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By Patrick Cairns. Source: MoneyWeb

In the current market environment, alternative investments are attracting a lot of attention. Where returns are low and uncertainty is high, investors are eager to find uncorrelated sources of risk and return.

In South Africa, an option that is seeing promising growth is venture capital companies that operate under Section 12J of the Income Tax Act. Not only do they offer the potential of attractive returns, but under Section 12J the entire amount invested in these vehicles is deductible from the investor’s taxable income in the year that it is made, and it will remain tax free as long as it is held for five years.

This enabling legislation, which was brought into effect in 2014, has encouraged rapid growth in this market.

“The number of Section 12J registered companies is steadily growing,” says Malcolm Segal of Grovest. “A whole cluster registered earlier this month and I would imagine that by February 28 there will be close to 50 if not more than 50 registered with the Financial Services Board.”

Due to the tax benefits of these investments, Section 12J companies generally raise funds towards the end of the tax year. And with a growing number of options available, investors looking at these vehicles need to consider what might best suit their requirements.

“What is exciting is that we are seeing different theses and different appetites emerging,” says Richard Asherson of Westbrooke Capital. “There are now players in sectors including hospitality, agriculture, mining, general growth capital and technology.”

For investors, these different exposures will translate into different kinds of performance.

“While they are all venture capital companies, their risk profiles can be very different,” says Segal. “For example the risk-reward profile of our alternative energy fund is significantly different to that of our disruptive technology fund.”

Further improvements

While the benefits of these vehicles is already attractive, Asherson says that the industry is engaging with the South African Revenue Service and National Treasury around ways that the legislation could be improved even further. The first thing he believes would make a significant difference is if it removed the double taxation that exists on investors when changes are made within a fund.

“Currently if we sell any of the underlying portfolio companies there will be capital gains tax on those transactions, and when we distribute the profits to investors there will either be dividends withholding tax or capital gains tax again,” he explains. “If you look at a unit trust structure, however, there is no capital gains tax paid within the portfolio. If that could be addressed it would make a material difference to investor returns and their appetite to invest.”

The second change he would like to see is the opportunity to contribute to a Section 12J company as a

payroll deduction, as is the case with retirement funding vehicles. This would allow salaried investors a greater opportunity to use these funds.

“For a PAYE employee, tax is deducted from their salary and they get the net amount paid to them every month,” Asherson says. “For that person to invest in a Section 12J company they would need to have surplus liquidity and essentially get a refund on that tax. Whereas an individual paying provisional tax would have more liquidity at their disposal to invest and is therefore more able to do so.”

Investor approach

“When we talk to potential investors we are very specific in our recommendations,” says Segal. “We emphasise that you have to have visibility on a five-year lock up, otherwise this investment doesn’t achieve what it is intended to achieve. Secondly, the amount you invest should not exceed your taxable income in any tax year. And finally the amount you invest should not be more than 5% to 7% of your total assets.”

Keeping those guidelines in mind, investors should consider how a Section 12J investment could benefit their portfolios.

“Where it really works well is for investors with an established portfolio looking for a niche investment where they are getting some tax benefits but more importantly an investment that is uncorrelated to traditional equity and listed property markets,” says Asherson. “They can see a Section 12J investment as a portion of their portfolio in the alternative space.”