[vc_row fullwidth=”true” fullwidth_content=”false” css=”.vc_custom_1511253087767{padding-top: 50px !important;padding-bottom: 50px !important;background: #f0f1f2 url(https://westbrooke.co.za/wp-content/uploads/2017/02/triangle-grey-top-left-600×600.png?id=166) !important;background-position: 0 0 !important;background-repeat: no-repeat !important;}” el_class=”blog-content”][vc_column width=”1/12″][/vc_column][vc_column width=”10/12″][vc_column_text css=”.vc_custom_1538466119336{margin-bottom: 0px !important;}”]By: Rabie Smal   Source: DealMakers

The venture capital incentive in terms of section 12J of the Income Tax Act, No. 58 of 1962 (the Act), is a mechanism attempting to accelerate the economy and enhance private investment and equity funding in small and medium-sized South African businesses.

This tax incentive provides an upfront income tax deduction for investors, by subscribing for shares in venture capital companies which invest those funds in qualifying small businesses. Section 12J has been in place for nearly a decade with the intention to address a key challenge to grow small and medium-sized businesses in South Africa, as identified by the 2008 South African Budget Review, through access to equity finance.

Section 12J has however not been properly utilised until recently, when favourable tax amendments (which we explain later) were made to s12J resulting in an increase in cash inflows under the s12J asset class. According to the 2018 Budget Review and the website of the South African Revenue Service (SARS), there are now 103 registered s12J venture capital companies, up from only one in 2008, with total investments of approximately R2,5bn. The venture capital industry under s12J has therefore only really gained traction in the last 3 years. There are, however, still some issues frustrating increased participation in this industry.

Brief overview of section 12J
Essentially, s12J provides an incentive to private investors to invest in venture capital companies who, in turn, invest in qualifying small and medium South African businesses, providing necessary equity injections for such businesses. Investors in the venture capital companies, in turn, get a full 100% upfront income tax deduction of those funds invested.

The process involves (i) an investor subscribing for equity shares in a SARS approved s12J venture capital company, (ii) the approved venture capital company issuing a share certificate to the investor, (iii) the investor claiming an income tax deduction for the subscription amount incurred and (iv) the venture capital company in turn allocating capital and investing in a qualifying company. As mentioned above, the venture capital company must be s12J approved by SARS. The Act requires certain conditions to be met before SARS will approve a company as a s12J venture capital company. Some of the requirements include that the company must be a resident; its tax affairs must be in order; it must be registered in terms of section 7 of the Financial Advisory and Intermediary Services Act, No. 37 of 2002 (FAIS); and the sole objective of the company must be the management of investments in qualifying companies.

Any taxpayer (including individuals, corporate bodies or trusts) with a taxable income may invest under s12J. There is no statutory annual or lifetime cap for the amount that a taxpayer may invest in an approved 12J venture capital company.

There is, however, a practical cap, as no investor’s holding in a venture capital company may exceed 20% in a single fund. This is discussed in more detail below.

The income tax relief is provisional but becomes permanent if the shares in the venture capital company are held for 5 years. Therefore, a taxpayer can claim the income tax deduction in the year of assessment in which the investment was made, but if the shares in the venture capital company are sold before the expiry of the 5 years, the taxpayer is obliged to pay SARS the income tax deduction previously received. If shares in the venture capital company are sold after the 5-year period, the proceeds from the disposal will be subject to capital gains tax. Further, dividends paid to taxpayers by the venture capital company remain subject to dividends withholdings tax.

The Act also requires certain conditions to be met by investee companies in which s12J approved venture capital companies may invest. These conditions include:

  • the company must be a resident and its tax affairs must be in order;
  • the company must not be a “controlled group company”. An investee company will be a “controlled group company” if it has a shareholder (being a company) that holds, directly or indirectly, at least 70% of the shares in that investee company;
  • the company must be unlisted or a junior mining company (that may be listed on the Altx of the JSE Limited);
  • during a year of assessment, the sum of the “investment income” derived by the company must not exceed 20% of its gross income for that year of assessment; and
  • the company may not carry on an impermissible trade; this includes trades carried on in respect of immovable property (other than as a hotel keeper, including bed and breakfast establishments and student accommodation), financial or advisory services, trading as a bank, long term or short-term insurer, gambling and activities relating to alcohol, tobacco products or ammunition.

There is a statutory sunset period which ends on 30 June 2021. Accordingly, the income tax relief under s12J only applies to shares in venture capital companies acquired on or before 30 June 2021.

Developments 
As mentioned above, s12J only recently gained traction. What has changed? Two major catalysts for increased investment in the s12J asset class were: (i) previously, the maximum book value of a business that a venture capital company could invest in was R20m. In 2014, this threshold was increased to R50m (generally, at R20m, fund managers were not interested as the investment was too small); and (ii) from an investor perspective, the tax deduction was initially only a temporary deferment, but in 2014 the income tax deduction was made permanent when the investment was held for more than 5 years.

Anti-avoidance 
Naturally, one should deploy capital into businesses in the economy within the spirit and intention of the Act. To ensure that this is done, s12J includes several anti-avoidance provisions. These provisions are listed below:

  1. An investor in an approved venture capital company may not be a “connected person” in respect of that venture capital company. This basically means that (i) a natural person cannot own, directly or indirectly, 20% or more of the equity shares or voting rights in the venture capital company and (ii) a company cannot own, directly or indirectly, more than 50% of the equity shares or voting rights in the venture capital company;
  2. At least 80% of the capital raised through the issue of shares by the venture capital company, must be utilised to acquire qualifying shares in qualifying companies. Further, the book value of the assets of such qualifying companies may not exceed (i) R500m, where the qualifying company is a junior mining company; or (ii) R50m, for other qualifying companies;
  3. The investment into a single qualifying company may not exceed 20% of the capital raised by the venture capital company;
  4. As mentioned above, the qualifying company may not be a “controlled group company”, which means that a venture capital company may not own 70% or more of the equity shares in the qualifying company; and
  5. As mentioned above, the venture capital company must be registered in terms of the FAIS Act, which means that such a venture capital company must have a “key individual” in its employment and the FSB must issue it with a certificate.

The determination of whether an investor is a “connected person” (see paragraph i above), whether the venture capital company invested 80% of the capital raised in qualifying companies (see paragraph ii above), whether the book value of such qualifying companies exceeds the maximum size and whether investment into a single company exceeds 20% of capital raised (see paragraph iii above), is delayed until the end of the year of assessment, after the expiry of 36 months from the date of the first venture capital company share issuance, and then determined each year thereafter.

The implications of being a “connected person” are that if, at the relevant time of determination, an investor is a “connected person” in relation to the venture capital company: (i) no income tax deduction will be allowed in respect of the subscription amount; (ii) the Commissioner of SARS must, after due notice to the venture capital company, withdraw the s12J approval of that company retrospectively; and (iii) an amount equal to 125% of the expenditure incurred by an investor for the subscription of the company’s shares must be included in the income of the venture capital company in the year of assessment in which the approval is withdrawn, if corrective steps, acceptable to the Commissioner for SARS, are not taken by the company within a period stated in the notice given by the Commissioner.

With respect to whether the venture capital company invested at least 80% of the capital raised, invested in companies exceeding the maximum book value threshold and whether investment into a single company exceeds 20%, only points (ii) and (iii) above apply.

Challenges
There are still some barriers to entry and issues which prohibit up-take in the industry, as illustrated below.

Regarding points ii and iii above, venture capital companies’ scope of investment is often limited when a suitable qualifying company is identified, as they cannot invest more than 20% of capital raised into the qualifying company. This results in companies often missing out on more funding, having to negotiate and engage with more parties, or not getting any funding at all. Furthermore, the test to determine whether the venture capital company deployed 80% of the capital raised in qualifying companies, as mentioned above, is performed three years after the first venture capital company share was issued, not three years after the date of issuance of each particular share. The impact of this is that s12J fund managers cannot conduct multiple fund raises into the same vehicle and therefore need to create new s12J compliant venture capital companies for each year’s funds raised.

Even when there are arm’s length transactions, venture capital companies will typically only invest in investee companies if they are able to exploit s12J. The “controlled group company” test may prevent arm’s length investments into a qualifying company, as the s12J venture capital vehicle cannot own more than 70% of a qualifying company’s equity shares. Further, s12J is silent as to when the “controlled group company” test must be applied, which results in difficulties for venture capital companies.

The “connected person” test also poses practical difficulties for venture capital companies as they regularly need to monitor increased investments to ensure that a single investor does not own 20% or more of the company. The retrospective withdrawal of a venture capital company’s status with reference to the “connected person” test is also concerning to managers.

Venture capital companies are often unable to invest in small businesses structured with various operating entities in the same group, as they may fall foul of the “investment income” test. For example, where an operating company within a group receives distributions from its subsidiary operating company which exceeds the “investment income” threshold (i.e. 20% of its gross income), then the first mentioned operating company will not be a “qualifying company” and, accordingly, a venture capital company may not invest in such a company.

The liquidity of the investment is also a major concern for investors. It is important that the venture capital company has a clear exit strategy and path to liquidity. One can only grow with sufficient capital so, if the 20% ceiling is reached, another investment will have to be found.

The sunset period expires on 30 June 2021; this is the date when the National Treasury decides whether or not to extend the legislation. This may discourage more managers from joining the market as there is some uncertainty with respect to the future of this asset class. This, however, does not prejudice existing investors.

Although a taxpayer can claim an income tax deduction of the subscription price paid for its venture capital company shares, the proceeds from the disposal thereof will be subject to capital gains tax with a base cost of zero allocated to the shares. Accordingly, there is no base cost in the shares to safeguard the subsequent proceeds from such disposal from capital gains tax in the hands of the disposing investor. To make a s12J investment more attractive, exempting the disposal of the shares from capital gains tax would be welcomed.

There are various provisions of s12J which require clarification by SARS; the need for an interpretation note on the legislation has thus been emphasised. By way of illustration, a company trading as a bank and a “financial services provider” is classified as “impermissible trades” under s12J. This seems unambiguous but results in uncertainty with venture capital companies which invest in tech start-ups providing information technology services linked to the financial services sector, such as online payment facilitators.

Conclusion 
Section 12J started out slowly and has lately seen significant up-take as a result of recent amendments.

Despite the favourable changes in 2014, it is clear from the above that there are still some administrative and legislative issues preventing further investment into this asset class. The National Treasury has illustrated in the 2018 budget that it is committed to making capital more accessible to small and medium-sized businesses.

On 16 July 2018, the National Treasury, in terms of the draft Taxation Laws Amendment Bill, proposed further amendments to s12J. These amendments include rules relating to the qualifying company test and when the controlled group company test needs to be applied. Some contentious proposed changes are the restriction on venture capital companies and qualifying companies to only have a single class of shares and the requirement that qualifying companies should get most of their income from transactions with persons who are not shareholders (direct or indirect) of the qualifying company and who are not connected persons to such shareholders.

Some proposed amendments are encouraging while others, such as the limitation on the classes of shares, will be of concern to approved venture capital structures. We will have to wait and see to what extent approved venture capital companies and the s12J industry take exception to these amendments and make submission to the National Treasury regarding their concerns, and whether the amendments, which are proposed to take effect on 1 January 2019, will result in s12J achieving its objective to stimulate the South African economy.[/vc_column_text][/vc_column][vc_column width=”1/12″][/vc_column][/vc_row]