Treasury tweaks venture capital tax regime

File picture: Ziphozonke Lushaba

File picture: Ziphozonke Lushaba

Published Jan 23, 2017

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Pretoria - Life for venture capital

companies may become a little easier due to a proposed small, but significant,

change to the way timing of finding initial investors for their investment funds is dealt with.

Government announced the venture capital

company (VCC) regime several years ago to encourage equity funders to invest in

small businesses.

The main attraction of the regime is a full

tax deduction of the amount taxpayers invest in a VCC. The VCC will then use

the funds raised to buy shares in small companies with big potential.

However, an anti-abuse provision in the

legislation makes it hard for VCCs to find entry-level investors without breaching

the provision. 

Venture capital investments is said to

offer a 20 percent return on investments. However, it is not for the

faint-hearted or for people who need fast access to their cash.

National Treasury has acknowledged concerns

about finding initial investors to provide seed funding for the VCC without

breaching requirements in the legislation.  

The provision deals with the “connected

person test” which aims to prevent the possible recycling of funds among “connected

persons”.

A connected person includes someone who

holds more than 20 percent of the VCC shares without another majority

shareholder. A connected person will not enjoy the tax benefit.

Treasury has now proposed a change where

the connected person test will be delayed for three years after the first

shares are issued by the VCC. Only after the three-year period will it be done

at the end of every year of assessment.

“In an already challenging economic

environment, it is believed that the additional risks associated with the

application of the connected person test will prevent many VCC’s from raising

capital,” treasury explained its reason for change.

“It [the delayed test] should enable the

VCC’s to find additional start-up or angel investors, and give them more

flexibility when they issue the shares in the start-up phase of the VCC,”

treasury said.

There is currently only a handful of the approximately

40 approved companies actively raising and investing funds into small

businesses.

Several other changes to the regime,

besides the latest proposed improvement, have already been implemented to raise

investor excitement about the concept.

It includes an increase in the asset value

of the “qualifying companies” to R50 million in small businesses and R500 million

in junior mining companies.

Read also:  Changes expected for venture capital incentive

The recoupment provision - where taxpayers

had to repay the tax benefit if they did not hold on to their VCC shares – has

also been scrapped. If they hold on to it for at least five years, the tax

benefit becomes permanent.

A recent study by the Bureau for Economic

Research (done for the Small Enterprise Development Agency) shows that the number

of small and medium sized enterprises (SMEs) in South Africa increased by only

3 percent, from 2.18 million in the first quarter of 2008 to 2.25 million in the

second quarter of 2015.

This growth is significantly less than the

14 percent expansion in gross domestic product (GDP) over the same period. The

VCC regime started in 2009.

Social entrepreneur 

Guy Harris, a social entrepreneur, says the

big problem with the South African economy is the “missing middle”. It (the

economy) consists mainly of large companies with 500 or more employees with a

“sparse number” of medium businesses.

Harris is involved in an initiative to fast

track high job growth SME’s in the Kensington, Langa, Observatory and Pinelands

area of Cape Town, extending to Mowbray, Athlone and Woodstock.

He says the mind-frame in South Africa is

to find large amounts of money (funding) from a small amount of people

(investors). The country needs a small amount of money from a large amount of

people.

Harris says he has had high hopes for the

VCC tax incentive, but compliance costs and legislative restrictions make it

unattractive and costly.

Small funds become unviable – defeating the

object of finding funding. The country needs to address all the missing middles,

including access to mid-size debt and equity.

Gidon Novick, founder of Lucid Ventures, is

upbeat about the VCC regime. Lucid Ventures started in 2015 and has raised an

initial capital base of R80 million from 30 investors. It wants to raise another R40 million this year.

It has invested R25 million in four companies –

providing either seed capital to start the business, or development funding to

an existing business.

Novick, who is the founder of kulula.com,

says they have been able to raise funds “fairly seamlessly” as they could

demonstrate that they have a good investment pipeline.

“I am quite bullish about the opportunities

in South Africa. The country has a lot of entrepreneurs and the environment to

start a business is pretty good, although there are some pain-points like

opening a bank account and registering for Value Added Tax.”

There are good entrepreneurs with good and

proven concepts, but they do not have growth capital and do not have the

strategic framework to effectively grow their businesses.

He says the VCC regime has obvious

advantages such as the tax benefit (which according to him has an internal rate

of return of about 8% built in over five years) and a potential investment

return of 20% on its portfolio.

It also has disadvantages. It is not a

liquid investment and certainly not an investment for people who want to have

access to their funds in the medium term. 

“That is the nature of venture capital,” he

adds.

There is no listing requirement for VCC

shares, limiting the investor’s resell opportunities. Once an investor claims

the tax benefit on a VCC investment the base cost of the shares is reduced to

zero for the calculation of capital gains tax when the shares are sold.

Novick considers this unfair as non-VCC

venture capital investors will have a base cost equal to the cost of the share

at the time of purchase.

Emil Brincker, national head of tax at

Cliffe Dekker Hofmeyr, says the interest in the VCC regime has grown in the

past year.

“The VCC regime has an important role to

play as it focuses on more substantive entities . . . One issue that can be

considered, is to (again) increase the asset values of the qualifying companies

in which VCC’s can invest.”

The South African Institute of Tax

Professionals (SAIT) says a significant reason why VCC’s are struggling to

attract investors is because it is often “tax inefficient”.

Many of the investments in a small business

is aimed at setting up the business, helping it to stay on its feet or to grow

the business.

VCC’s normally has an “exit plan” for

investors where the shares in the small business are sold to another player in

the same industry. The proceeds are then distributed to the VCC

shareholders. 

SAIT says the venture capital company will

suffer capital gains tax of 22.4% on the disposal of the shares and the

individual investor will pay 15% dividend withholding tax on the dividends

(proceeds) distributed by the VCC.

The investor will also pay capital gains

tax of 16.4percent% if the VCC repurchase their shares or if they are able to sell it

to a third party investor within five years.

Review

Erika de Villiers, head of tax policy at

SAIT, says it recommends a “review and redesign” of the VCC regime to meet its

initial objectives.

“The multiple levels of taxation should be

addressed, possibly by exempting the VCC from capital gains tax on the disposal

of their investments in the small businesses or by introducing fiscally

transparent vehicles,” she says in a SAIT submission. Calculations by the South

African Venture Capital Association (SAVCA)

show that once the rate of return exceeds

19% per annum the tax benefit of the upfront deduction is less that the

additional tax cost of investing into the VCC.

The VCC is taxed on the capital gain of the

proceeds from selling its shares in the small business at 22.4 percent. The dividends

distributed to the investors (in the VCC) they pay the 15 percent withholding tax.

With a direct investment the individual

only pays capital gains tax on the disposal of its shares in the business (effective

16.4 percent).

The elimination of multiple levels of tax

by using a fiscally transparent vehicle should mean that from a tax perspective

the investors are neutral whether they invest directly into the underlying

ventures or through the VCC. 

“This would mitigate tax uncertainty. They could

then choose to invest through a VCC purely based on the merits,” she says.

An example of a fiscally transparent

vehicle is real estate investment trusts (REITs) which allows smaller investor

to directly participate in the higher returns generated by real estate

properties.

Keith Engel, CEO of SAIT, says REITs have a

capital gain exemption at the investment entity level which allows REITs to

sell real estate and entities mainly holding real estate free from capital

gains tax.

“The VCC needs to be able to sell VCC

controlled businesses free from capital gains tax.

“The elimination of multiple levels of tax

in the VCC regime is probably more important than the upfront deduction,” SAIT

says.

Brincker says treasury is keen to establish

a regime that can work and is willing to consider any proposals.

BUSINESS REPORT ONLINE

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