The Austrian market is characterised by predominant debt financings. The security and equity capital requirements for such debt financings affected in particular small and medium-sized companies. As those companies don't necessarily have access to capital markets, they face a financing gap which might be closed through equity financing.
Although there was arguably a significant need for private equity and venture capital (PE) in Austria as a consequence of the predominant structure and size of Austrian corporates, it was not until the mid-eighties when an industry began to develop in Austria. This was very late compared to other European countries. Despite dynamic development of the Austrian private equity market starting in the mid-nineties and lasting until recent years, it is still underdeveloped compared to other European countries.
This is demonstrated by Austria remaining at the end of the scale with a percentage of investments as share of the GDP at 0.005% as opposed to a European average of 0.05%. After the upswing, the investment activities of Austrian PE investors has declined in the last two years. According to figures recently published by the Austrian Private Equity and Venture Capital Organisation (AVCO), fundraising has dropped in 2008 by nearly 50% to €231 million compared to €431 million in 2007. The investment activities of Austrian PE investors continued to decline less sharply to €231 million in 2008 compared to €256 million in 2007. Although the downturn of the Austrian PE market also results from the general economic crisis, the Austrian legal framework also has its share in this development.
The old regime
The first approach to close the financing gap for small and medium-sized companies dates back to 1994. The Tax Reform Act established a preferential tax regime for certain companies providing equity to small and medium-sized business. These so called Mittelstandsfinanzierungsaktiengesellschaften (MFAGs) have become the dominating and most popular fund vehicle and main fund structure. MFAGs were organised in the form of an Austrian stock corporation for the purpose of investing in small and medium-sized enterprises.
Pursuant to section 6b of the Corporate Income Tax Act (Körperschaftsteuergesetz or KStG) as applied prior to its amendment and introduction of the new regime, the profits of an MFAG were entirely exempt from corporate income tax. This remained the case until the end of the fifth calendar year following the year of registration and after this five year period, profits from investments were exempt. Tax exemption, however, was subject to certain conditions: that at least 70% of the equity had to be invested; investments had to be mainly made in small and medium-sized companies; 75% of the investments had to be made in Austrian companies; and an investment must not have exceeded 49% of the share capital of the investee company meaning that no majority investments were allowed.
The MFAG was intended to close the financing gap by bundling the raising of capital on the capital markets while spreading the risk by allocation among different companies. This purpose should have been promoted by the benefit of tax exemption. Although the MFAG was accepted by market participants, they criticised, the lack of flexibility due to the numerous requirements for being granted the benefits of an MFAG.
The new regime
Following a ruling of the European Commission (EC), according to which the regulations contained in former section 6b KStG violated EC state aid rules, an amendment to section 5, subpara 14 and section 6b of KStG has been enacted as of January 1, 2008. The new law was called Mittelstandsfinanzierungsgesellschaften-Gesetz 2007, or MiFiG, and covered private equity and venture capital fund vehicles (Mittelstandsfinanzierungsgesellschaft, or MFGs). It is no longer possible to incorporate new MFAGs and already existing MFAGs will lose their beneficial status upon expiration of the five year period from registration.
In order to qualify as MFG, fund vehicles have to meet numerous conditions also under the new regime. The MFG must be established in the form of a limited liability company or a stock corporation with a minimum share capital of €7.3 million. The purpose of the MFG is limited to investing money while carrying out any of its own business is excluded.
The MFG is also subject to a number of investment rules, the most important of which are:
- The MFG must invest at least 70% of the funds in companies (Finanzierungsbereich). The remaining 30% of the funds can be held as cash, bank deposit or in the form of bonds (Veranlagungsbereich).
- The MFG may only acquire minority participations up to 49%.
- Each investment made by the MFG may only account for a maximum of 20% of the equity capital of the MFG.
- The risk capital measure must provide for tranches of finance not exceeding €1.5 million per investee company over each 12 months.
- The investment must be made by way of providing seed, start-up or expansion capital only.
As opposed to the old regime, an MFG does not have to invest predominantly in Austrian companies, but must acquire participations in non-listed small or medium-sized companies within the meaning of Annex I of EC Directive No 70/2001/EC in the European Union or the European Economic Area.
Investments in enterprises in difficulty (within the meaning of the Community guidelines on State aid for rescuing and restructuring businesses in difficulty) as well as investments in the ship building, coal and steel industries are not permitted.
Furthermore, exemption from corporate income tax under the new regime is subject to requirements for the management of the MFG. The management must make its decisions profit-oriented and must manage investments in compliance with commercial principles. For such purpose the management shall in particular prepare a business plan for each investment (including product, sales or profitability planning), present a clear and realistic exit strategy and establish an advisory committee which shall be involved in the decision making process. The management's compensation must be linked to the MFG's return and must therefore be performance based compensation.
Under the new regime, a MFG is tax exempt for its earnings derived from its investments in companies (Finanzierungsbereich) but not for its earnings derived from bank deposits and bonds (Veranlagungsbereich). This is dependant, however, on the MFG carrying out the fund activities in accordance with section 6b KStG for at least seven years. Otherwise tax exemption will be revoked retroactively. MFGs are also tax exempt from capital duty and stamp duties occurring in connection with its establishment.
The legal framework under MiFiG 2007 for private equity and venture capital does not reflect the needs of industry participants, but has put pressure on existing finance corporations for medium-sized businesses, start-ups and fund companies engaged in fundraising. In some cases they may be forced to flee into foreign structures, where the framework conditions for private growth capital conform to international standards and are more attractive than in Austria.
Critics in particular highlight that under the new regime an MFG may not be used for buy-out transactions and that tranches of finance are limited to €1.5 million. It is therefore to be assumed that applicability of the MFG for purpose of financing small and medium-sized companies will be very limited due to the new restrictive regulations and will therefore not serve, or serve to a very limited extent only, as a fund vehicle for PE in the future.
Investment Company Act
Due to the non-competitive legal framework for PE in Austria, discussions between the private equity industry and the Ministry of Finance commenced in early 2008. They discussed establishing an alternative structure that meets the expectations of international investors. This led to the publication of a draft of the Capital Market Strengthening and Innovation Act (Kapitalmarktstärkungs- und Innovationsgesetzes 2008) introducing the Investment Company Act (Investmentgesellschaftengesetz – IGG) for the implementation of an alternative investment vehicle (Investmentgesellschaft) which would benefit from large tax exemptions compatible with EC state aid rules.
Legal form and shareholders
The alternative investment vehicles (Investment Companies) may be established in form of Austrian limited partnerships (Investment-Partnership) or in form of Austrian stock corporations (Investment-Stock Corporation). The seat and the place of management must be located in Austria.
The draft Investment Company Act provides for limitations regarding the shareholders of an Investment-Partnership as only domestic corporations or comparable corporations seated in the European Union or in the European Economic Area may invest in such Investment-Partnership. Natural persons may not invest. With regard to Investment-Stock Corporations, no such limitations exist. Investors in Investment-Stock Corporations may either be natural persons or legal persons irrespective of whether they are seated in Austria, the European Union, the European Economic Area or any third country.
Share capital and purpose
The minimum share capital of Investment Companies should amount to €2 million, irrespective of whether established in the form of a limited partnership or in the form of a stock corporation. While there is no minimum participation requirement for investors in an Investment-Stock Corporation, investors in an Investment-Partnership must hold a partnership interest of not less than €50,000. €25,000 must be paid upon foundation of the partnership.
The purpose of an Investment Company shall be limited to the investment of risk capital which, pursuant to the draft Investment Company Act, means the provision of capital for the purpose of setting up and launching a business. It also covers it's development to a profitable business or its development to a business being able to participate on the capital markets aiming at a public offering.
Investment requirements and restrictions
Investments may be made by way of:
- Participation as a limited partner in a limited partnership provided that the purpose of such partnership is not limited to the management of assets;
- Silent partnerships provided that such silent partnership includes participation in hidden reserves and the company value;
- Participation in a stock corporation or limited liability company; or
- Acquisition of jouissance rights provided that such jouissance rights also includes participation in the profit and winding-up profits of the investee-company.
The provision of debt capital to investee companies is limited and only permitted by way of so called "Annexfinanzierungen" (additional debt financings) that are bonds, participation rights, loans or silent partnerships provided that such partnership excludes participation in hidden reserves and the company value.
When investing, an Investment Company must invest more than 50% of its capital in companies. This means that the capital must be predominantly invested in risk capital investments but not in additional debt financings. With regard to a single investment, however, additional debt financings may exceed the risk capital investment-tranche.
Investments in holding companies are not permitted. Some scholars argue, however, that it should be differentiated between mere holding companies and managing holding companies as the prohibition of investing in holding companies shall only relate to mere holding companies.
For purpose of risk diversification an Investment Company may only invest up to 25% of its equity capital in one single target. Besides such equity investment a target company may be provided with debt capital by Additional Debt Financings as those are not comprised by the 25% limitation.
Investments must be held for at least one year but not longer than ten years.
Management and information requirements
According to the draft Investment Company Act the management of the Investment Company shall be provided by either the managers of the Investment Company itself or by a separate management company. In any event, the management – both of the Investment Company or of the third party management company – is subject to specific requirements set forth in the draft Investment Company Act.
The assets of the Investment Company shall be deposited with a separate depositary bank which in turn shall be liable to the Investment Company and the investors for any damages resulting from non-compliance or default with regard to its obligations.
Investment Companies shall also be subject to publicity requirements and shall publish and update certain information on a quarterly basis. In a specific information document the information disclosed includes data on the Investment Company itself, the depositary bank, the managers and supervisory bodies, the auditor and the main shareholders. Certain financial information, risk factors, characteristics for the company, information about the investee companies, investment criteria and basics of the business plans are also disclosed.
Finally each Investment Company must be enlisted in a specific list held with Österreichische Kontrollbank.
Tax framework
Investment-Stock Corporations and corporations which hold an interest in an Investment-Partnership shall be exempt from corporate income tax with regard to capital gains from disposals of participations held by the Investment Company. Such tax exemption shall not be subject to any specific requirement except for that the participation must have been directly held by the Investment Company. An exemption from corporate income tax with regard to capital gains from disposal of foreign investments would be subject to a minimum participation of at least 10% and a minimum duration of such participation of at least one year. Following an amendment of the KStG (Corporate Tax Act), however, any capital gains from a disposal of foreign investments where participation was less than 10% may also be tax exempt under certain conditions.
Investment-Stock Corporations and corporations holding an interest in an Investment-Partnership shall also be tax exempt with regard to income received from additional debt financings whereas such tax exemption shall be subject to the following limitations:
- a tax exemption shall only apply in so far as the financing structure on the level of the investee company corresponds to the financing structure on the level of the investment company (the ratio of debt capital to total capital); and
- a tax exemption shall not apply if the average percentage of additional debt financings on the level of the investee company exceeds 50% of the aggregate invested capital in such investee company.
It should be emphasised that although interest from additional debt financings on the level of the Investment Company is tax exempt, interest of debt financing on the level of the Investment Company shall not be tax exempt.
Investment-Stock Corporations shall neither be permitted to serve as parent company of a tax group or even to participate in such tax group. Investment-Partnerships shall not be subject to such limitation. Investee companies of the Investment-Partnership, however, may not be included in a tax group of any investor.
Although the draft Investment Company Act does not provide for retroactive elimination of tax benefits, for example by way of subsequent levy of Corporate Income Tax on interest from additional debt financings or capital profits from preceding years, tax benefits shall cease to apply in case of constant breach of its provisions.
Vague terms
The initiative of the Capital Market Strengthening and Innovation Act is highly welcomed and must be seen as an important step toward creation of competitive legal framework in Austria. Certain issues should still be rethought so that, in the end, the legal framework will be up to a competitive standard doing justice to Austria as an international competitive financial and economic centre.
The draft Investment Company Act contains, inter alia, provisions relating to permitted investments and excessive information and publicity requirements which, from a practical point of view, will make it nearly impossible to use the structure.
With regard to the definition of permitted investments as set forth in the draft Investment Company Act, the use of vague terms for the definition most likely will cause legal uncertainty. Moreover, the current definition of permitted investments excludes the entire buy-out business.
Also, the information and publicity requirements are problematic as their required scope and frequency are too extensive. The information must be disclosed in a way similar to prospectuses entailing respective liability. Investment companies and investee companies alike won't hardly be able to fulfil those obligations with reasonable efforts.
Besides, the concept of the management of the investment company's assets by a third party depositary bank seems not only practically but also legally unfeasible. For example, from a legal point of view it is impossible to deposit unsecuritised participations such as shares in limited liability companies or silent participations.
The current draft Investment Company Act does not contain any provision as to who shall decide and confirm whether the management of an investment company fulfils the requirements set by the Investment Company Act. This is problematic as all tax benefits cease to apply in case of sustained breach of those requirements.
Significant step forward?
A main reason for the underdevelopment of the Austrian Private Equity and Venture Capital market in the past can be seen in the lack of suitable and competitive legal framework for private equity and risk capital investments. Unfortunately, the current regulations under the new regime with the MFG are not suitable to improve the situation. The new legal initiative in form of the Capital Market Strengthening and Innovation Act introducing the Investment Company Act, however, is an important step toward suitable legal framework in Austria.
Although, in terms of its content, it still needs to be optimised if the goal that the Ministry of Finance has set itself is to be achieved with the current draft bill, the Capital Market Strengthening and Innovation Act would in any event constitute a significant improvement of the legal framework for PE in Austria. With the required tuning made, the Austrian legal framework might make a significant step forward and boost the development of the Austrian PE market. Yet it is unclear whether and when it will be implemented.
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About the author
Christoph Wildmoser is a partner at Herbst Vavrovsky Kinsky. He predominantly advises corporate clients and institutional investors on private equity and venture capital transactions. He also represents financial institutions in structured finance transactions. |
Contact information
Christoph Wildmoser
Herbst Vavrovsky Kinsky
Dr. Karl Lueger-Platz 5
1010 Vienna
Tel: +43 1 904 21 80 0
Fax: +43 1 904 21 80 210
Web: www.hvk.at |
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About the author
Philipp Kinsky is a founding partner of Herbst Vavrovsky Kinsky. He advises a wide range of listed and non-listed companies as well as financial institutions in corporate finance, private equity, venture capital and capital markets transactions. |
Contact information
Philipp Kinsky
Herbst Vavrovsky Kinsky
Dr. Karl Lueger-Platz 5
1010 Vienna
Tel: +43 1 904 21 80 0
Fax: +43 1 904 21 80 210
Web: www.hvk.at |