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Tax issues: Nothing ventured, nothing gained

Every Issue

Cite as: (2004) 78(7) LIJ, p. 80

Although it is not widely known, the Pooled Development Funds program offers a broad range of benefits and tax concessions.

The Pooled Development Funds program

Small and medium-sized enterprises (SMEs) often have difficulties in obtaining venture capital funding. Without such investment many SMEs may not be able to achieve their full potential and, as a result, the wider economy will not be able to benefit from the innovations and job prospects that these entities can provide. Over the years, the federal government has developed various schemes to stimulate venture capital investment in Australia, including the establishment of the Pooled Development Funds (PDF) program. Although the PDF program has been in existence for around 12 years, it is not a very well-known scheme. The purpose of this article is to outline the broad features of the PDF program and to highlight some of the main benefits offered under it, as well as some of the limitations.

Registration of PDFs
The PDF program is established under the Pooled Development Funds Act 1992 (PDF Act). The aim of the scheme is to encourage patient equity capital investment in SMEs that carry on eligible businesses. Under the scheme, companies may apply to the PDF Registration Board (PDF Board) to be registered as PDFs. The benefit of registration is that PDFs and their shareholders are entitled to a broad range of tax concessions. The burden of registration, however, is that PDFs must comply with various restrictions imposed under the PDF Act.

PDF operating and investment restrictions
The PDF Act requires PDFs to operate solely as investment vehicles. Once a company is registered as a PDF, it must carry on a business of making and holding “PDF investments” and it must generally not enter into a transaction other than in the course of, or for the purpose of, carrying on that business. PDFs are only permitted to invest in eligible investee companies and to make a limited range of “unregulated investments” (such as loans and deposits with a bank and investments in the short-term money market with an authorised money market dealer). Broadly, eligible investee companies are companies whose assets do not have a total value in excess of $50m and that do not have, as their primary activity, an “excluded activity” (namely retail sale operations or acquisitions or disposals of interests in, or development of, land).

PDFs may only make the following kinds of investments in investee companies:

  • they may subscribe for (or, with the approval of the PDF Board, buy from a third party) shares in such companies;
  • they may acquire non-transferable options in such companies; and
  • they may lend money to such companies (up to a maximum of 20 per cent of the PDF’s shareholders’ funds).

Unless the PDF Board approves otherwise, PDFs may only invest in ordinary shares in an investee company and those shares must not have been “pre-owned” (i.e. PDFs must generally subscribe for new shares). This is designed to ensure that fresh equity capital is injected by PDFs into investee companies. Furthermore, unless the PDF Board approves otherwise, immediately after an investment is made, the total of all amounts paid on shares in the investee company held by the PDF must equal at least 10 per cent of the total of all amounts paid on the issued shares in the company. As a result, the second and third kinds of investments mentioned above (i.e. options and loans) may only generally be made after a PDF first makes the requisite amount of equity investments in the company.

To ensure that PDFs spread their investments a PDF is not permitted, unless the PDF Board approves otherwise, to invest more than 30 per cent of the sum of its shareholders’ funds and all amounts unpaid on its issued shares in any one investee company.

There is also an important requirement that a PDF must believe, on reasonable grounds, that its investment in an investee company is made solely or principally for use in doing one or more of the following:

(a)

establishing an eligible business carried on, or to be carried on, by the investee company;

(b)

substantially expanding the production capacity, or capacity to supply services, of an established eligible business; or

(c)

substantially expanding existing markets, or developing substantial new markets, for goods or services supplied in the course of an established eligible business.

Capital raising restrictions

The PDF Act also imposes restrictions on the way in which PDFs may raise capital. As a general rule, PDFs are prohibited from borrowing money and therefore must raise capital principally by issuing shares.

In addition, a person together with their associates is generally prohibited from holding more than 30 per cent of a PDF’s issued shares. This restriction is designed to prevent a PDF from being controlled by any one group of shareholders. Importantly, however, banks, life offices and widely held superannuation funds fall outside this rule and they can own “captive PDFs”.

PDF Board’s monitoring role
The PDF Board has the role of monitoring PDFs and it can give directions to PDFs.

Sanctions may be imposed where the PDF Act has been contravened. In particular, a contravention of the legislation may result in a PDF’s registration being revoked.

Furthermore, criminal penalties may be imposed on those officers or investment managers of the PDF that knowingly or recklessly are involved in aiding or abetting the contravention.

Tax concessions
To encourage investment in PDFs, the following tax concessions are available to PDFs and their shareholders:

1.

Reduced PDF tax rates. Unlike other companies which generally pay tax at the rate of 30 per cent, PDFs pay tax at reduced tax rates. For this purpose, PDFs are generally required to divide their taxable income into the following two components:

  • an “SME income component” which is taxed at the rate of 15 per cent (this component relates to income and gains made by the PDF from its SME investments, such as dividends paid from investee companies and gains from the disposal of shares in such companies); and
  • an “unregulated investment component” which is taxed at the rate of 25 per cent (this component relates to income and gains made by the PDF from its other investments, such as bank deposits).

2.

Disposal concession. Shareholders in PDFs (whether Australian residents or non-residents) are exempt from both income tax and capital gains tax on any gains that arise from the disposal of their PDF shares. Conversely, they are not entitled to any deduction or capital loss in respect of any losses that arise on disposal of their shares.

3.

Dividend concession. Shareholders in PDFs are exempt from both income tax and withholding tax on franked and unfranked dividends paid by PDFs. Resident shareholders may, however, choose to be assessed on the franked portion of PDF dividends (together with the “gross up” amount for the franking credits), in which case they are entitled to benefit from the franking offset for the franking credits allocated to such dividends. This choice benefits shareholders that pay tax at rates below the general corporate tax rate (e.g. complying superannuation funds).

4.

Venture capital franking concession. PDFs can maintain “venture capital franking accounts” to reflect income tax that is reasonably attributable to a CGT event arising in relation to their SME investments. Credit balances in these accounts can be used to pay “venture capital franked dividends”. These dividends are exempt from tax in the hands of complying superannuation entities (other than self managed superannuation funds). Further, even though the dividends are exempt in the hands of such entities, they are nevertheless still eligible for franking offsets in respect of the “venture capital franking credits” allocated to such dividends. This may be contrasted with what occurs where complying superannuation entities receive “ordinary” franked dividends from a PDF. As discussed above, they can choose for such dividends to be either exempt (in which case no franking offset is available) or assessable (in which case they must include the dividends together with the relevant gross up amounts in their assessable income but will be entitled to the franking offset).

The PDF concessions operate within the general scheme of the tax legislation and therefore operate subject to both general and specific anti-avoidance rules. In particular, shareholders in a PDF should note that in order to benefit from any franking offsets, they would generally need to have held their shares at risk for a minimum holding period.

Further, a PDF cannot “stream” the payment of venture capital franked dividends only to those entities who can benefit from them (i.e. complying superannuation entities).

Conclusion

Although the regulatory restrictions that are placed on PDFs under the PDF Act are quite onerous and restrictive, the tax concessions available under the regime are also quite generous. The possibility of using a PDF as an investment vehicle for making venture capital investments should therefore be carefully considered.

While PDFs are not necessarily the ideal vehicle for all forms of venture capital investment, they certainly can provide useful tax benefits in appropriate cases.

In addition to the PDF regime, there is also a range of relatively new venture capital tax concessions targeted specifically at non-resident investors. These concessions will be discussed in a later column.


JANE TRETHEWEY is a partner in the Tax Group of Blake Dawson Waldron, practising in corporate and international tax. STEPHEN BARKOCZY, is an associate professor at Monash University and a consultant with the Tax Group of Blake Dawson Waldron.

tax@liv.asn.au

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