Investors wanting to invest in Section 12J still have until 30 June to invest before Treasury’s sunset clause on this South African tax incentive takes effect. This is what you need to know before investing in Section 12J for the last time.
Background to the end of the Section 12J tax deduction
The incentive was introduced in 2009 and now has well over R10 billion under management. These investments offer investors a 100% tax reduction for making an investment in SMMEs in selected industries.
The incentive was always subject to a sunset clause, as many incentives are. Section 12J was initially implemented for 12 years, after which the legislation was due to be reviewed and a decision regarding its future taken. Unfortunately, Treasury decided against an extension, citing concerns regarding the effectiveness of the underlying investments in meeting its objectives, amongst others. There is also need to increase tax collections, which may also have impacted this decision, especially during the pandemic.
No changes other than a hard stop to the deduction
Fortunately, there is still one last chance to take advantage of the 100% tax deduction offered by Section 12J, which ceases at the end of June 2021. Other than the deductibility of the investment post June, nothing has changed regarding the incentive and its compliance requirements.
The cap of R2,5 million for individuals and trusts and R5 million for companies remains, as well as the industries that you may invest in and the minimum five-year hold period. The capital gains consequence on exit also remains. There is no additional tax risk for investors who invest prior to 30 June 2021 and the rules of engagement for 12J remain the same.
However, the cancellation of Section 12J and the requirement to invest by the end of June 2021, outside of the traditional February ‘tax season’, does raise some important additional considerations:
Asset managers versus structuring houses
There are many providers offering Section 12J investments and unfortunately, not all will be able sustain their business models once the sunset clause becomes effective. This is an important consideration – investors should understand if (and how) their asset manager intends to sustain their business and whether they will still be around to manage client investments with the same level of skill and interest in years to come.
Section 12J providers can broadly be classified as either asset managers or structuring houses. In my view, asset managers are likely a safer choice, especially if they have a larger business where Section 12J is just one of the options offered. They also have a reputation to uphold, which incentivises them to make sure that they do as well out of their Section 12J investments as they do with the rest of their investments.
Structuring houses that were formed to create 12J structures could be riskier. Enquire about their plans and the incentives they have to ensure that their services continue four or five years from now.
Beware guaranteed income and buy backs
Promises of guaranteed income and buy backs should also be carefully considered. Guarantees are only as valuable as the strength of the guarantor i.e. the balance sheet that underpins this guarantee. In addition, such promises may put your investment at risk as Section 12J companies are required to invest in equity shares and not guaranteed instruments. Do not be impressed by a clever marketing pitch when it might not be substantiated with substance.
Choose your investment mandate wisely
The mandate and industry you are investing in is as important as ever, specifically as a large portion of Section 12J investments have been made in hotels, which for obvious reason have become very tough. Don’t forget that a Section 12J investment is an investment in a private business in a specific sector – you should have a high degree of confidence in the investment fundamentals of the sector in which you invest and should not invest purely for the tax.
Estimating your taxable income for February 2022
Section 12J investments are traditionally concluded in February each year as this aligns to the end of an individual taxpayer’s tax year end. At this point, it is relatively easy to know one’s tax position prior to deciding on the amount to invest in a Section 12J company. For the 2022 tax year, however, your investment must be made by 30 June 2021 (before the sunset clause comes into effect). Most of us will not know our taxable income now, which means that you will need to estimate your taxable income before deciding on the quantum of your investment. If you get this estimate wrong, you might lose out by either over or under investing. If you over invest, you might not be able to utilise your full Section 12J tax relief. I would suggest rather being conservative.
What if my tax event takes place after 30 June?
This isn’t necessarily a problem. As an individual, your Section 12J deduction is available against all taxable income events which take place in the 28 February 2022 tax year, even if they occur after the sunset clause (e.g. capital gains, salaries, bonuses, etc.)
Basics of investments still apply
The same fundamental investment principles apply. Consider the manager you are investing with and what you are investing in. Ask your manager questions including: what level of risk you are taking for the returns promised? Do you target pay a dividend and if so, how often? How do you calculate the returns which you are quoting – are fees included? What is your track record in managing and exiting Section 12J funds successfully?
With this in mind, a Section 12J investment remains a very attractive investment on a risk-adjusted basis – investors should act swiftly to take advantage of the Section 12J tax relief for the last time before 30 June 2021.
Dino Zuccollo, principal at Westbrooke Alternative Asset Management and chairman of the Section 12J Association of South Africa.