Importance of Venture Capital for Albania and general tax issues

Venture capital[1] is an essential source of finance for companies and benefits in particular innovative start-up SMEs that may face difficulty in accessing traditional bank lending or finance through stock exchanges.  VC is capital co-invested with the entrepreneur in order to provide seed or start-up capital, or to fund an expansion of the business. The bulk of the capital is in equity form, not debt. The high risk that investors take over a long term of investment and the increased risk of loss are offset by the expectation of higher than average returns.

From a public policy viewpoint in the EU, VC has long provided equity finance to young, innovative, high-potential, growth-oriented SMEs and businesses. These companies are vital for job creation, economic growth, innovation and competitiveness enhancement. Thus, VC investment activity is consistent with the EU’s Lisbon Strategy objectives, as well as with many other EU policy goals, such as SME initiatives, the Competitiveness and Innovation Programmes, and the development of cross-border clusters to support technology transfer.

What about Albania or other states of Balkans?

Usually, in Albania an investment fund may be established under the law For Collective Investment Entrepreneurship, as a contractual joint ownership. There are no specific tax regime for Venture Capital investments is provided under Albania tax law for Venture Capital investment funds (venture capital being defined as investment in securities of unlisted companies). The VC in Albania are VAT exempt.

Investments in Venture Capital can be made through an investment fund, a limited liability company (LLC), a joint-stock company (JSC), partnership or non-profitable organization as an open investment fund.

It might be helpful to present a list of different players and the illustration in the top of a typical cross-border VC fund structure. The ownership of fund could be a(a) corporate investors, (b) banks, (c) government agencies, (d) family offices, (e) funds of every type.

The structure of the VC fund is composed by five major components:

(i) Investors, which provide capital, which is pooled together by external managers (VC Management Companies/ VC Fund Managers) into collective investment vehicles (usually called VC funds). The investors seek external VC Management Companies with the investment objectives, track record and capabilities that best match their requirements.

(ii) VC fund, which is a collective investment vehicle into which the investors commit their capital. Typically, the fund’s life is ten years (with a possible extension of one to three years), but this varies considerably between funds. VC funds are established under a variety of legal forms and regimes.

(iii) VC Management Company (or Fund Manager). This entity manages the VC fund. In the case of a transparent fund structure, the VC Fund Manager or an entity in the VC Fund Manager’s group is usually the fund’s ‘General Partner’ with unlimited liability, or a related entity.

(iv) Portfolio company. This receives the capital. Portfolio companies are predominantly unlisted young high-potential growth companies or companies quoted on exchanges that need an active ownership that can help them to achieve growth and to secure funding for expansion. They are typically too small and generally not profitable enough to raise capital in the public markets or to secure a bank loan or complete a debt offering.

(v) Advisory company. In the case of VC cross-border investments a local presence in other jurisdictions may be required to enable the VC Fund Manager to find new investments in those jurisdictions and to look after investments it has acquired there. Often such a local presence will be limited to advisory activity because of concerns that if it operates as a Manager it could, as in the case of the Fund Manager, risk being treated for tax purposes as a permanent establishment of the VC fund or its investors in the state of the portfolio company.

These advisory entities analyze the local market, identify and evaluate potential investment opportunities and prepare investment proposals with appropriate input from the VC Fund Manager. These proposals are then submitted to the VC Fund Manager for a decision on whether to proceed with an investment or not.

However, despite the benefit of the VC industry to the economy there are concerns that cross-border venture capital investment may be hindered by tax, legal and regulatory requirements and that this could lead to the underperformance of the venture capital industry and, consequently, to insufficient venture capital investment. The venture capital industry maintains that tax issues are, in fact, a significant obstacle to cross-border venture capital investment.

In an analyze made by ALTAX experts about the main tax issues related to cross-border VC investments the key issues consist in three points.

The first issue arises because it is generally necessary for the venture capital fund manager to be present himself or have a representative present in Albania into which an investment will be made, in order to assist in the management of the target company. This local presence may mean that the treatment of the fund manager should be advised as a branch or “permanent establishment” of either the fund or of the investors and apply taxation accordingly. In the Albania, is applied profit tax for the return on the investment, for the fund and investors.

As a solution in this case it is that tax authorities should normally treat the local activities of a venture capital fund manager as those of an “independent agent” that would not create a “permanent establishment” for the venture capital fund.

The concept of a permanent establishment is necessary to ensure that jurisdictions can protect the tax bases. Without this concept, a business could be carried on in a country and not be taxable there if it was not carried on as a separate business through a local entity such as a subsidiary. If a permanent establishment exists then it normally follows that the profits attributed to that establishment are subject to tax in the state where it is situated. It would normally be a matter of discussion between the taxpayer and the tax authorities to agree on the appropriate level of profits to be attributed to the permanent establishment.

The second tax issue identified it is the fact that venture capital funds may currently be treated in very different ways for tax purposes. One direction it is that tax authorities may treat a fund as non-profitable for tax purposes, looking through the fund to tax the individual investors, whilst another may treat the fund as profitable and therefore taxable in its own right. This mismatch in tax treatment may cause difficulties in the application of double taxation treaties and consequent unrelieved double taxation. In some cases, the different classifications of the funds may also result in double non-taxation; income and gains may not be taxed anywhere either at the level of the fund or of the investors.

To address the double taxation, the possible suggestion it is the mutual recognition of the classification for tax purposes of the legal forms of venture capital funds. This would entail the tax authorities recognizing the tax classification and tax treatment of a venture capital fund.

If this approach is not feasible, the judgment should be based in a classification of certain commonly used forms of venture capital funds and publish a list indicating in each case whether they are non-profitable or profitable. According to that, at least the publication of information on how the Albanian tax and commercial legislation treats different types of venture capital funds for tax purposes would be beneficial.

The third tax issue identified is the fact that investors in non-profitable venture capital funds may currently have to file individual claims with foreign tax authorities for any cross-border double taxation treaty relief to which they are entitled. This can be difficult in practice due to the complexity of the claim procedures and may mean that many investors will not claim the relief to which they are entitled to.

In this regard, therefore the expert advice that venture capital funds should be able to claim tax treaty relief on behalf of their investors.

As mentioned above, one of the key concerns that a VC Fund Manager has when managing a VC fund across borders, is to ensure that its activities (or those of the adviser) do not create a permanent establishment for the VC fund itself or for the investors in the fund in any jurisdiction other than that in which the VC fund is based or in which the investors are resident. This is to prevent double taxation arising (at both the level of the deemed permanent establishment, and at the level of the investors) which would make investing in private markets uneconomic for investors.

The venture capital industry states that in practice, in order to avoid the risk of double taxation or to increase legal certainty about how venture capital investments will be taxed, they have to set up offshore or to use various costly and complex fund structures and tax planning techniques. This is not an optimum solution either from the industry’s or from the EU’s perspective.

It appears, therefore, that any tax measure to facilitate cross-border venture capital investment should aim to ensure that legal certainty for investors is increased and that problems of discrimination and double taxation are removed. In addition, however, in line with the EU’s goal of combating tax avoidance and evasion, any such tax measure would have to ensure that Member States’ taxing rights are safeguarded and that no tax loopholes are created.

The VC industry could make a greater contribution to the EU economy if the tax environment across the EU, in particular in Balkan and specifically in Albania states, took better account of the industry’s specific concerns and did not differentiate between this investment class and investments in public equity. If funds were able to operate across borders, they would achieve economies of scale. In addition, specialized sectoral expertise would emerge which would increase investment amounts, diversify portfolios and improve investors’ return.

[1] Venture capital (VC) is a subset of private equity. VC investments are those which are made in unlisted companies for the launch, early development or expansion of a business