TAXING TIMES FOR TECH SECTOR

I foolishly waded into the debate surrounding the proposed introduction of a capital gains tax on foreign investments. It was foolish because it's required a lot of research on my part of a particularly complex and confusing bill. Still, after reading the comments of people in the IT industry and talking to people who could be affected adversely by the capital gains tax, I felt compelled to write something.

Here's the column I wrote in the Herald on the subject. It's followed by Dr. Cullen's indignant response and my own right of reply:

Peter Griffin: New tax spells doom for Silicon Valley south
Tuesday July 25, 2006

The Government's tax and investment policies have done nothing over the past six years to give the IT industry the kick-start it desperately needs to become internationally competitive.

Now a proposed capital gains tax on foreign investment threatens to extinguish the hopes of New Zealand technology companies attempting to tap capital markets abroad.

Forget trying to replicate the "Silicon Valley effect" in New Zealand. Forget mimicking Singapore, Ireland, Israel and China, whose investment and tax policies let innovative companies grow at home and abroad.

All I see ahead is more of the same for New Zealand's IT industry - piecemeal grants dished out here and there, little offered to entice IT multinationals who want to invest locally and an environment that makes it more attractive to sell your entire company than pursue global expansion using an overseas stock market listing.

Add to that the acute skills shortage fuelled by the exodus of our best graduates across the Tasman and the picture looks grim for the current generation of IT start-ups.
By now you're probably familiar with the details of the tax change: the new regime would tax 85 per cent of the rise in value of an investor's portfolio of non-Australasian shares, provided it originally cost more than $50,000 and hasn't depreciated in value below that level.

The amount taxable in any one year is capped at 5 per cent of the market value at the start of the year. Any gain above that cap is carried forward but ultimately all 85 per cent of the income will be taxed in subsequent years. It means that those who are rewarded for diversifying their investments will be penalised when they bring their money home, leaving them less to reinvest back in New Zealand.

This tax will hit everyone who invests overseas, but the impact on the technology sector will be particularly great. That's because New Zealand companies working in software and hardware development, nanotechnology and biotechnology, eventually have to go to where the market action is.

That generally involves partnering with companies in the US and Britain, our key technology export markets apart from Australia, and seeking foreign capital. Few New Zealand IT companies list on foreign exchanges. The most successful listing abroad has been Neville Jordan's Nasdaq float of his company MAS Technology.

"It took 20 years for MAS Technology to reach its market capitalisation - when it listed, [this] was around $150 million. Now there are two others and myself who have left the company and realised the share capital gain. We have invested and started up new companies," Jordan told the Herald back in February 2000.

"In the two years since the company listed, and with people leaving and reinvesting their capital, their combined market capitalisation has shot up to what equates to a doubling of the market capitalisation. The net result is that of multiplicity ... this is where you can get the Silicon Valley effect, once you can get enough people reinvesting in New Zealand, this can grow very, very quickly," Jordan added.

The tax change proposed by the Government makes the scenario Jordan outlines less realistic. He embarked on a US listing knowing that if the market capitalisation of his company increased, he would be able to bring the money back to New Zealand for reinvestment without being hit with a capital gains tax.

The Nasdaq listing had an element of risk; it's very expensive to maintain a listing and the level of information you must divulge can serve as market intelligence for your competitors.

With the capital gains tax thrown in, I really can't see why any New Zealand company would list. That's a great shame because listing allows a larger capital market to be accessed while the company's owners and New Zealand-based investors are given an opportunity to share in its success.

Our most successful IT companies have generally been sold to foreign companies, with the exception of navigation instrument maker Rakon, which listed on the NZX last year.

A world leader, Rakon has the potential to be a Nasdaq-listed, New Zealand-controlled company. The capital gains tax means that if it does migrate its listing abroad, its New Zealand shareholders base is likely to disappear.

The proposed tax will also hurt innovative New Zealand companies like biotechnology specialist Virionyx, which plans to keep its operations in New Zealand but float in the US to fund Aids drug trials.

"Having some high-profile successes with some serious money coming back into New Zealand is exactly the shot in the arm that this risk capital sector of the market needs," Virionyx chief executive Simon Wilkinson told the Herald last week. "And against that, this tax will just completely gut it."

There needs, at the very least, to be exemptions for investments in companies that have operations in New Zealand. The US and Britain, the two key markets for the IT industry, should be excluded from the tax change which, according to documents obtained by the Herald, is going to be revenue-neutral anyway - the $40 million cost of excluding Australia expected to be about the same as the extra revenue gained by taxing 85 per cent of share gains in other countries.

The lack of investment in our IT industry, relative to other countries, needs to be addressed not encouraged.


Finance Minister Dr. Michael Cullen responds.

Michael Cullen: One law for all when it comes to taxing gains from outside NZ
Tuesday August 1, 2006

Finance Minister Michael Cullen defends his tax changes on overseas investment, and says a Herald columnist has got it wrong.

Legislation before Parliament includes reform of tax rules on income from investment in shares.

The reform is necessary because the rules for share investment now operate very unevenly.
They overtax some investors, favour direct investment by individuals over investment through managed funds, and favour investment in some countries over investment in others.

The reforms are designed to put the tax treatment of all these types of share investment on the same footing.

In a column last week, under the headline "New tax spells doom for Silicon Valley South", Peter Griffin commented on the Government's overseas tax proposals for share portfolios and their supposed effect on the venture capital industry.

Griffin's column revealed a lack of awareness of how closely the Government is working with the venture capital industry.

This consultation will ensure that venture capital investors who seek funding from overseas capital markets are not adversely affected by the reforms.

Among the sweeping generalisations Griffin made were that "this tax will hit everyone who invests overseas, but the impact on the technology sector will be particularly great" and that the rules would "extinguish the hopes of New Zealand technology companies attempting to tap capital markets abroad" by imposing capital gains tax on any share gains brought back to New Zealand for reinvestment in the company.

Griffin is behind on the state of play. The new rules are not aimed at New Zealand venture capital companies that go overseas to get the money they need to grow.

In calling for an exemption from the rules for new technology companies, Griffin fails to realise that the bill before Parliament recognises the important differences between passive investment in a managed fund and direct investments in venture capital companies that have gone overseas to get foreign money to pay for their next stage of development. This means New Zealand venture capital investors in such companies will be taxed as they are now.

The Government is also well aware that some such venture capital cases fall outside the current exemption in the bill. For this reason, the Government has instructed officials to develop comprehensive proposals to deal with industry concerns.

These steps show the Government is willing to listen to and provide solutions to the venture capital industry's concerns.

With the proposals for research and development credits announced last week as part of the business tax review and the announcement of a limited partnership regime, they send a clear message to the venture capital industry about the Government's commitment to fostering it as a vital component of the Government's economic transformation strategy.

Peter Griffin replies:
Dr Cullen has misunderstood or chosen to ignore the thrust of my argument. He is referring to investments in New Zealand start-ups that are undertaken by venture capital companies.

The proposed tax rules have exemptions to cover these types of investors when the start-ups move overseas. These exemptions need further scrutiny.

But venture capital is only one source of investment for growing technology start-ups, which are often owned by a small handful of shareholders who finance growth in the early stages entirely from revenue and cut costs by taking salaries at below market rates in return for a stake in the company.

At some stage, the company may undertake a public float to fund further growth. It may be more attractive to do this overseas, where there is a greater appetite for technology investment.
A listing on the Nasdaq or FTSE exchanges can also give credibility to a company, and get it noticed by potential customers and partners.

Once listed, these companies will be considered "foreign companies" and under the proposed tax rules a capital gains tax will effectively be applied to the capital gains of its New Zealand investors if the collective shareholding of New Zealanders is below 10 per cent of the company.

Once a public float dilutes the shareholdings of New Zealanders, it is likely that the combined shareholding will be below 10 per cent of the total share allocation.

The company's founders and other New Zealanders who believed in the company and invested in the hope of their shares appreciating will therefore be subject to the capital gains tax if they do anything other than reinvest their gains in more shares.

The proposed tax rules make taking Kiwi companies global less attractive and threatens to alienate investors and employees in companies that have international ambitions.