House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

Chapter 1 - Tax exemption for profits on venture capital investments

Outline of chapter

1.1 This chapter explains the new tax exemption on venture capital investments. In particular, it explains what conditions must be met before the tax exemption can apply, and who can access it. The detailed description of what constitutes a VCLP and an AFOF is discussed in Chapter 2.

Context of amendments

1.2 The purpose of this measure is to extend the tax exemption already provided to certain non-resident tax exempt pension funds (contained in Subdivision 118-G, and sections 26-70 and 51-55 of the ITAA 1997) to gains derived from investments in eligible venture capital companies by non-residents from certain jurisdictions.

Summary of new law

1.3 The new law provides an exemption from income tax on profits or gains on equity investments made by a VCLP in Australian companies whose assets are not more than $250 million, to partners in the VCLP that are:

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tax-exempt residents of Canada, France, Germany, Japan, the United Kingdom or the United States of America;

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venture capital funds of funds established and managed in Canada, France, Germany, Japan, the United Kingdom or the United States of America; and

•

taxable residents of Canada, Finland, France, Germany, Italy, Japan, the Netherlands (excluding the Netherlands Antilles), New Zealand, Norway, Sweden, Taiwan, the United Kingdom or the United States of America, and who hold less than 10% of the committed capital of the VCLP.

1.4 The exemption is also available to partners in an AFOF, which is a partner in a VCLP, that are:

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tax-exempt residents of Canada, France, Germany, Japan, the United Kingdom or the United States of America;

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venture capital funds of funds established and managed in Canada, France, Germany, Japan, the United Kingdom or the United States of America; and

•

taxable residents of Canada, Finland, France, Germany, Italy, Japan, the Netherlands (excluding the Netherlands Antilles), New Zealand, Norway, Sweden, Taiwan, the United Kingdom or the United States of America, and who hold less than 10% of the committed capital of the AFOF.

1.5 Tax-exempt residents of the specified countries who invest directly in the Australian companies that qualify as a venture capital investment will also qualify for the exemption if they register with the PDF Board.

Detailed explanation of new law

The exemption

1.6 Eligible non-resident partners in a VCLP are exempt from tax on their share of the profit or gain made on the disposal by the VCLP of an eligible venture capital investment, so long as the investment was owned by the VCLP for at least 12 months and held at risk. Conversely, any loss on that investment is not deductible. [Schedule 1, items 3, 4 and 6 of the TLA(VC) Bill; sections 26-68, 51-54 and 118-405 of the ITAA 1997]

1.7 Similarly, eligible venture capital partners in an AFOF (the AFOF itself is a partner in a VCLP) are exempt from tax on their share of the profit or gain on the disposal of an eligible venture capital investment and losses or deductions are not available. The gain or loss on an eligible venture capital investment is made by a partner in an AFOF regardless of whether the venture capital investment disposed of was made by the AFOF, or a VCLP in which the AFOF is a partner. [Schedule 1, items 3, 4 and 6 of the TLA(VC) Bill; sections 26-68, 51-54 and 118-410 of the ITAA 1997]

Convertible notes and convertible preference shares

1.8 If a VCLP, an AFOF or an eligible foreign resident acquires a share in a venture capital investee company by converting a convertible note or a convertible preference share issued by the company, the 12 month period the share is required to be held commences from the time the partnership or foreign investor acquired the convertible note or convertible preference share. [Schedule 1, item 6 of the TLA(VC) Bill; subsections 118-405(3), 118-410(4) and 118-415(3) of the ITAA 1997]

Eligible venture capital partners

1.9 An eligible venture capital partner is a partner in a limited partnership where the partner is:

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a tax-exempt resident of Canada, France, Germany, Japan, the United Kingdom or the United States of America;

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a foreign venture capital fund of funds (see paragraph 1.21); or

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an entity that is a resident of Canada, Finland, France, Germany, Italy, Japan, the Netherlands (excluding the Netherlands Antilles), New Zealand, Norway, Sweden, Taiwan, the United Kingdom or the United States of America and holds less than 10% of the partnership's committed capital.

1.10 To be an eligible venture capital partner, a foreign venture capital fund of funds, together with any connected entity, must not hold more than 30% of the partnership's committed capital. A tax-exempt resident of the specified countries can hold up to 100% of the partnership's committed capital. [Schedule 1, item 6 of the TLA(VC) Bill; paragraphs 118-420(1)(a) and (b) of the ITAA 1997]

1.11 An entity is a connected entity of another if one is an associate of the other within the meaning of 'associate' in section 318 of the ITAA 1936 or, if the entity is a company, another member of the same wholly-owned group. However, the association between entities that are connected entities only because of being partners in a VCLP or an AFOF is disregarded in determining whether:

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an entity is an associate of another for the purposes of the 30% limit on the amount of committed capital a partner may have in a VCLP; or

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a partner qualifies for the exemption because its interest in the VCLP or AFOF together with that of connected entities is less than 10%.

[Schedule 1, item 6 of the TLA(VC) Bill; subsection 118-420(2) of the ITAA 1997]

Committed capital

1.12 A partner's committed capital is the total amount the partner may become obliged to contribute to the partnership, including any amount to be contributed by way of debt.

1.13 This amount is the committed capital whether the partner actually contributes the amount obliged and whether any amounts paid as contributed capital are returned to the partner.

1.14 The partnership's committed capital is the sum of each partner's contributed capital. [Schedule 1, item 6 of the TLA(VC) Bill; section 118-445 of the ITAA 1997]

Tax-exempt non-residents

1.15 An entity is a tax-exempt non-resident if:

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the entity is not a resident of Australia and is a resident of Canada, France, Germany, Japan, the United Kingdom, the United States of America or any other country prescribed in regulations; and

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the entity's income is exempt, or is effectively exempt, from taxation in the country in which it is resident.

1.16 The existing exemption, which is limited to foreign superannuation funds, is expanded to include other tax-exempt non-resident entities such as endowment funds and foundations. These entities may invest either directly or as partners of limited partnerships. [Schedule 1, items 6 and 23 of the TLA(VC) Bill; subsections 118-420(3) and 995(1) of the ITAA 1997]

1.17 An entity is effectively exempt from taxation if:

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a law of that country;

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a decree, proclamation, instrument or direction (however described) issued by a competent authority in that country; or

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an administrative arrangement in that country,

has the effect that no tax, or an insignificant amount of tax, is paid on income derived by the entity. This will include entities which are required to pay tax on particular classes of income representing an insignificant portion of their total income, for example, a United States pension fund that derives some unrelated business taxable income that is subject to tax, while the remainder of their income is exempt. An entity which does not pay tax because tax is levied on a flow-through basis, or does not pay tax because of the operation of a double tax treaty, will not be regarded as exempt from tax. [Schedule 1, item 6 of the TLA(VC) Bill; paragraph 118-420(3)(c) of the ITAA 1997]

Foreign venture capital funds of funds

1.18 A foreign venture capital fund of funds can be:

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a limited partnership; or

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an entity which is not taxed as an entity in its country of residence, whether by operation of law or election, but the entity's income is taxed to members in accordance with their interests in the entity.

[Schedule 1, item 6 of the TLA(VC) Bill; subsections 118-420(4) and (5) of the ITAA 1997]

1.19 An entity that is a general partner of a VCLP cannot be a foreign venture capital fund of funds. [Schedule 1, item 6 of the TLA(VC) Bill; paragraphs 118-420(4)(c) and (5)(d) of the ITAA 1997]

1.20 A limited partnership can be a foreign venture capital fund of funds if the partnership was established in Canada, France, Germany, Japan, the United Kingdom or the United States of America. The general partner must also be a resident of one of these countries. It is possible that a limited partnership may be established in one of the specified countries and the general partner may be a resident of another specified country. [Schedule 1, item 6 of the TLA(VC) Bill; paragraphs 118-420(4)(a) and (b) of the ITAA 1997]

1.21 An entity that is not a limited partnership can be a foreign venture capital fund of funds if:

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it is not taxed as an entity in its country of residence but its income is taxed to members in accordance with their interests in the entity; and

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it was established in Canada, France, Germany, Japan, the United Kingdom or the United States of America and is a resident of one of those countries. The entity may be established in one of the specified countries but be a resident of another specified country.

[Schedule 1, item 6 of the TLA(VC) Bill; paragraphs 118-420(5)(a) to (c) of the ITAA 1997]

Taxable non-residents

1.22 An entity other than a tax-exempt non-resident or a foreign venture capital fund of funds, may also qualify as an eligible venture capital partner, if:

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the partner is a resident of a specified country (see paragraph 1.23); and

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the committed capital of the partner and any connected entities (except entities that are connected only because of being partners in the same VCLP or AFOF) must be less than 10% of the partnership's committed capital.

[Schedule 1, item 6 of the TLA(VC) Bill; paragraph 118-420(1)(c) of the ITAA 1997]

1.23 The partner must be a resident of one of the following countries:

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Canada;

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Finland;

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France;

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Germany;

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Italy;

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Japan;

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the Netherlands (excluding the Netherlands Antilles);

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New Zealand;

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Norway;

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Sweden;

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the United Kingdom;

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the United States of America; or

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any other foreign country prescribed by regulation.

[Schedule 1, item 6 of the TLA(VC) Bill; paragraph 118-420(6)(a) of the ITAA 1997]

1.24 However, a partner who holds less than 10% of the committed capital of a VCLP or AFOF is not an eligible venture capital partner if it is:

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a general partner of a VCLP; or

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a tax-exempt non-resident or a foreign venture capital fund of funds.

[Schedule 1, item 6 of the TLA(VC) Bill; paragraph 118-420(6)(b) of the ITAA 1997]

1.25 A trust cannot be an eligible venture capital partner if an Australian resident:

•

is or is likely to become presently entitled to a share of the income of the trust for the purposes of Division 6 of Part 111 of the ITAA 1936; or

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has or is likely to have an individual interest in a share of the income of the trust for the purposes of Division 5 of Part 111 of the ITAA 1936.

The Australian resident may be presently entitled to, or have an individual interest in the income of the trust, either directly or indirectly through one or more interposed partnerships or trusts. [Schedule 1, item 6 of the TLA(VC) Bill; subsection 118-420(7) of the ITAA 1997]

Direct investment - eligible venture capital investors

1.26 It is not necessary to invest in a VCLP or an AFOF to access the capital gains tax concession. A tax-exempt non-resident who is a resident of Canada, France, Germany, Japan, the United Kingdom or the United States of America, and is registered by the PDF Board as an eligible venture capital investor, can also make a direct eligible venture capital investment which qualifies for the tax exemption. [Schedule 1, item 6 of the TLA(VC) Bill; section 118-415 of the ITAA 1997]

1.27 The registration requirements for an eligible venture capital investor are discussed in Chapter 5.