VCLP Reforms And New ESVCLP Regime

Overview

On 29 March 2007, the Government introduced Tax Laws Amendment (2007 Measures No. 2) Bill 2007 (the Bill), which contains the proposed changes to the Venture Capital Limited Partnership (VCLP) regime and the creation of the Early Stage Venture Capital Limited Partnership (ESVCLP) regime.

These proposals were first announced in the May 2006 Budget, as part of a package of measures to increase activity in the venture capital sector. Both regimes will fall under the responsibility of the Venture Capital Registration Board (VCR Board), being the former PDF Registration Board.

As part of this package, the Government is also committing $200 million for a further round of funding of the Innovation Investment Fund programme. This programme provides Government funds alongside funds from private investors to encourage the development of new companies, particularly those with a technology focus.

Changes to the VCLP regime

Introduction

When the VCLP regime was introduced into Australia in 2002, there were a number of restrictions on investment and registration. It has long been argued that these restrictions on Australian VCLPs render the vehicle less competitive in comparison to equivalent investment vehicles overseas and that this has contributed to a shortage of early-stage venture capital funds in Australia.

The private equity community was therefore unsurprisingly abuzz in May 2006 when the Treasurer announced reforms directed at further fostering investment in the venture capital sector and potentially "relaxing" some of the restrictions imposed by the initial legislation.

In his Press Release of 9 May 2006, the Treasurer said as follows:

The resounding question on everyone’s lips at the time of the Press Release was just how relaxed the Treasurer proposed to be? We now have the answer to that question.

The Reforms

The reforms announced in the Bill are broadly as follows:

Australian Nexus Test

The current "Australian Nexus Test" provides that at the time the investment is made:

• The investee company must be an Australian resident; and

• If it is the entity’s first investment in the company, the investee company must also have more than 50 per cent of its employees and assets located in Australia for 12 months after the investment is made.

This test has been "relaxed" under the Bill to enable a VCLP to hold up to 20% of its committed capital in investments that do not satisfy the Australian Nexus Test. That is, up to 20% of the VCLP’s committed capital can be invested directly in foreign companies.

Residency requirements for limited partners, general partners and VCLPs

Changes are proposed to the residency requirements affecting limited partners, general partners and VCLPs as a result of the reforms to the Capital Gains Tax (CGT) treatment of foreign residents (effective from December 2006). The CGT changes have removed Australian CGT on most assets disposed of by foreign residents.

The amendments contained in the Bill extend the existing restrictive definition of ‘eligible venture capital partner’ which is limited to residents of certain specified countries.

Under the Bill, a VCLP can be established in Australia, or any country with which Australia has a double tax agreement (DTA). Further, a general partner can be resident in Australia or a "DTA country".

Importantly, the rules under which non-residents obtain tax-free flow through treatment on gains and profits from the disposal of an investment by a VCLP will be broadened. Under the Bill, the exemption for non-resident eligible venture capital partners, being tax-exempt investors, foreign venture capital fund of funds (FOF) and portfolio investors (ie, less than 10%), will no longer depend upon those partners being resident in specific countries. Rather, all such partners will be exempt provided that they are resident in any foreign country.

Type of Investments

Currently, an ‘eligible venture capital investment’ is, broadly, an investment in a company or a holding company that is at risk and has been made through the acquisition of shares or options. The Bill proposes to allow eligible investments to be made through the acquisition of convertible notes, that are equity interests, and to allow investments to be made in unit trusts.

There are a number of qualifications that must be met in order for an investment in a unit trust to be an eligible venture capital investment. The requirements are comparable to those applying to investments in companies including, for example, that the total amount of the partnership interest in the unit trust (and connected entities of the unit trust) cannot exceed 30 per cent of the partnership’s committed capital. In addition, the predominant activity of the unit trust cannot be in ineligible venture capital investment as defined under the existing legislation.

Other amendments

Other amendments include:

• Reducing the minimum committed capital requirement for registration of a VCLP from $20 million to $10 million; and

• Allowing for the appointment of auditors for investee companies to occur at the end of the financial year of investment.

Comment on VCLP reforms

The Government is to be commended for the improvements to the VCLP regime. The "wish-list" of the venture capital sector was unlikely to be met in full, and so, for example, the prohibition on investing in the financial services sector remains.

Nevertheless, the sector should focus on the positives in the changes announced. The relaxation in the Australian Nexus test will conceivably allow some funds to expand into the Asia-Pacific region, and allow increasing Trans-Tasman activity with New Zealand. Similarly, the ability to invest in convertible notes is recognition of the realities of the sector.

Whilst the expansion of the CGT exemption for non-residents is to be welcomed, we are now left with the unusual result that the specific incentives targeted at venture capital investors are in some cases, less beneficial than the general CGT exemption available to non-residents! For example, the specific venture capital exemption extends to all foreign portfolio investors (ie, less than 10%), whereas the general CGT exemption for non-residents will exempt all non-resident investors – whether more or less than 10% – provided that the underlying investee company is not "land-rich". As a result, nonresident venture capital investors will look to the general CGT exemption.

The new ESVCLP regime

Introduction

The Government is also committed to enhancing the venture capital regime by the introduction of the ESVCLP rules, which are designed to encourage investment in startup enterprises with a view to commercialisation of the activity. The goal is that small and medium businesses seeking capital injections to finance future activities of relatively high risk and expanding businesses should find it easier to obtain capital. The ESVCLP regime will complement the VCLP rules, and encourage additional funding at the smaller end of the market.

ESVCLPs are limited partnerships that will be treated as a flow-through vehicle for tax purposes. Partners, whether resident or foreign, will be exempt from income tax and CGT on all income and gains derived from eligible investments and disposals of eligible investments made through the ESVCLP.

The aim of providing a tax concession for ESVCLPs is to encourage venture capital investment in early stage start-up to assist expanding businesses with high growth potential.

ESVCLP requirements

The ESVCLP regime is very much based on the existing rules applying to VCLPs, with additional integrity rules and some key differences in certain qualification requirements. In common with a VCLP, an ESVCLP:

• Is to remain in existence for between 5 and 15 years.

• Cannot carry on any activities which are not related to making eligible venture capital investments.

• Is to be established in Australia or a DTA country, and the general partner must be resident in Australia or a DTA country.

The notable registration requirements specifically applicable to an ESVCLP are as follows:

• The committed capital of the partnership must be between $10 million and $100 million.

• The committed capital of any partner, together with associates, cannot generally exceed 30% of the total committed capital of the partnership.

• All of the partnership’s investments must be eligible venture capital investments. The meaning of eligible venture capital investment, in the context of an ESVCLP, is essentially the same as for a VCLP, with the exception that the total value of an investee entity’s assets, at the time of investment, cannot exceed $50 million (as compared to $250 million in the VCLP regime). Consistent with the changes made to the VCLP regime, an ESVCLP can also invest in units in a unit trust and convertible notes.

• An investee entity with assets that exceed $250 million must be divested (further discussed below).

• Each investment complies with the partnership’s approved Investment Plan, and the partnership acts in accordance with that plan (the Investment Plan requirements are discussed below).

Compulsory divestment

As previously foreshadowed, the ESVCLP regime includes a compulsory divestment requirement if, at the end of a year of income, the total assets of an investee entity (and any connected entity) exceeds $250 million.

The Bill provides for a period of grace of six months (with the possibility of a further three month extension) after year end. However, failure to divest within these time limits will result in the revocation of the ESVCLP registration.

As is the case for valuing assets of a VCLP, the test to be applied is generally based on the last audited accounts for the entity. As a result, the value of an investee entity will increase by capital raisings or the retention of profits. On the other hand, the increase in value of internally generated goodwill or intellectual property would not generally be reflected in the accounts for the entity.

Investment Plan

In order to be registered, an ESVCLP must submit an Investment Plan, which the VCR Board must accept as "appropriate". In determining whether the Investment Plan is appropriate, the VCR Board must have regard to:

• the stages of development of the entities in which the partnership proposes to invest;

• the levels of cash flow of those entities;

• the levels of technology of those entities;

• the proportions of intellectual property to total assets of those entities;

• the levels of risk and return of those entities;

• the amount of tangible assets and collateral of those entities against which borrowings may be secured;

• the requirements relating to an ESVCLP making and holding investments;

• whether the partnership’s committed capital can only be used in relation to early stage venture capital, and whether it can be transferred to other entities;

• whether the Investment Plan is connected with other plans for investment that, if combined with the Investment Plan, would lead to the partnership exceeding the $100 million fund limit; and

• any additional matters specified in any guidelines which may be issued.

Once an Investment Plan is approved, it is possible for the ESVCLP to submit a replacement plan, which must also be accepted by the VCR Board as appropriate.

In order to be registered, the VCR Board must also be satisfied that the partnership has access to skills and resources necessary to implement the Investment Plan, and is reasonably likely to be able to implement its Investment Plan.

Tax treatment

Whilst limited partnerships are generally treated as though they are companies for income tax purposes, an ESVCLP (like a VCLP) will be treated as a flow-through for tax purposes. In particular, this means that:

• The ESVCLP is not liable to income tax.

• A partner’s share of income (for example, dividends paid by an investee company) derived from an investment held by the VCLP is exempt from income tax.

• A partner’s share of a capital gain or capital loss arising from the disposal of an investment by the partnership is disregarded.

• A partner’s share of any gain or profit (on revenue account) from the disposal or realisation of an investment by an ESVCLP is exempt from income tax.

• A partner’s share of a loss (on revenue account) from the disposal or realisation of an investment by an ESVCLP is not deductible.

The above treatment applies to partners, whether resident in Australia or overseas.

In respect of carried interests, under existing law, a general partner in a VCLP is subject to CGT in respect of a payment of a carried interest. Further, such a payment is expressly not treated as an income amount to the general partner.

This treatment of VCLP carried interests will be extended to general partners of ESVCLPs.

Comment on new ESVCLP regime

Incentives to attract additional funds to the venture capital sector are to be applauded. The focus on the smaller end of the venture capital sector, and the tax free treatment for investors will be expected to provide increased funding and activity. Nevertheless, it is appropriate to reflect and ask whether the end result is the optimal outcome? For example:

• It is unclear from a policy perspective as to why the Government capped the size of the fund to $100 million. Many funds, even in the early stage sector, are increasingly raising in excess of $100 million.

• The $50 million cap on the assets of Investee companies is likely to present managers with problems as we have witnessed in relation to the VCLP structure.

• The Government has retained the divestment requirement (outlined in the May 2006 Press Release) for an investee company that grows such that its assets exceed $250 million. Even if one was to accept the policy intention behind this, the matter could have been addressed in other ways (for example, to remove certain of the tax incentives on value realised in excess of $250 million, rather than requiring what may be a premature exit).

For investors, all income from investments, and all income and capital gains from disposals will be exempt from Australian tax. This will apply to residents and foreigners alike. Whilst this is good news for investors, it means that investors will not be entitled to deductions or capital losses for unsuccessful investments. Furthermore, it follows that any interest incurred on funds borrowed by investors or the ESVCLP will be nondeductible.

The reality is that the target sector is a high risk sector, such that unsuccessful investments and resulting losses are not unexpected. Further, the lack of tax deductible funding for investors and the ESVCLP will need to be considered in funding and structuring investments.

Whether managers and investors alike are convinced by the attraction of the ESVCLP regime will become apparent over time.

Commencement date

The proposed changes in respect of both the VCLP and the ESVCLP regimes will commence from the start of the 2007/2008 year of income.

This publication is intended to provide a general information only and should not be relied upon as giving legal advice. For legal advice on a specific issue, please contact one of the lawyers at Gilbert & Tobin