Submission to the Ralph Review

Recommended Exemption

What will be the tax cost to Australia?

AVCAL's opinion is that there will be no tax cost to Australia if the proposed tax reform is implemented. As the US and UK funds have not and will not come to Australia given the present CGT incidence, the economic growth desired and the subsequent capital gains are not happening. Accordingly, no existing tax revenue would be forgone as a result of the proposed changes.

In addition, any potential loss of CGT receipts occurs in the future and only after a company has been successful. In the meantime, the tax revenue will be boosted significantly as a consequence of the increased income earned by venture capital backed companies and from taxes on the salary and wages of their employees.

In 1996 venture capital backed companies in Australia contributed $129M9 in tax to the revenue and this does not include the tax paid on the salaries taken home by the employees of these firms or tax paid from the suppliers or customers of these businesses.

This conclusion is supported by the findings of the US Senate Joint Economic Committee who refer to historic evidence "that capital gains tax reductions tend to increase tax revenue. When capital gains tax rates were lowered in 1978 and again in 1981, revenue climbed steadily. Conversely, when the tax rate was increased in 1987, revenue began declining despite forecasters predictions it would increase".

In summary, we again note that as venture capital is not being invested into Australia, there is no tax revenue being forgone as a result of granting a CGT exemption.

Should a nil or small CGT rate be applied?

The US, the UK and the vast majority of other countries do not tax non-resident investors who earn capital gains on the sale of their venture capital investment. If Australia wishes to be internationally competitive in the venture capital market, it must also allow these gains to be tax-free. We note that Australian superannuation funds, which invest into the US venture capital market, are not subject to US capital gains tax on their profits.

For example, if the US were to adopt the Australian taxation system, then Australian superannuation funds would be subject to a 36% tax in the US and could only utilise a 15% foreign tax credit in respect of this amount. To provide an after tax return of similar value the US investment would have to be a third again as good as a local investment. This is unlikely and Australian super funds would not invest in the US if this were so.

We note that as the US has a more developed taxation system than Australia, our super funds are investing into the US economy. While this benefits our super funds it also benefits the US economy. The Australian economy should be allowed to participate in these benefits by having a level playing field. The tragedy is that it is the Australian Government that has unwittingly tilted that field against the Australian economy.

US pension funds are tax exempt. Hence, the effect of a 36% Australian capital gains tax is to only make it worthwhile for these funds to invest in Australian companies that will outperform their international counterparts by an additional 56%. A reduced Australian tax rate would reduce this effect (15% rate would require an additional return of 18%) but until it is reduced to nil, Australian entrepreneurial companies will be competing at a disadvantage.

Based on AVCAL members' own extensive discussions with offshore pension funds and confirmed by the recent Deloitte survey, we do not believe any of the exempt offshore funds will invest in Australian venture capital trusts until their exposure to CGT is nil.

Australian investors are not disadvantaged

Australia currently has 37 double tax treaties with countries around the world. The basic philosophy of these treaties is to establish which jurisdiction should have priority to tax entities of one jurisdiction, which derive income from activities in the other. In short, the treaties decide whether the income should be taxed in the jurisdiction of the entity or the jurisdiction of the activity.

The exemption proposed in this submission would bring Australia into line with the rest of the world, which does not impose tax on the income of venture capitalists in the jurisdiction of the activity. Australian super funds pay 0% in the US US pension funds should pay 0% in Australia.

Australia (and the rest of the world) currently tax super funds in their own jurisdiction. An Australian super fund investing into the US is only taxed in Australia at the appropriate Australian maximum nominal rate 15% (typically 7-8% or less is paid). Likewise, a US or UK super fund investing into Australia should only be taxed in the US or UK at their appropriate local rate.

Furthermore, we have demonstrated in section 3 above that our changes will stimulate incremental funds and investment into the Australian economy without displacement of the local investors. That is, the proposed changes will not adversely effect existing Australian investors. In fact, the arrival of experienced offshore investors should educate and encourage heretofore reluctant Australian investors to allocate more of their funds to the venture capital sector.

Should the tax changes encourage all stages of the venture capital process?

Venture capital can assist small companies to grow into large companies. This assistance is required at all stages of the development of the companies, starting with seed capital, moving into expansion capital and pre IPO ("initial public offering") funding. Venture capital provision for Management Buyouts ("MBO"), Management Buyins ("MBI") must also be included at all three stages of growth.

Any development of just one of these stages will result in a bottleneck in the creation of dynamic large companies and will negate the benefits achieved or achievable at other stages. For example, the benefits of a strong seed capital environment will be lost if those companies can not access adequate expansion capital or need to go offshore to find such capital.

Having noted this, AVCAL does realise that as seed capital represents the highest risk investment for venture capitalists this sector typically struggles for funds as compared to other stages. Hence, the Government initiatives, such as the Innovation Investment Fund program, are to be applauded. However, unless the entire Australian venture capital industry is strengthened the benefits that result from this program will be much less than they should be.

A comparison of the percentage of funds committed to seed capital by the venture capitalists in the US, UK and Australia shows the following:

US (mature venture capital market)26%
UK (maturing market)15%
Australia (immature market) 9%

Another statistic demonstrating the relative immaturity of the Australian venture capital market is the average age of venture capital backed companies 9 years in Australia versus 4.5 years in the US.

This confirms AVCAL's view that as the Australian venture capital industry matures with greater funds under management, so too will the availability of seed capital expand as demonstrated in the US and UK.