House of Representatives

Explanatory Memorandum

(Circulated by authority of the Minister for Industry, Scienceand Resources, Senator the Hon Nick Minchin)

REGULATION IMPACT STATEMENT

Description of the PDF Program

The Pooled Development Fund Act 1992 (PDF Act) provides for the registration of investment companies called Pooled Development Funds (PDFs) on application to the PDF Registration Board (the Board). The Program is administered by the Board with support from the Department of Industry, Science and Resources.

As companies, PDFs can raise capital by issuing shares to investors. Under the PDF Act, income earned by these funds from investments in eligible small and medium sized enterprises (SMEs), is taxed at a concessional rate of 15per cent. PDF income that is not SME equity income, predominantly unregulated investment income, such as interest earned on capital raised but not yet invested in SMEs, is taxed at a concessional rate of 25 per cent. In addition, dividends in the hands of investors in PDFs are exempt from tax and gains made by investors as a result of trading shares in PDFs are exempt from capital gains tax. To ensure symmetry of gains and losses, any losses from disposal of shares in PDFs can not be used to offset investors other taxable capital gains.

Reviews of the PDF Program

The PDF Program was considered by the (Mortimer) Review of Business Programs, which reported in June 1997. The Mortimer Review recommended that the Program should be retained but that the Programs objective should be amended so that the Program more clearly targeted investment in small, high technology firms.

The PDF Program was reviewed by a task force of officers from the Department of Industry, Science and Resources, the Treasury and the Australian Taxation Office with support from a consultant as part of the Commonwealths Legislation Review Program under the National Competition Policy Agreement. In addition, the Prime Minister announced in his December 1997 statement Investing for Growth that as part of the review the Government would consider options to improve the effectiveness of the Program.

In the 1998 election campaign, the Coalitions industry policy statement Making Industry Stronger promised to: remove current restrictions which limit ownership to 30 per cent of a PDF for regulated Australian superannuation funds and similar overseas pension funds and limited partnerships of such funds; permit PDFs to buy back their own shares subject to Corporations Law and allow funds to return capital to their shareholders under specified conditions; permit funds to make loans to equity investees, including through investment in convertible notes, subject to a maximum 20 per cent of the value of their capital base; and permit the merger of PDFs where no cash consideration is paid to shareholders as part of the merger, other than a genuine dividend.

Problem

At the broadest level, the problem addressed is a perceived market failure in investment decisions, whereby growing SMEs have difficulty attracting patient equity and venture capital to commercialise new ideas and to finance rapid expansion of growing businesses. Market participants suggest these difficulties reflect such issues as information difficulties (both availability and cost) and risk aversion. Further, there are views that the tax system may inhibit investments through restrictions on the use of tax losses and a capital gains tax that does not match preferential treatment overseas, thereby discouraging international venture capital investments in Australian SMEs.

The Government has announced a package of responses to this issue, including specific proposals to improve the operation of the PDF Program as discussed here, and complementary initiatives. Several other Government programs have recently been announced or extended to assist innovative firms to commercialise new ideas. The Innovation Investment Fund program provides support to high-technology start-ups (it delivers higher levels of support but is more tightly targeted than the PDF Program). The Commercialisation Emerging Technologies program will educate emerging early stage companies about the requirements of investors. The Venture Awareness program will establish a set of investment benchmarks for Australian venture capital, and help Australian investment funds to improve their evaluation of venture capital investments. These programs are complementary to the PDF Program.

The problem addressed by the changes considered here is therefore the narrower issue of how to improve the effectiveness of the PDF Program by improving its commercial flexibility and attractiveness whilst maintaining the integrity of the tax incentive. The Government is addressing broader tax policy issues through its response to the Review of Business Taxation.

Objectives

The PDF tax concession does not attempt to address directly the perceived market failure concerning investment decisions discussed above. Rather, its broad approach of reducing tax rates on PDF investments aims to encourage a higher level of investment in growing SMEs than would otherwise occur. Over time, successful PDFs should provide a positive demonstration effect to investors generally.

The review task force recommended that the objectives of the PDF Program be changed from to encourage the provision of patent equity capital to small and medium sized Australian companies to a more precisely stated objective that explicitly recognises but does not restrict the Program to venture capital and explicitly points out the Program is targeted to growing SMEs rather than the wider range of all SMEs. Thus the new objective of the PDF Program is to develop and demonstrate the market for patient equity capital, including venture capital, for growing small and medium sized enterprises and to provide a more competitive tax regime for patient equity and venture capital investments in growing small and medium sized enterprises.

Options

The perceived problem with the PDF Program, as stated by the Mortimer review (in 1997) amongst others, is that PDFs have been underutilised to date. To this end, options to improve the utilisation of the Program were considered.

A package of options is being implemented to increase the attractiveness of the PDF Program by increasing its commercial flexibility so that PDFs can operate more like other venture capital funds, by allowing, for example, the repayment of capital by PDFs to investors, the use of options and the issuance of loans to investee companies. The potential importance of superannuation funds and overseas pension funds as a source of patient equity and venture capital for growing SMEs has also been accommodated by allowing complying, but not excluded, superannuation funds and similarly regulated overseas pension funds (or limited partnerships of such funds) to own up to 100per cent of a PDF, in the same way that banks are already allowed.

The task force was concerned to prevent the tax concession being abused as a tax minimisation vehicle without providing additional patient equity and venture capital to growing small and medium enterprises. In considering a tax incentive such as that provided by the PDF Program, the ability of taxpayers to restructure existing arrangements to benefit from the concession without changing their underlying behaviour, and so not contribute to the objectives of the Program, needs to be recognised. For this reason the task force placed some restrictions on the options it developed and did not recommend other possible options to make the Program more attractive. It also proposed options to improve the efficacy of compliance monitoring and enforcement to ensure that the Program meets its objective, while at the same time does not impose an undue burden on participants.

Impact Analysis

Between 1992 and October 1999, 72 PDFs have been registered by the Board, of which 26 are active in the sense that they have collectively raised over $350m of capital, over $70m of which was raised in 1998-99. Of the capital raised, over $210m has been invested in 200 SMEs, including $60m in 1998-99. The balance is deposited in bank accounts waiting to be invested. Interest in PDFs in recent years suggests the Program is growing strongly after a slow start.

As at 30 June 1998, in the order of 85 per cent of PDF investments have been in firms with total assets of less than $30m, well below the statutory limit of $50m. Most initial investments by PDFs are between $0.5m and $2.0m, which most commentators believe to be the weakest area in the equity market. A significant proportion (at least 25 per cent) of PDF investments appear to be supporting the commercialisation of R & D. Some 35 per cent of PDF investment is at the start-up and early stage of investment, about 50 per cent of investment is at the expansion stage, with the remainder at the later stage (eg, management buy-outs).

The cost to taxpayers of the PDF Program in 1999-2000 is estimated to be approximately $3million per annum in forgone tax revenue and slightly less than $400,000 per annum in administrative costs. The forgone revenue is expected to rise as the Program continues to grow and investments are realised, while the administrative costs are expected to be relatively stable.

Most of the changes increase the commercial flexibility of the PDFs. The effect of these changes in increasing the attractiveness of the Program will be to encourage the provision of additional patient equity and venture capital to growing SMEs through the PDF Program.

On the supply side, the increased flexibility of the Program will improve its attractiveness to investors and specifically to superannuation funds and similarly regulated overseas pension funds that will be able to own up to 100 per cent of a PDF, rather than be limited to a maximum 30 per cent. On the demand side, the new ability of PDFs to lend to their equity investees will improve the attractiveness of the financial support that PDFs may provide to growing SMEs.

The behavioural response to the proposed improvements to the PDF Program is difficult to estimate. It is therefore difficult to be specific about the expected impact of the changes on the amount of money in the PDF Program and available for investment in growing SMEs and on the cost to revenue.

Increased compliance monitoring requirements have been implemented. These changes will not have an onerous effect on participants. Indeed many PDFs voluntarily provided some of the additional information in their annual return for 1997-98, and other changes will simply change the timing of information provision. These changes are necessary to ensure that the Program is not being abused and to assist the PDF Registration Board in alerting PDFs to any potential concerns when they arise, rather than after the annual return is provided.

Consultation

The PDFs, their investors and investee companies, potential investors including superannuation funds, advisers to superannuation funds, State Government departments and other participants and interested parties in the patient equity and venture capital markets were consulted during the review of the PDF Program.

Those consulted were generally supportive of the PDF Program and a large number of possible improvements to the Program were canvassed. Those suggestions that could be implemented without adversely affecting the integrity of the Program or the tax system generally are being adopted.

Conclusion and Recommended Option

To continue the PDF Program, with a further review to be conducted in 2002-03, and adopt the following measures to make the Program more effective and commercially attractive.

1.

Amend the objective of the Program to better reflect its rationale, to become to develop and demonstrate the market for patient equity capital, including venture capital, for growing small and medium sized enterprises and to provide a more competitive tax regime for such investments.

2.

Permit widely-held complying Australian superannuation funds and similarly regulated overseas pension funds and limited partnerships of such funds to wholly own a PDF.

3.

Permit PDFs to buy back their own shares and to return capital to their shareholders, subject to a waiting period of two years for a new or merged PDF, and permit PDFs to make loans to equity investees subject to a maximum of 20 per cent of the PDFs capital base.

4.

Allow the PDF Registration Board to approve the acquisition of non-transferable options in investee companies as additional investments and to approve the merger of PDFs as long as no cash consideration is paid to shareholders as part of the merger, other than a bona fide dividend.

5.

Amend the PDF Act to improve compliance and performance monitoring and to provide the PDF Registration Board with the power to revoke registration for non-compliance with any of the provisions of the Act.

6.

Change the test that the PDF Registration Board must be satisfied that an applicant for a new PDF can and will take certain action in the future to one where the Board must be satisfied that the applicant is, on the evidence presented, reasonably capable of implementing the plan provided to it.

7.

Amend the current definition of the term associate to state that it does not apply where the association did not exist prior to the persons becoming shareholders in the PDF.

Implementation and Review

Amendment of the Pooled Development Fund Act 1992 will be required to give effect to the conclusions of the review.

A second review is proposed in 2002-03, based on the additional information that will be available at that time as a result of the proposals to improve the monitoring of the Program.

Subsequent amendments (Lower Tier Investments)

In keeping with its commitment to continuously improve the PDF Program, the Treasurer, the Hon Peter Costello MP, and the Minister for Industry, Science and Resources, Senator the Hon Nick Minchin, recently announced that the Pooled Development Funds Act 1992 would be amended to close a loophole in the Act, thereby creating a more equitable program for all relevant PDFs.

The Pooled Development Funds Act 1992, Part 4.28A: Indirect Investments , specifies that the Act applies to investments made by a PDF through controlled interposed entities as if the PDF had made the investments directly.

The change will prevent PDFs from participating indirectly in investments that are not in keeping with the objectives of the PDF Program. Some PDFs had undertaken, or were considering, investments in businesses, through controlled eligible investee companies, which would not satisfy the Act's eligibility criteria if they were made directly by the PDF. The changes to the Act specify that from 4August 1999, the date of an announcement of the change, any lower tier investments by controlled investee companies must comply with the requirements of the Act.

The subsequent amendment is expected to have a negligible impact on the existing PDFs. For example, out of a total of 210 investees who have received funds from PDFs registered with the PDF Board, only 2 businesses, invested in by one PDF, could be adversely affected by the closing off of this loophole. Further, the size of the investments by the relevant PDF are relatively small. Overall, the amendment is unlikely to have a substantial direct, or indirect, effect on business and is not likely to restrict competition.

Consultation

This amendment was suggested by the PDF Registration Board. Consultations were held with the Department of the Treasury, and the Department of the Prime Minister and Cabinet.

Any prior public consultation, as part of a comprehensive RIS, would have encouraged additional investments by some PDFs to take advantage of the loophole.