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.