SMEs, investors to lose out with new threshold and changes to Section 12J [Opinion]

In the past financial year South Africa’s Section 12J investment class didn’t only attract the attention of SA taxpayers — who were looking to reduce their income or capital gains tax liabilities — but unfortunately attracted the attention of the National Treasury too.

This was mostly due to the large value of investments made by SA taxpayers into Section 12J investments.

Effectively, the Section 12J investment class saw assets under management double in just one year, through the investment of over R3.7-billion by SA taxpayers, bringing the total assets under management in the region of R7-billion.

One would assume that Treasury would be encouraged by the amount of capital invested in Section 12J investments as the investment vehicle was introduced to provide equity funding to small and medium-sized enterprises (SMEs), through an upfront tax incentive for taxpayers who invest in Section 12J investments.

The new Section 12J limit means individuals and trusts can only claim an annual tax deduction of up to R2.5m and corporates of R5m

Simply put, if the taxpayer invests R100, he or she could claim up to R45 back from the South African Revenue Services (Sars) and generate a return from the full R100 invested (if invested wisely).

There is a clear short-term upfront cost to the fiscus, however, Treasury should be rewarded through long term sustainable tax revenue collected from the SMEs who receive the funding.

Unfortunately, due to many factors, including rampant corruption and fruitless and wasteful expenditure, Treasury is under pressure to collect as much tax revenue as possible.

One approach to “protect the fiscus”, which Treasury has taken, is the introduction of an amendment to Section 12J which would limit the amount a SA taxpayer can invest in a Section 12J investment (see this earlier story — Ed).

Placing a limit on SME investments

The proposed limit which was contained in the Revised Draft Response Document on the 2019 Tax Bill last week will see individuals and trusts only being permitted to claim a maximum tax deduction of R2.5-million and corporates of R5-million, per year.

The consequence of this amendment is that high-net-worth investors and corporates will be limited in terms of how much they can invest in the investment class, likely leading to a significant reduction in last year’s record investment of R3.7-billion into Section 12J investments.

This will reduce the amount of private sector investments in SMEs, likely resulting in more capital leaving our shores and fewer jobs created.

This limitation won’t impact the large majority of Section 12J investors who typically invest between R100 000 to R500 000.

The majority of investors, however, account for a disproportionately lower amount of Section 12J capital and hence local SMEs who would have been benefactors of the additional 12J investment capital will be affected.

This is most certainly a short-sighted approach by Treasury given that we are only now starting to see billions of rands being made available to SMEs in key sectors of the economy, which will lead to job creation and growth over the long term.

Extended period may lower returns

A further unexpected amendment, relates to the time frame in which the Section 12J investments must invest investors’ capital.

Up until this amendment, a fund manager had three years in which to invest investors’ capital, failing which the Section 12J investment would be non-complaint with the legislation.

Treasury has now extended this time period to allow the fund manager four years in which to invest funds under management into qualifying investments.

This amendment comes as a surprise as a number of the larger Section 12J investments have failed, to date, to invest a significant amount of capital under management into SMEs. While preventing non-compliance is desirable, this amendment may adversely affect investors into Section 12J investments that invest capital at a slow rate, as their capital may sit idle for a longer period.

As a result, investors who take part in Section 12J investments which have failed to invest funds timeously, will likely see a lower return from their investments.

Even more concerning is that it’s likely that investors in these funds will be required to hold their investment for longer than expected due to the investment taking longer to generate the returns anticipated.

Future investors should therefore be mindful of the total percentage of capital invested by the Section 12J investment, into qualifying investment, before making an investment. If appropriate steps are taken towards timeous investment, then this amendment will likely not significantly affect investors.

The Section 12J incentive has created a new SME investment class which is only now starting to flourish and is completely supported by the private sector, both from an investor perspective and from an asset management perspective.

Hopefully, the introduction of these amendments will provide Treasury with the comfort it needs to extend the incentive currently coming to an end on 30 June 2021.

More on Section 12J funds

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

Jonty Sacks is a partner of Jaltech Fund Managers which oversees a number of Section 12J funds