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Investors use loophole in VC tax incentive to invest in own companies – Sars

Investors are using a loophole in a SA venture capital (VC) tax incentive to invest in companies connected to them and benefit from a whopping 125% write-off on their taxable income, the SA Revenue Services (Sars) revealed yesterday.

The incentive, which falls under Section 12J of the Income Tax Act and came into effect in 2009, entitles investors that invest in accredited VC companies that then invest in small businesses, to make a tax deduction of 125% in the year that the investment was made.

Last week saw an outcry from South Africa’s venture capital (VC) and private equity sector over amendments the National Treasury plans to make to the incentive in an effort to close the door on abuse of the incentive by investors.

A key amendment is that The National Treasury wants to allow only one class of shares in VC companies themselves and the “qualifying” companies that they invest in. The proposals also call for a ban on trading between the investor in the VC company and the targeted qualifying company.

The SA Revenue Service (Sars) told Ventureburn in response to a media query yesterday that investors are using different class shares to get around the incentives connected person rule — one of the anti-avoidance measures contained in the Income Tax Act which governs the incentive.

Investors are using a loophole in the 12J VC tax incentive to invest in companies connected to them and benefit from a 125% write-off on their taxable income

An investor must not be a connected party to the VCC or to the qualifying company which receives the investment.

“This is to ensure that investors, who have capital and companies, do not use such capital for the benefit of their companies and get a tax deduction — which would otherwise not have been available,” said Sars.

Sars said there is a “general trend” to investors using the authorisation of different share classes by approved VCCs to circumvent the connected party rules.

“Through such share classes, an investor who owns an underlying qualifying company receives a ‘capital injection’ in that qualifying company while simultaneously receiving a tax deduction in his or her personal capacity for the amount invested in the approved VCC,” said Sars.

‘Sars yet to specify abuse’

Sars’ response comes as last week the body that represents the industry — the Southern African Venture Capital and Private Equity Association (Savca) — claimed it doesn’t know what abuse Sars is referring to.

In response to a Ventureburn request for comment last week, Savca head of regulatory affairs Shelley Lotz said Sars and the National Treasury have “yet to specify the abuse they’ve identified”.

“Savca is aware that they (Sars) are aware of abusive structures relating to putting luxury homes and capital expenditure through VCCs. This, however, hasn’t been explicitly stated by either Sars or the National Treasury,” she said.

‘Multiple share classes is global practice’

Commenting on the National Treasury’s plan to do away with different share classes, Lotz said while this may help curb some tax abuse it has also caught in its net strictly commercial applications of different share classes.

Most fund managers she pointed out, use multiple share classes to allocate performance incentives to the fund manager and to raise different tranches of capital.

Perhaps the greatest problem, said Savca, is that global best practice in venture capital investing requires different share classes at the investee level for different rounds of capital raised, as these have different pricing with different rights attached.

“These are strictly commercial applications with no tax considerations applied and we have provided extensive evidence to this effect in our submission,” she said.

Lotz said the organisation, along with a credible research partner, will be undertaking a survey of all VCCs to gather information on the economic impact of the investment incentive for the benefit of National Treasury.

Savca declined to share with Ventureburn the submission it made to Parliament’s finance standing committee last week as part of the public participation process.

Read more: State must close door on those that misuse VC tax incentive [Opinion]
Read more: Savca raises concern over governance issues in Section 12J VC tax incentive
Read more: Venture capitalists welcome Section 12J proposals but call for more changes
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Read more: Can 12J VC tax incentive create the jobs South Africa badly needs?
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Featured image: stevepb via Pixabay (CC0 Creative Commons)