House of Representatives

Explanatory Memorandum

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

Chapter 2 - Venture capital limited partnerships

Outline of chapter

2.1 This chapter explains the taxation treatment of VCLPs, AFOFs and VCMPs. Although these partnerships are limited partnerships, they will be treated as ordinary partnerships for Australian tax purposes. Treating these entities as ordinary partnerships allows the income, profits, gains and losses of the partnership to flow-through to partners who are then taxed according to their respective tax status. The chapter also explains the requirements a VCLP or an AFOF must satisfy for it to be treated as an ordinary partnership for Australian tax purposes.

Context of amendments

2.2 Limited partnerships are the preferred vehicle for venture capital investments internationally. Venture capital investors typically invest in venture capital projects through intermediaries such as limited partnerships or funds of funds to diversify their portfolio of venture capital assets in the most cost efficient manner and to access specialist venture capital management.

Summary of new law

2.3 The new law establishes 3 new limited partnerships, VCLPs, AFOFs and VCMPs, and provides for their tax treatment as ordinary partnerships. Partners in these partnerships will be taxed on their share of the income, profits, gains and losses of the partnership according to the partner's tax status. This flow through treatment for VCLPs and AFOFs will be conditional on each of the partnerships being registered by the PDF Board as a VCLP or AFOF. The partnership will cease to be a VCLP or AFOF if its registration is revoked by the PDF Board. There is no registration process for VCMPs.

2.4 As a VCLP, an AFOF or a VCMP is a limited partnership, loss limitation rules will limit the deduction allowable to limited partners for partnership losses to the extent of the partner's exposure to the loss.

Detailed explanation of new law

Venture capital limited partnerships

2.5 A limited partnership is a VCLP at a particular time if the PDF Board registers it as a VCLP and the registration is in force. [Schedule 1, item 6 of the TLA(VC) Bill; subsection 118-405(2) of the ITAA 1997]

2.6 A limited partnership may be registered as a VCLP if:

•

it is formed under a law of any Australian State or Territory or under a law of Canada, France, Germany, Japan, United Kingdom, United States or any part of those countries;

•

its partnership agreement specifies that the partnership is to remain in existence for at least 5 years but not more than 15 years;

•

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

•

its committed capital is at least $20 million;

•

its only investments are eligible venture capital investments;

•

the only debt interests held by it are permitted loans (see paragraph 5.15); and

•

the general partner has notified the PDF Board that the VCLP has sufficient funds to begin it's investment program.

[Part 2, sections 9-1 and 13-1 of the VC Bill]

2.7 Every general partner must be a resident of one of those countries but not necessarily a resident of the country in which the partnership was formed.

Australian venture capital funds of funds

2.8 A limited partnership is an AFOF at a particular time if the PDF Board registers it as an AFOF and the registration is in force. [Schedule 1, item 6 of the TLA(VC) Bill; subsection 118-410(3) of the ITAA 1997]

2.9 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;

•

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

•

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 eligible venture capital investments in a company in which a VCLP (in which the AFOF is a partner) already holds an investment;

•

the only debt interests held by it are permitted loans (see paragraph 5.15); and

•

the general partner has notified the PDF Board that the AFOF has sufficient funds to begin it's investment program.

[Part 2, sections 9-5 and 13-5 of the VC Bill]

Venture capital management partnership

2.10 A limited partnership that is a general partner of a VCLP or an AFOF and only carries on activities related to being a general partner is a VCMP. The partnership ceases to be a VCMP if any of these circumstances change. [Schedule 2, item 16, subsection 94D(3) of the ITAA 1936]

2.11 A partner in a limited partnership is a general partner if the partner's liability is not limited. [Schedule 2, item 2, subsection 6(1) of the ITAA 1936]

Taxation of VCLPs, AFOFs and VCMPs

2.12 Under the existing law, limited partnerships come within the definition of corporate limited partnerships in section 94D of the ITAA 1936, and are taxed as if they were companies (Division 5A). The bill amends section 94D to provide that a VCLP, an AFOF or a VCMP cannot be a corporate limited partnership. VCLPs, AFOFs and VCMPs will therefore be treated as ordinary partnerships for taxation purposes. [Schedule 2, item 16 of the TLA(VC) Bill; subsection 94D(2) of the ITAA 1936]

2.13 Section 92 of the ITAA 1936 provides for the calculation of the net income or a partnership loss of a partner in an (ordinary) partnership. Each partner is assessable on its share of net income and a deduction is allowable to each partner for its share of any partnership loss.

2.14 In the absence of any exemption, each partner's share of the net income derived by a VCLP, an AFOF or a VCMP will be included in the partner's assessable income under subsection 92(1). If the partner is a resident of Australia, the partner will be assessable on the whole of its share of the net income or, in the case of a non-resident partner, the partner will be assessable on its share of the net income of the partnership that is attributable to Australian sources.

Loss limitation

2.15 If a VCLP, an AFOF or a VCMP makes a partnership loss, the deduction allowable to a limited partner in respect of that loss cannot exceed the amount of the partner's financial exposure to the loss. This amount is calculated by deducting the following from the amount of capital contributed by the limited partner:

•

the amount of contributed capital the partnership has repaid to the partner;

•

the total of all deductions allowed to the partner for partnership losses incurred in previous income years; and

•

the amount of any debt of the partner that is secured by the partner's interest in the VCLP or the AFOF.

[Schedule 2, item 13 of the TLA(VC) Bill; subsection 92(2AA) of the ITAA 1936]

Example 2.1

A partner contributes $100,000 to a VCLP. The partner finances the contribution with $20,000 of its own and a loan of $80,000 secured by the partner's interest in the VCLP. The lender values the partner's interest in the VCLP (or AFOF) at $70,000 so the partner provides an asset, such as shares, valued at $10,000 as security. The partner's amount worked out under the method statement is:

Partner's contribution	$100,000
Less: Contribution Repaid	nil
Deductions allowed for previous losses	nil
Debt secured by interest in VCLP	$70,000
Amount	$30,000

The partner's share of the partnership loss for the 2002-2003 year of income is $40,000. The deduction allowable to the partner is reduced to $30,000

2.16 Deductions may be allowable in later years of income for partnership losses that were not allowable to the partner in the income year it was incurred because of the new subsection 92(2AA). The amount of the deduction not allowed in the year of income in which the loss was incurred is referred to as the 'outstanding subsection 92(2AA) amount'. [Schedule 2, item 14 of the TLA(VC) Bill; subsection 92A(1) of the ITAA 1936]

2.17 A limited partner has an outstanding subsection 92(2AA) amount if:

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the deduction otherwise allowable for a partnership loss in a previous year of income was reduced under subsection 92(2AA); and

•

the amount of partnership loss deductions that was not allowable to the partner in a previous year or years of income because of subsection 92(2AA) exceeds the deductions for these losses that have been allowed in later years of income.

[Schedule 2, item 14 of the TLA(VC) Bill; subsection 92A(2) of the ITAA 1936]

Example 2.2

Following on from the previous example, in the 2003-2004 year of income the partner's share of the partnership loss incurred for that year is $5,000. During that year the partner contributed further capital of $20,000 which was financed from the partner's funds. There has been no change in the amount of the debt or the value of the security provided.

Amount worked out using the method statement in subsection 92(2A):

Partner's contribution	$120,000
Less: Contribution Repaid	nil
Deductions allowed for previous losses	$30,000
Debt secured by interest in partnership	$70,000
Amount	$20,000
Subtract: partner's share of partnership loss for the year	$5,000
Step 1 amount	$15,000
Outstanding subsection 92(2AA) amount	$10,000

As the amount worked out under step 1 is greater than the outstanding subsection 92(2AA) amount, the amount of the deduction allowable to the partner for previous years losses is the outstanding subsection 92(2AA) amount ($10,000).

If the partner's additional contribution during the 2003-2004 income year was only $10,000, the deduction allowable to the partner for previous years losses would be:

Amount worked out using the method statement in subsection 92(2A):

Partner's contribution	$110,000
Less: Contribution Repaid	nil
Deductions allowed for previous losses	$30,000
Debt secured by interest in VCLP	$70,000
Amount	$10,000
Subtract: partner's share of partnership loss for the year	$5,000
Step 1 amount	$5,000
Outstanding subsection 92(2AA) amount	$10,000

As the amount worked out under step 1 is less than the outstanding subsection 92(2AA) amount, the amount of the deduction allowable to the partner for previous years losses is the amount worked out under step 1 ($5,000).

2.18 Division 36 of the ITAA 1936 provides for the deduction of tax losses incurred in previous years of income. The loss represented by a partner's outstanding subsection 92(2AA) amount will not be able to form part of a partner's tax loss that would be deductible under Division 36. These section 92(2AA) losses are deductible only where the conditions in new subsection 92A(1) are met. [Schedule 2, item 14 of the TLA(VC) Bill; subsection 92A(3) of the ITAA 1936]

2.19 These loss limitation rules are necessary to protect the integrity of the measure. Without these rules limited partners would be able to claim deductions for losses to which they were not exposed. Other jurisdictions, including Canada, New Zealand, the United Kingdom and the United States of America, also have rules to limit the pass through of losses to limited partners.

Capital gains

2.20 Capital gains made on assets held by a VCLP, an AFOF or a VCMP will be taxable to a partner in the same way as interests on assets held by an ordinary partnership. For example, as the CGT provisions are the primary code for taxing gains and losses made by superannuation funds, approved deposit funds and pooled superannuation trusts (section 304 of the ITAA 1936), gains flowing to any of these entities as a limited partner in a VCLP or AFOF will be taxed as capital gains.

2.21 Any capital gain or loss on the realisation of assets held by the VCLP or AFOF, including the carried interest distributed by a VCMP, will be taxed according to the partner's tax status. Thus, individuals who are partners in a VCMP will qualify for the CGT discount on the carried interest if they satisfy the other requirements for the discount.

Change of entity status

2.22 Where a limited partnership becomes or ceases to be a VCLP, an AFOF or a VCMP during an income year (but not on the first or last day of the income year) the following periods will be treated as a separate income year:

•

the period from the beginning of the income year to the day before the partnership becomes a VCLP, an AFOF or a VCMP;

•

the period from the day the partnership became a VCLP, an AFOF or a VCMP to the end of the income year, or the day the partnership ceased to be a VCLP, an AFOF or a VCMP, if earlier; and

•

the period from the day before the partnership ceased to be a VCLP, an AFOF or a VCMP to the end of the income year.

[Schedule 2, item 12 of the TLA(VC) Bill; section 18A of the ITAA 1936]

2.23 Amendments to various provisions of the ITAA 1936 and ITAA 1997 are necessary to deal with the creation of separate income years for periods in an income year when a partnership's status as a VCLP, an AFOF or a VCMP changed. The following provisions are amended to deal with these separate income years:

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the definition of 'year of income' in the ITAA 1936 to include as a year of income the separate income years created in an income year in which the partnership became or ceased to be a VCLP, an AFOF or a VCMP [Schedule 2, item 8 of the TLA(VC) Bill; paragraph 6(1)(b) of the ITAA 1936] ;

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provide that the separate income years created will be included in references to an year of income in the ITAA 1936 [Schedule 2, item 9 of the TLA(VC) Bill; subsection 6(2) of the ITAA 1936] ;

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provide that references to accounting period adopted in lieu of a year of income includes the separate years of income created because of a change in the partnership's status [Schedule 2, item 10 of the TLA(VC) Bill; subsection 6(2AA) of the ITAA 1936] ;

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exclude partnerships whose status changes as a result of becoming or ceasing to be a VCLP, an AFOF or a VCMP during a year of income from being required to seek the leave of the Commissioner to adopt a different accounting period as a year of income [Schedule 2, item 11 of the TLA(VC) Bill; subsection 18(1) of the ITAA 1936] ;

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provide that each separate accounting period of an income year that is a separate income year because of a change in the partnership's status is the income year for which income tax is worked out [Schedule 2, item 18 of the TLA(VC) Bill; paragraph 4-10(2)(b) of the ITAA 1997] ; and

•

provide that if an entity has an accounting period that is not the same as the financial year, the accounting period is an income year. The will allow the different accounting periods created because of a change in the partnership's status during a financial year to be separate income years [Schedule 2, item 20 of the TLA(VC) Bill; paragraph 9-5(2)(b) of the ITAA 1997]

2.24 Amendments have also been made to the notes to relevant sections to include references to the separate income years created because of a change in the partnership's status. [Schedule 2, items 19 and 21 of the TLA(VC) Bill; subsections 4-10(2)(note) and subsection 9-5(2)(note) of the ITAA 1997]

2.25 The definition of 'income year' in subsection 995(1) of the ITAA 1997 is amended to include as an 'income year' the separate accounting periods created in an income year in which the partnership became or ceased to be a VCLP, an AFOF or a VCMP. [Schedule 2, item 24 of the TLA(VC) Bill; subsection 995-1(1) of the ITAA 1997]

2.26 A new note has been added at the end of the definition of 'income year' in subsection 995(1) of the ITAA 1997. This note refers to the separate accounting periods created in an income year in which the partnership became or ceased to be a VCLP, an AFOF or a VCMP that are treated as separate income years. [Schedule 2, item 25 of the TLA(VC) Bill; subsection 995-1(1)(note) of the ITAA 1997]

Losses

2.27 If a limited partnership that becomes a VCLP, an AFOF or a VCMP incurred a tax loss before it became a VCLP, an AFOF or a VCMP, the tax loss is not deductible to the VCLP, AFOF or VCMP. [Schedule 2, item 23 of the TLA(VC) Bill; section 195-65 of the ITAA 1997]

2.28 However, if a limited partnership ceases to be a VCLP, an AFOF or a VCMP, any tax loss that occurred before the partnership became a VCLP, AFOF or VCMP will qualify for deduction under Division 36 as a tax loss of the partnership. [Schedule 2, item 23 of the TLA(VC) Bill; section 195-70 of the ITAA 1997]

2.29 The special rule that restricts a limited partnership with a tax loss that has become a VCLP, an AFOF or a VCMP from deducting that loss while it is a VCLP, an AFOF or a VCMP will be included in the list of special rules about tax losses. [Schedule 2, item 22 of the TLA(VC) Bill; section 36-25 of the ITAA 1997]

2.30 As mentioned above, where the status of a VCLP, an AFOF or a VCMP changes during an income year, the partnership will have at least two income years. These income years will be less than 12 months. Thus, each of the income years will be shorter than the standard income year under which income tax is worked out. This shorter period may result in income tax being worked out, in some circumstances, on an inappropriate basis. In these cases, the Commissioner will have power to make a determination modifying the operation of a provision to take into account the fact that the particular accounting period is shorter than 12 months. [Schedule 2, item 23 of the TLA(VC) Bill; subsection 195-75(1) of the ITAA 1997]

2.31 The determination can only be made to modify the operation of a particular provision to take into account the fact that the partnership's accounting period is shorter than 12 months. [Schedule 2, item 23 of the TLA(VC) Bill; subsection 195-75(2) of the ITAA 1997]

2.32 Any determinations made will be disallowable instruments for the purposes of section 46A of the Acts Interpretation Act 1901 . [Schedule 2, item 23 of the TLA(VC) Bill; subsection 195-75(3) of the ITAA 1997]