Following international trends, predominantly those in the United Kingdom and the United States, Australia has recently undertaken reform of tax and partnership legislation to establish the internationally recognised Limited Liability Partnership (LLP) structure.
This has been touted by various commentators as the “world’s best practice” structure, designed to attract venture capital from offshore institutional investors and retain domestic investment.
The Limited Partnership structure is the investment vehicle of choice for the venture capital industry worldwide, and embodies 30 years of operational experience.1
Venture capital typically involves the pooling of funds to purchase shares in companies with potential. The venture capitalist then helps grow the business in the hope of selling their shares (or otherwise exiting) at a profit which recognises the higher risk implicit in this kind of investment.
Venture capital is crucial to lubricating the wheels of entrepreneurship and ensuring that New Zealand innovation and intellectual property are owned and commercialised in New Zealand, creating employment and stimulating economic growth.
The converted suggest that the LLP structure:
- will become the primary vehicle for venture capital investment
- will assist with the investment of superannuation savings into unlisted companies, and
- is crucial if New Zealand is to attract greater foreign investment.
The LLP structure is extremely useful for raising investment capital for industries which have intensive start-up costs and undertake substantial research and development, and which as a result incur significant up-front losses. The film, biotechnology, scientific and technological industries typically fall into this basket.
The appeal of the LLP structure lies in three key features:
- flow-through tax treatment – with the losses on start-up being passed through to investors
- limited liability with associated protection to professional venture capital investors, and
- a look and feel which is familiar to those who deal with international funds.
Where are we now
In New Zealand at the moment, a significant level of venture capital fund investment is undertaken via a co-investment structure under a partnership arrangement.2 This gives a tax advantage, but exposes the fund investment vehicle to joint and several liability and responsibility for the actions of other partners. These structures also lack international acceptance.
Pitching New Zealand
When seeking overseas investment, the hopeful may have a 15-minute maximum pitch time. They do not want to spend half of that time explaining New Zealand’s legal structures and different approach. They are better to model themselves on accepted international norms – which do not require explanation – and ensure the focus remains on core business and value issues. Many have found US investors are reluctant to even consider non-LLP vehicles.
In a document seeking input on recommendations being made by the New Zealand Venture Capital Association (NZVCA) to the New Zealand Government regarding adoption of the LLP model, Christopher Twiss, the executive director of NZVCA stated:
"This is without doubt the most important current policy initiative for New Zealand venture capital and private equity industry."
Clearly, if New Zealand is to keep pace with international developments and effectively compete for foreign investment, the LLP structure must be embraced. It is encouraging to see Michael Cullen allude to this in his speech to the New Zealand Venture Capital Association 2nd Annual Conference, indicating that the necessary tax changes will be implemented from 1 April 2004. The Ministry of Economic Development is expected to issue a paper on this topic, which is welcomed given the need for awareness and stimulation of educated debate.
This edition of Counsel will explain the rationale behind LLPs, provide a summary of some of the aspects of the Australian LLP regime, and look at improvements designed to make New Zealand a more attractive investment destination.
Applying the Australian model to the New Zealand context
The Australian model is a logical starting point for New Zealand. It also gives New Zealand the opportunity to go one step further and learn from the Australian experience.
What is the LLP structure
Under the LLP structure, each limited partner (LP) will generally seek funds from investors or other funds. When the LP invests, its liability is limited to its investment in the partnership. The LP makes its investment and is largely passive (there are limited exceptions to this – discussed under the “Safe Harbours” section later in this Counsel). An LLP’s assets will usually be held by a general partner (GP) who is fully liable for the activities of the partnership (although a GP may limit its liability by forming a company to achieve some degree of protection).
Under the Australian model, certain types of investors from specified countries are exempted from Australian tax on investment gains, these being gains from sale of investments rather than pidends or other revenue from investments held. In effect, the Australian model provides exemptions to certain capital gains tax on investments, which would otherwise be taxable in that country.
New Zealand has no capital gains tax and therefore any potential tax benefits from implementation of the LLP structure in New Zealand would initially appear marginal. However, in this context and generally speaking, capital gains on investments only fall on capital account and are tax-free if the investments are made other than for the purpose of disposal. If not, they are likely to fall on revenue account and be taxable.
A particular problem for venture capital investments through fund vehicles relates to the fund’s desire to exit its investment and realise a profit, typically within five years and through a trade sale or initial public offering on the relevant stock exchange. The issue in the context of New Zealand is the implication that all investments made by a fund vehicle are to be liquidated within a finite timeframe. This implies that investments made by the funds are made for the purpose of disposal, are deemed to fall on revenue account and are taxable.
This is a disadvantage which, compared to international investment options, renders the investment climate in New Zealand unattractive. There is potential to address this in any LLP reforms, and as mentioned above an indication of some change has been made in the Minister of Revenue’s speech to the NZ Venture Capital Association on 29 October 2003.
Limited Liability Partnership
Australia’s partnerships are governed on a state-by-state basis. Each state has its own partnership legislation that needs to be revised for the LLP reforms to be effective. So far the Victorian reforms have been completed, with New South Wales close behind. Australian Venture Capital Association Limited (AVCAL)3, in reviewing the state limited partnership laws, determined that modernisation was required before investors would invest through limited partnerships.
The main issues for modernisation were:
- clarifying that the LLP is itself a separate legal entity, and
- ensuring that neither the GP nor the LLP acts as agent for the LPs. (An LP does not want the GP treated as its agent as this would make the LP liable for the GP and ruin the drive of the legislation to create limited liability for the LP.)
One of the most significant hazards of the LLP is that although it looks like a partnership it is not strictly treated as such. For example, in its home country, as long as the LP meets legislative requirements, there is no joint and several liability. However, there is a concern that LPs’ liability will be unlimited if the partnership trades in overseas jurisdictions under different partnership regimes. Accordingly, the benefit of limited liability back home might be lost in relation to those overseas dealings.
This matter has rarely been considered by common law courts and there is no precedent on point which confirms that a statutory limitation of partner liability would be recognised outside the home country of the LLP. General legal consensus is that there is a risk that a foreign court would not recognise the limitation of liability of LPs.4
It was considered that the ambiguity surrounding this issue represented substantial risk to investors and may block the use of LLPs as an effective vehicle for international transactions.
Accordingly, a crucial aspect of the reform of the Australian state partnership laws was aimed at ensuring that the LLP base legislation treats the partnership as a separate legal entity sheltering the LP from legal responsibility for partnership actions. How the parties conduct their business in foreign jurisdictions is also likely to impact on whether the LPs’ limitation of liability is effective in those jurisdictions.
Investors into New Zealand have an inherent advantage in that they do not have to consider state-by-state partnership legislation, which is a prospect faced by many investors into Australia.
In New Zealand, a special partnership (limited partnership) established under the Partnership Act 1908 is not a separate legal entity. Rather, it is a partnership which accords some of its partners limited liability status. The liability of special partners to contribute to the liabilities and obligations of the partnership is limited to the amount recorded in a certificate at commencement of the partnership, with the liability of any GP unlimited.
To address the issue of foreign treatment of special partnerships and LLPs established in New Zealand, legislative changes (as in Australia) will be necessary.
Under various state Australian partnership laws, LPs were prohibited from participating in the management of the investment (subject to a set of “safe harbours”). Generally, the venture capital process is very “hands-on” with the venture capital investor helping the investee implement and give effect to their ideas, by providing both capital and expertise.
However, this involvement by LPs ran the risk of breaching that prohibition on “management participation” – with the undesirable consequence that LPs lose their limitation of liability. Given the nature of the venture capital process being medium to long-term / patient capital, investors are not prepared to simply part with their money without some form of management input – and in certain circumstances, ability to control.
Accordingly, a very prescriptive list of safe harbours was introduced into or expanded under the Australian state laws to allow for the specific dynamics of the venture capital management involvement. For example, under the Victoria Partnership (Venture Capital Funds) Act 2003, and if permitted in the partnership agreement, a limited partner will not be regarded as taking part in the management of the business by virtue of voting on any resolution or examining the state or prospects of the businesses of the partnership or advising, or consulting with, other partners in relation to these matters.5
While the New Zealand Partnership Act 1908 does not prohibit LPs from participating in the investment, it has a number of features that will make it unattractive to international venture capital investors, including:
- providing that only general partners can transact the business of the partnership, leaving uncertain what level of involvement an LP can have
- providing that an LP would lose unlimited liability status if the LP’s name is used when carrying out business
- deeming LP limited liability to be lost if there is a substantial error in the LLP formation certificate – even if the LP is unaware, and is not in a position to know, that the information was erroneous, and
- more generally, and not surprisingly given it is almost a century old, it reflects practices and policy concerns which were more relevant at the beginning of last century than at the beginning of this century.
Altogether these provisions create considerable doubt in the mind of a potential international investor as to their liability exposure. The risk is that the 15-minute window to sell the investment opportunity could be largely taken up trying to explain the special character of the New Zealand investment vehicle.
Similar to the Australian regime, given the nature of venture capital investment and the level of participation that is required by LPs, there is a need to legislate in New Zealand for “safe harbours” which:
- set out clear zones within which an LP may participate in the management of the investment. (Rather than following an exact prescriptive and at times confusing list of safe harbours, New Zealand needs to consider a few concise and clear principles establishing these safe harbours.)
- enable LPs to participate in the management of the partnership without tainting their limited liability status.
By way of example, circumstances in which an LP might participate should include a change in the nature of the partnership business and where issues of financial performance arise.
Go one up
The ability to go one step better
The table included in this Counsel looks at some aspects of the Australian LLP regime and offers a preferred approach for New Zealand to go that one step further.6
It is expected that the amount of foreign investment through adoption of the LLP structure has potential to exceed $1 billion7, and as a result provide a considerable boost to New Zealand’s GDP.
There is a drive to make investing in New Zealand attractive, easy and familiar to those investing in international markets. Many in the investment community have already faced the prospect that US investors will only look at “familiar” LLP structures – because they are comfortable with them.
We need a modern approach, adopting international standards but going one step further where possible. A useful start, in the writer's opinion, would be to:
- not wait for the much-heralded review of New Zealand’s Partnership law, but to move swiftly, and
- forget tinkering with the dated Partnership Act 1908 and start fresh and simply with an LLP Act in 2004.
Andrew Green, CEO AVCAL, AVCAL media release 8 May 2003.
- We have not considered the potential for a Loss Attributing Qualifying Company (LAQC) as a vehicle to pass through tax losses. This is an option open to some professional investors, but it would not suit most venture capitalists because of the unlimited liability for tax losses and the cap on the number of shareholders required for an LAQC.
- The Australian Venture Capital Association Limited, AVCAL, is the national association in Australia that represents the venture capital industry’s participants, promotes the industry and encourages investment in growing business enterprises.
- Lindley & Banks on Partnership supports the position that there is no certainty that a court outside the jurisdiction of formation of a limited partnership would give full effect to such an entity. R.C. l’Anson Banks, Lindley & Banks on Partnership (2002, 8th Ed, Sweet & Maxwell, London, at page 845).
- `Under the Victoria Partnership (Venture Capital Funds) Act 2003 there are a number of activities which a limited partner is permitted to undertake without tainting its limited liability status.
- Picking up on recent NZVCA recommendations and incorporating a few other ideas, including recommendations by Andrew Green, CEO of AVCAL.
- According to a report compiled by Ernst & Young Entrepreneurial Services and the NZVCA, “The NZ Venture Capital Monitor 2002: Plus 1st quarter results 2003”.