Overview and Key Recommendations
The Australian government has regularly stated that it recognises the need to support competition, innovation and productivity in the Australian financial services sector. This was emphasised by the Prime Minister in his speech to the Singapore Fintech Festival, stating “I have been an enthusiastic believer in the potential of this dynamic sector” and that “Fintech is integral to the economy we are rebuilding”[i]. Senator Andrew Bragg, Head of the Senate Fintech Committee, has also highlighted the government’s goal of making Australia a fintech hub, saying in a recent LinkedIn post that he “wishes to ensure Australia is the premier fintech destination in the Asia Pacific”[ii].
The statements made by the government so far are warmly welcomed, as are the actions taken, including the appointment of a Special Envoy for Business and Talent Attraction. However, in order to flourish, fintech businesses require capital, and Australia currently lags far behind in this regard.
Source: OECD Statistics Directorate [iii] *data from last available year
If the level of Venture Capital investment in Australia is compared internationally, the degree to which we are falling behind becomes clear. The amount of Venture Capital investment in Australia, when measured as a percentage of GDP is only 3.4% placing Australia 22nd out of 37 OECD nations — a position that does not reflect the Government’s desire to make Australia a leading destination for innovation and investment. Further, Australia has a disproportionately low share Venture Capital investment in the crucial seed, start-up and early stages that foster innovation. In terms of early-stage Venture Capital investment, Australia ranks 25th in the OECD.
Source: OECD Statistics Directorate [iii] *data from last available year
Source: OECD Statistics Directorate [iii] *data from last available year
What is the Early Stage Venture Capital Limited Partnership (ESVCLP)
The ESVCLP scheme was set up to promote investment in to the early-stage Australian tech sector, and to drive economic growth and jobs, to foster new enterprises, and promote entrepreneurship[iv]. However, legislation specifically excludes investment under the scheme into businesses undertaking financial services. Some exceptions to the exclusion of investment into financial services were introduced in 2018, but the legislation remains extremely ambiguous, and these reforms do not go far enough to assist Australian fintech businesses.
Investment into early stage fintech businesses is being hampered by these exclusions.
In addition, the tax offsets and other incentives provided under the scheme are significantly lower than comparable schemes in other countries. Further, it is common for governments around the world to support their local fintech sectors by making targeted direct investments into venture capital through sovereign wealth funds or development schemes.
Members of the government, including the Prime Minister and Sen. Bragg have recognised these current issues around taxation and tax incentives for Australian fintech, and have highlighted the imperative to resolve them. In Singapore, Prime Minister Morrison said “there are plenty of fronts where we have so much still to do — particularly in deregulation, taxation, and especially skills development”. At the recent Australian Fintech Awards, Sen. Bragg stated “we need a more tax-friendly regime for FinTech and growth businesses”[v].
If the Federal Government wishes to support the Australian fintech sector and allow Australia to compete on a global scale, then it should consider key policy changes.
Seed Space Recommendations
- That the finance-related activity test be removed from ESVCLP rules.
- The cap on CGT exemptions under the ESVCLP scheme be raised from its current limit of $250m.
- The ESVCLP tax offset be raised, so as to bring it into line with comparable international programs.
- That the level of ESVCLP tax offset and the ESIC tax offset be harmonised to reduce market distortions.
- The Australian Future Fund (AFF) be given a specific mandate to direct some minimum portion of funding to the Australian fintech sector, through Australian Venture Capital investment managers.
Activity-Based Restrictions on ESVCLP Eligibility
The Early Stage Venture Capital Limited Partnership (ESVCLP) program is designed to incentivise investment in early-stage Australian businesses by providing a 10% tax offset and Capital Gains Tax exemptions to investors.
While early-stage fintech businesses were completely excluded from the ESVCLP program initially, this was recognised by the government in 2018 as a significant barrier for innovative, high-growth potential fintech start-ups. Legislative changes were made with the goal of ensuring support to fintech businesses. However, the enabling legislation still excludes key fintech-related sectors, specifically: “banking”, “providing capital to others”, “leasing”, “factoring”, “securitisation”, and “insurance”. Early-stage Australian businesses operating in these areas are prevented from accessing venture capital investment under the ESVCLP program.
According to the EY Fintech Census 2020[vi], 29% of Australian fintechs operate in “lending”, 30% in “payments, wallets and supply chain”, 18% in “wealth and investment”, 14% in “challenger/neo bank”, 10% in “asset management and trading”, and 5% in “insurance/insuretech”. This indicates that approximately half of Australian fintech start-ups are excluded from the ESVCLP program.
The activity-related restrictions create several potential issues for investors, and for the wider Australian economy. First, the current restrictions create uncertainty for investors about which businesses may or may not be eligible. This has led to investors declining to invest in fintech businesses that otherwise show great potential in the Australian market. This is further exacerbated by a lack of regulatory guidance around the ESVCLP program.
Legislative changes made in 2018 sought to make the development of technology for use in finance eligible, and so increase the eligibility of fintech businesses. However, this requires early-stage businesses to prove that 75% of employees, assets and revenue are primarily engaged in technology development.
While on face-value this seems reasonable, the 75% threshold is extremely high, and the only businesses able to meet it are those who place no emphasis on commercialisation. In the case of early-stage businesses, many are at a pre-revenue stage of development and have assets primarily in the form of cash. In these cases, demonstrating activities attributed to assets and revenue is either impossible, or imposes an immense regulatory burden on early-stage businesses. In effect, the legislative reforms of 2018 have failed to remove the barriers to participation for Australian early stage fintechs.
As an alternative to the activity-related restrictions, the ESVCLP program currently includes a number of safeguards that prevent invested funds from being used for purposes outside of the goals of the ESVCLP program. This addresses the concern that investments could be used to fund loans or debt, or could be used to fund investments in other listed or unlisted shares to generate an investment return. Any such use of funds are ineligible under the ESVCLP program, and investors do not receive the tax benefits and incentives of the program.
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In addition to these restrictions, it is important to note that venture capital investments are typically structured in such a way that any such investment would be made under a different legal structure, and through a different entity that is not registered as an ESVCLP and that doesn’t receive the benefits.
In the case of debt, when an early-stage business is raising a credit facility, it is typically structured entirely separately from the company’s equity ownership. There are a range of reasons for this structure. First, that debt investments have a much shorter investment period than an equity investment made by a venture capital fund, which will expect to hold the investment for up to ten years. Second, an equity investment inherently carries more risk, and venture capital investors expect a higher rate of return in exchange for the risk and the longer investment period.
The separate debt and equity structure means that funds raised for the credit facility are used solely to provide credit, and that funds raised through venture capital are used to fund the operation and expansion of the business, including hiring staff, performing research and development and paying suppliers. If a venture capital investor wishes to participate in the debt investment, they must do so through a separate investment agreement. In the case of the ESVCLP program section 118–425 mandates that “To avoid doubt, a debt interest cannot be an eligible venture capital investment”[vii] and would preclude any such investment from receiving the tax benefits and incentives of the ESVCLP program.
In the case of equity investments, the ESVCLP program includes a number of safeguards that ensure than investments are only made in businesses that are true early-stage businesses, and are predominantly based in Australia. These safeguards include tests on the location of employees, the size of assets of the business, and that the business is not listed on a stock exchange. Crucially, section 118–425 of ESVCLP legislation includes the mandate that “The [investee] company must not invest, in another entity, any part of the amount invested”[viii], meaning that invested funds may not be used for any acquisition, buyout, or further investment unless it also meets the stringent early-stage and Australian location tests of the ESVCLP program.
The final and most critical issue is the support of early stage fintech as an industry within Australia. At present, the Australian financial services sector as a whole accounts for 9% of Australian GDP[ix], and creates over 450,000 jobs[x]. It is both well established and highly profitable as a sector of the Australian economy, but it is being challenged by new global entrants and products.
Australian fintechs have shown a remarkable ability to develop innovative and popular products and services, and to compete in international markets. However, unlike the incumbents of the financial services sector, these early-stage businesses require support and investment to grow and compete on an international stage.
If investment in Australian fintech remains limited, there is a serious risk that the financial products and services used by Australian businesses and individuals will no longer be provided by Australian businesses. If this occurs, the financial sector could cease be a cornerstone of the Australian economy, at a huge expense to jobs, exports and incomes.
Seed Space Recommendations
Based on this, Seed Space recommends that the finance-related activity test be removed from the ESVCLP rules, to allow Australian early-stage fintechs to compete for funding and grow on an equal basis with other tech sectors.
Capital Gains Tax Exemption Limits
At present the ESVCLP program provides an exemption on capital gains up to a certain level — specifically the point at which an individual investee company has a total value of $250m, regardless of size of the individual investment. This creates a unique problem for Venture Capital investors due to the distribution of returns. In the normal operation of a VC fund the majority of investments will only make a small return, and most of the total return will come from a small number of highly successful businesses. Effectively this means that the CGT exemptions are smaller for early-stage VCs than they appear.
When compared to other Australian investment incentive programs, it is notable that CGT exemption cap only applies to the early-stage ESVCLP program. Specifically, the VCLP program targeted at later-stage investment has no such cap on the exemption of capital gains. Effectively, this acts as an additional disincentive to investment in early-stage Australian businesses.
Seed Space Recommendations
Seed Space recommends that the cap on CGT exemptions is raised so as to remove this disincentive to investment in early-stage businesses.
Distortion Caused by Different Tax Offset Rates Between ESVCLP and ESIC
An additional issue is the difference in tax treatment between the ESVCLP and ESIC programs. The Early Stage Innovation Company (ESIC) program provides similar tax offsets and CGT exemptions, but is targeted at investors who invest directly, rather than through a fund. The ESIC program provides a 20% tax offset, as opposed to the 10% tax offset under the ESVCLP program. This difference in tax treatment encourages investors to hold investments directly, disincentivises investors from holding a diversified portfolio, and has the potential to limit the number of businesses able to access investment funding.
Seed Space Recommendations
Seed Space recommends that the government seek to harmonise the tax offsets provided by the ESVCLP and ESIC programs.
Fintech Investment Support in the UK and Internationally
The UK is arguably the world’s leading fintech hub, attracting over $US50b in fintech investment in 2019[xi] (compared with $US2b in Australia. This position has been advanced through a combination of tax incentives, financial support, and a long-standing collaboration between government, regulators and UK fintech industry bodies.
Amongst the UK’s investment tax incentive programs, the Enterprise Investment Scheme (EIS) provides investors with a 30% tax offset on investments up to £2m per annum, exemption from Capital Gains Tax (CGT)[xii], and the ability to offset other capital gains up to approximately 50% of individual annual EIS investment. Additionally, the Seed Enterprise Investment Scheme (SEIS) provides a tax offset of 50% per annum for investments in early-stage businesses. These incentives are considerably more favourable than the Australian ESVCLP’s 10% offset and CGT exemption that is capped at $250m.
Internationally, many jurisdictions have programs similar to ESVCLP with more favourable terms, some examples include: In Japan, the Open Innovation Tax Credit (OITC) provides a 25% tax offset of as well as CGT exemptions for foreign investors [xiii]; In Germany, the INVEST program provides a 20% tax offset [xiv], and in Ireland the Employment and Investment Incentive (EII) provides a 40% tax offset [xv]. In the US, the Qualified Small Business Stock (QSBS) program [xvi] provides investors with a CGT exemption of up to 100%.
Seed Space Recommendations
Seed Space recommends that the government seek to raise the ESVCLP tax offset, so as to bring it into line with comparable international programs.
Direct Financial Support to the Fintech Sector
In addition to investment incentives, the UK government provides direct financial support to fintechs through government backed loans and investment by the British Business Bank, and through grants from the government-funded innovation body, Innovate UK. The government also supports fintechs through substantial R&D tax credits, extensive collaboration with industry through the Fintech Delivery Panel and Tech Nation, and has implemented a Knowledge Transfer Partnerships program to fund salaries for PhD students specialising in AI, cybersecurity and other fintech-related fields to work at selected fintechs. Additionally, as a response to COVID 19, the UK government has created a Future Fund program to provide matched investment up to £5m for early-stage UK businesses.
Finally, both fintech and early-stage Australian tech businesses are areas that are currently overlooked by Australia’s sovereign wealth fund, the Australian Future Fund (AFF). At present, of the AFF’s 14 selected investment managers in the venture and growth sector, 9 are US-based, 4 are based in China, and none are located in Australia, or focus on Australian investments. By encouraging the AFF to select additional Australian managers in the early-stage fintech space, the government could meet the goal of fostering and growing innovative early-stage businesses, while at the same time ensuring strong returns from a growing sector of the economy.
Seed Space Recommendations
Seed Space recommends that the AFF be given a specific mandate to direct some minimum portion of funding to the Australian fintech sector, through Australian Venture Capital investment managers.
References
[i] Morrison, Scott. (2020, December). VIRTUAL SPEECH — SINGAPORE FINTECH FESTIVAL. Retrieved from https://www.pm.gov.au/media/virtual-speech-singapore-fintech-festival
[ii] Bragg, Andrew. (2020, December). FinTech people: get your submissions in!. Retrieved from https://www.linkedin.com/posts/andrew-bragg-3296b823_fintech-people-get-your-submissions-in-activity-6742382652646678528-KQy_
[iii] OECD. (2020, December). Venture Capital Investments. Retrieved from https://stats.oecd.org/Index.aspx?DataSetCode=VC_INVEST
[iv] Australian Government — Department of the Treasury. (2016, March). Turnbull Government introduces tax incentives to boost growth and jobs. Retrieved from https://ministers.treasury.gov.au/ministers/scott-morrison-2015/media-releases/turnbull-government-introduces-tax-incentives-boost
[v] Bragg, Andrew. (2020, November). FinTech Awards Speech. Retrieved from https://www.andrewbragg.com/post/fintech-awards-speech
[vi] Earnst & Young and Fintech Australia. (2020, October). EY FinTech Australia Census. Retrieved from https://www.ey.com/en_au/financial-services/how-australian-fintechs-are-planning-to-emerge-stronger-from-the-crisis
[vii] Australian Government. (2020, December). Income Tax Assessment Act 1997. Retrieved from https://www.legislation.gov.au/Details/C2020C00404/Html/Volume_3
[viii] Australian Government. (2020, December). Income Tax Assessment Act 1997. Retrieved from https://www.legislation.gov.au/Details/C2020C00404/Html/Volume_3
[ix] Reserve Bank of Australia. (2020, December). Composition of the Australian Economy. Retrieved from https://www.rba.gov.au/snapshots/economy-composition-snapshot/pdf/economy-composition-snapshot.pdf?v=2020-12-14-11-16-01
[x] Australia Bureau of Statistics. (2020, February). Labour Force, Australia, Detailed, Quarterly. Retrieved from https://www.abs.gov.au/statistics/labour/employment-and-unemployment/labour-force-australia-detailed-quarterly/latest-release#data-download
[xi] KPMG. (2020, September). Pulse of Fintech H1 2020. Retrieved from https://home.kpmg/content/dam/kpmg/xx/pdf/2020/09/pulse-of-fintech-h1-2020.pdf
[xii] HM Revenue & Customs. (2019, January). Tax relief for investors using venture capital schemes. Retrieved from https://www.gov.uk/guidance/venture-capital-schemes-tax-relief-for-investors
[xiii] BDO. (2020, June). New “Open innovation tax incentive”. Retrieved from https://www.bdo.global/en-gb/microsites/tax-newsletters/world-wide-tax-news/issue-55-june-2020/japan-new-open-innovation-tax-incentive%E2%80%9D
[xiv] Federal Ministry for Economic Affairs and Economy. INVEST — Grant for venture capital. Retrieved from https://www.exist.de/EN/Network/Partners/Invest/inhalt.html
[xv] Revenue Ireland. (2019, March). The Employment and Investment Incentive (EII) Relief for Investment in Corporate Trades. Retrieved from https://www.revenue.ie/en/tax-professionals/tdm/income-tax-capital-gains-tax-corporation-tax/part-16/16-00-10.pdf
[xvi] Andersen Global. Qualified Small Business Stock (QSBS). Retrieved from https://www.andersen.com/services/for-private-clients/business-owners-and-entrepreneurs/qsbs/