There are a few factors that have combined to make venture capital an interesting prospect during otherwise tough times for private equity. Deal flow is improving, with debt financing less of an issue, values coming down and confidence in exit possibilities in the next 3-5 years going up.
Despite the opportunities, venture capital fund managers seeking to raise funds in the GFC are struggling. Fund managers, particularly new fund managers, can no longer expect that the usual domestic investors will be able to commit to new funds. Commonwealth funding initiatives are also likely to prove inadequate in the current climate. Although the Commonwealth continues to support the Innovation Investment Fund (IIF) program, the strong preference for using the ESVCLP under the current tranche is problematic, as the ESVCLP structure has investor spread requirements which, absent statutorily permitted relief, are difficult to meet in the current climate. Additional funds are also being made available to support existing fund managers licensed under the IIF Rounds 1 and 2, Pre-Seed Fund, Renewable Energy Equity Fund and ICT Incubator programs, via the newly announced Innovation Investment Follow-on Fund (IIFF) program, but this may prove less than efficacious given the small pool of investments that would be both eligible and in a position to use such funding.
As a result, venture fund managers are starting to look more seriously at the possibilities for attracting foreign investment, putting the spotlight, once again, on VCLPs and ESVCLPs.
VCLPs and ESVCLPs have too much baggage
Recent experience has confirmed what most people have known since the VCLP was first introduced – the VCLP and ESVCLP come with a lot of baggage. The VCLP gives beneficial tax treatment to certain classes of foreign investors in exchange for making investments that meet certain criteria; the ESVCLP gives beneficial tax treatment to all investors but imposes further restrictions on investments. The complexity of the investment criteria meant that from the beginning most VCLPs have been set up in conjunction with stapled companion funds (usually one or more trusts), to enable fund managers to make ineligible investments, but such companion funds receive different tax treatment. Moreover, companion funds have been actively discouraged by the Venture Capital Committee in relation to ESVCLPs. It is difficult for these structures to compete with funds established in countries that have flow-through structures that do not come with these complexities.
Certain classes of foreign investors are better off investing directly
In order to benefit from the capital gains tax exemption offered by the VCLP, an investor is restricted to less than 10% of the VCLP's fund commitments. But any foreign investor could invest directly and benefit from the general capital gains tax exemption, for investments held on capital account that do not constitute "Taxable Australian Property". Particularly for overseas investors that are interested in more limited exposure to the Australian market, this may prove a more attractive option.
Changes to Taxation of Managed Investment Trusts (MIT) may further limit the use of VCLPs and ESVCLPs
The 2009-2010 Federal Budget (the Budget) proposes that Australian MITs, except those which are taxed in a manner similar to companies (eg, trusts which are subject to Division 6C of the Income Tax Assessment Act 1936), may make an irrevocable election to apply the CGT regime as the primary method for taxing certain disposals of assets. This means that one of the key advantages to the VCLP regime (ie deemed capital account treatment), is now shared by entities qualifying under the MIT regime. This proposed change represents a welcome development for investors in MITs and enables them to obtain some certainty in relation to the taxation treatment of gains and their eligibility for the CGT discount concession (and in the case of non-resident investors, an exemption from Australian tax on distributions of gains on disposal of eligible MIT assets except assets that are Taxable Australian Property). So, to the extent that the proposed investment vehicle qualifies for MIT treatment, this means that VCLPs and ESVCLPs (with all of their attendant baggage) may be less desirable.
Impact of the Budget generally on venture capital
Two other key issues emerged from the Budget which are relevant to venture capital – the incentivisation of management of investee companies and the tax position of those companies. These changes relate to employee share schemes and the R&D tax concession.
Employee Share Schemes – In a negative for employee remuneration schemes, changes proposed in the budget mean that taxpayers who receive discounts on the acquisition of vested shares and options under an Employee Share Scheme will be taxed in the income year in which they receive them (even if the shares or options are qualifying). A consultation process has now commenced and draft legislation has been released, which has lessened the adverse impact of the Budget announcement. The key features of the revised proposals include:
- deferral of taxing point until vesting in respect of shares, options and rights (Deferral Plans);
- limited tax exemptions for certain employees (broadly, with taxable income (grossed up for certain fringe benefits, superannuation contributions and negative gearing losses) of no more than $150,000; and
- a start date for acquisitions on or after 1 July 2009.
Even with the modifications proposed by the Government, significant changes are anticipated in the structure and use of share and option based remuneration schemes. Many existing schemes will require extensive modification.
R&D Tax Concession - From 2010-2011, a simplified R&D tax credit is to be introduced which will provide a 45% refundable credit for firms with an annual turnover of less than $20 million (this equates to a tax concession of 150%). Furthermore the measure applies to small companies in a tax loss position and is not subject to a limit on the level of R&D expenditure which they undertake. For businesses with a turnover exceeding $20 million, the new non-refundable credit will be 40% and will equate to a tax concession of 133%. Importantly the credit will be available to companies undertaking R&D in Australia where the intellectual property is held offshore. At first blush, this represents a welcome development which provides additional concessions, simplifies the currently complex R&D regime, and makes Australia a desirable location from where to conduct R&D (even when the underlying IP is owned outside of Australia). However, the categories expenditure which will qualify for the concession are expected to be more limited than under the current law.