Sars Section 12J VC companies –  hype versus substance [Opinion]

There are many legal ways for South African taxpayers to reduce their tax burden, and investing in a SA Revenue Service (Sars) approved Section 12J venture capital company (VCC) is one of them.

However, opinions are divided on the hype of a tax break versus the substance of sustainable investment returns.

The 101 on Section 12J

Section 12J is not an asset class in itself, but rather a provision in the Income Tax Act that was introduced in 2009 to address one of the main challenges to the economic growth of small and medium-sized enterprises (SMEs) —  access to equity finance.

The Section 12J objective is to facilitate investment in SA SMEs that will foster innovation, create and maintain jobs, grow the economy and ultimately broaden the tax base.

Qualifying investors (any SA taxpayer) in an approved VCC can compensate for risk and enhance their return on investment by claiming amounts incurred on acquiring VCC shares as a full deduction from taxable income in the tax year that the investment is made.

Opinions are divided on the hype of the Section 12J tax break versus the substance of sustainable investment returns

Approved VCCs issue venture capital shares and investor certificates. The VCC will, in turn, invest in qualifying investee companies in exchange for qualifying shares.

Download the Section 12J External Guide by Sars for more info.

What VCCs can invest in

VCCs are somewhat restricted in terms of what they can invest in, but it depends how far from the original Section 12J objective they stray. Qualifying investees are unlisted SA companies with a book value of assets not exceeding R50-million post-investment (R500-million in any junior mining company).

The investee must trade mainly inside South Africa at the time of investment and it may not carry on an “impermissible trade”, such as: immovable property (except trade as a hotel keeper or bed and breakfast establishment), the provision of financial or advisory services, gambling, and any trade carried on in respect of liquor, tobacco, arms or ammunition.

Different 12J offerings

By February last year, R3.64-billion had been raised by VCCs and this number is expected to grow to over R5-billion when the February 2019 dust settles.

Currently there are around 150 different Approved VCC’s to choose from with different value propositions and varied track records (see the list here). It seems like a few broad investment focus areas are emerging:

1) SME investment (venture capital and private equity)
2) Small hotels/ hospitality property
3) Small hotels/ student housing
4) Junior mining exploration
5) Asset-backed rentals

Beyond the tax break

Investment in a Section 12J VCC should be about more than the tax incentive.

Sure, investors start the investment process in a favourable Internal rate of return (IRR) position due to the immediate tax benefit, but the skillset of the VCC team will determine how that IRR grows or erodes.

It can be a daunting task to figure out which VCC to trust with managing your money and qualifying investors need to be confident that there is goal alignment.

The VCC itself needs to have a solid business model, relevant experience and traction verticals to indicate that it can execute its strategy and adhere to governance protocols through the 12J hype.

Increased governance

Like all investments, governance is key. But when a tax incentive is involved, extra caution should be taken to ensure that the investment structure and strategy is compliant with legislation.

Recently National Treasury implemented a number of amendments to narrow the scope for potential abuse. The tighter legislation has led to greater certainty and has been a positive development for compliant VCCs.

To protect SA investors, Section 12J VCCs are regulated, requiring a license from the Financial Sector Conduct Authority (FSCA) and approval from Sars. Some abide by a code of conduct as members of Savca — an industry body that provides guidelines and standards to the venture capital and private equity investment industry.

Section 12J VCCs are also in the process of establishing a Section 12J industry body to work with policy makers to ensure the sustainability of the regime (see this story).

The risks

There are some obvious inherent risks in handing over your hard-earned cash to a fund management team that will invest it on your behalf. But some of the specific 12J risks include:

Creative business models  —  The sole objective of any VCC must be the management of investments in qualifying companies.

Structure of the investment vehicle  —  Section 12J VCCs have structured themselves in various different ways, some with creative interpretations of the law to mitigate investment downside risks. But in doing so the risk of non-compliance may have increased.

Impermissible investments  — Risk of non-compliance if the VCC invests in controlled group companies or other impermissible or non-qualifying investees.

Investment in non-qualifying shares  —  (After a grace period of 36 months), 80% of the expenditure incurred by the VCC to acquire assets must be for qualifying shares (an equity share issued to a VCC by a qualifying company).

Non-deployment of capital —  Because no single portfolio investment may account for more than 20% of the funds received by a VCC (after 36 months), it effectively means that any VCC should aim to make at least five investments in time, so there needs to be a qualified pipeline.

Performance of the underlying portfolio —  To provide equity finance to SMEs generally means that the investment is unsecured, so if the investee businesses fail, returns will be diminished and the equity investment may even be lost.

Fees charged  — The economics of venture capital is based on the premise that interests are aligned with reasonable ongoing management fees and a vested interest in performance fees after investor funds have been returned. Or is it?

Exit strategy  —  Investors need to be comfortable with a long-term investment and that the VCC has a viable exit strategy from fairly illiquid assets, as the tax deduction is recouped if a taxpayer disposes of the VCC shares within five years;

Potential tax leakage –  Other than the initial deduction for investors in the VCC, there are no special tax benefits for VCCs on exit, and standard Income Tax, Dividend Withholding Tax and Capital Gains Tax rules will apply.

Withdrawal of VCC status  — Non-compliance by a VCC to the stipulated requirements could trigger withdrawal of an approved VCC status. In such an event, an amount equal to 125% of the aggregate amounts contributed by investors must be included in that VCC’s income in the year of assessment in which such approval has been withdrawn.

Nothing ventured, nothing gained

While many Section 12J offerings mitigate downside risks in various ways, they are more suitable for investors in a high-income bracket with a balanced investment portfolio who are prepared to accept the risks inherent in investments of this nature.

VCC investors should preferably have an interest in local entrepreneurship and job creation in order to add value to a rewarding journey.

They should nevertheless conduct appropriate due diligence on the VCC and its risk or return profile, seek professional advice and ensure they are investing in a reputable and experienced VCC with the appropriate skills to invest in and build SMEs into assets of value with substance that can result in future exit strategies.

Some credible financial institutions and wealth managers have already conducted thorough due diligence exercises on the top VCCs to endorse for their client base, so look out for those.

Read more: Section 12J funds that invest in property are a tax dodge says Vinny Lingham
Read more: New Vinny Lingham linked R500m VC fund currently mulling 15 investments [Updated] 
Read more: SA VC Kingson Capital launches R400m fund to target tech startups, black SMEs [Updated]
Read more: Section 12J industry body established to ensure industry sustainability
Read more: What investors should look for in a Section 12J VC company [Opinion]
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
Read more: Investors clamouring for 12J VC incentive following tax hike – fund managers
Read more: Can 12J VC tax incentive create the jobs South Africa badly needs?
Read more: Foreign investment injection could propel South Africa’s VC ecosystem, 12J funds

Keet van Zyl is a partner at venture capital company Knife Capital, which managed KNF Ventures, a Section 12J fund. This article originally appeared as a post on Medium. See the original here.