Investments made by early stage venture capital limited partnerships (ESVCLPs) and venture capital limited partnerships (VCLPs) are afforded special tax treatment for the purposes of the Income Tax Assessment Act 1997 (ITAA 97) provided they meet certain criteria as ‘eligible venture capital investments’ (EVCIs).
The eligible venture capital investment requirements allow ESVCLPs and VCLPs to invest through convertible notes issued by a company, as long as the convertible notes are considered equity interests for tax purposes, rather than debt.
The primary reason for structuring a pooled investment vehicle as either an ESVCLP or VCLP are the tax advantages they provide for eligible investors. These tax advantages include that:
- ESVCLPs and VCLPs are both flow-through entities for tax purposes;
- ESVCLP investors (both domestic and foreign) pay no tax on their share of returns (capital or income) when an ESVCLP disposes of an eligible investment;
- eligible foreign investors in a VCLP also do not pay capital gains tax on their share of returns the VCLP makes from eligible venture capital investments; and
- ESVCLP investors receive a non-refundable carry forward tax offset of up to 10% of their eligible contributions (but can’t claim tax losses).
Eligible venture capital investment requirements
For an ESVCLP investing in an entity (the investee entity), the entity meets the eligible venture capital investment requirements providing it satisfies either s118–425 (investment in a company) or s118–427 (investment in a unit trust), and s118–428 (additional investment requirements for ESVCLPs) of the ITAA97. The requirements include restrictions on the investments that an investee entity can hold or acquire.
One of the key requirements is that the investment must only be in new shares or units, or options to acquire shares, units or convertible notes (that are not debt interests).
Therefore convertible notes, other than convertible notes that are debt interests, qualify as an eligible venture capital investment. If the convertible note is a debt interest, it is not an eligible venture capital investment.
Convertible notes will be a debt interest where there is an effectively non-contingent obligation on the issuer company to repay to the noteholder the amount received upon issue of the notes. In the same manner, for the notes to be equity there needs to be an effectively contingent obligation to repay the investment.
What this means in practice is that where a convertible note confers a right on the noteholder to determine whether or not to convert the notes into equity, failing which the notes must be redeemed in cash at the maturity of the notes, this will create an effectively non-contingent right on the issuer to repay the notes and result in the notes being considered debt for tax purposes.
However, where the issuer company has the right at any time to convert the notes into equity at its election, or, where the convertible note deed contains trigger events (e.g. IPO, trade sale or qualifying financing), the occurrence of which would allow the company to elect to convert the notes into shares in the company (or where conversion automatically occurs), this will result in only a contingent obligation on the issuer to redeem the notes, provided there is a real possibility (as opposed to no chance or a very remote possibility) of those trigger events occurring prior to maturity.
An analysis of the terms of any convertible note instrument to determine who has the right to call for conversion or redemption of the notes is therefore critical to determining whether a convertible note will qualify as an EVCI.
A SAFE (simple agreement for future equity) note is also a convertible security that allows the investor to buy shares in a future equity round. To be an eligible venture capital investment, a SAFE note must have the characteristics of a convertible note and not be a debt interest. Therefore, an analysis of the terms of the SAFE note in accordance with the above summary will be required to determine whether it meets the EVCI requirements.
Convertible notes come in many shapes and sizes and can contain many different terms. If you want to attract investment from ESVCLPs or VCLPs, or you are a general partner of such a partnership, our specialist team can provide guidance and recommendations to ensure you won’t fall foul of the EVCI requirements!