House of Representatives

Explanatory Memorandum

(Circulated by authority of the Minister for Housing and Assistant Treasurer, the Hon Michael Sukkar)

Chapter 2 Innovation measures

Outline of chapter

2.1 Schedule 2 to the Bill amends the venture capital and early stage investor tax concession provisions in the ITAA 1997 to make minor changes to ensure that the provisions operate as intended.

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

Context of amendments

Venture capital

2.3 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.

2.4 The Commonwealth provides various tax concessions to support Australian venture capital investments; specifically the VCLP and ESVCLP programs.

VCLPs

2.5 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.

2.6 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 general partners for their successful management of the partnership's investments ('carried interests') are taxed on capital account, thus potentially entitling them to the CGT discount if they have been a partner for over 12 months and meet the other eligibility requirements for the CGT discount.

ESCVLPs

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

2.8 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.

Early stage investors

2.9 A separate incentive was also introduced for early stage investors outside of the venture capital framework. Broadly, this incentive allows eligible investors that acquire shares in an innovation company in an income year to receive a carry forward tax offset for that income year equal to 20 per cent of the amount paid for the shares. However, the total amount of this offset to which an entity and its affiliates is entitled in an income year cannot exceed $200,000.

Summary of new law

2.10 Schedule 2 to this Bill amends the ITAA 1997 to make minor changes to the venture capital and early stage investor provisions relating to CGT transactions, MITs and the early stage investor tax offset to ensure that the provisions operate as intended.

Comparison of key features of new law and current law

Detailed explanation of new law

2.11 Schedule 2 to this Bill amends the ITAA 1997 venture capital tax concession and early stage investor provisions to make minor technical changes to ensure that the provisions operate as intended.

CGT amendments

2.12 The Tax Laws Amendment (Tax Incentives for Innovation) Act 2016 amended the ITAA 1997 to provide concessional CGT treatment for investments in ESVCLPs and VCLPs. Schedule 2 makes changes to these provisions to ensure that they operate as intended.

Clarifying the treatment of valuation year capital gain

2.13 Section 118-408 imposes a cap on the extent to which tax concessions are available to ESVCLPs disposing of investments made once the $250 million threshold has been exceeded by the investee. If the total value of the assets of the investee entity (and any connected entities) exceeds $250 million at the end of an income year, and the ESVCLP 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.

2.14 Under subsection 118-408(2) the amount of the partially exempt capital gain that is not disregarded in a later income year is:

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Normal capital gain less valuation year capital gain

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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;

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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 six months after the end of the income year in which the $250 million threshold was first exceeded.

2.15 This makes clear that the valuation capital gain is determined based on what the capital proceeds would have been if the events resulted in the gain happening at the end of the period six months after the end of the relevant valuation year, and other matters relating to the amount of the gain were determined on a reasonable basis taking into account this premise. While this requirement was already implicit in the law, the amendment clarifies what is involved to make it easier for taxpayers to understand their obligations. [Schedule 2, item 1, subsection 118-408(2)]

Additional investment requirements for ESVCLPs

2.16 Section 118-428 sets out the additional investment requirements for ESVCLPs for pre-owned investments.

2.17 These requirements include an investment cap that limits the amount an ESVCLP can invest in pre-owned investments to 20 per cent of the ESVCLPs committed capital.

2.18 The amendment clarifies that the cap only applies if an entity's total pre-owned investments, rather than an entity's total investments, would exceed 20 per cent of its committed capital. While this is implicit in the law, to avoid doubt, the law is amended to expressly state this requirement. Following the amendments the ITAA 1997 provides that a pre-owned investment can only be acquired by an ESVCLP if the sum of the following does not exceed 20 per cent of the partnership's committed capital:

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the value of the pre-owned investment at the time of investment; and

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the value of all other pre-owned investments that the ESVCLP owns at the time of investment.

[Schedule 2, item 2, subparagraph 118-428(2)(c)(ii)]

Managed investment trusts

2.19 The Tax Laws Amendment (Tax Incentives for Innovation) Act 2016 amended the MIT eligibility provisions in Division 275 of the ITAA 1997 to permit MITs to invest in an ESVCLP or VCLP (refer to paragraphs 2.132 to 2.141 of the Explanatory Memorandum to Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016). Two consequential amendments are made in relation to these earlier amendments.

Australian venture capital fund of funds

2.20 MITs will now also be able to invest in AFOFs by including them in the exception that permits them to invest in ESVCLPs and VCLPs.

2.21 The earlier amendments to the MIT eligibility provisions permitted MITs to invest in ESVCLPs and VCLPs. This was achieved by providing an exception that, for the purposes of considering whether a trust was a trading trust (making it ineligible to be a MIT), that investments in ESVCLPs and VCLPs would be disregarded.

2.22 Under subsection 118-410(3) an AFOF is a limited partnership that, at a particular time, has been registered by the PDF Registration Board established under the Pooled Development Funds Act 1992 as an AFOF and the registration under Part 2 of the Venture Capital Act 2002 is, or is taken to be in force.

2.23 A limited partnership may be registered as an AFOF if:

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it is formed in Australia;

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every general partner is resident in Australia;

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its partnership agreement specifies that the partnership is to remain in existence for at least 5 years but not more than 20 years;

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it only carries on activities which are related to the making of eligible venture capital investments;

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its only investments are investments in a VCLP or an ESVCLP or eligible venture capital investments in a company that a VCLP or an ESVCLP (in which the AFOF is a partner) already holds an investment;

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the only debt interests held by it are permitted loans; and

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the general partner has notified the PDF Registration Board that the AFOF has sufficient funds to begin its investment program.

[Schedule 2, items 15 and 16, subsection 275-10(4A)]

Definition of public trading trust

2.24 The earlier amendments to the MIT eligibility provisions did not fully take into account the interaction between the MIT eligibility rules in Division 275 of the ITAA 1997 and the public trading trust provisions in Division 6C of Part III of the ITAA 1936.

2.25 Subsection 102T(16) of the ITAA 1936 has the effect that if a trust is a public trading trust then it cannot be a MIT.

2.26 A unit trust is a public trading trust if it satisfies the requirements set out in section 102R of the ITAA 1936. They are:

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it is a public unit trust in relation to the relevant year of income;

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it is a trading trust in relation to the relevant year of income; and

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it is a resident unit trust in relation to the relevant year of income or it was a public trading trust in relation to a year of income preceding the relevant year of income.

2.27 Under sections 102M and 102N of the ITAA 1936 a trading trust is a trust that carries on business that is not wholly an eligible investment business.

2.28 Most trusts that are MITs would satisfy the first and third conditions for being a public unit trust, meaning that the only reason they are not public trading trusts is because they are not trading trusts.

2.29 As outlined in paragraphs 2.132 to 2.137 to the Explanatory Memorandum to Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, due to their unique features, there are concerns that investments in ESVCLPs and VCLPs may not be eligible investment business. If this was the case, trusts that invest in ESVCLPs and VCLPs could be considered to be public trading trusts. Similar issues could arise for MITs that invest in AFOFs as a result of the changes outlined in paragraphs 2.19 to 2.23 above.

2.30 Schedule 2 amends the definition of public trading trust to ensure that in considering if a trust is a public trading trust, investments in ESVCLPs, VCLPs and AFOFs are disregarded if trusts are MITs. [Schedule 2, item 18, subsection 102R(5) of the ITAA 1936]

Early stage investor tax offset

2.31 Division 360 of the ITAA 1997 provides for the early stage investor tax offset. Amendments are made to ensure that the provisions operate as originally intended.

2.32 For further information on the early stage investor tax offset refer to paragraphs 1.16 to 1.109 of the Explanatory Memorandum to Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016.

Investments should not entitle an investor to both the ESVCLP tax offset and the early stage investor tax offset

2.33 An amendment is made to ensure that where an investor is entitled to the ESVCLP tax offset they do not also qualify for the early stage investor tax offset. This is done by including an eligibility requirement for the early stage investor tax offset which has the effect that an investor will only qualify for the offset if they are not an ESVCLP. [Schedule 2, item 5, subparagraph 360-15(1)(a)(ia)]

2.34 The ESVCLP tax offset is a non-refundable tax offset provided to limited partners in ESVCLPs in the income year in which they make contributions to the ESVCLP. The ESVCLP tax offset encourages additional investment in early stage venture capital by reducing the effective cost of such investments. For further information on the ESVCLP refer to paragraphs 2.17 to 2.47 of the Explanatory Memorandum to Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016.

30 per cent interest restriction

2.35 In order to qualify for the early stage investor tax offset, an investor must not hold more than 30 per cent of the equity interests in an early stage innovation company or any entities connected with that company. This is tested immediately after the time the relevant equity interests are issued. For further information refer to paragraphs 1.37 to 1.39 of the Explanatory Memorandum to Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016.

2.36 The 30 per cent equity interest test is amended to clarify what is meant by 30 per cent of the equity interests in the company or entity. The amendments provide that an interest holder has an equity interest of 30 per cent of more if they:

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are entitled to receive more than 30 per cent of any distributions of income and capital in the company or entity; or

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exercise, or control the exercise of more than 30 per cent of the total voting power in the company or entity.

2.37 This change ensures that the equity interest test for the early stage investor tax offset applies in a manner that is consistent with how it is applied in other parts of the income tax law (for example subsection 328-125(2)). [Schedule 2, item 6, paragraph 360-15(1)(f)]

Widely held companies and their subsidiaries should not qualify for the offset

2.38 It was intended that the early stage investor tax offset would be available to all types of investment (whether an investment is made directly by an investor that is a corporation or an individual or by that investor indirectly through an interposed trust or partnership) other than 'widely held companies' (as defined in subsection 995-1(1)) and 100 per cent subsidiaries of these companies. For more information refer to paragraph 1.16 of the Explanatory Memorandum to Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016.

2.39 Paragraph 360-15(1)(a) of the current law restricts investments through widely held companies and wholly owned subsidiaries of these companies. An amendment is made to make clear that the same restriction applies for investments made indirectly through trusts and partnerships. [Schedule 2, item 7, subsection 360-15(2)]

2.40 This amendment also clarifies that the early stage investor tax offset is available to a member of a partnership or trust where the investment has been made through a chain of trusts or partnerships. For example, Trust A owns an interest in Trust B which owns an interest in Trust C. If Trust C makes an investment in an early stage innovation company that would entitle it to the early stage investor tax offset (were it not a trust), members of Trust A would be entitled to the early stage investor tax offset. [Schedule 2, item 7, subsection 360-15(2)]

Amount of the early stage investor tax offset - general case

2.41 For the purposes of calculating the amount of the early stage investor offset, the offset is 20 per cent of the amount of the sum of any money and non-cash benefits received or entitled to be received by the company in return for the issue to the shareholder of the shares. The value of the non-cash benefits is their value at the time the shares were issued to the shareholder. [Schedule 2, item 8, subsection 360-25(1)]

2.42 Non-cash benefits include any property or services that are provided or required to be provided.

2.43 The amount of the offset is based on all of the money and non-cash benefits provided to the company in return for the issue of the shares, including consideration provided as a deposit or to acquire an option or other right that is subsequently exercised.

2.44 There are no other changes to how section 360-25 operates. For more information refer to paragraphs 1.40 to 1.45 of the Explanatory Memorandum to Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016.

Amount of the early stage investor tax offset - members of trusts or partnerships

2.45 Two amendments are made to section 360-30 that sets out the amount of the tax offset for members of trusts and partnerships (refer to paragraphs 1.51 to 1.56 of the Explanatory Memorandum to Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016 for guidance on how this provision operates).

Limiting the amount of the early stage investor tax offset that can be claimed in an income year

2.46 An amendment is made to limit the amount of the early stage investor tax offset that can be claimed by an entity to $200,000 each income year where the investment is made indirectly through a partnership or trust. While section 360-25 currently includes a limit of $200,000 for investments made directly, there is no limit for indirect investments. This change ensures that the $200,000 income year limit applies as a single combined limit to both direct and indirect investments. [Schedule 2, item 9, subsection 360 30(1A)]

2.47 As part of this change, a minor consequential amendment is made to the rules setting out the amount of the early stage investor tax offset for trustees to clarify that, for the purpose of this calculation, it is not relevant if members of the trust have reached this cap. [Schedule 2, item 11, paragraph 360-35(b)]

Entitlement to tax offset to reflect entitlement to a fixed proportion of any capital gains

2.48 If a member of a trust or partnership is entitled to a fixed proportion of any capital gain from investments that would result in the trust or partnership being entitled to the tax offset if that entity was an individual, then the member's share of the offset must be that fixed proportion. For example, such a fixed proportion normally exists for the holders of units in unit trusts. Where such a fixed proportion exists, the trustee must determine that the member is entitled to that amount or proportion and cannot make a contrary determination.

2.49 The provisions setting out this requirement are amended to specify that the relevant disposal is the disposal of the investment that would give rise to or gave rise to the entitlement to the early stage investor tax offset. This ensures there is no ambiguity where different entitlements exist in relation to different assets. [Schedule 2, items 4 and 10, subsections 61-770(3) and 360-30(3)]

Early stage innovation company

2.50 Schedule 2 makes three amendments to the definition of what is an early stage innovation company in section 360-40.

Recently incorporated or registered in the Australian Business Register

2.51 To satisfy the recently incorporated or registered in the ABR requirement the company:

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must have been incorporated in Australia within the last three income years (the latest being the current income year at the test time); or

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if it has not been incorporated within the last three income years - then it must have been registered in the ABR within the last three income years (the latest being the current income year at the test time); or

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if it has not been registered in the ABR within the last three income years - then:

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it must have been incorporated in Australia within the last six income years (the latest being the current year); and

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it and any wholly-owned subsidiaries must have incurred expenses of no more than $1,000,000 in total over the last three income years (the latest being the income year before the current income year at the test time).

2.52 The expenditure component of the 'if it has not been registered in the ABR within the last three income years' component has been modified so that the expenditure part of this test is applied to the last three income years with the latest being the income year before the current income year at the test time. This provides certainty to the company as it knows, at the test time, whether this component of the test is satisfied. Previously under the test one of the three years was the current income year which, at the test time, had not concluded. [Schedule 2, item 12, subparagraph 360-40(1)(a)(ii)]

Foreign companies are not early stage innovation companies

2.53 An amendment is made so that companies that are foreign companies as defined in the Corporations Act 2001 are no longer able to be early stage innovation companies. [Schedule 2, item 13, paragraph 360-40(1)(f)]

Clarification of when a company is doing something

2.54 Under paragraph 360-40(1)(e), to be an early stage innovation company, a company has to engage in certain activities or hold certain interests. The amendment includes a note to clarify that, under the general principles of agency, this can include the company engaging other entities to hold these things or perform activities for it, or on its behalf. [Schedule 2, item 13, note following subsection 360-40(1)]

Application and transitional provisions

2.55 The amendments made by Part 1 of Schedule 2 to this Bill apply as follows:

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item 1 - applies to CGT events occurring on and after 1 July 2018; and

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item 2 - applies in relation to investments made on or after 1 July 2018.

[Schedule 2, item 3]

2.56 The amendments made by Part 2 and Part 3 apply to income years commencing on and after 1 July 2018. [Schedule 2, items 14 and 17]

2.57 The amendments made by Part 4 apply in relation to the 2016-17 year of income and later income years. This amendment applies retrospectively to ensure that the law operates as it always was intended to operate. This ensures that trusts that acted in a manner that complied with the intended manner of operation of the law are not adversely impacted by a technical omission that was made in Tax Laws Amendment (Tax Incentives for Innovation) Act 2016 . [Schedule 2, item 19]

2.58 Schedule 2 to this Bill commences on the first day of the next quarter to commence following the day of Royal Assent. [Clause 2]