Questions and Answers on removing tax obstacles to cross-border venture capital
European Commission - MEMO/10/160 30/04/2010
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Brussels, 30 April 2010
Questions and Answers on removing tax obstacles to cross-border venture capital
What is venture capital?
Venture capital means investment in unquoted companies for the launch, early development or expansion of a business. Venture capital typically involves high risk and, in compensation for this risk, carries the expectation of high returns. Venture capital is crucial for companies that are potentially high growth, and is particularly important during the early growth stages of such companies (start-up and development).
How are venture capital investments managed?
Venture capital investments are typically made via an investment fund managed by a venture capital management company. The venture capital fund is usually an unincorporated arrangement such as a limited partnership. A venture capital management company, that usually has several funds under its control, may be a partnership or a company and may be quoted on a stock exchange.
Why is venture capital important?
Venture capital financing is a vital source of growth capital for SMEs. The European Private Equity and Venture Capital Association (EVCA) states that on average more than 90% of the companies financed with venture capital every year in Europe are SMEs. It is essential at the early and expansion stages of innovative SMEs, when the income flow of the SME may be low or inexistent. Traditional bank lending may be unsuitable in the early days, if the SME is not yet ready to assume interest payments. Moreover, the repayment of principal and interest on bank loans can limit the cash flow flexibility of the business at a crucial time. Innovative, growth-oriented firms often require large amounts of financing to invest in R&D, marketing and training.
While innovative companies are a relatively small proportion of the total number of SMEs, they have the potential to yield high benefits in terms of creating new jobs and developing new technologies. A 2005 study by EVCA reported that companies in the EU receiving private equity and venture capital created one million new jobs between 2000 and 2004; over 60% of these jobs were created by venture capital-backed companies and employment in these companies grew by 30% per annum. In addition, innovative and growth-oriented firms backed by venture capital spend on average 45% of their total expenses on R&D.
What is the context of the report published by the Commission today?
The Commission has been looking at ways of improving the environment for cross-border venture investment and has been considering action that could be taken at EU level to this end.
As part of this work, the Commission established the Expert Group on Removing Tax Obstacles to Cross-border Venture Capital investments. This consisted of 33 experts from business, national administrations and tax firms. They were appointed in their personal capacity and were asked to perform their duties independent of outside influence. The mandate of the group was to identify cases of double taxation and other direct tax obstacles to cross-border venture capital investment and to consider possible ways of overcoming such obstacles.
The report summarizes the group's main findings and conclusions on how to remove tax obstacles to venture capital investment in the EU. The annexes of the report contain important background information, such as a glossary, descriptions of the tax treatment of venture capital vehicles in the different EU Member States and a review of the case law of the Court of Justice of the EU relevant to cross-border venture capital investments.
What are the main tax problems for venture capital identified in the report and the main solutions proposed?
The report finds that the European venture capital market is not meeting its potential, and that venture capital tends to be restricted to domestic markets rather than extending across the Internal Market. While there are some natural obstacles to cross-border venture capital investment (language differences, legal requirements etc), there are also a number of tax problems, due to a lack of cohesion between the 27 Member States´ tax systems, which are holding investment back.
There are two main tax problems identified in the report, and possible solutions are recommended:
Firstly, a local presence of a venture capital fund manager in the Member State into which an investment is made may be crucial for the purposes of locating and managing the investment. However, such a local presence may be treated as a taxable branch ("permanent establishment") of the fund (or of the investors if the fund is transparent) in that State. This could lead to double taxation, if the return on the investment is taxed both in the country where the investment is made and in the country or countries where the fund and the investors are located. Such double taxation can make investing in private markets uneconomic for investors, and may therefore deter them from making cross-border venture capital investments. The expert group would, therefore, like EU Member States' tax authorities to issue clear statements confirming that they would always treat the local activities of a venture capital fund manager as those of an "independent agent" and not a “permanent establishment”. This would reduce the double tax problems for venture capital investment.
Secondly, it was found that a venture capital fund may currently be treated in very different ways for tax purposes in different Member States. Double taxation can arise if, for example, one State treats a venture capital fund as taxable in its own right while another State looks through the fund and taxes the individual investors instead. To avoid this risk the VC fund manager would have to interpose into the VC fund structure a legally certain entity, such as a holding company, which, in turn, would involve a significant and un-commercial additional cost. The group therefore suggests that EU Member States should agree on guidelines or conclude a legally binding agreement ensuring mutual recognition of the tax classification of venture capital funds or else publish a list clarifying the classification of the common forms of such funds.
How will the Commission follow up on this report on tax obstacles to cross-border venture capital investment?
The Commission will present the report to Member States´ tax authorities and invite them to comment on the findings. On the basis of the feedback, the Commission will consider the best ways to proceed in tackling tax obstacles to venture capital in the EU. The Commission will also take this issue into consideration in its ongoing work to deal with the issue of double taxation (see IP/10/469).
What else is the European Commission doing to encourage venture capital?
With the High Growth and Innovative SME Facility (GIF) (MEMO/06/259), the European Investment Fund, on behalf of the European Commission, invests in venture capital funds which focus on small high-growth firms. A condition for an investment is that all investment decisions are made on the basis of commercial market principles. The EIF stake in such funds enables them to invest more in early-stage SMEs and to attract additional investors more easily. Funds which specialise in eco-innovation will have the possibility of proportionately higher EU participation. The GIF builds on the achievements of previous EU schemes, through which some €309 million were invested in 39 funds in the last decade, leading to investments in a total of 357 small firms. The catalytic effect of these schemes is substantial, as the EU investment amounted to just 17% of their combined total capital.
In 2007, the Commission proposed that Member States should work towards mutual recognition of national frameworks for venture capital funds (IP/08/15). The Council, European Parliament and Economic and Social committee adopted conclusions supporting this goal. However, the process has not yet led to results; most Member States have not yet taken any significant measures that would make fundraising and investing across borders easier for venture capital funds.
The Commission proposal for a Directive on Alternative Investment Fund Managers (AIFMs) (IP/09/669) aims to create a comprehensive and effective regulatory and supervisory framework for AIFMs, including venture capital, in the EU. Subject to compliance with high and stringent regulatory standards, the proposed Directive would give AIFMs Single Market rights in return, permitting AIFMs established in Europe to provide their services in the Community and market European Alternative Investment Funds across the EU. The Directive would also allow the marketing of Alternative Investment Funds from non-EU countries into the Community, but on the condition that these countries comply with stringent requirements on regulation, supervision and cooperation, including on tax matters. With respect to proportionality and the impact of the proposed AIFM Directive on VC business, the proposed Directive acknowledges the need to ensure that smaller managers are not subject to disproportionate requirements and that venture capital companies are not put under additional pressure, because their continuing ability to provide risk capital is of particular importance in the current economic climate.
The Small Business Act (IP/08/1003) commits the Commission and calls on Member States to take measures to facilitate SMEs' access to finance, including to venture capital.
The EU 2020 Strategy (IP/10/225) highlighted the importance of SMEs for Europe's economic re-growth and proposed actions to support them including the development of innovative financing solutions to make an efficient European venture capital market a reality.