BILLS DIGEST NO. 117, 2015–16              4 May 2016

Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016

Dr. Nitin Gupta
Economics Section 

Date introduced: 16 March 2016

House:  House of Representatives

Portfolio: Treasury

Commencement: Schedule 1 and most of Schedule 2 of the Bill will commence on the later of 1 July 2016 or Royal Assent. The commencement of Items 73 and 75 of Schedule 2 is dependent on the passage of the Tax Laws Amendment (New Tax System for Managed Investment Trusts) Bill 2015.

Links: The links to the Bill, its Explanatory Memorandum and second reading speech can be found on the Bill’s home page, or through the Australian Parliament website.

When Bills have been passed and have received Royal Assent, they become Acts, which can be found at the Federal Register of Legislation website.

All hyperlinks in this Bills Digest are correct as at May 2016.

Purpose of the Bill

The Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016 (the Bill) seeks to:

•       amend the Income Tax Assessment Act 1997 (ITAA 1997) to promote investment in Australian start-ups and early stage innovating companies

•       amend the Venture Capital Act 2002 and the ITAA 1997 to improve the attractiveness of venture capital[1] regimes for investors.

Structure of the Bill

The Bill has two Schedules. Schedule 1 seeks to amend the ITAA 1997 to encourage new investment in Australian early stage innovation companies with high growth potential by providing investors, who invest in such companies, with a tax offset[2] and a capital gains tax exemption for their investments. These amendments form part of the Tax Incentives for Early Stage Investors measure.

Schedule 1 also creates a new requirement for early stage innovation companies to report information about their investors to the Australian Taxation Office, so that the eligibility of investors for tax offsets and capital gains exemptions can be determined.

Schedule 2 to this Bill amends the early stage venture capital limited partnership (ESVCLP)[3] and venture capital limited partnership (VCLP)[4] regimes within the Venture Capital Act and ITAA 1997 to improve access to venture capital investment and make the regimes more attractive to investors.

The amendments provide an additional tax incentive for limited partners in new ESVCLPs, relax restrictions on ESVCLP investments and fund size and clarify the legal framework for venture capital investment in Australia.

Background

The Bill seeks to implement measures announced by the Government in the National Innovation and Science Agenda on 7 December 2015.[5] The measures were included in the Mid-Year Economic and Fiscal Outlook 2015-16, released on 15 December 2015.[6]

According to the Minister’s second reading speech, the measures included in the Bill ‘will help to encourage innovation, risk taking and an entrepreneurial culture in Australia’. [7] Furthermore, the ‘Bill delivers upon two commitments: providing concessional tax treatment to investment in innovative, high-growth start-ups; and reforms to the arrangements for Venture Capital Limited Partnerships to improve access to capital, and make the regime more user-friendly and more internationally competitive’.[8]

The Australian Government currently provides a series of tax concessions to companies to facilitate innovative activities through the Research and Development (R&D) tax incentive, Early Stage Venture Capital Limited Partnership (ESVCLP) and Venture Capital Limited Partnerships (VCLP). However, venture capital funds typically target companies that are more advanced in their innovation activities and are expected to attract needed capital. Early stage innovators face more acute financial constraints, which are not adequately addressed by the current framework, and the Bill seeks to alleviate these.[9]

These proposed changes are intended to encourage and support innovation, risk-taking, and an entrepreneurial culture in Australia.[10]

Committee consideration

The Bill has not been referred to Committee for consideration.

Senate Standing Committee for the Selection of Bills

The Senate Committee for the Selection of Bills in its meeting on 16 March 2016 deferred its consideration of the Bill to its next meeting.[11]

Senate Standing Committee for the Scrutiny of Bills

The Senate Standing Committee for the Scrutiny of Bills considered the Bill but had no comment on it.[12]

Policy position of non-government parties/independents

Labor has been supportive of the Bill, and of the specific provisions in it. Its main rationale for supporting the Bill is to improve the environment for angel investors[13] and venture capital firms.[14]

On 3 May 2016, Senator McKim, on behalf of the Australian Greens, tabled amendments to the Bill.[15] These amendments provide for alternative criteria for eligibility to register as an Early Stage Innovation Company (ESIC). The Bill provides that a company must pass a number of tests in order to qualify as an ESIC (see proposed section 360-40 of the ITAA 1997, at item 1 of Schedule 1). One of these tests is the ‘principles-based’ test, under which the company must demonstrate that it is focused on developing its innovation for commercialisation and that it has the potential for high growth, can address a broader than local market and has competitive advantages.[16] The amendments proposed by the Greens would ensure a company is able to meet the ‘principles-based’ part of the ESIC test where it is has ‘an economic, social, cultural or environmental mission that is consistent with a public or community benefit’ and ‘reinvests the majority of the profit it makes to fulfil that mission’.[17]

Senator McKim explained that the proposed amendment addresses a perceived gap in the Bill:

The gap that we would seek to fill is around social enterprises. It is important that people understand that there is a movement developing in Australia around social enterprises—that is, a company that has not only an economic mission but a social, cultural or environmental mission consistent with a public or community benefit. We think that those companies should also have the opportunity to attract further investment by the way and the means that the bill proposes for companies that have an economic aim.[18]

Position of major interest groups

On 14 February 2016, the Treasury released a discussion paper Tax incentives for early stage investors to assist in the design of concessional tax treatment for investors through a non-refundable tax offset and a capital gains tax (CGT) exemption on investments that meet certain eligibility criteria.[19] At the time of writing, Treasury had not published submissions to the discussion paper, but some organisations have made them available on their own websites.[20] These submissions provide some guide to the views of major interest groups on the provisions of the Bill.

The Australian Venture Capital Association, in its submission to the discussion paper, considered, amongst other things, that the proposed eligibility criteria for an eligible innovation company (which are the same in the Bill as in the discussion paper[21]) ‘will, in practice prove to be extremely limiting as many start-ups will fail in at least one, if not all, of these criteria at the time of the initial investment’.[22]

In its submission to the Treasury consultation paper, Research Australia, which is an alliance of 160 members and supporters advocating for health and medical research in Australia, was ‘generally supportive’ of the investor and capital gains tax concessions.[23] Research Australia noted:

[The proposal] is an important measure to improve Australia’s capacity to innovate, and has significant potential to increase both economic benefits and health outcomes derived from Australia’s significant investment in health and medical research.[24]

A number of groups, including the Australian Venture Capital Association (AVCAL) and start up financiers BlueChilli and OneVentures, are reported as supporting urgent action on start-up incentives prior to an election to avoid an ‘investor strike’ and a ‘chilling’ impact on the market.[25]

Financial implications

According to the Explanatory Memorandum, the Bill has the following financial impact on the Budget (see tables 1 and 2):[26]

Table 1: Schedule 1:

2015-16

2016-17

2017-18

2018-19

2019-20

Nil

Nil

-$65m

-$65m

-$65m

Source: Explanatory Memorandum, Tax Laws Amendment (Tax Incentive for Innovation) Bill 2016, p. 3.

Table 2: Schedule 2:

2015-16

2016-17

2017-18

2018-19

2019-20

Nil

Nil

Unquantifiable

Unquantifiable

Unquantifiable

Source: Explanatory Memorandum, Tax Laws Amendment (Tax Incentive for Innovation) Bill 2016, p. 4.

Schedule 1 also has an estimated compliance cost of $1.25 million per year. This cost has been fully offset within the Treasury portfolio.[27] Schedule 2 imposes minor transitional and ongoing operational costs on venture capital investors and their advisers.[28]

Statement of Compatibility with Human Rights

As required under Part 3 of the Human Rights (Parliamentary Scrutiny) Act 2011 (Cth), the Government has assessed the Bill’s compatibility with the human rights and freedoms recognised or declared in the international instruments listed in section 3 of that Act.

The Government considers that the Bill is compatible.[29] The Government considers that Schedule 1 of the Bill engages, but is compatible with, the right to privacy contained in Article 17 of the International Covenant on Civil and Political Rights (ICCPR).[30][31]

Key issues and provisions

Schedule 1: Tax incentives for early stage investors (TIFESI)

Schedule 1 to the Bill deals with tax incentives for early stage investors (TIFESI). The TIFESI provisions seek to fill an important gap between the initial (pre-concept) stage of a firm’s lifecycle, where financing typically happens through self-funding, family and friends, and government support and tax incentives for innovating firms (like the R&D tax offset); and the commercialisation stage where firms have grown to a point where they can approach venture capital firms for further, more extensive financing.

This intermediate stage, commonly known as the ‘valley of death’, is particularly risky for firms which need to establish the proof-of-concept and the profit-potential of their innovation. This is the stage where most start-up companies fail because of their vulnerability to cash-flow volatility.[32]

Investors will not be able to access the incentives until they enter into investing arrangements with qualifying early stage innovating firms, and this is verified by the firms themselves to the Australian Taxation Office (ATO).

The amendments in Schedule 1 insert new Division 360 ‘Early stage investors in innovation companies’ into the ITAA 1997.[33] New Division 360 contains one subdivision, Subdivision 360-A ‘Tax incentives for early stage investors in innovation companies’. This new Subdivision sets out the circumstances in which an investor would qualify for tax offsets and exemptions from capital gains tax requirements by acquiring shares in qualifying companies.[34] This is significant because existing tax incentives do not specifically target investments in early stage innovating companies.

Investors who invest in qualifying early stage innovation companies (ESIC) will be entitled to a 20 per cent non-refundable tax offset (proposed subsection 360-25(1)). The qualification requirements for an ESIC are set out at proposed section 360-40 of the ITAA 1997. However, there are restrictions on the amounts of offsets and investment amounts that would apply.

For investors who meet the requirements of the sophisticated investor test at section 708 of the Corporations Act 2001, there is no limit to how much they can invest in an early stage innovating company. However, the amount of tax offset for qualifying shares would be capped at $200,000 (proposed subsection 360-25(2)). For retail (or non-sophisticated) investors, proposed section 360-20 limits the amount of money invested to $50,000 in an income year. This latter provision is to provide some protection to retail investors.

Proposed subsection 360-15(1) sets out the criteria for entitlement to a tax offset.

Proposed subsection 360-40(1) stipulates that in order to be a qualifying ESIC, a firm should meet certain criteria including:

1. It has been recently incorporated or registered in the Australian Business Register (ABR) (proposed paragraph 360-40(1)(a))

The company:

•       must have been incorporated in Australia within the last three income years (the latest being the current income year at the test time)

•       if it has not been incorporated within the last three income years — then it must have been registered in the ABR within the last three income years

•       if it has not been registered in the ABR within the last three income years, then:

–      it must have been incorporated in Australia within the last six income years and

–      it and any wholly-owned subsidiaries must have incurred expenses of no more than $1,000,000 in total across all of the last three income years.

2.              It had total expenses of $1 million or less in the last income year (proposed paragraph 360-40(1)(b))

3.               It had assessable income of $200,000 or less in the last income year (proposed paragraph 360-40(1)(c))

4.               It is not listed on a stock exchange (proposed paragraph 360-40(1)(d))

5.               It meets the ‘innovation test’ at proposed section 360-45 or the ‘principles test’ in proposed paragraph 360-40(1)(e).[35] (The principles test is discussed in the ‘Policy position of non-government parties/ independents’ section of this Digest, above).

Schedule 1 also provides for exemptions from capital gains taxes realised on shares in qualifying ESIC that have been held for between one and ten years (proposed section 360-50).

Schedule 2

Venture capital investment

Schedule 2 to the Bill amends the early stage venture capital limited partnership (ESVCLP) and venture capital limited partnership (VCLP) regimes within the Venture Capital Act 2002 and the ITAA 1997 with the aim of attracting more venture capital investment (both local and foreign) to Australia.[36] The tax incentives proposed in this Schedule would reduce the effective costs associated with these investments.[37] This is important because Australia’s record in venture capital investments is quite poor compared with other advanced countries, [38] and ensuring the future growth of Australia would require the inflow of such investments to drive innovation outcomes.

There are several important key provisions introduced in the Schedule 2 of the Bill. Chief amongst these is the introduction of an additional tax offset for limited partners in ESVCLP (item 2 of Schedule 2, proposed section 61-760 of the ITAA 1997). The offset amount is equal to up to 10 per cent of contributions made by the partner to the ESVCLP during an income year (proposed subsection 61-765(1) of the ITAA 1997).

Schedule 2 also relaxes restrictions on ESVCLP fund size and investments. It amends the Venture Capital Act to increase the maximum fund size for ESVCLPs from $100 million to $200 million (item 6 of Schedule 2, amended subparagraph 9-3(1)(d)(ii)of the Venture Capital Act. This would increase the upper limit of the fund size within which the ESVCLP can register and remain as an ESVCLP.

Currently an ESVCCLP must divest its investment in an entity once the value of the entity’s assets exceeds $250 million (paragraph 9-3(1)(i) and subsections 9-3(3) and (6) of the Venture Capital Act). Items 15 and 16 of Schedule 2 repeal this requirement, but restrict tax concessions for these investments.[39]

The amendments generally apply from 1 July 2016. However, the tax offset from investments in new ESVCLPs applies to contributions made on or after 1 July 2016 to ESVCLPs that become unconditionally registered on or after 7 December 2015.[40]

Concluding comments

The Bill makes specific arrangements to improve the targeting of tax benefits to investors who make genuine investment in early stage innovating companies with the intention that these investments will improve the innovation and commercial outcomes in Australia. This means that minor innovations or practices that do not represent actual innovation (such as introducing a new product in Australia that is already being sold elsewhere) will not be eligible for tax incentives.

The Bill also allows a broad, multi-dimensional definition of innovation to provide maximum flexibility to firms in order to suit their particular circumstances. It is also to be expected that companies that do attract investments would gain access to the managerial and marketing expertise that venture capital firms typically possess. This would be invaluable in successful commercialisation of innovation.

However, there are two main types of constraints that could arise for innovating companies.

First, while the Bill seeks to improve targeting/identification of the correct type of investors (that is, those who are investing in the right type of company in order to qualify for tax incentives) it places the onus of reporting primarily on the innovating companies themselves; their reporting to the ATO will help the latter to validate the tax offset claims of the investors. This can create additional administrative burdens on the innovating firms that are otherwise constrained in terms of overall resources.

Second, the tax incentives are aimed at investors that would potentially be investing in innovating companies rather than the companies themselves. There is a ‘self-selection’ element in this framework, where investors wanting to access the benefits would need to decide whether to invest in eligible companies. This in turn would be conditional on their assessment of the associated costs, benefits, risks and strategic priorities. Therefore, whatever benefits that flow to the companies themselves would do so in a highly indirect way. The innovating firms’ outcomes would be conditional on these decisions, and fundamentally disconnected from the intrinsic profit potential of the innovation itself.

Moreover, it would still place the onus on the early stage companies to attract or appeal to investors in the first place, and may divert scarce resources from further innovation or associated product development.

In other words, while the Bill may serve to increase the overall pool of resources available for investing, it will not serve to improve the targeting/matching of innovating firms with investor, nor provide direct access to funds that facilitate innovating activity.

These constraints may undermine the intended objectives of the Bill, that is, bridging the ‘valley of death’ described above. Venture capital firms typically invest in firms that can demonstrate a ‘proof-of-concept’ by translating an idea into a working product, and then help to commercialise it and ‘take it to the market’. However, getting to the product development stage can impose significant financial constraints on the innovating early stage firms as well. This initial funding to assist firms to ‘get off the ground but not fly’ is important in a firm’s life cycle, and it is to be expected that the firms would use these funds to get to a point where they could approach venture capital firms, stock markets or banks for more substantial equity or debt-based funding.

This remains a critical gap, which the Bill does not address. This is probably the most important point that must be borne in mind. Moreover, the Bill seeks to incentivise risk-taking by investors, but will not necessarily promote risk-taking by the entrepreneurs or innovative firms themselves.

There is evidence that inadequate access to finance is the biggest impediment to innovation for small and medium enterprises. As shown in the recently released Securing Australia's Future: Australia’s Comparative Advantage, a 2012 survey by the Australian Bureau of Statistics on constraints to innovation showed that 43 per cent of small firms and 20 per cent of medium-sized firms identified funding as the biggest impediment to innovation; this contrasted with only 12.5 per cent of large firms that noted funding as a constraint.[41] However, for innovation-active firms, the constraints are even more acute. Relative to the all-firms case, 66 per cent of innovating small firms considered financing to be the biggest impediment to innovation. The corresponding responses for medium and large firms were 25 per cent and 16 per cent, respectively.[42]

Despite the fact that innovation helps to improve productivity, competitiveness and growth, this smaller segment of the market typically finds it extremely difficult, if not impossible, to access the traditional sources of financing (including venture capital) that are available to relatively more established firms or those with more demonstrable products.

Members, Senators and Parliamentary staff can obtain further information from the Parliamentary Library on (02) 6277 2500.

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[1].              Venture capital refers to long-term equity capital that specialist investor firms invest in new companies that have limited operating history and are too small to be able to get loans from banks or capital from public markets. These investments typically involve high levels of risk, and in return for their investments, venture capital firms get significant share of ownership equity, as well as control over company decisions.

[2].              Tax offsets, sometimes referred to as rebates, directly reduce the amount of tax payable. They are different from tax deductions, which indirectly reduce the tax payable by reducing the assessable income first.

[3].              An ESVCLP is a venture capital fund that invests specifically in early-stage or start-up companies, and receives favourable tax treatment, which is conditional on specific criteria being met.

[4].              A VCLP is a venture capital fund, which is structured as a limited partnership that makes eligible investments and is registered under the Venture Capital Act. A limited partnership is made up of two or more partners who jointly carry on business with a view to profit. However, unlike the general case (where each partner has unlimited liability for debts and obligations incurred), a limited partnership limits the liability of one or more partners. Moreover, a limited partnership must have at least one general partner, whose liability is unlimited.

[5].              Australian Government, ‘National Innovation and Science Agenda’, National Innovation and Science Agenda website.

[6].              S Morrison and M Cormann, Mid-year Economic and Fiscal Outlook 2015–16, December 2015, pp. 120-121.

[7].              S Morrison, ‘Second reading speech: Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016’, House of Representatives, Debates, 16 March 2016, p. 3251.

[8].              Ibid.

[9].              Explanatory Memorandum, Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, p. 5.

[10].              Ibid.

[11].              Senate Standing Committee for the Selection of Bills, Report, 4, 2016, The Senate, Canberra, 17 March 2016.

[12].              Senate Standing Committee for the Scrutiny of Bills, Alert digest, 5 of 2016, The Senate, Canberra, 3 May 2016, p. 28.

[13].              An angel investor is typically an affluent individual who provides capital for a business start-up, usually in exchange for ownership equity in the business.

[14].              E Husic, ‘Second reading speech: Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016’, House of Representatives, Debates, 2 May 2016, p. 66.

[15].              N McKim, ‘Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016 – Amendments moved by the Australian Greens’, Senate, sheet 7916, 3 May 2016.

[16].              Explanatory Memorandum, Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, op. cit., p. 19.

[17].              N McKim, ‘Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016 – Amendments moved by the Australian Greens’, op. cit., proposed sub-paragraph 360-40(1)(e)(iii).

[18].              N McKim, ‘Second reading speech: Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016’, Senate, Debates, 3 May 2016, p. 16.

[19].              Treasury, Tax incentives for early stage investors, Discussion paper, Department of Treasury, Canberra, 14 February 2016.

[20].              Treasury, ‘Tax incentives for early stage investors’, Treasury website.

[21].              Proposed section 360-40 of the ITAA 1997 at item 1 of Schedule 1 to the Bill.

[22].              Australian Venture Capital Association (AVCAL), ‘Tax incentives for early stage investors’, Submission to Treasury, Inquiry into the policy discussion paper on Tax incentives for early stage investment, 24 February 2016, p. 2. 

[23].              Research Australia, ‘Tax incentives for early stage investors’, Submission to Treasury, Inquiry into the policy discussion paper on Tax incentives for early stage investment, February 2016, p. 3.

[24].              Ibid., p. 7.

[25].              M Bailey, ‘Bring forward incentives for start-ups, Labor urges’, The Australian Financial Review, 23 March 2016, p. 9.

[26].              Explanatory Memorandum, Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, op. cit., pp. 3–4.

[27].              Ibid., p. 3.

[28].              Ibid., p. 4.

[29].              The Statements of Compatibility with Human Rights for both Schedules to the Bill can be found at pages 33–35 and 78–79 of the Explanatory Memorandum to the Bill.

[30].              Explanatory Memorandum, Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, op. cit., p. 356.

[31].              The Statement of Compatibility with Human Rights can be found at pages 78-79 of the Explanatory Memorandum to the Bill.

[32].              Explanatory Memorandum, Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, op. cit., p. 6.

[33].              Income Tax Assessment Act 1997.

[34].              Explanatory Memorandum, Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, op. cit., p. 7.

[35].              Ibid., pp. 17–19.

[36].              Venture Capital Act 2002.

[37].              Explanatory Memorandum, Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, op. cit., p. 43.

[38].              E Husic, ‘Second reading speech: Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016’, op. cit., p. 66.

[39].              Explanatory Memorandum, Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, op. cit., p. 39.

[40].              Ibid., pp. 45 and 74–75.

[41].               G Withers, N Gupta, L Curtis, N Larkins, Securing Australia's future: Australia’s comparative advantage: final report, Australian Council of Learned Academies, Melbourne, August 2015, p. 121.

[42].              Ibid.