Venture capital tax break: Here’s how property investors killed the golden goose – SA tax expert

South Africans have been vocal about the abuse of taxpayers’ funds in the hands of politicians, with former president Jacob Zuma and his pals helping themselves to money through elaborate business deals. Helping the villains has been the accounting fraternity, with the executives of KPMG growing wealth for themselves and the KPMG empire by leeching on the system. Elsewhere in the economy, clever accountants have been at work showing investors how to take advantage of tax perks designed to boost small business development and, in turn, nurture job creation to, instead, buy property. They haven’t done anything illegal, but their actions explain why the government has had a re-think on a clause that had the intent of increasing the number of start-ups, but instead has helped property investors build portfolios. Chartered Accountant Sinesipho Maninjwa dissects the numbers to highlight a tax game that is hindering employment growth. – Jackie Cameron

Section 12J – Is the Honeymoon over?

By Sinesipho Maninjwa*

Synopsis

Reflecting on the last Tax Indaba (held last week of August), a key focus on the seminar was the future of Section 12J Venture Capital deduction, which has a sunset clause that takes effect on 30 June 2021. There was an intense amount of lobbying to extend the deduction notwithstanding the industry’s adjusting to a new amendment that came into effect on 21 July 2019. The amendment states that in the upcoming tax year, tax-deductible investments in approved companies, who in turn make investments in start-ups would be limited to R2,5 million. To register its lament the industry formed an association to contend with tax authorities over the amendment’s dampening effect on the capital allocation thus desirability to fund venture capital activity.

Background and context

In 2009, the South African Revenue Service (SARS) introduced Section 12J into the Income Tax Act. The provisions of the act enabled individuals and/or companies to write off investments into new ventures. The write off includes expenses incurred in exchange for issue of shares from a qualifying venture capital company not carrying on an impermissible trade in the year of assessment. More simply, an investor can write off against their taxable income the value of the shares bought from a registered venture capital company. The Venture Capital Company (VCC) operates as a Small, Medium, or Micro enterprise (SMME) funds that invests in new ventures.

The overarching purpose of the legislation is to incentivise private capital to invest in the creation and the development of new ventures in the country and resolve the following issues,

  • Funding Gap: In terms of the report issued by the Banking Association of South Africa, there is a funding gap of between R86bn and R356bn for SMMEs.
  • Unemployment: The recently released Statistics South Africa show the 2019 official unemployment rate has increased to 29% in Q2 (a QoQ rise of 1.4% from 27.6% in Q1).
  • Gross Domestic Product: The latest GDP figure, released on 3 September 2019 shows that the economy grew by 3.1 % (in comparison to a 3% contraction in Q1). This was largely driven by the mining and manufacturing sectors and more specifically due to higher resource prices and stable electricity supply.

The requirements for qualifying investee company were structured to be pretty flexible and to allow for venture capital investment across industries except sector that attract sin taxes and financial services, in general for qualifying assets not to exceed R50m (R500m for Junior Miners).

How has Section 12J performed?

The legislation has been in effect for just over 10 years. Since the regime was introduced in 2009, 165 funds registered albeit only 120 are currently active. Assets under management currently total at an impressive R6.7bn. Again, the regime prescribes that investors can claim the full amount used to acquire shares in the s12J company as a deduction from taxable income in the year of that investment. Therefore at face value the recently promulgated amendment to cap the deductible amount on may look to have an adverse effect on the industry thus seeming counter intuitive to the regime’s spurring greater capital allocation towards SMMEs.

Table 1: Section 12J – Asset Allocation

Sector Capital Allocation Risk profile Rating
Property 58% Low
Asset Rental/ Renewable Energy 20% Medium
Private Equity 18% High
New Venture Capital 4% High

*Source: Jonty Sacks s12J – Jaltech (2019)

Although a significant amount of capital has been raised, the unintended consequence of flexible requirements was an under-allocation in new ventures, tabled at 4% above. The tax authorities had sought to prioritise new ventures with this regime yet instead the property sector benefitted most from the tax allowance. Furthermore, the asset allocation spread shows that the s12J companies which enjoyed the taxation value uplift were drawn from traditional safer asset classes. Thus despite government’s efforts to introduce incentives towards riskier new assets, the regime was applied more as a tax avoidance measure by taxpayers enjoying excessive tax deductions. Also, according to the National Treasury, the four year average expenditure incurred by a new VCC shareholders to obtain VCC shares ranged between R1.3m and R2.1m per annum. This stat justifies the cap set at R2.5m and belies the S12J community’s contention with the amendment.

Conclusion: The way forward for Section 12J

Section 12J has forged a new community of investors however has fallen short on directing capital towards new ventures. In terms of basic Investor logic, what should incentivise anyone to invest in any asset class is the belief that the returns are of a significant enough value to warrant the outflow of cash with post regard to the tax dispensation. The drive should always be about the possibility of good returns, amplified by a conducive tax regime. Before the sunsets clause on June 2021, the hope is the amendment will cause the reform towards greater new venture investment. The downer seems to be that the tax deduction preoccupied the growth in s12J community and informs the lobbying rigour to extend the regimes. If that were to happen it would be prudent for government to be more stringent in balancing new venture development with enough tax incentives and BBBEE imperatives. The industry features very few Black people or even Women – an overhang of or congruent with the general demographics of the SA financial services sector.

  • Sinesipho Maninjwa CA(SA)