding company exception is generally no longer necessary.

2.95 However, if the holding company exception were simply removed, the regime would be more restrictive in the period between the time when the holding company receives the investment from the ESVCLP, VCLP, AFOF or eligible venture capital investor and the time when it invests that amount. Although a company may take six months to make any acquisition, the general changes (discussed above) would require that the holding company control an eligible venture capital investment at the time of the investment by the VCLP, ESVCLP, AFOF or eligible venture capital investor in order to satisfy the predominant activity test.

2.96 To address this issue, the amendments include a special rule allowing a company to satisfy the predominant activity test in relation to an investment by a VCLP, ESVCLP, AFOF or eligible venture capital investor in the company. This rule will be taken to be satisfied if:

•

the sole purpose of the company is to make an investment or investments that are eligible venture capital investments (disregarding the requirement relating to the committed capital of the partnership); and

•

within six months of the first investment made by that VCLP, ESVCLP, AFOF or eligible venture capital investor in that entity, the company has used all of the amount invested in it to:

-

make eligible venture capital investments (disregarding the requirement relating to the committed capital of the partnership); or

-

engage in activities that are ancillary or incidental to that purpose.

[Schedule 2, item 28, subsection 118-425(14A)]

2.97 However, the rule will only be taken to be satisfied for the period starting immediately before the first investment made by that VCLP, ESVCLP, AFOF or eligible venture capital investor in that entity, and ending six months after that first investment. From this time, the holding company will need to satisfy the revised predominant activity test based on the activities of its controlled entities. [Schedule 2, item 28, subsection 118-425(14A)]

Example 2.6: Bolt-on acquisition - complementary activity

An ESVCLP is unconditionally registered on 3 July 2016. The ESVCLP makes an investment in ProsGEN on 30 July 2016. ProsGEN is a prosthetics start-up, specialising in 3D printing. ProsGEN is an eligible venture capital investment.

In December 2018, ProsGEN acquires a controlling interest in Bluprinted, a state-of-the-art 3D printing company in America. This acquisition provides ProsGEN with opportunities for rapid expansion. Bluprinted does not meet the location within Australia requirement, but would otherwise be an eligible venture capital investment.

A general partner of the ESVCLP applies to Innovation Australia requesting that Innovation Australia exercise its discretion to determine that the location of Blueprinted should be disregarded for the purposes of the predominant activity test for a two year period. The ESVCLP expects that the activities of Bluprinted would only fail the predominant activity test for a two year period, as Bluprinted will transfer 70 per cent of Bluprinted staff and assets to Australia in the next two years.

Innovation Australia decides that the investment remains an eligible ESVCLP because:

•

the activities of Bluprinted are complementary to one or more activities of ProsGEN; and

•

in all the circumstances, the failure of the location within Australia test will only be temporary.

Accordingly, Innovation Australia makes a determination in writing to the ESVCLP's general partner that the location of Blueprinted should be disregarded for the purposes of the location within Australia requirement for a two year period.

Example 2.7: Investment in holding company - six month rule

On 5 January 2017, a VCLP invests $20 million in Retention, a holding company. Retention's only purpose is to make eligible venture capital investments. On 12 March 2017, Retention uses all of the $20 million to make eligible venture capital investments.

Accordingly, Retention satisfies the predominant activity test in relation to the VCLP's investment because:

•

the sole purpose of Retention is to make investments that are eligible venture capital investments (disregarding the requirement relating to the committed capital of the partnership); and

•

within six months of the first investment made by the VCLP, Retention has used all of the $20 million invested in it to make eligible venture capital investments (disregarding the requirement relating to the committed capital of the partnership).

Widely held FVCFFs

2.98 This Schedule amends the ITAA 1997 and the VCA 2002 to allow a foreign venture capital fund of funds (FVCFF) to hold more than 30 per cent of the committed capital of an ESVCLP and extend their access to CGT and other income tax concessions in relation to eligible venture capital investments, if the FVCFF is a widely held FVCFF at the time of the CGT event. [Schedule 2, items 46 and 52, paragraph 118-420(1)(ba) of the ITAA 1997 and paragraph 9-3(5)(e) of the VCA 2002]

2.99 Prior to these amendments, no investor in an ESVCLP could hold more than 30 per cent of the committed capital of the partnership (paragraph 9-3(1)(e)) without a specific waiver by Innovation Australia (section 9-4 of the VCA 2002) unless the investor was an authorised deposit-taking institution, life insurance company, certain public authorities or widely held complying superannuation funds.

2.100 Further, an investor would not be an eligible venture capital partner (and hence entitled to the relevant tax concessions for their investment made through a VCLP or AFOF) if the sum of their investments (together with any investments by their connected entities) exceeded 30 per cent of the committed capital of the partnership (see section 118-420).

2.101 These amendments allow widely held FVCFFs to hold larger stakes in Australian eligible venture capital investments as their widely held ownership means that they do not need to be subject to the same control test as other entities with potentially more closely held ownership structures.

2.102 An entity is a widely held FVCFF if:

•

the entity is a FVCFF;

•

each other entity that:

-

if the entity is a limited partnership - is a general partner of the partnership; or

-

otherwise - exercises day to day control of the entity;

is a foreign resident;

•

the entity is a 'widely held entity'; and

•

at least 90 per cent of the rights to the income of the FVCFF are ultimately held by eligible venture capital partners that are not FVCFFs.

[Schedule 2, items 47 and 51, subsection 118-420(6) and definition of 'widely held foreign venture capital fund of funds' in subsection 995-1(1)]

2.103 'Widely held entity' has the meaning given by subsection 842-230(2) and section 842-235. [Schedule 2, items 48, 49 and 51, paragraph 842-230(1)(aa), subsection 842-230(2) and the definition of 'widely held entity' in subsection 995-1(1)]

2.104 An entity will be a widely held entity if, broadly, no other entity directly or indirect holds an interest in the first entity of more than 20 per cent and no five entities have interests in the entity that would together amount to more than 50 per cent (see subsection 842-230(2)).

2.105 An entity will also be a widely held entity if it does not meet this test but either:

•

has not met this test at any point but is actively seeking to expand its membership in such a way as to become widely held (such as a new fund that is in the process of gathering investment); or

•

the entity does not meet this test as it is in the process of closing down.

2.106 This test ensures that ownership interests in widely held FVCFF are genuinely widely dispersed.

2.107 The concept of a widely held entity forms part of the definition of 'IMR widely held entity', for the purposes of the Investment Manager Regime set out in Subdivision 842-I. These amendments have created a separate term (widely held entity) for this element of the definition in section 842-230 in order to allow it to be used in the context of other provisions. They have also made other minor changes to the structure of the provision as a consequence of the creation of this new defined term. The amendments do not alter the meaning of IMR widely held entity. [Schedule 2, items 48, 49 and 50, paragraph 842-230(1)(aa), subsection 842-230(2) and paragraph 842-235(6)(a)]

2.108 More information of the meaning of a widely held entity can be found in the Explanatory Memorandum for the Tax and Superannuation Laws Amendment (2015 Measures No.1) Bill 2015, which first introduced the concept of an IMR widely held entity.

Example 2.8: Widely held FVCFF

An FVCFF is unconditionally registered on 6 July 2016. The FVCFF invests in a VCLP and an ESVCLP during the 2016-17 income year. The FVCFF holds more than 30 per cent of the committed capital of both the VCLP and the ESVCLP.

The FVCFF is a widely held FVCFF, because all of the general partners of the FVCFF are foreign residents, it is widely-held, and at least 90 per cent of the value of the FVCFF is ultimately held by eligible venture capital investment partners that are not FVCFFs.

A CGT event occurs on 7 January 2017 as the FVCFF receives capital gains from both its VCLP and ESVCLP. The FVCFF is able to disregard the capital gains because it is a widely held FVCFF at the time of the CGT event.

Rulings by Innovation Australia on ineligible activities

2.109 VCLPs, ESVCLPs and AFOFs may not always be certain whether a particular activity is or would be an ineligible activity. In order to minimise investor uncertainty, these amendments provide a mechanism for Innovation Australia to provide public or private guidance about whether particular activities are ineligible activities.

2.110 Specifically, Innovation Australia may make a public or private ruling that a particular activity is not or would not be an ineligible activity in relation to an investment in an entity by a VCLP, ESVCLP or AFOF. These rulings may be about the status of an activity generally or be limited to specified circumstances. [Schedule 2, item 61, Division 362 of the TAA 1953]

2.111 Innovation Australia may make public rulings as appropriate. However, Innovation Australia may only make a private ruling in response to an application by a general partner of a limited partnership registered as a VCLP, ESVCLP or an AFOF. [Schedule 2, item 61, sections 362-5, 362-25 and 362-30 in Schedule 1 to the TAA 1953]

2.112 While these rulings are made by Innovation Australia, they are made under the Taxation Administration Act 1953 (TAA 1953) and are generally subject to the same processes, rules and requirements as public and private rulings by the Commissioner. [Schedule 2, item 61, sections 362-70 and 362-75 in Schedule 1 to the TAA 1953]

2.113 A ruling by Innovation Australia is a public ruling if it is published and also states that it is a public ruling. Innovation Australia must publish a notice of the making or withdrawal of a public ruling in the Commonwealth Gazette. If a public ruling is withdrawn, the withdrawal must not take effect before the notice is published. [Schedule 2, item 61, subsections 362-5(2) and (3) and sections 362-15 and 362-20 in Schedule 1 to the TAA 1953]

2.114 Although rulings by Innovation Australia are generally subject to the same or similar requirements as tax rulings by the Commissioner, they cannot be modified by the Commissioner (and nor can Innovation Australia modify rulings by the Commissioner). Consistent with this distinction, rulings (and the failure to make a private ruling) by Innovation Australia are subject to review under the processes set out in the VCA 2002 rather than the objection process under the tax law. [Schedule 2, item 62, paragraphs 29-1(k) and 29 - 1(l) of the VCA 2002]

2.115 After making a private ruling, Innovation Australia must provide notice of the ruling to the applicant and the Commissioner. If Innovation Australia refuses to make a private ruling it must notify the applicant and provide reasons for the refusal. A private ruling must state that it is a private ruling and must identify the entity it applies to and specify the activity to which it relates. [Schedule 2, item 61, sections 362-35 and 362-40 in Schedule 1 to the TAA 1953]

2.116 The applicant for a private ruling may give Innovation Australia a notice requiring Innovation Australia to make the ruling if, at the end of 60 days after the application, Innovation Australia has not made the ruling or told the applicant that Innovation Australia has declined to make the ruling. The 60 day period is extended in particular circumstances, such as where Innovation Australia requests further information. If Innovation Australia does not make a ruling within 30 days of such a notice being given, Innovation Australia is taken to have refused to make a ruling. [Schedule 2, item 61, section 362-50 in Schedule 1 to the TAA 1953]

2.117 A public or private ruling by Innovation Australia applies from the time it is published, or from the time specified in the ruling. [Schedule 2, item 61, section 362-10 and 362-45 in Schedule 1 to the TAA 1953]

2.118 A public or private ruling will cease to apply at such time as the ruling may specify, or otherwise when the ruling is withdrawn. [Schedule 2, item 61, sections 362-15 and 362-55 in Schedule 1 to the TAA 1953]

2.119 Consistent with the current requirements on the Commissioner, Innovation Australia must withdraw a public or private ruling if it is no longer satisfied that it is correct, or if the ruling is inconsistent with the decision of a court. [Schedule 2, item 61, sections 362-20 and 362-60 in Schedule 1 to the TAA 1953]

2.120 Venture capital investments are often complex and illiquid. Forcing entities that have relied upon guidance that has been found to be incorrect to swiftly dispose of such investments could potentially place them at a significant financial disadvantage. It could also significantly harm the entity in which the investment has been made. Given this, the amendments provide a period that is sufficient for investors to arrange for an orderly disposal of the investment, avoiding potential losses and other costs associated with the rushed disposal of an investment and the risk of deregistration.

2.121 As a result, unlike taxation rulings, rulings by Innovation Australia under these provisions continue to bind the Commissioner and Innovation Australia until the end of the income year after the income year in which the ruling is withdrawn, but only to the extent that the ruling affected investments made before the withdrawal took effect. [Schedule 2, item 61, section 362-65 in Schedule 1 to the TAA 1953]

2.122 It is expected that Innovation Australia will consult with the Commissioner when making or withdrawing a ruling, given the implication of Innovation Australia's rulings for the Commissioner's administration of the tax law. However, the final responsibility for making and withdrawing rulings rests with Innovation Australia.

Example 2.9: Innovation Australian and private rulings

John is a general partner of a VCLP. The VCLP is considering investing in Fintech Co, a company that develops specialised transaction software for use by financial institutions for lending purposes.

John is unsure if Fintech Co is an eligible venture capital investment because he is uncertain whether the activities of Fintech Co are considered to be providing capital to others, which is included on the list of ineligible activities in (subsection 118-425(13)).

John contacts Innovation Australia about his concerns and applies for a private ruling. Having regard to all the circumstances and taking into account the material provided by John, Innovation Australia considers that the activity of the development and sale of software is not an ineligible activity, even where the software may be used by customers who engage in an ineligible activity such as finance. Innovation Australia also consults with the Commissioner.

Innovation Australia issues a private ruling to John that the activities of Fintech Co are not ineligible activities.

John may rely upon this ruling in relation to any investment in Fintech Co. that the VCLP in which he is a partner makes. Both Innovation Australia and the Commissioner must administer the law in relation to John's VCLP on the basis of the view outlined in the ruling, until the end of the income year after the income year in which the ruling is withdrawn.

Example 2.10: Innovation Australia and public rulings

Heather is a general partner of a VCLP. The VCLP is considering investing in Robuddy, a construction robotics company. Robuddy designs and produces state-of-the-art robots for use in building construction. Heather is unsure if Robuddy is an eligible venture capital investment because she is uncertain whether the activities of Robuddy are ineligible activities (for the purposes of the predominant activity test). Property development and construction of infrastructure facilities are ineligible activities (subsection 118-425(13)). Heather is unsure whether construction robotics would come within these categories of ineligible activities.

Heather contacts Innovation Australia about her concerns. Innovation Australia has received submissions from a number of other taxpayers on similar issues and considers that the activity of construction robotics is not an ineligible activity, given that the sale of robots for use in construction is distinct from directly engaging in construction itself. Innovation Australia has also consulted with the Commissioner.

Having regard to all the circumstances and taking into account the material provided by Heather and others, Innovation Australia issues a public ruling that construction robotics is not an ineligible activity.

This ruling does not affect whether the sale of construction robots is an ineligible activity. However to the extent that Robuddy or other entities act in accordance with the ruling, the Commissioner and Innovation Australia must act in accordance with the ruling until the end of the income year following the income year in which it is withdrawn.

Excluding small entities from eligible venture capital investment auditor requirements

2.123 Previously, for an investment in an entity to be an eligible venture capital investment, the entity was required to have a registered auditor by the end of the income year in which the investment was made and at all subsequent times.

2.124 However, the requirement to appoint a registered auditor and have audited accounts or an audited statement can be onerous. Small proprietary companies and many unit trusts are generally not required to appoint a registered auditor or prepare financial statements under the Corporations Act 2001.

2.125 Accordingly, this Schedule amends the venture capital auditor requirement to align it more closely with auditor requirements for companies under the corporations law. This removes the cost of auditor fees for small entities and therefore encourages greater investment in lower value eligible venture capital investments that are more likely to be closer to start-up phase and therefore in greater need of support.

2.126 Under the amendments an entity that is an eligible venture capital investment only requires an auditor to be appointed either from the later of, the income year in which the investment is made, or a later income year in which any of the following conditions are met:

•

it is a public company or a large proprietary company within the meaning of the Corporations Act 2001 for the financial year corresponding with that income year;

•

it is a unit trust and if it was a company it would have been a public company or a large proprietary company within the meaning of the Corporations Act 2001 for the financial year corresponding with that income year; or

•

the total value of the assets of the entity exceeds $12.5 million.

[Schedule 2, items 64 and 66, subsections 118-425(5) and (5A) and subsections 118-427(6) and (6A)]

2.127 If an auditor is not required to be appointed, and the entity chooses not to have an auditor at that time and does not have audited accounts, the value of assets and investments of an eligible venture capital investment on a particular date for the purpose of Subdivision 118-F is:

•

the amount stated to be the market value in a statutory declaration made within the period of twelve months ending on that date by:

-

the directors of the company for an entity that is a company; or

-

the trustee of the unit trust for an entity that is a unit trust; or

•

if no statutory declaration has been made, the market value of the assets and investments on that date.

[Schedule 2, items 65, 68, 69 and 70, subsections 118-425(10A), 118-428(4) and 118-440(2A) and section 118-450]

2.128 If the Commissioner is satisfied (based on reasonable grounds) that an amount stated to be the market value of an asset or investment in a statutory declaration is inaccurate, the value of the asset or investment is instead its market value at the time, rather than the amount stated in the statutory declaration. This ensures that there is a mechanism to address wrongful declarations that are made. [Schedule 2, item 70, subsection 118-450(1)]

2.129 If an eligible venture capital investment entity:

•

has appointed a registered auditor (even if they are not required to appoint a registered auditor); or

•

is required to appoint an auditor (even if they have not done so);

then the alternative valuation method provided by these amendments is not available. The value of the asset or investment is that shown in a statement, prepared in accordance with the accounting standards and audited by the entity's auditor, showing that value as at a time no longer than 12 months before that time. [Schedule 2, item 67 and 68, subsections 118-427(11) and 118-428(4)]

2.130 An auditor is required to be appointed from the end of the income year in which the investment is made if the auditor appointment requirement is met for that income year. Alternatively, if the criteria for appointment is first satisfied in a later income year, then the auditor needs to be appointed from the time that the criteria for appointment is met in that later income year. [Schedule 2, items 64 and 66, subsections 118-425(5A) and 118-427(6A)]

2.131 If an auditor must be appointed, they must be registered as an auditor:

•

in any State or Territory in Australia; or

•

under a law that applies in the country in which the entity is a resident.

[Schedule 2, item 71, the definition of 'registered auditor' in subsection 995-1(1)]

Example 2.11: Auditor appointment - valuation of assets

An EVCLP invests in Leaco, a private company, by buying 20 per cent of its share capital in the 2017-18 income year. Leaco has assets with a total market value of approximately $10 million.

Leaco is an eligible venture capital investment for the EVCLP. No auditor needs to be appointed for the 2017-18 income year as the gross value of Leaco's assets does not exceed $12.5 million in that income year and Leaco is not a public company or large proprietary company.

The value of Leaco's assets for the purposes of the venture capital rules is the current market value. In August 2017 the directors of Leaco make a statutory declaration of the market value of Leaco's assets. The declaration states that Leaco has $10 million in assets. There is no contrary evidence of the value of Leaco's assets.

Consequently, for the purposes of the venture capital rules, the value of Leaco's assets is $10 million for the 2017-18 income year.

In the 2019-20 the assets of Leaco for the first time exceed $12.5 million in value. The directors are required to appoint auditors for the 2019-20 income year.

Improving access to funding from managed investment trusts

Addressing uncertainty about venture capital investment and trading requirements

2.132 Currently, there is uncertainty about whether MITs can participate as a limited partner in an ESVCLP or VCLP without affecting their status as a MIT.

2.133 This uncertainty arises as one of the requirements for an entity to be a managed investment trust is that it must not:

•

if it is a unit trust, be a trading trust for the purposes of Division 6C of Part III of the ITAA 1936; or

•

if it is not a unit trust, either:

-

carry on a trading business within the meaning of Division 6C of Part III of the ITAA 1936; or

-

control or be able to control another entity that carries on such a business.

2.134 These restrictions are intended to ensure that MITs are primarily engaged in passive investment. However, in the context of investments in VCLPs and ESVCLPs, the unusual features of these types of entities mean that there are concerns that these restrictions may be breached merely by being a limited partner in such a partnership.

2.135 The amendments address these concerns by allowing a MIT to disregard its investment in and through an ESVCLP or VCLP when determining if it is a trading trust, carries on a trading business or controls an entity that carries on such a business, in certain circumstances.

2.136 An interest that a MIT has in a VCLP or ESVCLP is disregarded when determining if a trust is a trading trust, carries on a trading business (within the meaning of Division 6C of Part III of the ITAA 1936) or controls or is able to control (directly or indirectly) another entity, provided that:

•

the MIT is not the general partner of the ESVCLP or VCLP; and

•

the MIT does not hold more than 30 per cent of the committed capital of the ESVCLP or VCLP.

[Schedule 2, items 73 and 75, subsections 275-10(4A) and (4B) of the ITAA 1997 and subsections 12-400(2A) and (2B) in Schedule 1 to the TAA 1953]

2.137 The requirement that the MIT must not hold more than 30 per cent of the committed capital includes capital committed by entities that are its associates, but not associates that are authorised deposit-taking institutions, life insurance companies (including public authorities that carry on life insurance business) or widely held complying superannuation funds within the meaning of section 4A of the Pooled Development Funds Act 1992 (this is the same requirement that applies to most investors in ESVCLPs as a result of the operation of paragraph 9-3(1)(e) and subsections (4) and (5) of the VCA 2002). [Schedule 2, items 73 and 75, subsections 275-10(4A) and (4B) of the ITAA 1997 and subsections 12-400(2A) and 12-400(2B) in Schedule 1 of TAA 1953]

2.138 Some of the provisions affected by these amendments are also being amended by the Tax Laws Amendment (New Tax System for Managed Investment Trusts) Bill 2015. This Schedule includes contingent commencement provisions for some of its amendments linked to the commencement of that Bill. This will ensure that the same outcome arises regardless of whether or not that Bill has commenced. [Schedule 2, section 2 and items 73 and 75, subsections 275-10(4A) and (4B) of the ITAA 1997 and subsections 12-400(2A) and (2B) of the TAA 1953]

Addressing uncertainty about capital account elections

2.139 The amendments also address uncertainty about whether a MIT is eligible to elect to have the CGT regime apply as the primary code for determining tax outcomes for venture capital investments.

2.140 Generally, MITs may choose to have any gains or losses resulting from certain investments they own taxed on capital rather than revenue account (see section 275-100). However, such a choice may only be made in relation to investments that the fund owns. For investments made through a VCLP or ESVCLP, as the limited partnership is itself a separate legal entity, it is not clear that the MIT owns the asset.

2.141 The amendments provide that for the purposes of making this choice, a MIT should be treated as owning an asset to the extent that the MIT has an interest in the asset as a limited partner in a VCLP or ESVCLP. This ensures that MITs are able to elect that CGT is the primary code for calculating MIT gains or losses in such circumstances. [Schedule 2, item 74, subsection 275-100(1A)]

Consequential amendments

2.142 This Schedule includes a number of minor and consequential amendments to the tax law, including changes to guidance material, to reflect the substantive changes to the tax concessions for venture capital investments. [Schedule 2, items 1, 9 to 12, 14, 25, 31, 34, and 54 to 61, the item headed early stage venture capital limited partnerships in the list in section 13-1, subparagraph 118-407(1)(d)(iv), notes 1 and 2 to subsection 118-407(1), subsection 118-407(5), definition of 'divestiture registration requirement' in subsection 995-1(1), note 3 to subsection 118-425(3), note 4 to subsection 118-427(4), subsection 118-435(1), note to subsections 118-425(13) and 118-427(14) and the definitions of private ruling and public ruling in s.995-1 in the ITAA 1997 as well as section 357-1, subsection 357-5(3) and the note to section 357-50 in Schedule 1 to the TAA 1953]

2.143 This Schedule also includes a number of minor and consequential amendments to the VCA 2002. [Schedule 2, items 17 to 19, 35 to 41 and 43, section 17-3, paragraph 17-5(1)(ab), section 17-15, paragraphs 15-1(ga) and (gb), 15-10(c), (d) and (e), 21-20(g), (h), (i) and (j) and 29-1(i) and (j) of the VCA 2002]

2.144 This Schedule also makes a technical amendment to the rules for conditional registration in the VCA 2002. This amendment clarifies that conditional registration is available in circumstances in which a partnership has complied with all of the requirements in applying to Innovation Australia for registration, but has not yet met the substantive requirements to be unconditionally registered. [Schedule 2, items 77 to 82, paragraphs 13-5(1)(b) and (c), 13-5(1A)(b) and (c) and 13-5(2)(b) and (c) of the VCA 2002]

Application and transitional provisions

Application provisions

ESVCLP tax offset

2.145 The ESVCLP tax offset is available for contributions made at any time to ESVCLPs but only if they became unconditionally registered on or after 7 December 2015, subject to the transitional requirement outlined below. [Schedule 2, item 4]

Example 2.12: ESVCLP registered after 1 July 2016

An ESVCLP is unconditionally registered after 1 July 2016 and its partners contribute $20 million to the ESVCLP for the 2016-17 income year. The contributions are invested in eligible venture capital investments by 31 August 2017. Accordingly, the partners of the ESVCLP are entitled to a non-refundable carry-forward tax offset equal to up to $2 million each for the 2016-17 income year.

Example 2.13: Contributions made to ESVCLPs registered before 7 December 2015

The limited partners of an ESVCLP that becomes unconditionally registered prior to 7 December 2015 make contributions of $30 million each on 1 July 2016. These contributions are used by the ESVCLP for eligible venture capital investments by 30 June 2017. No tax offset applies to these contributions or any later contributions made because the ESVCLP was unconditionally registered prior to 7 December 2015, being the date of announcement of this measure. However the other amendments in Schedule 2 apply.

2.146 The only form of registration that is taken into account for the purposes of this application rule is unconditional registration (noting that conditionally registered ESVCLPs are not ESVCLPs). Accordingly, an ESVCLP tax offset is not available in any circumstances if a partnership became unconditionally registered as an ESVCLP before 7 December 2015, but is available for contributions to funds that were conditionally registered before this time and then became unconditionally registered on or after 7 December 2015.

2.147 In many cases, the date of effect of an ESVCLP's unconditional registration is backdated to the date it first became conditionally registered. Any such backdating of the time of registration prior to the time at which the registration requirements in section 13-1 of the VCA 2002 are met is not taken into account in working out if an ESVCLP became unconditionally registered on or after 7 December 2015. The application provision refers to the date that an ESVCLP became registered, ie. the day registration was granted, not the date from which their registration was effective. [Schedule 2, item 4]

2.148 The amendments also include a transitional rule affecting the treatment of contributions to ESVCLPs that become unconditionally registered on or after 7 December 2015 for the first income year starting on or after 1 July 2016 and earlier income years. Such contributions mostly comprise contributions to entities that were conditionally registered as an ESVCLP at the time of the contribution and later become unconditionally registered and had the effect of their unconditional registration backdated.

2.149 In such circumstances the tax offset available in relation to contributions in any income years prior to the income year starting on or after 1 July 2016 is recognised in the 2016-17 income year. The contributions are treated as being contributions made in the 2016-17 income year, including for the purposes of notifying members. However, unless a partner is a member of the ESVCLP on 30 June 2017 they will not be entitled to a tax offset. [Schedule 2, item 5]

2.150 Although the transitional rule applies to contributions made prior to Royal Assent, it is wholly beneficial to affected partners of ESVCLPs as it provides a benefit to affected parties in the form of a tax offset.

Example 2.14: Contributions made before 1 July 2016 to ESVCLPs registered on or after 7 December 2015

An ESVCLP is conditionally registered on 7 December 2015 and becomes unconditionally registered on 21 February 2016. The ESVCLP has four limited partners. The four partners make contributions of $20 million each to the fund on 1 March 2016. These contributions are used by the ESVCLP for eligible venture capital investments during the 2015-16 income year.

As the ESVCLP was unconditionally registered on or after the date of announcement of the measure, the tax offset applies to the contributions made on 1 March 2016 as these amounts are invested in eligible venture capital investments by 30 June 2016. Under the transitional provision the tax offset is available for the 2016-17 income year.

All other amendments in Schedule 2 also apply to the ESVCLP from 1 July 2016.

Increase to ESVCLP fund size cap

2.151 The increase to the ESVCLP fund size cap applies to the registration of partnerships under the VCA 2002 as ESVCLPs on or after 1 July 2016 including both new and existing ESVCLPs. [Schedule 2, item 7]

Removal of ESVCLP divestiture registration requirement

2.152 The removal of the divestiture requirement applies in relation to the 2016-17 income year and later income years. This means that following 30 June 2016, taxpayers no longer need to dispose of investments that previously exceeded the divestiture threshold, as this will no longer form part of the registration requirements for an ESVCLP. [Schedule 2, item 20]

2.153 Entities that exceed the divestiture threshold at the end of the 2015-16 income year are not required to divest, but if they dispose of the asset more than six months after the start of the 2016-17 income year, any capital gain will only be partially disregarded.

CGT exemption for fixed and unit trust beneficiaries of partners in ESVCLPs

2.154 The CGT exemption applies in relation to payments made, in respect of a unit or interest in a trust, in an income year starting on or after 1 July 2016. [Schedule 2, item 23]

Requirements for entities in which VCLPs, ESVCLPs and AFOFs invest

2.155 The amendments made to the ITAA 1997 concerning entities in which VCLPs, ESVCLPs and AFOFs can invest generally apply in relation to the 2016-17 income year and later income years. [Schedule 2, subitem 44(1)]

2.156 The amendments to sections 15-1 and 21-20 of the VCA 2002 apply in relation to the first financial year to start on or after Schedule 2 commences and to later financial years. Schedule 2 commences on the later of Royal Assent and 1 July 2016. [Schedule 2, subitem 44(2)]

2.157 The amendments to section 15-10 of the VCA 2002 apply in relation to the first quarter to start on or after the commencement of Schedule 2 and to later quarters. [Schedule 2, subitem 44(3)]

Pending applications under section 25-15 of the VCA 2002

2.158 Special transitional rules also apply to determinations concerning ineligible activities under section 25-15 of the VCA 2002. These rules ensure that pre-existing applications are not affected by the restructuring of this provision as a result of the amendments.

2.159 The amendments to section 25-15 of the VCA 2002 apply after the commencement of Schedule 2 to applications made under subsection 25-15(1) of that Act that were pending immediately before that commencement as if they had been made under paragraph 25-15(1)(a) of that Act as so amended. This ensures that pending applications are not invalidated by the changes. [Schedule 2, subitem 45(1)]

2.160 The amendments of section 25-15 of the VCA 2002 apply after the commencement of Schedule 2 to applications made under subsection 25-15(1A) of that Act that were pending immediately before that commencement as if they had been made under paragraph 25-15(1)(d) of that Act as so amended. Similarly, this ensures that pending applications are not invalidated by the changes. [Schedule 2,subitem 45(2)]

Foreign venture capital funds of funds

2.161 The amendments made by Part 6 apply in relation to the 2016-17 income year and later income years. [Schedule 2, item 53]

Innovation Australia rulings that activities are not ineligible activities

2.162 The amendments made by Part 7 apply in relation to the 2016-17 income year and later income years. [Schedule 2, item 63]

Auditor appointment requirements

2.163 The change to the auditor requirements for eligible venture capital investments applies in determining auditor appointments for the 2016-17 income year and later income years. [Schedule 2, item 72]

Venture capital investment and MITs

2.164 The amendments made concerning MITs apply in relation to the 2016-17 income year and later income years. [Schedule 2, item 76]

2.165 The amendments to the MIT regime in the ITAA 1997 to allow MITs to disregard their investment in and through an ESVCLP or VCLP when determining if they are a trading trust, carry on a trading business or control an entity that carries on such a business only commence from the date that Schedule 4 to Tax Laws Amendment (New Tax System for Managed Investment Trusts) Bill 2016 commences and do not commence at all if it is not enacted. [Schedule 2, Item 4 of clause 2 to the Bill]

2.166 The amendments to the MIT regime in the TAA 1953 to allow MITs to disregard their investment in and through an ESVCLP or VCLP when determining if they are a trading trust, carry on a trading business or control an entity that carries on such a business only commence if Schedule 4 to Tax Laws Amendment (New Tax System for Managed Investment Trusts) Bill 2016 has not commenced prior to 1 July 2016. [Schedule 2, Item 6 of clause 2 to the Bill]

STATEMENT OF COMPATIBILITY WITH HUMAN RIGHTS

Prepared in accordance with Part 3 of the Human Rights (Parliamentary Scrutiny) Act 2011

Schedule 2 of the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016

2.167 This Schedule is compatible with the human rights and freedoms recognised or declared in the international instruments listed in section 3 of the Human Rights (Parliamentary Scrutiny) Act 2011.

Overview

2.168 Schedule 2 amends the Early Stage Venture Capital Limited Partnership (ESVCLP) and Venture Capital Limited Partnership (VCLP) regimes within the Venture Capital Act 2002 and Income Tax Assessment Act 1997 to improve access to tax concessions for venture capital investments.

2.169 The amendments provide an additional tax incentive for limited partners in new ESVCLPs, relax restrictions on ESVCLP investments and fund size and clarify the legal framework for both ESVCLPs and VCLPs and also Australian venture capital fund of funds and foreign venture capital fund of funds.

2.170 The amendments generally apply from 1 July 2016. However, the tax offset from investments in new ESVCLPs applies to contributions made on or after 1 July 2016 to ESVCLPs that become unconditionally registered on or after 7 December 2015.

Human rights implications

2.171 This Schedule does not engage any of the applicable rights or freedoms.

Conclusion

2.172 This Schedule is compatible with human rights as it does not raise any human rights issues.