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Pay less tax and be patriotic? Yes it can be done

The attraction of the upfront income tax relief, via Section 12J, is that it effectively reduces the cost of the investment, thereby boosting overall returns.

We all know that the South African economy is facing headwinds: we are in a technical recession, the rand is weak, unemployment is at an all-time high. So what can you do to help, and save tax at the same time?

Economies are grown by entrepreneurs and risk takers who invest capital to create or design goods or services to sell to others. However, a serious constraint to launching a new business in South Africa is access to capital. In July 2009, National Treasury, via Sars introduced a tax incentive described in Section 12J of the Income Tax Act, for investors (individuals, trusts and corporates) who invest in employment-generating businesses, selected and managed by qualifying, approved venture capital companies (VCCs) and their respective asset managers.  

Section 12J permits investors to claim a 100% deduction of the cost of the shares issued by the VCC, provided certain requirements are met. The objective of the rebate is to incentivise investors to take the risk of investing in small- and medium-sized companies that offer employment opportunities, thereby creating measurable social returns. Initially there was a poor response from the investment community, as Sars’ terms and conditions were too restrictive.

However, the Section 12J legislation has been tweaked a few times and according to Sars, the changes have led to an increase in participation from taxpayers. Unfortunately the Sars website does not offer details of trends or the total invested in qualifying funds to date. One of the main participants in Section 12J investments, Westbrooke Alternative Asset Management, estimates that approximately R3.6 billion has been raised in the industry to date.

So how does Section 12J work?

  • You can write off 100% of your investment capital against taxable income in the year in which the investment is made, as long as you hold the VCC shares for five years. There are no annual or lifetime limits to the amount you can invest. The attraction of the upfront income tax relief is that it effectively reduces the cost of the investment, thereby boosting overall returns. For example, VCC shares priced at R1, have an effective cost of 55c (assuming a marginal tax rate of 45%) for individual investors (or 72c where the investor is a company).
  • Capital gains on qualifying investments disposed of by the VCC are taxable. Dividends on VCC shares are subject to the 20% dividend’s tax, unless the investor qualifies for an existing dividend tax exemption.
  • VCCs may invest in companies with a book value of assets less than R50 million, or R500 million in the case of junior mining companies. Note that the VCC regime is subject to a 12-year sunset clause that ends on June 30 2021.

Restrictions

The Section 12J deduction is subject to a number of provisions. VCC companies have to meet certain requirements, as do investors. There are rules (recently amended) that govern the relationship between ‘connected persons’: those who own the VCC and those who invest in them. There are also rules that govern the deductible amount if the investment was financed via a loan or by credit. For more, see the Sars website by clicking here, or the draft guide to VCC investments, published in the Draft Guide on Venture Capital Companies, published in June 2018.

VCCs are structured differently

Potential investors should note that not all VCCs offering Section 12J investment opportunities are structured in the same way. Some have a structure similar to a unit trust, designed to ensure that investors have exposure to a wide range of projects, while others require investors to buy tranches of participatory units. Some sell investment opportunities throughout the year, while others have a buying season timed to coincide with the financial year. According to Sars, as of August 2018 there are 113 approved VCCs for Section 12J investments. Click here for the total list.

What sort of sectors do the venture capital companies invest in?

Popular sectors for investment include hospitality and tourism-related projects and student accommodation (where meals are provided), as these businesses are all employment generators. Other popular sectors include renewable energy projects, logistics, healthcare and vertically integrated food businesses.

Sars has a long list of sectors that Section 12Js may not invest in. Examples include trading-in, refurbishing or letting immovable property (other than hotel-keeping) as well as any trade carried on by banks, long- or short-term insurers or money lenders. Gambling and trading in liquor, tobacco, arms or ammunition are also on the no-no list.

Investment minimums and fees

The minimum investment amount varies but typically starts at R500 000. Fees are structured similar to hedge funds with a basic fee of 1% to 2% per year, in addition to a performance fee in the 20% range if pre-determined targets are met. In addition, some VCCs charge upfront fees. Fees earned by the managing VCC should be aligned with the risks and level of management required. Any gains are subject to capital gains tax.

So how do you go about choosing a suitable project?
About 13% of Rosebank Wealth Group’s client base has made investments in Section 12J companies, with our assistance. Clearly only those investors who understand the risks are advised to participate. We have assisted by scrutinising both the qualifying companies and their underlying investments. We have channelled our clients into just six of the 113 available VCCs.

  • In our view, the best underlying investments are those that would be attractive investments, even without the tax incentive to invest in them. Investors should try to match the investment risk of the opportunity with their personal risk appetite. Although not all 12J companies are ‘high-risk/high-return’ (some have been designed with capital preservation in mind), investors should remember that investing in small- and medium companies is more risky than investing in larger companies.
  • We are very much in favour of supporting those initiatives that observe both the spirit and the letter of the law; that is those which are upfront about attaining social returns. In the past, some VCCs have abused the rebates and have been penalised by Sars.
  • Be mindful of liquidity risk. After you have been invested in your elected company for five years, you might be ready to exit the investment. However, at this time it might be difficult to sell your shares at full value as VCC shares tend to be highly illiquid. There is no statutory requirement for VCC shares to be listed. Some VCC companies anticipate this problem and build in an exit strategy designed to reduces the risk of losing value. At this stage, buyers of ‘second-hand’ VCC shares will not benefit from upfront income tax relief.
  • The key to a successful Section 12J investment is choosing the right VCC manager. The managers have to select, manage and monitor the underlying investments, and ensure that tax compliance and governance is in place.

ADVISOR PROFILE

Trevor Lee

Rosebank Wealth Group (Pty) Ltd

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