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The survival and longevity of small and medium enterprises (SMEs) in South Africa have always been top of mind when economic growth and job creation surface in discussions.A plethora of incentives, programmes and financing plans have come and gone over the years.
One incentive that held much promise has been the section 12J venture capital company (VCC) tax incentive. The incentive was created when section 12J – which legislates the tax treatment of investments in VCCs – was inserted into the Income Tax Act.
This beneficial tax regime was introduced in 2009, offering investors a 100% tax deduction on the amount invested in the VCC, which in turn invests in qualifying SMEs.
The objective was to raise equity funding for small businesses that would otherwise not have had access to funding, either because of their size or the inherent risk associated with the company.
However, it was not long before the first of a range of policy changes were implemented to address perceived abuse, and more recently to protect the fiscus from the increased popularity of VCC investments.
According to industry players, the incentive only really took off in 2015 – halfway through its lifespan – when National Treasury lifted the investment limitation of R750 000 per tax year and a lifetime limit of R2.25m. It took off from a R1bn asset class at inception to R8.5bn of assets currently under management.
Just as it started to take off, a new investment limitation was introduced. The sun will set on the section 12J VCC tax incentive in June 2021 if there is no compelling reason to extend it – something industry players are hard-set to fight for.
The caps
Last year, Treasury introduced new investment limits of R2.5m per year for individuals and trusts, and R5m for companies in a VCC structure. Only 25% of investors in VCCs were companies.
A tax deduction of R5m per year will barely move the needle on some of the larger listed entities’ tax bills, says Dino Zuccollo, fund manager at Westbrooke Alternative Asset Management and chair of the 12J Association of South Africa.Westbrooke manages around R2.5bn of the total investments, has more than 1 000 investors and has made investments in 50 underlying assets.
It has deployed capital of more than R1bn since 2016. According to the association, the targeted returns on investments in VCCs across the board ranged between 15% and 40% per year.
Investors
There has been an evolution in the type of investors into VCCs. Initially it was mostly ultra-high net-worth individuals investing significant amounts – often individuals with large once-off capital gains tax bills who needed to mitigate their tax liability.
“However, we are increasingly starting to see the likes of doctors, lawyers, bankers, accountants and people who run their own businesses who have a decent enough tax bill starting to look at section 12J to mitigate some of their tax liability and to get exposure in an alternative investment vehicle,” says Zuccollo.
The 100% upfront tax deduction also acts as a supplement to retirement fund contributions. These deductions (in retirement funds), says Keith Engel, CEO of the South African Institute of Tax Professionals, have been capped for quite some time.
“The upper and very wealthy are subject to the contribution limitations for their pension contributions, so section 12J acts as a top-up. The deduction is recouped on disposal of the investment (in the form of capital gains tax).”
He notes that retirement fund contributions are limited to ensure that affluent taxpayers do not use their contributions to undermine paying their fair share of tax.
Engel adds that section 12J was never investor-focused. “The focus was to channel funds from the super wealthy into small and entrepreneurial ventures that were perceived to generate more growth for the economy.”
Investees
Jonty Sacks, a partner at Jaltech Fund Managers – a boutique financial consulting firm specialising in section 12J fund management and administration – says if one considers the wording of the legislation, it is clear that Treasury intentionally prevented VCCs from investing in businesses which do not have a significant impact on job creation.
This includes residential and commercial property investments, professional services businesses and businesses trading in alcohol, gambling or tobacco. “The legislation also prevents venture capital companies from acquiring more than 69.9% of the share capital of the company in which it invests, thereby preventing the entrepreneur from being completely diluted,” he says.
To increase the speed at which investment and growth in the economy occurs, Treasury initially introduced a rule requiring venture capital companies to invest 80% of the capital raised within three years.
This has now been extended to four years.This does, however, have certain consequences for both the investors and the qualifying companies. In February 2019 only R3.6bn of the R8.5bn in investments had been deployed.
The concerns
There has been an explosion in the number of companies raising funds in section 12J structures, however, there is real concern about the availability of suitable investment opportunities to deploy the funds. Brian Butchart, managing director at Brenthurst Wealth, says this can cause a potential drag on the return on investments.
And as it is, they are not optimistic about the local market – not because they are negative or unpatriotic – but because of the major issues facing the country.
“Eskom comes to the top of the pile (of issues). No matter what industry you are in, and no matter what section 12J investment you are in, it will be impacted at some point," he says.
The impact is already visible in the returns on the local stock market, he says. “Earnings are simply not coming through, and I think Eskom is a major issue across all industries. SA is also such a tiny market, and there are so many other opportunities offshore which have offered much better returns at substantially less risk than the SA market in many respects,” says Butchart.
Engel says the goal with the section 12J incentive has been to create a funding vehicle for SMEs that generate employment. “The problem is that good investments may not lie in employment-creating businesses.
Good investments are often high-tech, low-employment,” he points out.The 12J Association of SA commissioned some research on the job creation potential of the incentive.
A high-level assessment by PwC found that the association’s member base – which administers R5.7bn of the total assets under management – can potentially create or sustain 27 000 jobs. However, the introduction of the investment caps will impact the amount of funds raised and the number of potential jobs that can be created.
Despite the obvious drawbacks, in a market where equities and property have been struggling, the incentive is one of very few mechanisms available to convince investors to invest their money for at least five years onshore, says Westbrooke’s Zuccollo.Investors need to understand what they are investing in.
They also need to make sure their fund manager has a realistic exit strategy and charges reasonable fees. Some fund managers have charged net investment performance fees of up to 40%. “You need to do your due diligence on the underlying investments, and you must have conviction that it will be liquid at the end of your five-year period.
You need to have confidence in the fund manager to find the liquidity,” says Zuccollo. Butchart expresses serious concerns about the “second-hand market” for VCC shares.
“Qualifying companies are often illiquid, private equity-styled investments and, unlike with listed equity investments, there is no ready-made secondary market for VCC shares.
There are also no tax breaks for second-hand buyers of shares.”Engel points out that section 12J funds are built on a small set of large contributors and not a widespread set of investors as with a collective investment scheme.There are not many super wealthy people (and their money) left in the country and the new cap of R2.5m will impact the viability of many funds going forward.
“Treasury may also believe it is not able to afford the section 12J relief due to overall revenue constraints.”Zuccollo says many fund managers set their investment minimums at R1m, probably because they did not want to administer too many investors.
“The investment cap potentially opens section 12J to a wider base of investors, because it forces (fund) managers to accept smaller minimums. The cap is the natural evolution of an asset class that has grown in popularity," he says.
This is a shortened version of the story that originally appeared in the 6 February edition of finweek. You can buy and download the magazine here or subscribe to our newsletter here.
