Contributed by Deborah Johns, Partner and Muhunthan Kanagaratnam, Partner, Gilbert + Tobin
The Treasury Laws Amendment (Tax Integrity And Other Measures) Act 2018 (the Fintech Reforms) amends the income tax law and the Venture Capital Act 2002 to ensure that the venture capital tax concessions for early stage venture capital limited partnerships (ESVCLPs) and venture capital limited partnerships (VCLPs) are available for investments in fintech businesses, at least to some extent.
The amendments take effect in relation to investments made on or after 1 July 2018. Although there are differences between the ESVCLP and VCLP regimes, the predominant activities test described below is the same for (and the Fintech Reforms apply to) both regimes.
This article focuses on ESVCLPs since fintech investments are a particular area of focus for early stage investors; however, managers of VCLPs who target fintech investments must also be mindful of the practical issues set out below.
The fintech issue
The law provides various tax incentives to investors in an ESVCLP in exchange for the ESVCLP making certain kinds of investments, known as “eligible venture capital investments” or EVCIs. These tax incentives include flow-through treatment for the ESVCLP and the possibility that gains made on the sale of EVCIs held for more than 12 months will not be subject to tax in Australia.
EVCIs must meet a number of different criterias, including that the investee satisfies at least two of the following three requirements:
- more than 75% of the assets (by value) of the investee or its controlled entities must be used primarily in activities that are not ineligible
- more than 75% of the employees of the investee or its controlled entities must be engaged primarily in activities that are not ineligible activities, and
- more than 75% of the total assessable income, exempt income and non-assessable, non-exempt income of the investee and its controlled entities must come from activities that are not ineligible activities.
Ineligible activities include certain kinds of finance, including banking and the provision of capital to others, as well as insurance. As these activities are closely associated with the fintech sector, this has led to a fair bit of confusion as to whether investments in fintech start-ups can constitute EVCI.
The issue only arises in the circumstances where the investee could be construed to be engaging in an ineligible activity (like banking, the provision of capital to others or insurance) — not all fintech start-ups would be. But for those whose business does touch on these activities, the general rule of thumb, before the Fintech Reforms were enacted, was that an investee whose technology enabled others to engage in ineligible activities would not itself be considered to be engaging in an ineligible activity. However, this “rule of thumb” was not enshrined in law and in any case has been somewhat difficult to apply in practice.
To make matters worse — the predominant activities test outlined above is an ongoing requirement. That means that an investee that met the test when an ESVCLP first made an investment in it may fail the test as its business evolves, causing the investment to cease to be an EVCI.
The requirement to hold only EVCIs is what is known as an “investment registration requirement”. If Innovation and Science Australia suspects that an ESVCLP does not meet the investment registration requirements (including the requirement to hold only EVCIs), it must notify the ESVCLP that it will deregister the ESVCLP if it is satisfied that, after a cure period, the ESVCLP still does not meet the investment registration requirements. In this context, the general partner must, within the cure period, either convince Innovation and Science Australia that the investment is an EVCI, or sell it. Failure to do one of those things will eventually result in the deregistration of the ESVCLP.
What do the Fintech Reforms do?
The Fintech Reforms attempt to provide some clarity around the predominant activities test for those investees that may otherwise be considered to be engaging in, eg, banking, providing capital to others or insurance, by focusing on whether the investee is in fact developing technology or applying technology in a novel way. The Fintech Reforms provide that an activity of an investee is not an ineligible activity for the purpose of qualifying as an EVCI if it is:
- developing technology for use in relation to finance, insurance or making investments
- an activity that is ancillary or incidental to the activity of developing technology referred to above, or
- covered by a finding from Innovation and Science Australia that it is a substantially novel application of technology.
The concept of “developing technology” is deliberately not defined, and therefore has its ordinary meaning. The Explanatory Memorandum suggests that it covers “things done to create, understand and apply technological innovation” and can extend to adapting existing technology for a novel use. The Fintech Reforms also introduce some flexibility to enable the legislation to keep up with developments in the area by:
- allowing regulations to be passed which may circumscribe the availability of the above exclusion, and
- allowing Innovation and Science Australia to make public or private findings as to whether an activity amounts to a substantially novel application of technology.
There is, unfortunately, very little guidance as to what constitutes “developing technology” or “a substantially novel application of technology”, so all the Fintech Reforms have done is to shift the grey area to new ground.
Moreover, the Fintech Reforms do not solve the significant issue that the predominant activities test is an ongoing one, meaning an investment may cease to be an EVCI as the investee’s business evolves. Indeed, the Explanatory Memorandum relating to the Fintech Reforms makes it clear that, over time, “a business may become less likely to satisfy the predominant activities test as its activities shift from developing the underlying technology to commercialisation, building market share and other uses of the now established technology”.
As a result, general partners must still monitor investments to ensure they pass the “predominant activities” test on an ongoing basis, and while the Fintech Reforms have provided some further guidance in circumscribing what constitutes an ineligible activity, general partners still face considerable challenges in identifying when an investment actually crosses (or is in danger of crossing) that line. This may put pressure on fund managers to dispose of investments at less than optimal times or in a less than optimal way.
[This article was originally published in CCH Tax Week on 9 November 2018. Tax Week is included in various tax subscription services such as The Australian Federal Tax Reporter and CCH iKnow. CCH Tax Week is available for subscription in its own right. This article is an example of many practitioner articles published in Tax Week.]