Tax incentives for venture capital

Tax incentives for venture capital

Venture capital is early-stage financial capital provided by individuals, companies or venture capital companies (VCCs) to high-potential and potentially higher-risk start-up venture companies (VCs). A VCC is a company incorporated to obtain funds in the form of equity capital or loan capital, which are then invested in the VC in the form of seed capital, start-up or early-stage financing.  A venture capital management corporation (VCMC) manages, on behalf of a VCC, the investments of a VC at different stages of the life-cycle, i.e., seed capital, start-up or early-stage financing.

In Budget 2018, to encourage venture capital activities, the Government proposed the following extension and updates to the previous venture capital incentives in Malaysia (see Special Tax Alert - Highlights of Budget 2018 – Part I):

• A VCC will be exempted from the payment of income tax in respect of statutory income on all sources of income, other than interest income arising from savings or fixed deposits and profits from syariah-based deposits. It was proposed that the investment limit of a VC at the seed, start-up and early stages be reduced from 70% to 50%.
• A VCMC is exempted from the payment of income tax in respect of statutory income derived from its share of profits received on investments made by the VCC. It was proposed that the income which is exempted be expanded to include income received from management fees and performance fees in managing the VCC funds.
• It was proposed that companies or individuals with business income from investing in VCC funds created by a VCMC be given a tax deduction equivalent to the amount of investment made, restricted to a maximum of RM20 million per year for each company or individual.

To legislate the above, the following Orders and Rules were gazetted on 15 April 2022, and are deemed to be effective from the year of assessment (YA) 2018.

The Order provides that a VCC is exempted from the payment of income tax in respect of statutory income on all sources of income, other than interest income arising from savings or fixed deposits and profits from syariah-based deposits, commencing from the YA the VCC obtains its first certification from the Securities Commission Malaysia (SC). The first certification received shall not be later than 31 December 2026.

The exemption shall be for a period of five YAs or the YAs equivalent to the remaining life of the fund established for the purpose of investing in a VC, whichever is lesser.

To qualify for the exemption, for each YA in the exemption period the VCC shall obtain a certification from the SC confirming that:

(a)       It has invested at least 50% of its invested funds in the form of seed capital financing, start-up financing, early-stage financing or any combination of such financing in VCs,

(b)       It was registered with the SC between 27 October 2017 and 31 December 2023, and

(c)        It has not invested in a VC which is a related company* of the VCC at the  point the first investment is made

*As defined under Section 2(1) of the Promotion of Investments Act 1986 (PIA)

Where a VCC incurs a loss from the disposal of investment in a VC for any YA within the exemption period, the loss can be carried forward to the YA following the post-exemption period to be deducted against the statutory income on all sources of income.

The following terms have been defined in the Order:

(i)   Seed capital financing

Financing provided by a VCC to a VC for research, assessment and development of an initial concept or prototype purposes

(ii)  Early-stage financing

Financing provided by a VCC to a VC as:
(a)  Capital expenditure or working capital to initiate the commercialization of a  technology or product,
(b)  Additional capital expenditure or additional working capital to increase production capacity, marketing or product development, or
(c)  An interim financing for a VC that is expected to be listed on the official list of a stock exchange

(iii) Start-up financing

Financing provided by a VCC to a VC for product development and initial marketing

(iv) VCC

A company which:

(a)  Is incorporated under the Companies Act 2016 (CA),
(b)  Is registered with the SC, and
(c)  Invests in one or more than one VC in the form of seed capital financing, start-up financing or early-stage financing

(v)  VC

A company which is:
(a)  Incorporated under the CA,
(b)  Resident in Malaysia in the basis period for a YA, and
(c)  Involved in utilizing the seed capital financing, start-up financing or early-stage financing for:

a. Activities or products promoted under the PIA,
b. Technology-based business activities as specified in the guideline in relation to VC tax incentives issued by the SC,
c.  Products or activities that have been developed under the research and development scheme approved by the Ministry of Science,Technology and Innovation, or
d. Products, services or activities that have been developed under the research, development and commercialization grant scheme approved by the Malaysia Digital Economy Corporation Sdn Bhd

The Order also stipulates that the exemption granted does not absolve the VCC from any requirement to submit any return, statement of accounts or any other information as required under the Income Tax Act 1967 (ITA).

With this, the Income Tax (Exemption) (No. 11) Order 2005 [P.U.(A) 75/2005] is revoked effective from YA 2018. However, any exemption which has been granted under P.U.(A) 75/2005 will remain in place for the remaining YAs of the relevant exemption period. Any application for exemption under P.U.(A) 75/2005 which is pending approval, shall be dealt with under P.U.(A) 115.

The Order provides that a VCMC is exempted from the payment of income tax in respect of the following statutory income derived from the management of VCC funds:

(a)  Share of profits,
(b)  Management fees, and
(c)   Performance fees (including performance bonus and carried interest)

The income received by the VCMC from a VCC is to be stipulated in the agreement on the management of the investments of the VCC, entered into by both parties.

The exemption applies from YA 2018 to YA 2026.

The following terms have been defined in the Order:

(i)   VCC

A company which:

(a)   Is incorporated under the CA and registered with the SC,
(b)   Invests in one or more than one VC in the form of seed capital financing, start-up financing or early-stage financing, and
(c)   Has obtained certification from the SC that the company has complied with the conditions to qualify for the exemption under P.U.(A) 115 (see  above)

(ii)   VCMC

A company which:

(a)  Is registered with the SC,
(b)  Has been verified by the SC that for each YA in which the VCMC is exempted from the payment of income tax, the company:

i.  Has an adequate number of full-time employees in Malaysia, and
ii. Has incurred an adequate amount of annual operating expenditure in Malaysia

Where a VCMC incurs losses from the management of VCC funds for any YA within the exemption period, the losses can be carried forward to the YA following the post-exemption period to be deducted against the statutory income derived from the management of VCC funds (as specified above).

The VCMC is required to maintain a separate account for income derived from the management of VCC funds. The income derived from the management of VCC funds is to be treated as a separate and distinct source of business income for the VCMC.

With this, the Income Tax (Exemption) (No. 12) Order 2005 [P.U.(A) 77/2005] is revoked effective from YA 2018. However, any exemption which has been granted under P.U.(A) 77/2005 will remain in place for the remaining YAs of the relevant exemption period. In addition, any application for exemption under P.U.(A) 77/2005 which is pending approval shall be dealt with under P.U.(A) 116.

The Rules provide that in ascertaining the adjusted income of a company or an individual from its business for a YA, there shall be allowed a deduction equivalent to the:

(a)       Value of investment made in a VC, or

(b)       Value of investment or RM20 million, whichever is less, made in a VCC

The investment made shall be deemed to be incurred (and allowed a deduction) in the YA the investment has been held for a period of three years from the date the investment was made. The investment holding period is to be certified by the SC.

To qualify for the deduction, the company or individual is required to make the investment between 27 October 2017 and 31 December 2026.

For investments in a VC, the company or individual shall obtain a certification from the SC confirming that:

(a)    The investment is in the form of the holding of shares, which at the point of acquisition was not listed for quotation in the official list of a stock exchange,

(b)    The investment, in relation to a company, was not made in a VC which is its related company at the point the first investment was made,

(c)      The investment was made by providing seed capital financing, start-up financing or early-stage financing, and

(d)      The investment was held for at least three years from the date the investment was made

For investments in a VCC, the company or individual shall obtain a certification from the SC confirming that:

(a)    The investment is in the form of the holding of shares, which at the point of acquisition was not listed for quotation in the official list of a stock exchange,

(b)    i)   The investment, in relation to a company, was not made in a VCC which is its related company at the point the first investment was made, and

         ii)   The investment by the VCC (referred to in Point i) above) is not made in a VC which is a related company of the first-mentioned company

(c)     The investment was made by the VCC in a VC by providing seed capital financing, start-up financing or early-stage financing,

(d)      The VCC has maintained, on average over a three-year period (based on its annual audited financial statement), at least 50% of the VCC’s investments in one or more VCs, and

(e)       The investment was held for at least three years from the date the investment was made

The following terms have been defined in the Rules:

(i)    Individual

    Individual Malaysian-resident with business income

(ii)   Seed capital financing

    Financing provided by a company or an individual to a VC for research, assessment and development of an initial concept or prototype purposes

(iii)  Early-stage financing

Financing provided by a company or an individual to a VC as:
(a)  Capital expenditure or working capital to initiate the commercialization of a technology or product,
(b)  Additional capital expenditure or additional working capital to increase production capacity, marketing or product development, or
(c)  An interim financing for a VC that is expected to be listed on the official list of a stock exchange

(iv)  Start-up financing

    Financing provided by a company or an individual to a VC for product development and initial marketing

(v)   Company

     A company which:
     (a)  Is incorporated under the CA,
     (b)  Carries on a business, and
     (c)  Is a Malaysian-resident

(vi)   Related company

      As defined under Section 2(1) of the PIA

(vii)   VCC

      As defined under P.U.(A) 115 (see above)

(viii)   VC

       As defined under P.U.(A) 115 (see above)

The Rules shall not apply to a VCC that is exempted under P.U.(A) 115 (see above) for the whole of the tax-exempt period.

With this, the Income Tax (Deduction for Investment in a Venture Company) Rules 2005 [P.U.(A) 76/2005] are revoked effective from YA 2018. However, any company or individual who has made an investment for the YAs before YA 2018 and complied with the provisions of the P.U.(A) 117 but has not applied for a deduction under P.U.(A) 76/2005, is entitled to apply for a deduction under P.U.(A) 117.