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The Australian Information Economy Advisory Councils response to the Ralph review discussion paper,
A Platform for Consultation
The Australian Information Economy Advisory Council (AIEAC) was established in October 1998 to provide industry and community input to the Government on the information industries and information economy issues. The Council is chaired by Don Mercer, with Alan Baxter and Terry Cutler as Deputy Chairman. A full list of the members is attached.
The Council replaced the Advisory Board to the National Office of the Information Economy and the Information Industries Consultative Group.
Members of the Council serve in a personal capacity and not as representatives of their organisations. The views expressed in this submission are those of the Council, not of the Government or the Department.
The recommendations offered by the AIEAC fall into two groups:
Summary of recommendations
The key objective of the Ralph Review is set out in A Platform for Consultation:
The Council is taking this opportunity to provide the Review with input on matters of special significance to the information economy. Its intention is not to provide a comprehensive analysis of business taxation issues, but to highlight the importance of the information economy and innovation perspectives to Australias future taxation arrangements. What is fundamentally at stake in the reform of Australia's taxation system is the shape of the Australian economy in the next century.
We are in competition with other nations for footloose venture financial and intellectual capital. We must attract both types of capital in order to secure our long-term place in the global information economy. To a large extent, the way in which the taxation system rewards or constrains investment and expenditure will determine Australias ability to capture the benefits of the international economic restructuring being driven by technological change and industry convergence.
This restructuring has been under way for decades. The industrial economies of the developed nations, dominated by investments in physical assets, have been gradually displaced by the new "information economy", where the principal income-generating assets are intangibles. These assets range from widely-recognised forms such as copyrights and licences, through to less visible but equally important forms such brands, goodwill, workforce knowhow, and the tacit knowledge embedded in business systems.
The Council rejects the simplistic notion that taxation reform is a crude choice between the old primary and manufacturing sectors on the one hand, and the new services and information sectors on the other. Services and information products are key inputs to our increasingly sophisticated primary and secondary industries. Nothing will erode the competitive advantage of our industrial sectors more than the failure of our information and services economy to flourish. Australia needs smarter and more innovative agricultural and manufacturing industries in order to maintain and advance its position in an often hostile international trading environment.
Much of the pressure to reform Australias taxation arrangements springs from the tensions generated by this transition. The dominance of the services sector in the Australian economy is now well-established, but our taxation arrangements (and many other policies) still reflect the legacy of our industrial past. The Council believes that any taxation reform which fails to take account of this fundamental issue can not and will not stand the test of time.
The United States succeeded in creating the right investment environment for the industrial economy in the late 19th century and early 20th century. This led to an influx of British investment capital which turned the United States from a primarily agricultural to a primarily industrial economy in the space of a few decades. The transition from the industrial economy to the information economy will also create winners and losers. The countries which position themselves to exploit these changes will dominate the coming century. The countries which do not exploit them, or even resist them, will increasingly be marginalised.
The business taxation changes recommended by the Ralph Review, and the changes ultimately implemented by the Government, are a key plank of Australias response to that challenge. Australia is in competition with other countries, many of which are already taking active steps to restructure their taxation and other policy frameworks in order to capture a disproportionate share of the benefits of the information economy.
The Council believes that certain aspects of the taxation changes being considered by the Review will have great significance for the development of Australias information economy and its capacity to respond to the associated competitive challenges.
CAPITAL GAINS TAX (CGT) REFORM
Why is venture capital different?
Market failure issues
Policies to promote venture capital are typically justified by the failure of markets. In the venture capital context, these failures are generally due to the absence of well-informed markets. Information-related market failure is particularly prevalent in start-ups in the high technology area, where technological uncertainty is higher. These failures of venture capital markets have been analysed in recent publications by the OECD and the Australian Industry Commission (now the Productivity Commission), and a number of Government programs are in place in OECD countries which address the associated failure of markets to generate sufficient investment in start-ups and other new ventures.
Most countries which have addressed the failure of venture capital markets have adopted policies for concessional tax treatment of capital gains in start-up companies. This indirect approach is used because it offsets market failure across all venture investment sectors, not just the formal sector which is often the subject of other programs such as Government grants (such as those which were recently introduced into Australia). So-called angel investors and employee-investors, who do not have access to these programs, are able to benefit from the tax concession. This is important because angels and employees are an important source of financial capital for start-ups.
The United States has reduced the maximum capital gains tax rate which applies in venture capital markets to 20 per cent in recent years. This reduction has been accompanies by a significant increase in the amount of funds being invested in high-technology start-ups.
A significant proportion of venture capital funds globally are sourced from the United States, and the absence of major United States investors from Australian venture capital markets has contributed to Australias low levels of high-technology start-up investment and the absence of a critical mass of investment and management skills . The Councils view is that the United States market is the benchmark for venture investors world-wide, and must be the model for Australian policy for venture capital formation..
The Australian capital gains tax regime has a disproportionate impact on the venture capital market which makes it fundamentally unattractive to both domestic and foreign investors relative to other investments.
This disproportionate impact is due to the interaction between the special structural features of the venture capital market and the Australian capital gains tax regime (which was constructed according to certain assumptions).
Structural features of typical venture capital market which are relevant include:
All of these features result in a capital gains tax liability of investors in venture capital markets. Yet they are all legitimate stages in the development of a new venture.
The Council submits that Australias CGT regime was never intended to impose burdens of such a scale on legitimate commercial activity. The CGT regime was designed and introduced at a time when mergers, acquisitions and employee share issues were relatively infrequent and occasionally regarded with suspicion. Australias venture capital markets were embryonic, and the implications of a cascading tax on venture capital markets was not considered.
The assumptions which underpin the current CGT regime are no longer valid. The result is that the CGT now distorts investment behaviour by imposing high effective CGT rates on venture capital investments which do not fit an arbitrarily imposed "standard" model of capital accumulation.
International competitiveness issues
Australias continued adherence to its capital gains tax policies for venture capital markets has placed us out of step with many of our international competitors for scarce financial and intellectual capital for new ventures. Many of our competitors tax capital gains in venture capital markets at a lower rate than we do (reflecting international competition for venture capital), and do not tax non-cash transactions at all in the venture context. The review has recognised the consensus that this has discouraged both domestic and international investment in Australian venture capital.
The effective exclusion of major foreign investors in the venture capital market denies Australia more than financial capital; it denies us access to skills in venture capital management and to market liquidity which foreign investors would bring. This prevents Australian venture capital markets from realising economies of scale and learning economies. These economies are essential to the successful operation of venture capital markets which rely on heavy investment in specialised intangible assets such as skills in technology assessment, management and marketing.
All things being equal, the Australian CGT regime provides strong incentives for those start-ups to relocate to countries where venture capital can be raised more easily, and where more of the economic value that they generate will be ultimately captured by risk-taking investors.
Comments on the Discussion Paper
The Council welcomes the Reviews recognition of the consensus that the rate of capital gains tax on venture investments is an impediment to venture capital formation. However, the proposed ten-year taper of the CGT rate does not go far enough to solve the problem of high effective CGT rates. In the information industries the pace of change would completely outstrip such a measure.
For example, it was only four years ago that the Internet was recognised as a major force for change. In that time it has become the global backbone for the information economy and has spawned entire industries. Fortunes have been made and lost, and companies have appeared, been merged, taken over and dissolved with a lifecycle of little more than twelve months. Under the proposals contained in A Platform for Consultation, all of these changes would have been subject to a rate of CGT which would be regarded as punitive in most developed economies, and which would have sharply curtailed the liquidity of venture capital markets in the industry.
Further, the proposal to tax trusts as companies would be a heavy blow to venture capital formation in Australia if it were imposed indiscriminately on unit trusts. Unit trusts play a similar role to limited liability partnerships in the US venture capital industry. If they were taxed as companies, the risk management benefits of limited liability for unit holders would be swamped by additional corporate tax liabilities.
The Council believes that a number of measures are required to address these issues:
1. Lower rates of CGT on start-up investments
There is considerable evidence that Australias high effective rates of CGT are discouraging investment in Australian venture capital. This exacerbates the existing problems of market failure. Also, Australias taxation treatment of capital gains for active business-building investment is seriously out of line with the countries who are competing with us for scarce investment and intellectual capital for new ventures.
The Council recognises that a general lowering of the CGT rate would be neither necessary nor feasible. CGT concessions need to be focussed on areas of market failure, or where there are identifiable structural or international competitiveness issues, and where they will contribute to industry development and rapid economic growth. The Council suggests that concessions should differentiate between "active" investments (i.e. start-up and venture capital finance) and "passive" investments (e.g. real estate). The UK provides a precedent for such differentiation.
In order to discourage "speculative" abuse of CGT concessions, the Council agrees that a holding period would be appropriate, but strongly recommends that the length of the holding period should reflect the commercial lifecycle of investment in the industry. A five or ten year taper of CGT liability may fit the requirements of the biotechnology sector, but it will not address the requirements of the information sector, which is developing and growing at much higher rate than the wider economy. The global benchmark for tapering of capital gains tax is the United States, which provides for the maximum 20 per cent CGT rate to apply after only one year.
The Council recommends that Australia adopt a competitive stance on capital gains taxation of venture capital. The Council recommends that Australias rate of CGT on venture capital be aligned with that of the United States (the dominant global venture capital source) at 20 per cent with a one year holding period.
This measure would:
2. Tax treatment of Pooled Development Funds (PDFs)
The encouragement of domestic and foreign institutional investment in venture capital markets is currently being pursued through the pooled development fund (PDF) program. At present PDFs are taxed at the rate of 15 per cent - nominally a significant concession on the normal CGT rate. A recent review of the scheme found that PDF capital was key to business development where it was available, but that the growth of the funds had been slow.
The 15 per cent rate, however, remains a barrier to foreign superannuation funds, particularly those in the US. US pension funds have a variety of alternative country destinations for investment, many of which do not tax venture capital investment at all. This is reflected in the almost complete failure of the US pension funds to enter the Australian venture capital market, and to bring with them the liquidity and skills required to develop our venture capital markets.
The Council recommends that the tax rate on PDF investments should be competitive with the treatment afforded similar investments internationally, with a zero tax rate applying to both domestic and foreign institutional investment in PDFs.
3. CGT rollover for non-cash capital transfers
The current CGT arrangements impose taxation on non-cash transfers of equity. Such transfers can occur in a variety of contexts: scrip-for-scrip transactions such as mergers and acquisitions, employee share issues, and the distribution of shares to shareholders as a venture capital unit trust is wound up. This tax inhibits wealth creation by discouraging the restructuring of new ventures as the capital and management requirements of the firm change over its lifetime.
This is true across the economy, and will impose growing costs on innovative activity as services sector convergence accelerates. This convergence offers many opportunities for Australian service organisations to exploit new economies of scale and scope through mergers, acquisitions, separations and other restructures. In many cases these opportunities will be lost if the CGT regime continues to discourage firms from freely seeking the most effective capital and corporate structures.
The venture capital industry is particularly sensitive to this impediment. Start-ups and small investors typically do not have the cashflow required to meet these CGT liabilities because venture income is usually in the form of capital gain. This promotes "lock-in" of investors, inhibiting exit strategies and raising risk.
A Platform for Consultation suggests some relief, in that that CGT relief could be provided for scrip-for-scrip transactions, but this suggestion was limited to transfers between publicly listed companies. Clearly, this would generally exclude mergers between new ventures, the acquisition of new ventures by larger corporations through share swaps, or the distribution of shares to investor unit-holders as a trust is wound up.
The Council considers that the same principle is at stake in each of these cases, and there is no justification for an arbitrary differentiation between publicly listed and unlisted public and private companies and individuals. Indeed, such differentiation would amount to discrimination against small start-ups and individual investors in favour of established and publicly listed companies, and would create a distinct anti-innovation bias.
In the US venture capital funds are able to distribute shares tax-free to fund investors, giving investors the choice of retaining the shares, engaging in a (tax-free) scrip-for scrip transfer, or selling the shares. CGT is only payable where shares are actually sold for cash and the capital gain is thus realised. The Council submits that tax liability only ought be
The Council appreciates that the Review is concerned by the potential for abuse of a wide-ranging exemption from taxation on share transfers. However, it is the Councils view that tax avoidance issues should be addressed through anti-avoidance measures designed to restrict the benefits of any exemption to genuine active investments, not through the arbitrary application of rules which distort and discourage active and productive investment.
The Council recommends that CGT liability should only apply in venture capital markets where capital gains are actually realised as cash, and that share-only transactions and other swaps of productive assets should not attract CGT liability (subject to appropriate anti-avoidance requirements).
4. Preservation of taxation status of unit trusts for venture capital purposes
All countries where venture capital markets have developed significant breadth and depth share one basic characteristic. In those countries, legal entities such as trusts or limited partnerships (which limit risk to investors) are allowed to "pass through" capital gains to investors without incurring CGT liability. This prevents the cascading of the CGT rate in venture capital markets.
Venture capital funds in Australia have typically been established as unit trusts, allowing a tax-effective vehicle for the distribution of investment benefits while limiting investment risk. Limited partnerships have not been favoured in Australia due to their tax status as corporations.
The Review has proposed that trusts should generally be taxed like companies, but has also canvassed the possibility that "collective investment vehicles" (such as the unit trusts described above) be exempted from this requirement.
The Councils view is that this exemption for collective investment vehicles used for venture capital purposes is essential to the operation of venture capital markets in Australia. Reform of the CGT regime in order to address venture capital markets will avail little if a new corporate tax is imposed in its stead. Without such an exemption, Australia would once again be seriously out of line with its global competitors for investment and intellectual capital for new ventures.
The Council recommends that complete corporate tax exemption be retained for, at the very least, collective investment vehicles such as unit trusts which are used for investment in venture capital markets. In addition, the Council recommends that "pass through" of capital gains tax liability to investors in such vehicles should be preserved.
TAXATION TREATMENT OF INTANGIBLE ASSETS
The Australian taxation system makes generous provision for the depreciation of physical assets , including accelerated depreciation (which is currently under review). In contrast, limited provision is made for the depreciation of intangible assets. The arbitrary nature of this treatment is highlighted by the divergence between accounting and taxation treatment of intangible assets. While commercial accounting practice increasingly recognises the importance of intangibles to business success, the tax system has fallen behind.
This issue is closely related to the emergence of the information economy discussed above. In the long run, the investment in "information assets" which generate income in an information economy will be drawn to those jurisdictions where mobile financial and intellectual capital for new ventures is welcomed and rewarded. The current arrangements act as a brake on Australian investment in intangible asset accumulation and services sector expansion by making investment in these activities relatively "tax-inefficient".
Australia compares poorly with its major competitors for investment in venture capital. The US has a wide range of provisions for the amortisation of intangibles: the value of workforce, franchises and trademarks, software, government licences and permits, and even certain mortgage rights may be amortised. In recent months, the UK Exchequer has signalled its intention to align the taxation treatment of intangibles with accounting treatments. We are poorly equipped to compete with these countries for global financial and intellectual capital needed by new ventures.
There are two principal problems with the tax treatment of intangibles in the current tax system:
Reform of the depreciation system will not deliver immediate benefits. In that sense, the task cannot be described as urgent in the same way that CGT reform is urgent. The structural impact of taxation treatment is nevertheless considerable. Continued preferential treatment of physical assets over intangible assets will have a long-term impact on the structure of our economy, skewing investment towards primary and secondary industry. The Council submits that the Government should not favour one variety of asset over another, and that taxation treatment should be neutral to the extent possible.
The Council recommends that Treasury should adopt as a medium-term objective (over five years say) that the taxation of physical assets and intangible assets should be more closely aligned, by:
The Council believes that it is important to address impacts on revenue in a dynamic rather than a static context. Insistence on a static approach to the calculation of offsets will severely restrict the ability of the Review to make constructive recommendations which address the long-term structural issues facing the Australian economy.
The costs to revenue of the recommendations set out in this submission will be offset by new investment and economic activity which will generate new income and corporate taxation, and this must be taken into account. Indeed, it is likely that these changes may raise revenue if the rate of CGT is such that investors are more inclined to realise capital gains and pay the appropriate tax, as has been observed in the United States when similar concessions have been introduced.
To the extent that static offsets are required, the Council suggests that the current averaging provisions (which allow capital gains over a period of time to be taxed at the average marginal rate) could be dropped.
The dynamic approach to offsets is particularly important when considering issues such as the tax treatment of intangible assets. The firm view of the Council is that the proposed changes to taxation treatment of intangibles will not be a cost to revenue in the long run, because they will remove an impediment to investment in high-growth assets.
In fact, successful business tax reform should be revenue-positive in the long run because of the new ventures and economic activity which will be generated by a better alignment of the tax system with economic and commercial imperatives. Failure to address the taxation requirements of an information economy is the real threat to long term Government revenues.
4 June 1999
Chair and Deputy Chair
Chair, Mr Don Mercer (Former Chair National Office for the Information Economy Advisory
Board. Director, Orica Ltd, CSIRO, Australian Prudential Regulation Authority. Former
Chief Executive Officer, ANZ.)
Deputy Chair, Dr Terry Cutler, Managing Director, Cutler and Co.
Mr Peter Blanchard, Manager, Marketing and External Relations, Tradegate ECA
Ms Mara Bun, Manager Policy/Public Affairs, Australian Consumers Association
Mr Peter Coroneos, Executive Director, Internet Industry Association
Dr Wendy Craik, Executive Director, National Farmers Federation
Mr Clem Doherty, Like Minded Individuals
Mr Dennis Eck, Chief Executive Officer and Managing Director, Coles Myer Ltd
Professor Mike Grant, CEO, Imago Cooperative Multimedia Centre
Mr Steven Haines, Director, Trinitas Pty Ltd
Mr Tom Kennedy, Managing Director, Brainwave Interactive Pty Ltd
Mr Peter McLaughlin, Principal, World Competitive Practices
Mr David Merson, CEO, Mincom Pty Ltd
Mr Robert Norton, CEO Playford Centre
Mr Geoff Ross, Managing Director, Secure Network Solutions Pty Ltd
Mr Bob Savage, Managing Director/ CEO, IBM Australia
Mr Phil Singleton, Chairman, Service Providers Industry Association
Associate Professor Mark Sneddon, University of Melbourne Law School (Special Council, Clayton Utz)
Mr Ron Spithill, General Manager, Alcatel Australia
Dr Ziggy Switkowski, CEO, Telstra
Mr Bruce Thompson. Managing Director, Hewlett Packard Australia Ltd
Dr Paul Twomey, CEO National Office for the Information Economy and Special Adviser for the Information Economy and Technology
Mr Justus Veeneklaas, Former Chairman/Chief Executive, Philips Australia
Professor Robin Williams, Dean, Faculty of Art Design and Communication, RMIT