House of Representatives

Explanatory Memorandum

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

Chapter 3 Fintech and venture capital amendments

Outline of chapter

3.1 Schedule 3 to the Bill amends the income tax law and the Venture Capital Act 2002 to ensure that the venture capital tax concessions are available for investments in fintech businesses.

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

Context of amendments

Venture capital

3.3 Venture capital is a mechanism for financing new, innovative enterprises at the seed, start up and early-expansion stages of commercialisation. Venture capitalists invest funds in such enterprises in return for an equity share. The funds are used to develop an enterprise's ideas to the stage where their commercial potential is sufficient for the venture capitalist to sell its equity to another party.

3.4 The Commonwealth provides various tax concessions to support Australian venture capital investments; specifically the VCLP and ESVCLP programs. To be eligible for these tax concessions, among other things, VCLPs and ESVCLPs must only invest in entities that are predominantly engaged in activities that are not ineligible activities (see subsections 118-425(3), 118-425(13), 118-427(4) and 118-427(14)). Ineligible activities include many kinds of finance, insurance and making investments.

VCLPs

3.5 The VCLP regime supports investment in venture capital entities at the high-risk, start-up and expansion stages that would otherwise have difficulty in attracting investment through normal commercial means.

3.6 A VCLP is taxed on a 'flow-through' basis rather than being treated as a company for tax purposes like other limited partnerships resulting in the partners rather than the 'partnership' being taxed. One of the key benefits is that certain foreign partners are exempt from income tax on capital and revenue gains from disposals of eligible investments made by the VCLP, with corresponding losses also being disregarded. In addition, amounts received by certain partners for their successful management of the partnership's investments ('carried interests') are taxed on capital account.

ESCVLPs

3.7 The ESVCLP regime provides additional tax concessions for high-risk start-up entities (with a value of no more than $50 million).

3.8 Like VCLPs, ESVLPs are taxed on a 'flow-through' basis. However, the tax concessions are more generous than for VCLPs given the higher degree of risk involved. Both Australian and foreign investors are exempt from income tax on capital and revenue gains from disposals of investments made by ESVCLPs, with corresponding losses also being disregarded. Income derived from the partnership's investments, such as dividends, is also exempt from income tax.

Venture capital and fintech

3.9 As part of the 2016-17 Budget the Government announced reforms to the tax incentives for venture capital investors in relation to investments in financial technology or fintech.

3.10 Australia has a sophisticated, competitive and profitable financial sector underpinned by a strong regulatory system. As financial services become more globalised and technological disruption increases it needs to keep pace with innovation in banking and finance to stay competitive.

3.11 The Government is creating an environment to make Australia's fintech sector more internationally competitive. However, stakeholders have raised concerns that the access of the fintech sector to venture capital investment is currently restricted due to uncertainty about whether such investments are eligible venture capital investments.

3.12 Currently, for the purposes of the venture capital tax concessions, finance (to the extent it consists of banking, providing capital, leasing, factoring or securitisation), insurance and making investments for the purposes of, broadly, deriving passive income are ineligible activities (see subsections 118-425(13) and 118-427(14)). An investment in an entity is not an eligible venture capital investment if broadly, its predominant activities include ineligible activities (see subsections 118-425(3) and 118-427(4)).

3.13 The close relationship between fintech and these ineligible activities has given rise to questions about whether investments in companies and unit trusts engaged in the development of fintech are eligible venture capital investments.

3.14 In most cases such activities are not ineligible activities. Finance (particularly banking), insurance and making investments are relatively specific activities that are generally subject to comprehensive regulatory regimes. Developing technology or providing services to facilitate finance, insurance and making investments for the purposes of deriving passive income (including investments in shares, unlisted assets and real estate) is generally distinct from engaging in these activities. Such related services are not subject to the relevant regulatory regimes and likewise outside the scope of ineligible activities for the venture capital tax concessions.

3.15 Taxpayers can also obtain certainty about the status of investments for the venture capital tax concessions from Innovation and Science Australia. Innovation and Science Australia has the power to issue binding public and private rulings as well as powers to make determinations to effectively disregard activities for the purposes of the predominant activity test in certain circumstances - see subsections 118-425(14) and (14B) and 118-427(15) and (15A) of the ITAA 1997 and Division 362 in Schedule 1 to the Taxation Administration Act 1953 .

Summary of new law

3.16 Schedule 3 of this Bill amends the ITAA 1997 to provide that, despite the existing rules concerning ineligible activities, an activity is not an ineligible activity for the purpose of the venture capital tax concessions if it is:

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developing technology in relation to finance, insurance or making investments;

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ancillary or incidental to developing technology in relation to finance, insurance or making investments; or

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covered by a finding from Innovation and Science Australia that it is a substantially novel application of technology.

Comparison of key features of new law and current law

Detailed explanation of new law

3.17 Schedule 3 to this Bill amends the ITAA 1997 to ensure that the venture capital investment tax concessions are available for investments in fintech businesses.

3.18 Schedule 3 does this by making two changes to the activities that are ineligible activities for the purposes of the concessions. [Schedule 3, items 1 and 2, subsections 118-425(13A) and 118-427(14A)]

3.19 It should be noted that these amendments operate solely to reduce the scope of what activities are ineligible activities. Many businesses carry on activities relating to fintech that are not affected by these amendments as they have never been ineligible activities.

Development of technology

3.20 Schedule 3 excludes activities relating to the development of technology for use in relation to finance, insurance and making investments as well as activities that are incidental or ancillary to such development activities from being ineligible activities for the purposes of the venture capital tax concessions. [Schedule 3, items 1 and 2, paragraphs 118-425(13A)(a) and (b) and 118-427(14A)(a) and (b)]

3.21 Effectively, the amendments allow ESVCLPs and VCLPs to invest in entities with predominant activities that include the development of technology for use in finance, insurance or making investments (see paragraph 3.14).

3.22 Technology is used in its ordinary meaning; broadly, the practical application of science and engineering. It is not limited to physical devices and can include software. The use of the broad concept is intended to ensure that the meaning of the provision is not limited to current activities but can adapt in line with future developments and changes in practice.

3.23 'Developing technology' is likewise a broad concept, generally covering things done to create, understand and apply technological innovation. It can extend to adapting existing technology for a novel use, such as a novel product or service. It does not, however, generally include the mere use of existing technology, in a manner consistent with an established practice or practices for the use of that technology in the industry sector in which the business is operating.

3.24 The exclusion also covers activities that are incidental or ancillary to these development activities. This can include a wide range of connected activities including the use of the technology to develop or provide new products and services, even if this involves carrying out finance, insurance or investment activities that would otherwise be ineligible activities.

3.25 However, such activities must be incidental or ancillary to the development of technology. This is a matter that needs to be considered in all of the circumstances of the activity. Ultimately, to be incidental or ancillary, activities must be subordinate to the development activities.

3.26 For example, a business creating a substantially novel product in the form of a platform that allows investors to undertake micro-investment in a portfolio of securitised insurance policies and shares would likely satisfy this test during its development, testing and initial commercialisation (i.e. market testing). This is because, in these phases of development, it is likely the activities being carried on are incidental or ancillary to the development of the technology embodied in its product. This necessarily means that, over time, the business may become less likely to satisfy this test as its activities shift from developing the underlying technology to commercialisation, building market share and other uses of the now established technology.

3.27 It should be noted that the above example assumes that the activities amount to finance, insurance or making investments. In many cases, establishing a platform for others to engage in such activities (such as by connecting investment advisors with customers to facilitate investments between these two parties) would not constitute carrying on such activities and so would fall outside the scope of subsections 118-425(13) and 118-427(14).

3.28 Merely carrying on finance activities, insurance activities or investment activities using technology does not make these activities incidental to the development of the technology. However, for example if developers of investment software occasionally use it to make investments, this use may be an ancillary activity. This is likely to depend on the frequency, nature or size of the activities for which the developer uses the technology.

3.29 The amendments also allow for regulations to be made to prescribe activities to which this exclusion does not apply. Fintech is a rapidly changing area and this allows a quick response to emerging issues that result in unintended outcomes without qualifying the broad operation of the provisions. [Schedule 3, items 1 and 2, subsections 118-425(13B) and 118-427(14B)]

Substantially novel applications of technology

3.30 Schedule 3 also excludes activities from being ineligible activities because the activities are related to finance, insurance or making investments if the activities were covered by a finding from Innovation and Science Australia that the activities are a substantially novel application of technology at the time the investment was made. [Schedule 3, items 1, 2 and 3, paragraphs 118-425(13A)(c) and 118-427(14A)(c) and section 118-432]

3.31 This exclusion is intended to permit ESVCLPs and VCLPs to invest in entities that are engaged in substantially novel activities in relation to fintech, even if these activities have moved from the development of technology to its application (in many cases this may occur when a business moves from market-testing a product to full commercialisation).

3.32 To be substantially novel, an application of technology must be new or uncommon and must involve some degree of innovation. This means that many uses of new technology will be substantially novel applications, unless that use has become widespread. Applications of older technology may also be substantially novel, if the technology is used in a manner that is new or applied in a different way to general practice in the relevant industry sector.

3.33 It should be noted that, in this context, novel does not have the specialised meaning it holds in the Patents Act 1990 . In these amendments, novelty does not require that an application of technology be unique or wholly unprecedented. If multiple entities all adopt the same or similar new ways of using technology within a short period of time, each entity's activities may well represent a novel application of technology.

3.34 This could include, for example, entities developing similar new products or services before these products or services are widely available or commonly used in the relevant industry. It could also include the application of technology that is commonly used in one sector to another area where it has not previously been commonly used.

3.35 Determining if an application of technology is substantially novel is a complex question of fact. In order to provide certainty and clarity for investment, an activity must be covered by a finding to this effect from Innovation and Science Australia before an activity can benefit from the concessions.

3.36 There are two types of findings, private findings and public findings.

3.37 Innovation and Science Australia must make a private finding upon receiving a request for a finding in relation to an activity in the approved form, if satisfied that the relevant activities are a substantially novel application of technology. Substantially novel applications of technology can involve, for example, a new product or service based on an application of new or existing technology that is not consistent with the general practice of the relevant industry sector. [Schedule 3, item 3, subsections 118-432(2) and (4)]

3.38 These private findings are administrative in character and are not legislative instruments. They deal with the circumstances of a particular entity and may often involve confidential or commercially sensitive information about its business activities. They are also subject to merits review - see paragraph 3.48.

3.39 Innovation and Science Australia must notify the applicant in writing of their decision in relation to an application for a private finding. However a failure to do so does not affect the validity of a finding or a decision not to make a finding. [Schedule 3, item 3, subsections 118-432(5) and (6)]

3.40 Innovation and Science Australia may also make a public finding about a class of activities if it is satisfied that the relevant class of activities are a substantially novel application of technology. As public findings affect the legal treatment of a class of activities (rather than being specific to a particular entity), they are a legislative instrument, and this is specified in the amendments for avoidance of doubt. [Schedule 3, item 3, subsection 118-432(1)]

3.41 Both types of finding apply for the period specified in the finding by Innovation and Science Australia. This recognises that the novelty of activities is likely to change over time. In determining the appropriate period for a ruling to apply, Innovation and Science Australia is expected to balance the need for the status of particular activities to be reconsidered periodically with the need of stakeholders for certainty and the importance of follow-on investments. [Schedule 3, item 3, subsection 118-432(3)]

3.42 It should be noted that if an activity is covered by a finding at the time an investment is made, it is always excluded from being an ineligible activity for the purpose of that investment. This means that the expiry of a finding will not affect the status of existing investments as an eligible venture capital investment if the activities of the investee entity have not changed.

3.43 However, the finding only affects the treatment of the activities it covers. These activities must be considered together with all other activities of the relevant entity as well as the other conditions to determine if an investment in the entity is an eligible investment.

3.44 This means that, for example, an investment in an existing small insurer that adopts a substantially novel application of technology in one area of its business is still unlikely to satisfy the predominant activity test (see subsection 118-425(3) for companies or subsection 118-427(4) for unit trusts). While the finding allows it to treat the novel application as an eligible activity, its other insurance activities remain ineligible activities and so it is unlikely to satisfy the requirements of the predominant activities test.

3.45 In contrast, an investment in an existing small insurer that adopts a substantially novel application of technology in a way that is central to their business model is much more likely to satisfy the predominant activity test. In this case, a substantial portion of this business's activities are likely to relate to the commercialisation and other uses of the technology that are applications of the technology covered by the finding. Further a substantial part of the other activities of the business is also likely to include the continuing development and refinement of the technology. These types of activity would be treated as not being ineligible activities.

3.46 It is expected that Innovation and Science Australia will consult with the Commissioner of Taxation when making a finding, given the implication of Innovation and Science Australia's findings for the Commissioner of Taxation's administration of the tax law. However, the final responsibility for making findings rests with Innovation and Science Australia.

3.47 In the same way as for the development of technology, the amendments also allow for regulations to prescribe that this exclusion does not apply to prescribed activities. Fintech is a rapidly changing area and this permits a quick response to emerging issues that result in unintended outcomes without qualifying the broad operation of the provisions. [Schedule 3, items 1 and 2, subsections 118-425(13B) and 118-427(14B)]

3.48 Schedule 3 also makes an amendment to the Venture Capital Act 2002 to provide that the decision by Innovation and Science Australia to make (or not to) make a private finding is subject to the internal and AAT review in the same way as other administration decisions relating to the venture capital tax concessions. [Schedule 3, item 5, paragraph 29-1(m) of the Venture Capital Act 2002]

Consequential amendments

3.49 Schedule 3 makes a consequential amendment to Division 362 in Schedule 1 to the Taxation Administration Act 1953 to insert a note to confirm that the power of Innovation and Science Australia to make rulings about ineligible activities extends to cover the changes made to eligibility as a result of these amendments. [Schedule 3, item 4, notes to subsections 362-5(1) and 362-25(1) in Schedule 1 to the Taxation Administration Act 1953]

3.50 Schedule 3 also makes consequential amendments to the income tax law to include notes to explain the substantive amendments. [Schedule 3, item 3, notes to section 118-432]

Application and transitional provisions

3.51 The amendments made by Schedule 3 commence on the first day of the first quarter to begin after the day the Bill receives Royal Assent. [clause 2]

3.52 The amendments apply to investments made on or after 1 July 2018. [Schedule 3, item 6]