Australia and Israel Make Strides to Rescind Capital Gains Tax –

Finally fed up with countries like Singapore having easy access to foreign capital, Australia and Israel recently announced they will rescind certain capital gains taxes to encourage overseas investment into local private equity funds. While Australia is the latest country to make headlines on the tax issue, its news follows close on the heels of a similar decision by Israel and comes just weeks before Australian voters decide whether or not to keep Prime Minister John Howard and the Coalition government in power.

“The cynical view for why this reform was announced now is that we’ve got an election coming up,” said Peter Latham, a managing director with Sydney-based RMB Ventures Ltd. “But this is good for Australia and Australian entrepreneurs, no matter the exact reason for the timing.”

The new rules will provide capital gains tax exemptions to foreign endowment funds and fund-of-funds investing in Australia-based private equity firms. Foreign pension funds, which already enjoy such tax concessions, will not be affected.

According to a report commissioned by the Australian Venture Capital Association Ltd. (AVCAL), the proposal will help attract an annual investment bump of Australian dollars 1 billiion (US$507.5 million) from foreign investors. That report was aided, in part, by Buyouts publisher Venture Economics, which has worked with the AVCAL on its lobbying efforts over the past year.

“There is a competitive race in the Asia Pacific region to jump-start the high-tech sectors and VC markets,” said Venture Economics’ Anthony Romanello. “This is the latest step by Australia, and it is a significant one.”

All About Israel

Hoping to spark the slumping Israeli high-tech sector, Finance Minister Silvan Shalom also announced last month that Israel had temporarily suspended a controversial capital gains tax levied against foreign investors in Israel-based venture capital funds. The move follows more than two years of intense lobbying efforts by Israeli VCs, increased geopolitical instability and recent news that Herzelia, Israel-based Concord Ventures had indefinitely postponed fund-raising activities due to hostile market conditions.

“I think they made a decision when they felt they had no other choice,” said Yair Safri, a general partner with Concord Ventures. “We’ve waited a long time for this and were active participants in making it happen, but the right time to do it would have been two years ago, or at least 10 months ago.”

Similar criticisms are easy to find among Israeli VCs, who feel foreign investment in their funds has long been discouraged by a short-sighted economic policy that taxes the businesses of today at the expense of building the businesses of tomorrow. Indeed, not only have some Israeli entrepreneurs fled Silicon Wadi for Silicon Valley, but most local venture fund managers have been forced to spend precious hours convincing foreign limited partners that the investment process is neither risky nor complicated, and then even more time securing necessary capital gains tax waivers from the local tax authority.

“Of all the problems getting foreign investors to invest in Israel right now – and there are a number of them -the tax issue was certainly the one [those investors] were the most focused on,” said Erel Margalit, managing partner with Jerusalem Venture Partners.

And there were good reasons for such concerns. While almost every Israeli venture firm worth its salt was able to secure waivers that would protect its limited partners from the capital gains taxes, and double-taxation in particular, the rules still proved sticky for many foreign LPs.

Let Us In

One such case involved the California Public Employees Retirement System (CalPERS), which, through placement agent Grove Street Advisors, was poised to become the first U.S.-based pension fund to invest in an Israel-based venture capital vehicle. The deal, which involved a $5 million commitment to Apax Israel II, seemed fairly straightforward as the Israeli government was usually willing to grant waivers to investors deemed tax-exempt by their country of origin.

A problem arose, however, when it was revealed that CalPERS had a standard agreement with Grove Street whereby the Wellesley, Mass.-based agent was to supply one-half of 1% of any relevant CalPERS commitment. In the Apax case, that would have come to just $25,000, but the Israeli tax authority declared that for-profit Grove Street’s involvement would preclude Apax from receiving a waiver for the entire CalPERS commitment. In the end, Grove Street spent nearly as much amending the CalPERS commitment agreement as it would have been required to invest on the Apax deal in the first place. Moreover, the re-worked arrangement gave CalPERS newfound veto rights over Grove Street investment decisions.

“It was very complicated,” said Clint Harris, a partner with Grove Street.

Such complications have become so talked about among U.S.-based LPs that many have altogether avoided investing in Israel-based funds. This ruling, it is hoped, will change that by massively simplifying the tax structure until at least 2004.

One private equity pro hoping to benefit from the decision is Eyal Kaplan, a general partner with Walden Israel. His firm was originally planning to hold a final close on its $120 million-targeted third fund in October, but extended the fund-raising period so it can contact potential LPs who had previously shied away due to the tax complications.

“I think we’ll get at least some new investments out of this,” Kaplan said.

There are a handful of details surrounding the Israeli decision that have not yet been spelled out.

One such issue is whether or not it will affect commitments like those on which the $80 million Walden Israel III has already held a first close. Also, because the ruling is only effective through 2004, it is unknown if it applies to all commitments made in that window, or possibly just to exits. If the latter is the case, then funds like Walden and Concord would realistically be no better off than they were before the reversal.