The Finance (No. 2) Act 2008 addresses the taxation of profits received by a partnership or a company in respect of the management of certain investments. The incentive was announced as a means of offering an incentive to venture capital funds to re-locate to Ireland if they are considering investing in research and development activities. However, it also applies to Irish venture capitalists.
Summary:
Up to now, investors, such as the holders of the “carried interest”, paid capital gains tax, currently 22%, in respect of their “carried interest” earned in respect of investments. (As legislation is unclear and in the absence of Revenue guidance, there is a risk that Revenue could argue that income tax treatment (currently up to 50%) applied. This risk is low as Revenue has presumably been aware of the tax treatment that has been used since the early 1990s.)
In brief, this new relief confirms that “carried interest” received by a partnership or a company in respect of the management of certain R&D equity investments will be taxed as a chargeable gain. Furthermore, this gain will be subject to just 15% capital gains tax in the hands of the partners of a partnership and 12.5% in the case of a company. Clearly, the former offers a potentially valuable tax reduction to the investor.
Technical Analysis:
The favourable treatment outlined above only applies in respect of “carried interest” in relation to a “relevant investment”.
“Carried interest”, in this context means the share of profits (where the share ratio was agreed at the outset) that is received by a company or partnership in respect of the management of the relevant investment. The share of profits in question must not be greater than 20% of the total profits from the relevant investment.
A “relevant investment” is an investment which has been in place for at least six years and is in unquoted shares/securities of a private trading company, which remains in place for at least 6 years.
This company must carry on qualifying “research and development” or “innovation activities” and satisfy all of the following conditions:
Its business must be set up on or after 1 January 2009.
The business must not have been previously owned or carried on by another entity/person.
The business must not involve land dealing or development activities (other than construction) or work done in connection with mining or other work in connection with minerals or searching for or testing petroleum.
The share of profit is restricted to 20% of the total profits from this investment.
Qualifying “research and development” activities means systematic, investigative or experimental activities (ie it is expected that the activities be carried out in a planned, logical sequence, generally using a recognised methodology, with detailed documentation showing clear objectives, performance indicators and results at each stage) in a field of science or technology (ie natural sciences, engineering and technology, medical sciences and agricultural science), being one or more of the following:
Basic research, namely, experimental or theoretical work undertaken primarily to acquire new scientific or technical knowledge without a specific practical application in view,
Applied research, namely, work undertaken in order to gain scientific technical knowledge and directed towards a specific practical application or,
Experimental development, namely work undertaken which draws on scientific or technical knowledge or practical experience for the purposes of achieving technological advancement and which is directed at producing new or improving existing, materials, products, devices, processes, systems or services including incremental improvements.
In addition, for the company’s activities to qualify as “research and development” activities, the company must be able to demonstrate that it seeks to achieve scientific or technological advancement and that its work involves the resolution of scientific or technological uncertainty. The scientific or technological advancement should be a global advancement rather than just an advance for the company. Similarly, the resolution of an uncertainty should not involve seeking an answer to a query to which many scientists already have the answer. In other words, if the answer to the uncertainty has already been published in a science journal, the work done to find the answer will not qualify as research and development. However, it is acceptable for a company to seek to uncover knowledge that is not commonly available among the science world, eg trying to unravel a closely guarded recipe used by a competitor.
It should be noted that even if the research and development activities fail to resolve the stated uncertainty or achieve the required advancement, the work done will still qualify for research and development for the purposes of this new relief.
“Innovation activities” means the development of new technological, telecommunication, scientific or business processes. There is no clearer definition of innovation activities or guidance from Revenue. Therefore, in the case of a material investment, a Revenue ruling in advance may be advisable.