Tax laws put brakes on venture funds

By ANDREW LEWIS*

These are challenging times to raise venture capital funds and even more challenging times to encourage foreign funds to invest in a far-flung corner of the globe such as New Zealand.

With global equity markets in recession and technology stocks affected worse than any, exit opportunities for venture capital funds worldwide are scarce.

Most are preoccupied with shoring up existing investments at home and only a rare few are even considering new investments in foreign countries.

The timing is less than ideal for New Zealand, with its emerging venture capital and knowledge economy sectors and the launch of the Venture Investment Fund programme, which is seeking to attract up to $200 million of private capital for early stage funds, much of which will need to come from overseas.

This is a time New Zealand needs every advantage possible to make investment in New Zealand funds appear attractive by international comparison.

At first glance, the New Zealand tax environment looks like one of those advantages. After all, we have no capital gains tax and typically the primary investment motivation for venture capital investors (at the highest end of the risk spectrum) is the prospect of capital gains on their investments.

But it is not that simple.

Capital gains on investments will be tax-free only if the investments are made by the investor on capital account and not for the primary purpose of disposal for gain.

If investments are made for the primary purpose of disposal they will be deemed on revenue account and taxable at the applicable income tax rate of the investor (39 per cent for an individual or 33 per cent for a company).

This creates an all-or-nothing tax environment for gains made on disposal - 0 per cent or a minimum of 33 per cent. There is nothing in between.

A particular problem for private equity investments through fund vehicles - as distinct from private equity investments made directly by individuals or single entities - relates to the typical finite duration of those funds (usually 10 years).

The problem for a finite duration (closed end) fund in the context of New Zealand capital gains tax is that the finite duration and any related implication that all investments made by the fund vehicle must be liquidated within that finite timeframe imply that investments made by the funds are made for the primary purpose of disposal for gain and accordingly on revenue account and taxable.

Some promoters of recently established New Zealand-domiciled funds have sought to overcome this problem by adopting unincorporated co-investment structures where there is no separate fund entity and the fund manager effectively agrees to co-invest funds from each of the individual investors in the co-investment arrangement.

A principal objective of this type of structure is to ensure investors' tax position is no worse by investing in a fund than if they made the investments individually.

The co-investment structure prevalent in New Zealand is similar in many respects to the LLP (limited liability partnership) structure prevalent in overseas jurisdictions which have active private equity sectors (including the United States, Britain, France, Germany, Israel, Singapore and Canada), and is regarded as the international best-practice structure.

An LLP is also a tax flow-through structure where the investors, rather than any fund vehicle, are the taxpayers.

A significant disadvantage of the New Zealand unincorporated structure is that it is not internationally recognised and foreign investors need to be satisfied they are not worse off under that structure.

While the New Zealand unincorporated structure is similar in its tax treatment to an LLP, it is not an LLP with advantages of statutory recognition and familiarity.

Other disadvantages of the unincorporated structure include a lack of clear limited liability protection for investors and the risk the IRD will still consider the investors had a collective intention to liquidate investments within the finite fund period.

We are about to drop even further down the comparative attractiveness table where Australia is in the process of introducing legislation which will essentially recognise the internationally preferred LLP structure for qualifying venture capital funds and, more importantly, specifically exempt qualifying foreign investors from six key investor markets (the US, Canada, Britain, France, Germany and Japan) from any tax on their capital gains made on eligible investments through a qualifying fund.

All of this paints a picture of a tax environment which is unattractive by international comparison and which forces unfamiliar fund structures that pose apparent risks for investors.

We can ill-afford these disadvantages. As a small economy, we need comparative advantages from a taxation and legal compliance perspective rather than disadvantages.

* Andrew Lewis is a partner in Simpson Grierson.