The effect of Section 12J of the Income Tax Act on the South African venture capital regime

Section 12J of the Income Tax Act has been the talk of the town in many South African venture capital circles in the last few years, but ironically there has been a lot less action in the market than the government expected when implementing this tax incentive in 2009. This incentive seems very promising on face value, but at the moment there are still less than 10 approved Section 12J venture capital companies in the country. This is an exceptionally low number if we consider how popular a similar venture capital incentive in the United Kingdom has been over the years, which beckons us to take a closer look at the incentive to determine the reason for the market’s reluctance to explore this.

The rationale behind the incentive is quite simply to address the fact that one of the main challenges to the economic growth of small and medium-sized businesses in South Africa, is the inability of these businesses to secure equity finance to fund their growth.

In terms of Section 12J, any South African tax resident that invests in a venture capital company (VCC), approved and registered in terms of Section 12J, can claim income tax deductions in respect of the expenditure actually incurred to acquire shares in such VCCs, subject to certain conditions.

Section 12J VCCs are therefore intended to be a marketing vehicle that will attract retail investors to invest in VCC’s, whereas the VCC makes money by investing in smaller trading companies. These are entities which the VCC’s fund managers deem as having prospects of producing a favourable return on investment. These companies are generally referred to in this context as qualifying investee companies.

However, before a venture capital company can start trading as a Section 12J VCC, it has to apply to SARS to be registered as such, for the purpose of which the company must meet certain preliminary requirements. To meet these requirements, the company must:

  • be a South African tax resident and its tax affairs must be in order;
  • have as its sole object, the management of investments in qualifying investee companies;
  • not control (whether directly or through a related entity) any qualifying investee company in which it holds shares; and
  • be licensed as a financial services provider in terms of section 7 of the Financial Advisory and Intermediary Services Act, 2002.

The major risk for a Section 12J VCC and its investors alike, is that SARS can withdraw the approved VCC status if, during any year of assessment, the company fails to comply with the preliminary approval requirements as listed above. SARS may also withdraw the company’s VCC status, if the preliminary requirements are met but the company fails to satisfy the following additional requirements after the expiry of 36 months from the date of SARS approving the company’s Section 12J VCC status:

  • a minimum of 80% of the expenditure incurred by the VCC to acquire assets must be for shares in qualifying investee companies, and each investee company must, immediately after the issuing of the qualifying shares to the VCC, hold assets with a book value not exceeding R300 million in the case of a junior mining company or R20 million in the case of any other qualifying company; and
  • the expenditure incurred by the VCC to acquire qualifying shares in any one qualifying investee company may not exceed 20% of its total expenditure to acquire qualifying shares, which basically means that the VCC must have at least 5 investee companies in its portfolio.

What happens when a Section 12J VCC loses its status as such? Well, SARS can include in the VCC’s income in the year of assessment during which the status was withdrawn, an amount equal to 125% of expenses incurred to issue shares.

If you consider the fact that venture capital investments are generally regarded as high-risk, relatively illiquid investments, the picture seems even less rosy for investors if the drastic consequences of non-compliance looms as an additional risk to their investments.

However, in the 2014 National Budget Review, the government announced that it will propose one or more of the following amendments to the VCC regime:

  • making tax deductions permanent if investments in the VCC are held for a certain period of time;
  • allowing transferability of tax benefits when investors dispose of their VCC equity investments in VCC’s;
  • increasing the total asset limit for qualifying investee companies from R20 million to R50 million, and that of mining companies from R300 million to R500 million; and
  • waiving capital gains tax on the disposal of assets by the VCC.

These new changes are to be welcomed and have certainly sparked renewed interest in the market, which is still wide open for those that are willing to enter this relatively untapped opportunity. Whether the proposed reforms are substantial enough to give this incentive the required momentum to ignite the South African venture capital industry as intended by the government remains to be seen.

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