Malaysia's VC Tax Incentives
A prerequisite of a disagreement on the effectiveness of a policy would require that each hold the same view regarding the ultimate objective. While I cannot pretend to know the core objective on behalf of the policy makers, I can hold a view with respect to what I believe the objective ought to be.
OBJECTIVE To encourage greater private market financing of startups (venture companies) within Malaysia
Based on the objective, tax policies then should target reductions or waivers of taxes for the market participants. By effectively providing tax incentives, the intention is to alter the risk profile as a result of the tax benefit thereby encouraging greater market participation.
3 relevant tax incentives were introduced in April 2022 and are deemed to be effective from the tax year of assessment (YA) 2018.
Exemption provided to Venture Capital Company (VCC), the equivalent of the Limited Partnership entity of other jurisdictions
Exemption provided to Venture Capital Management Company (VCMC), the entity responsible for the investment management activities
Exemption to companies or individuals that invest into VCC Funds
If an entity claims the first exemption, the individuals and corporates are not permitted to claim the third exemption. Therefore, I focus the below conversation solely on the third exemption as it is, in my view, the potentially most important if revised.
I make no attempt to be a tax advisor, but I am a market participant in the Venture Capital ecosystem. To review the revisions, I rely upon EY Tax Alert found here.
Exemption to Companies or Individuals that Invest into VCC Funds
This was provided by “Income Tax (Deduction for Investment in a Venture Company or Venture Capital Company) Rules 2022 [P.U.(A) 117]”. Per EY:
The Rules provide that in ascertaining the adjusted income of a company or an individual from its business for a YA, there shall be allowed a deduction equivalent to the:
a) Value of investment made in a VC, or
b) Value of investment or RM20 million, whichever is less, made in a VCC
The investment made shall be deemed to be incurred (and allowed a deduction) in the YA the investment has been held for a period of three years from the date the investment was made. The investment holding period is to be certified by the SC.
To qualify for the deduction, the company or individual is required to make the investment between 27 October 2017 and 31 December 2026.
Stipulation (a) of the above is clear. There is an incentive provided for direct investments into startups (referred to here as Venture Companies, or VC). The majority of this investment will likely be Angel investing, which may already fall within the Angel Tax Incentive scheme.
Stipulation (b), which is focused on indirect investment via a Venture Capital fund, is limited by the requirement that it must be registered as a VCC.
The Limiting Factors of this Order
Digging deeper into the reasons this is a limiting factor, I highlight the following:
Historic Private Participation in VCC is Low - Currently, the vast majority of the committed capital to VCCs in Malaysia comes from either Government Agencies and Investment Companies (45.01% as of 2021) or Sovereign Wealth Funds (27.9% as of 2021). There is very little private market participation in the locally registered VCCs. So, then the effectiveness of this order would depend upon the creation of additional VCCs with participation from the private sector.
Effectiveness Dependent on New Fund Formation – According to the Securities Commission’s 2021 Annual Report, there was RM 5 billion in committed funds (USD 1.1 billion). Of this amount, 75% is reported to have been drawn. Thus, if these were to deploy capital, they essentially have already, and it is likely that a large portion of the undrawn capital is reserved for management fees. To encourage additional capital investment into startups, it would be necessary, therefore, that new funds are formed to be capable of deploying new capital into startups.
Malaysia VCC Registration as a Limiting Factor - Venture Capital funds are, by their nature, pooled investment vehicles that collect investment capital from a variety of investors to then invest onwards. The legal domicile of the Fund is determined by the preference and requirements of the Investors in the Fund, who are generally referred to as Limited Partners (LPs). This legal domicile of the Fund is not necessarily the same as the destination for the investment capital.
The larger the pools of capital, the more stringent the requirements and preferences of the LPs are. Many institutional LP are restricted by their own investment policies which legal jurisdictions the Funds must be domiciled in. By restricting the tax incentive for Malaysia-resident capital to a Malaysia registered VCC, this is limiting the ability of capital to pool together with additional sources of global capital for the purpose of investing in Malaysia.
The Funds under the government’s Penjana Kapital fund of funds initiative are registered in Labuan. As these would not be subject to regulatory approval by the Malaysia Securities Commission, they would not be registered as a VCC. This would imply that even these would either not be subject to the incentive or would require a form of exemption.
With the end objective being greater investment into startups based in Malaysia, the focus should be upon the downstream recipient of investment. The requirement that a Fund must be domiciled in Malaysia and registered as a VCC is an unnecessary limiting factor that will reduce the effectiveness of this policy.
Simple Modifications for Improvement
Instead of simply highlighting an issue, I would propose that the authorities instead stipulate the same incentives but with some changes to the requirements.
No Domicile Restriction - Instead of requiring the Fund be domiciled in Malaysia as a VCC, permit the broadening of the rule to apply to any jurisdiction. As mentioned above, the elimination of the domicile restriction will enable local capital to pool with foreign capital for greater impact.
In general, foreign capital prefers to pair with local capital, especially if the target investment space is early stage. This is the equivalent of not wanting to “go in blind”, so to say. By encouraging local capital with incentives, but without the geographic domicile restriction, this will enable the pairing of local with foreign capital into even larger pools of capital.
The investment incentive can still be subject to the additional restrictions that are already present in the current order.
Investments in Malaysian Startups - A key restriction on the tax incentive is that the Fund maintains, on average over the 3-year holding period required to claim the incentive, at least 50% of investments in Malaysian startups. If the Fund is not domiciled in Malaysia, there remains the question of verification in order to claim the incentive.
To verify records of ownership of the Fund entity in a Malaysian startup, these records would be registered with Suruhanjaya Syarikat Malaysia (SSM), or in English the Companies Commission of Malaysia. It would be easy to validate the investment amount and ownership in the Malaysian startup. This, however, assumes that the investment is in the form of preferred or common equity. Investments in SAFE Notes or other convertible instruments would not necessarily be registered, but can be verified by other means, payment of stamp duty on the contract for example.
The Fund entity can then provide verification of the partnership interest in the Fund by the Malaysian individual or corporate investor that wishes to claim the incentive.
A Path Forward
It is the pooling of capital that creates the biggest impact on a startup ecosystem. In order to maximize the impact, the incentives should not be structured in a manner that inhibits the pooling of capital. As structured, domestic capital will pool with other domestic capital. However, the jurisdiction of domicile is a limiting factor that will inhibit unlocking even further pools of capital. This is unnecessary to achieve the end objective of driving more capital flows into the startup ecosystem of Malaysia. By simply eliminating this restriction and focusing the verification process in claiming the incentive on its downstream use, more capital can be unlocked, and the impact will be substantially greater.