If you’re financially savvy, you’re not only investing for the long term, but you’re also making the most of the government’s tax breaks while doing so. As you no doubt know, you can claim a deduction on contributions to retirement funds of up to 27.5 percent (capped at R350 000 a year) of your income. And you can save on tax on interest income, dividends tax and capital gains tax (CGT) by investing in a tax-free savings account.
But there’s another type of investment that allows you to reduce your tax bill – and, in this case, the deduction you can claim is the full amount you invest, regardless of how much it is. Section 12J investments, as they are known, are becoming popular among high-net-worth investors who want to pay less tax and earn a reasonable return.
Section 12J was introduced into the Income Tax Act in July 2009 to provide individuals, companies and trusts with a tax incentive to invest in venture capital companies (VCCs), which fund small and medium-sized enterprises that are believed to have long-term growth potential in economic sectors that are often hard-pressed for financing. The aim was to encourage investors to participate in the capitalisation of these businesses, which will stimulate economic growth and create jobs.
Section 12J flew under the radar of most investors until 2014, when amendments made the tax deduction permanent if the investor holds the shares issued by a VCC for at least five years.
Realistically, most people cannot make use of this tax break, because VCCs require a minimum investment of at least R100 000 – more often R500 000. Therefore, the likely investor is someone in the top marginal tax bracket of 45 percent (a taxable income of R1.5 million or more a year) who wants to reduce his or her taxable income after making full use of his or her retirement fund and tax-free savings account deductions.
Investors must also be in a position to tie up their money for at least five years. If they sell their shares before then, they have to pay back the deduction.
Although the tax deduction makes for a compelling investment case, you should never invest in a product because of the tax benefits alone. “The tax benefit should be the bonus, not the main reason for investing,” says Wouter Fourie, the managing director of Ascor Independent Wealth Managers and the 2015/16 Financial Planner of the Year.
Malcolm Segal, the non-executive chairperson of Grovest, a VCC, agrees: “The underlying investments must work; section 12J should not just be about the tax sweetener.”
A closer look at the tax break
You benefit from the full tax deduction upfront in the tax year in which you make the investment. However, the tax break applies to your upfront investment only. You will pay dividend withholding tax if any dividends are paid out to you and you will be liable for CGT on the capital gains realised when you sell your shares in a VCC.
Note that, because you receive a 100-percent deduction when you buy the VCC shares, the base cost of your shares will be nil. The base cost of an asset provides investors with a “tax shield” that reduces the amount of the capital gain that is subject to tax, but this shield does not apply with a section 12J investment. If you’re on the top marginal rate of 45 percent, you will pay CGT at an effective rate of 18 percent on your capital gain if you sell your shares after five years. This is something you need to bear in mind when assessing the targeted return on offer.
The upfront tax deduction has some qualifications:
You cannot claim the tax deduction if you are a “connected person” when, or immediately after, you buy shares in the VCC. In the case of a natural person, this means you cannot own more than 20 percent of the shares in a VCC. Note that VCC shares bought by your relatives, within the third degree of consanguinity, are taken into account when determining whether or not you are a “connected person”, as are shares bought by someone related to your spouse, within the third degree of consanguinity.
If you take out a loan to buy shares in a VCC, the deduction is limited to the amount you actually transfer to the VCC, not the total loan amount. For example, if a bank lends you R1m to buy shares in a VCC, but you invest only R500 000, the deduction is limited to R500 000. Furthermore, if you use gearing, the legislation requires that you are genuinely at risk for the investment. This means you cannot use only your VCC shares as security for the loan, but must put up some form of personal surety. You will also not be regarded as at risk if the loan does not have to be repaid within five years.
As the legislation currently stands, the tax concession will end on June 30, 2021. In other words, you will be entitled to the upfront tax relief as long as you invest in a section 12J VCC before or on that date.
Venture capital companies
Section 12J has spawned a flourishing VCC sector. Segal estimates that there were more than 100 section 12J VCCs registered in February this year, compared with 70 at the end of September 2017. However, many of the registered companies are dormant.
Segal says VCCs had assets under management of about R3.8 billion in February this year, which is a big jump from the R1.8bn in February last year.
The gamut of VCCs ranges from small operations – basically “investment clubs” – to large asset management companies. Some of the big players are Westbrooke Alternative Asset Management, which manages about half of all section 12J investments in South Africa, Anuva Investments, Fairtree Capital and Grovest.
A section 12J-compliant VCC brings together investors and companies that qualify to be capitalised in terms of section 12J (see below). The VCC will issue shares and provide investors with share certificates and a tax certificate, which entitles them to claim a tax deduction on the expenditure incurred to acquire these shares. The VCC will, in turn, invest in qualifying companies, which will issue shares to the VCC.
VCCs are subject to strict regulation, to protect investors. They must have a Category Two licence with the Financial Services Board (FSB) and be registered with the South African Revenue Service (Sars). This means they are recognised by the FSB as being competent to make discretionary investment decisions. VCCs are required to keep records of all their investors and the entities in which they invest, and they must submit these records to Sars twice a year.
Although it is not mandatory, it is advisable that you deal only with VCCs that belong to the South African Venture Capital and Private Equity Association.
The legislation prescribes how VCCs must invest, namely:
- Three years from the date on which a VCC first issues shares, at least 80 percent of the VCC’s expenditure must be used to acquire shares in qualifying companies whose book value immediately after the investment is less than R50m, or R500m in the case of junior mining companies;
- A VCC cannot invest more than 20 percent of the funds it raises from investors in a single company;
- A VCC cannot acquire more than 69.9 percent of the shares in a qualifying company; and
- A VCC’s investment into qualifying companies must be of a pure equity nature.
Fourie says you should be able to answer the following questions before you commit your money:
- Have you done a thorough due diligence on the VCC’s management? Look at their qualifications and track record.
- Does the VCC have compliance systems in place? Find out whether the company is subject to an external audit, and who its legal and tax advisers are. Does the company have a third-party compliance officer?
- Does the investment team have experience and a proven track record in the area of private equity or unlisted investments?
- What type of businesses does the VCC invest in?
- How does the VCC select qualifying companies, and what due diligence does it undertake to assess the risk associated with these companies?
- Does the VCC have a convincing and properly articulated investment philosophy?
- Does the VCC have a disciplined, methodical and repeatable investment process?
- What are the VCC’s risk-management policies, and are they adequate?
- How are the asset managers remunerated – is it fair and aligned with the investors’ objectives?
- Do the asset managers have “skin in the game” – do they believe enough in what they are selling that they are willing to invest their own money?
VCCs use the money raised from investors to finance small and medium-sized businesses that have long-term growth potential. Businesses must meet certain criteria to qualify for section 12J financing:
The business must be a company.
It must be resident in South Africa.
It cannot be a controlled company in relation to a group of companies.
The company’s tax affairs must be in order with Sars. (Note that no special tax rules apply to qualifying companies.)
In any tax year, the total investment income derived by the company cannot exceed 20 percent of its gross income.
The company must be unlisted, except if it is a junior miner, which can be listed on Alt-X.
A qualifying company cannot be engaged in any of the following activities:
- Trade carried on in respect of immovable property, except the hospitality sector (including bed-and-breakfast establishments);
- Financial services, such as banking, long and short-term insurance, money lending and hire-purchase funding;
- Advisory services, including legal services, stock-broking, management consulting services, and tax advisory services, or auditing or accounting services;
- Gambling and casinos;
- The manufacturing, buying or selling of liquor, tobacco, firearms or ammunition; and
- Trade that is carried on mainly outside South Africa.
Excluding the activities listed above, qualifying companies operate in all sectors of the economy. VCCs tend to favour companies that, by capitalising on socio-economic and technological trends in South Africa, have the potential to generate significant returns in future. Therefore, it is common to find section 12J VCCs investing in companies seeking to take advantage of the “green economy”, digital technology, student accommodation, franchising and tourism.
You receive an immediate “return” of 45 percent (in the case of an individual on the top marginal rate, or a trust) or 28 percent (in the case of a company) on the money you invest, but this is thanks to the built-in tax deduction. What you really want to know is the return you could earn on your net investment, bearing in mind that you could tie up your money for five years in another asset class, probably with lower risk than a section 12J investment.
When a VCC quotes returns, you must clarify whether these are net of fees and tax, and include or exclude the tax deduction.
Fourie says that, when evaluating the returns on offer, the adage that applies to any other investment holds true: if it sounds too good to be true, it probably is.
As a guideline, he says, your starting point should be a return of inflation plus five percent after costs, excluding the benefit of the tax deduction. “This would be a very realistic target and achievable if you invested in a listed company. Higher returns will compensate you for the extra risk associated with investing in a VCC, and can be evaluated only by understanding the business in which you are investing.”
Three examples of the returns on offer:
- Anuva, which has been operating since 2015. Its internal rate of return (IRR), excluding the tax break and net of costs, was 26 percent at the end of February 2017. In other words, R1m invested in February 2015 would have grown to R1.594m in February last year. In terms of dividends, in 2016 the yield (net of costs) was 26 percent; in 2017, eight percent; and in the year to February 2018, eight percent.
- METTA Capital launched its Moderate Risk Fund earlier this year. This fund of funds consists of eight section 12J investments. The fund targets a net IRR of 16 percent, while the average dividend yield (net of costs) is five to eight percent a year.
- Westbrooke, which launched its first section 12J fund in 2016, targets an IRR of 16 to 18 percent after fees and taxes. The dividend yield depends on the underlying investment. Westbrooke ARIA, a portfolio of asset-backed rental businesses, targets an average annual yield of six percent based on the gross investment. Its STAC investment strategy, a portfolio of student accommodation operators, targets an annual average yield of five to six percent.
Note: A VCC’s IRR is the compounded rate of return on the investments, based on the investor’s risk capital and paid dividends.
Fees associated with a section 12J investment can include:
A once-off upfront, or capital-raising, fee. Anuva, for example, charges an upfront fee of two percent and METTA charges 1.6 percent. Westbrooke does not charge an upfront fee.
An annual fee. Anuva charges two percent; METTA charges 1.86 percent, plus a platform fee of 0.5 percent a year; Westbrooke charges two percent.
A performance fee. Anuva charges 20 percent of the dividends declared; METTA charges an average of 20 percent of the dividends declared; Westbrooke charges 20 percent of any amount returned to the investor above the net capital invested (that is, gross investment less the tax deduction) plus a performance hurdle (which is the 12-month JIBAR for the ARIA portfolio and the Consumer Price Index for the STAC strategy).
An exit fee. None of the abovementioned companies charges this fee.
What happens after five years?
What happens if you want to sell your shares once the five years are up? Qualifying companies are often illiquid, private equity-style investments, and, unlike with listed equity investments, there is no ready-made secondary market for VCC shares. Note, too, that buyers of second-hand VCC shares do not qualify for the tax break.
You need to establish whether the VCC has an exit mechanism or a strategy to create liquidity at the end of the five-year period. The VCC’s investment offer should include a commitment to realise the underlying investments after five years and return your original capital within a certain period.
The realisation strategies could include:
- Listing the qualifying company on the Alt-X;
- In the case of a property portfolio, converting it to real estate investment trust and listing it;
- Disposing of the qualifying company; and/or
- Disposing of the qualifying company’s assets.
Mitigating the risks
Fourie says potential investors should be knowledgeable enough to understand the potential rewards and risk of a VCC’s underlying investments. Venture capital, by definition, is capital invested in projects in which there is a substantial element of risk.
He says you should seek input from an independent financial adviser who can advise you on whether a particular section 12J investment is suitable for your investment portfolio.
Westbrooke says there can be significant differences in the nature of the underlying investments of the various VCCs, as well as the strategies that their investment managers employ. “You should therefore invest in a section 12J company that has a clearly defined investment risk strategy and approach that supports your risk appetite relative to the investment return profile.”
Investors seeking a lower-risk profile should invest in VCCs whose investment strategies are focused on capital preservation. “These strategies can, for example, include asset-backed investments and investments with predicable revenue streams,” Westbrooke says.
Some investors may find five years a long time to wait for a return of capital. “You could opt for an investment in a VCC that aims to provide an annual or semi-annual dividend throughout the investment period. Investors should assess the VCC’s investment thesis to ensure the underlying investments generate predictable ongoing cash returns. This is to ensure that the target dividend strategy is supported,” Westbrooke says.
Fourie says Sars or the FSB can withdraw a VCC’s section 12J status if it does not comply with all the legislated requirements. If this happens, you may have to pay back the tax recoupment.
“The last thing you want is to find out that the section 12J company in which you have invested loses its section 12J status due to regulatory non-compliance,” says Westbrooke. It says you can mitigate this risk by asking the VCC whether it has applied for and obtained a positive Sars ruling for its investment strategies, what tax opinions it has obtained, who its tax advisers are, and the system it has implemented to monitor the tax-related compliance risk.
In the Budget Review published in February, National Treasury noted that there has been significant growth in section 12J investments over the past two years. It said the legislation would be amended to encourage further uptake of these investments. Although the exact nature of the amendments is not yet known, Treasury’s comments have been taken as a positive sign that the section 12J regime will be extended beyond June 2021.