The growing venture capital market, is this for you?
Despite the promising tax incentive, investors should not blindly invest in a VCC
The Section 12J Venture Capital Company (VCC) tax incentive has been around since 2009, and has gained momentous traction after welcome changes to the law in 2016. There are now 104 approved VCCs, and a list can be obtained from the Sars website here.
Details of the incentive are also set out on the Sars website, while the investment opportunities and the tax benefits have also been fully covered in the press and in the VCC marketing companies’ websites. This programme is not only anticipated to provide qualifying companies with access to equity finance, but it also allows smaller investors entry into exciting new industries such as SA's renewable energy sector.
The 12J tax incentive is designed to give smaller investors entry into new industries such as SA's renewable energy sector.
The facts until you have seen it
To briefly recap: South African investors will be granted an immediate tax deduction of 100% of an equity share investment in the VCC. An equity share excludes fixed rate shares (for example preference shares and debt instruments). The investors may be individuals, trusts, or corporate entities. Individuals can also make an investment in a VCC through an intermediate passive investment holding company.
The objective of the tax incentive is also to encourage investment in high risk sectors, SME's and junior mining companies.
Visit some lions
The VCC, which must be registered with Sars and the Financial Services Board (FSB), is a special vehicle that has been created for the purpose of channelling these investments into a diverse portfolio consisting of different qualifying companies in different industries. The VCC is responsible for attracting retail investors, managing the funds on their behalf, and responsibly investing the funds in qualifying companies.
The objective of the tax incentive is to encourage investment in a high-risk sector, small and medium entities (SMEs) and junior mining companies (qualifying companies). Not all SMEs qualify for the incentive investment, such as fixed property rental businesses (other than hotel keeping), and those providing financial and professional services.
The tax benefit achieved, which constitutes a permanent deduction, will depend on the effective tax rate of the investor. However, if the investment is sold within five years a recoupment will be triggered. The VCC can invest R50 million in qualifying small businesses and R300 million in junior mining companies.
Despite the promising tax incentive, investors should not blindly invest in a VCC, and should take into consideration and understand the following:
The objective of the tax incentive is to encourage investment in high risk sectors, small and medium entities (SMEs) and junior mining companies.
● Don’t be misled by the marketing hype promising a high-quality investment with minimal risk. Choose the VCC carefully, and have knowledge of the industries that the VCC invests in. There are risks attached to any investment.
● The benefit achieved will be dependent on the effective tax rate (companies) and marginal tax rate (individuals). Don’t be misled by calculations using a marginal tax rate of 45%, this may not be your marginal tax rate.
● Be informed of the management fees charged by the VCC, and be aware of any hidden fees.
● If Sars withdraws the VCC's status, this will result in 125% of the expenditure incurred by investors to acquire the shares being deemed revenue, and taxable. Further, any withdrawal of an investment in a VCC in the first five years will trigger a recoupment.
● Only reputable VCCs should be transacted with. In these tricky times of captured companies, unreliable auditors, and rogue directors, I do not have any fool-proof suggestions in this regard. But take heed – caveat emptor (let the buyer beware).
Investors should not blindly invest in a VCC. If Sars withdraws the VCC's status it could have negative tax consequences.
● Inquire about the VCC’s exit strategy, and whether there will be a market for disposing of the equity shares in the VCC after the minimum period of five years.
● What return is expected from the VCC, and how will the VCC fund this return? The VCC may receive dividends from its investments, or it may sell the shares it holds in the qualifying companies. However, shares in unlisted companies are illiquid, and there may not be any investors willing to purchase a minority interest in an unlisted investment. Further, the qualifying companies may not be in a position to pay dividends, or may decide to reinvest any additional income in the business.
● Investors who purchase “second-hand” VCC shares will not qualify for the upfront deduction. The VCC will have to buy the shares back from the original investor, and issue new shares to the next investor.
● Be fully aware that this incentive scheme comes to an end on June 30 2021, however, if you have invested in a good product, you should still be earning a return.
● When the shares are sold after five or more years, Capital Gains Tax (CGT) on the full amount of the initial investment will be payable. In other words, the CGT base cost is nil.
● If an investor makes a capital loss on selling the equity share investment in the VCC, this loss may not be deducted from taxable income.
● The tax consequences and risks of investing in the VCC should be compared with that of investing in a share portfolio, as well as other investment products, taking into account the investor’s tax profile. Where the initial tax deduction arising from investment in the VCC results in a tax refund to be paid, consider the cost (time value of money) of the delay in receiving this tax refund. Any undue delay will negatively impact the investment return.
● An unintended consequence of this incentive could result in a saturation of investments in certain sectors. This will ultimately dampen the profitability of that sector, and the returns that the investor has anticipated. In other words, don’t invest in a sector that is becoming oversaturated.
Be very circumspect when it comes to VCC investments, and choose wisely.
Finally, the fact that a VCC is registered with Sars, does not mean that it will run a successful business, and will choose profitable investments. The VCC should ideally be registered with an industry body like The Southern African Venture Capital and Private Equity Association (Savca). However, a VCC is not mandated to not report into any regulatory body that will ensure that it adheres to certain standards.
What is of concern, is that in promising high returns, the VCC may very well resort to funding these returns with the funds derived from new investors. Many a Ponzi scheme has started in this fashion. Be very circumspect, and choose wisely.