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There’s more to Section 12J than ‘45% immediate tax relief’

Beware the pitfalls.

With the tax year end just more than a month away, there has been a growing marketing effort aimed at luring investors to Section 12J venture capital and private equity investments.

The Section 12J tax incentive is a government initiative aimed at assisting small and medium-sized businesses to access equity finance in the hope of creating jobs and boosting economic activity.

Investors can write off 100% of an investment into an approved 12J vehicle against their taxable income. Against the background of meaningful tax hikes and growing concerns about wastage of taxpayer money, this may seem like a no-brainer – effectively it means that investors can get ‘up to 45% immediate tax relief’.

And with the JSE moving sideways for more than four years, investors may easily be swayed by targeted returns of ‘40% per year or more’ in some of these funds.

But while some of these investments may be suitable for a specific type of investor, interested parties should make sure they understand the risks, tax benefit and liquidity constraints involved. There are now more than 100 registered Section 12J companies in South Africa, which have attracted more than R3.6 billion in total.

Dino Zuccollo, fund manager at Westbrooke Alternative Asset Management and founder member of the Section 12J Association of South Africa, says there is a spectrum of different quality asset managers and investments in the market.

While Section 12J offers a fantastic tax break, it is not good enough to just invest for the tax, he says. Investors should invest with an experienced manager with a track record of success, and need to do a due diligence on the manager to get comfort around their ability to deliver.

Craig Gradidge, investment and retirement planning specialist at Gradidge-Mahura Investments, says the firm does make use of the incentive for clients, but is very careful to ensure that clients understand the risk, tax benefit and liquidity constraints.

Higher risk profile

These investments have a much higher risk profile than traditional equity investments. There is usually very little diversification (unless it is a fund-of-fund) and investors must stay invested for a minimum of five years. If there isn’t a successful exit strategy in place, they may be locked in for longer, he adds.

While offers largely focus on the immediate tax relief of up to 45%, investors also need to realise that all the capital returned on exit will be subject to capital gains tax (CGT), even if this is less than the amount that was initially invested. The base cost is deemed to be zero.

“If you put in R1 million and it is a bad investment and you get R500 000 out, that [full] R500 000 is subject to capital gains tax.”

Importantly, investors should note that the targeted investment returns quoted on 12J brochures are based on the capital at risk and not the capital invested. They generally also assume that individuals pay tax at the highest marginal income tax rate of 45%.

In other words, if an investor invests R1 million in a 12J vehicle and gets a tax break of R450 000 from Sars in that tax year, the investment return quoted will be calculated on R550 000, not R1 million. Where a manager is quoting a targeted return of 18%, roughly 8% will be the result of the tax benefit. Moreover, someone who is paying income tax at a marginal rate of 30% won’t get the same type of return as someone paying at 45%.

Zuccollo says investors must ensure that if the manager is basing the returns on the net risk capital (thus accounting for the upfront tax deduction in their return calculation) they are also accounting for the CGT at exit.

He concedes that the way returns are calculated is complicated, but says it is necessary as the tax break is such a significant element of the return profile.

If someone invested in student accommodation and ordinarily received a 10% return per annum, a 12J investment in a similar venture would be done with the same amount of risk, but at almost double the return due to the tax break, he argues.

“I think you need to show that to an investor.”

Impact on retirement deduction

Investors should also consider how their retirement funding may impact their situation, Peter Hewett, managing director of Hewett Wealth, notes. An investor who earned R1 million during the tax year and who contributed R275 000 to a retirement annuity (the full 27.5% deductible contribution allowed) as well as R1 million to a 12J vehicle, will see their RA deduction being disallowed in that tax year.

“It will be carried forward to future years – you won’t be allowed to use it in that year because you didn’t earn taxable income. So you’ve got to be careful when you do your tax planning to make sure that you take into account what your true taxable income will be after you’ve made provision for your retirement funding contributions,” Hewett explains.

Other considerations include how long the fund manager and the projects have been around, what the projects entail, the audited financials of the entities and how the capital will be deployed.

Investors should also understand the costs involved. In line with other alternative investments, fees are generally higher than traditional unit trust-type investments and investors should get this set out in writing. Aggressive commissions should be cause for concern.

Hewett says the tax break is quite nice and that these may be suitable investments for certain clients, but they have to understand that this is effectively a private equity type of investment where they have very limited control of the risks they are exposed to.

Adds Gradidge: “It’s not for everybody. You’ve got to have that long-term view and you must be prepared to be invested for seven years at the minimum in case there are issues at exit. It is for someone with risk tolerance.”

Given that these are alternative assets, investors really shouldn’t have more than 5% to 10% of their portfolios invested in these assets, he adds.

Read:

Understanding the Section 12J marketplace

How to take advantage of the Section 12J benefit

12 things you need to know about Section 12J

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From the Westbrooke sponsored article: “Estimated total 12J industry assets under management stood at R3.6 billion at the end of November 2018.”

Slim segment of the equities market. Certainly not a convincing solution for, “creating jobs and boosting economic activity.” For that purpose, a tax holiday/honeymoon for qualifying start-up seems like a logical solution. Most SME’s fly by the seats of their pants in the first few years, and tax is the first corner to get cut. Paying off crash course years tax in the longer term with interest can curb tax evasion and boost cottage industries.

At long last an objective article on S12J investments, unlike the paid-for articles popping up everywhere on the internet. The frenzy being created reminds me a lot of the Sharemax and Picvest days.
Investment advisors need to be reminded that they will be answering to the Fais Ombud when something goes wrong in a scheme, over which you don’t really have insight, goes belly-up.
Then the promotors of these schemes will be long gone and its your reputation at risk.
I wouldn’t touch it with a barge pole. All for a lousy once off commission?

Agree 100% – when a return on an investment is too good to be true, it is normally not true or I am probably to conservative and will rather stick to the seven foot pole rule – don’t think of it and don’t touch it

Since the tax relief is real, are there any S12J funds worth looking at?
All the ones I’ve seen take all the IRR in fees, and effectively give you 10% IRR if you look just at the capital invested, far too low for the type of equity risk they’re taking – the bump in IRR being a function of the tax relief. I can get 10% no risk without a S12J fund, so why take on the highest risk of such an illiquid instrument to only get 15-18%?

Average capital raising target of one investment project is R200 million with majority requiring approx 2% upfront fee.That a pretty R4 million in the pocket of management on day 1…..and then the risks kick in….how convenient…

It is critical to understand where the manager of a 12J is earning fees. Some, not all, also earn consulting fees at the underlying qualifying company level which is usually not disclosed. Understanding all the fees is part of the due diligence that has to be done by the financial adviser or investor. Also be aware if the manager is earning performance fees on the risk or contributed capital. Don’t get me wrong, the 12J concept is a good one, particularly in what Treasury wants to achieve: stimulate small and medium sized businesses and provide employment. I totally agree this is an alternative asset class which is high risk and is not suitable for all investors. However for those who can stomach the risk, it is another option to help diversify your complete portfolio.

And bear in mind the performance fees may not be explicit. Dilution is sometimes the means to extract value, eg you pay for 5 shares of which 1 is issued gratis to the managers ; or the managers have some form of income preference. The devil is in the detail, but when I looked at these a few years ago my impression was that upfront costs to the investor were typically around 28%.

I don’t know how Dino Zuccollo can use the example of student accommodation and punt it as more beneficial using section 12J, since section 12J specifically defines an “impermissible trade” as including “any trade carried on in respect of immovable property other than that of a hotel keeper”.

Theyve got a student accommodation fund. Perhaps they run it as a hotel?

This is a paid for article by Westbrooke, Moneyweb offers the main slot to paying clients. Great for Westbrooke to warn the market around IRR calcs, where they take a large portion of the IRR through charing a performance fee on the tax deduction (read the fine print)

It seems that you do not want to be a Sec 12 J investor but the starter of a Sec 12 J fund.

Yes indeed, corporate investors should look at it for long term capital allocation purposes.

@JBlack try Bright Lights Solar VCC they have very reasonable fees and are very clear on how they install solar for sectional title. Sensible returns with manageable risk.

May have posted this 2 x. If so apologies.
Please would a journalist or someone without a vested interest write more on all the different 12J and give some ideas on whether they are successful

Most of these 12J are far removed from venture capital and fall more accurately in loan funding. In projects like student accommodation or solar IPP the funders are playing a banker role because the Basel rules have made it near impossible formbanks to finance projects other than those that only use funding as tax shelter.

btw these solar lease models are as mis-sold as life insurance policies, some proper crooks involved

Can someone do an article on the Urban Development Zone tax incentives? There are a few mixed-use developments claiming that buyers can qualify for the UDZ write-off. Not sure if there are any T&C’s attached.

(IIRC, it allows a percentage write-off against income tax, something along the lines of 20% per year, and you may not sell the property within 8 years of claiming the first write-off.)

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