Experts raise concern over new Section 12J rule that limits deductions for investors

Experts have raised concern over a new threshold for deductions that investors can make under Section 12J of the Income Tax Act, saying it will reduce the amount of funds that venture capital companies (VCCs) can raise.

The VC tax incentive, set up under Section 12J of the Income Tax Act, allows investors who make investments in approved VCCs — that then invest in qualifying small companies — a tax deduction.

The new rule, which came into effect on Sunday last week (21 July) will limit the amount that investors can deduct from their taxable income to R2.5-million a year.

Previously there was no such limitation on the deduction that investors could make annually.

‘Limiting the Section 12J deduction by a taxpayer to R2.5-million a year will reduce fund sizes and funding for SMEs’

Jonty Sacks (pictured above), a partner of Jaltech which oversees a number of Section 12J funds, told Ventureburn today that the limitation would act as a disincentive for investors (most of whom are high-net-worth individuals) to keep funds in South Africa, while reducing the amount that VCCs can raise.

In May, Sacks revealed that 58% of the estimated over R3-billion raised by Section 12J VC companies (VCCs) in the 2019 tax year went to the property sector. The remainder was made up of funds destined to private equity (18%) and asset rental or renewable energy (20%). The VC sector made up a mere four percent of total investments (see this story).

The National Treasury wants to get more 12J funds to invest in actual small businesses rather than property and in so doing drive job creation, but Sacks argues that investments in the property sector create more jobs than those in the VC sector.

‘Change will put corporates off investing’

The deduction threshold would also discourage corporates from investing in 12J funds as corporates are more likely to invest a figure of R20-million than R2-million, he argued. He estimates that funds from corporates made up just 10% of the R3-billion raised by Section 12J fund last week.

Aurik Investment Holdings CEO Pavlo Phitidis added that “without a doubt” the new deduction threshold would limit involvement by corporates in Section 12J.

Aurik’s Section 12J fund, “Linkmakers” which has been in operation for two years, taps corporates that make commitments to the fund to get BEE points for helping black suppliers. So far the fund has deployed R60-million in black-owned firms.

Venture capitalist and Knife Capital partner Keet van Zyl said last week that the new measure could have “some unintended consequences” in trying to curb abuse by Section 12J funds that are not “true venture capitalists”.

“Limiting the deduction by a taxpayer to R2.5-million per year going forward will reduce VCC fund sizes and thereby the availability of funding for SMEs,” he said in a tweet last week.

Draft TLAB has some unintended consequences in trying to curb abuse by #Section12J Funds that are not ”true venture capitalists”. Limiting the deduction by a taxpayer to R2.5m per year going fwd will reduce VCC Fund sizes and thereby the availability of funding for SMEs. pic.twitter.com/DFgztPT9Ld

— Keet van Zyl (@KeetvZ) July 21, 2019

‘Threshold aims to limit abuse’

The National Treasury said in an explanatory memorandum (opens as a PDF) published last week that the new limitation aims to limit abuse by investors of the tax incentive.

It said the new deduction would apply in respect of expenditure incurred by the taxpayer on or after 21 July 2019.

The National Treasury said when the venture capital company (VCC) tax incentive regime was introduced in 2008, an individual who invested in the VCC shares was eligible for a 100% deduction of the amount invested, but that this deduction was limited to R750 000 per tax year, with a lifetime deduction limit of R2.25-million.

In 2011, changes were made in the VCC tax incentive regime in order to make it more attractive and both these limitations were removed.

Over the past two years, the government, it said, had endeavoured to end the abuse within the tax incentive regime by making certain changes to the incentive.

“Despite government’s efforts to introduce these anti-avoidance measures, it has come to government’s attention that some taxpayers are still attempting to undermine the objectives and principles of the VCC tax incentive regime to benefit from excessive tax deductions,” it said.

The National Treasury said the average expenditure per year incurred by a new VCC shareholder to obtain VCC shares ranged between R1.3-million to R2.1-million in the past four years.

Westbrooke Alternative Asset Management’s Dino Zuccollo, who helped set up the Section 12J Association of South Africa (S12J Association in January this year (see this story) said the association is due to meet this afternoon and would discuss the effect the new deduction threshold will have on investment in the sector.

He added that the association is committed to engaging with The National Treasury to help clamp down on abuse, while at the same time ensuring that the incentive continues to help stimulate private investment in the SA economy.

More on Section 12J funds

Read more: Four Sars Section 12J venture capital funds that invest in SA tech startups
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

Featured image: Jaltech partner Jonty Sacks (Supplied)