The Venture Capital Company Regime in South Africa under section 12 J The Venture Capital Company Regime in South Africa under section 12 J | A News and Media article brought to you by Lyra-Consulting

Introduction

Section 12 J of the Income Tax Act (“ITA”) has got the attention of many people in the Venture Capital, Private Equity and a number of other industries including renewable energy, technology, engineering, procurement, construction, hospitality and even mining. For investors, this sector is now far more developed and offers a range of alternative investment options with a significant tax advantage. Section 12 J provides a tax incentive aimed to encourage private sector investors who might normally invest in traditional investments such as listed equities to invest into smaller businesses, specifically venture capital companies (“VCCs”).

The wide range of investment options available from various industries, some more high risk at start-up stage and others more private equity, has definitely enlivened the tax season for private investors looking for alternative investment opportunities. Some are private investment clubs while others are managed by asset managers.


12J Industry

The development of 12J has provided a much-needed boost in certain targeted industries. For example, in the junior mining industry the maximum investment amount that can be made by the section 12 VCC is ZAR 500M but s 12J will not limit investments made by large mining companies into junior mining companies. The technology industry has garnered much more support from private investors through VCCs. Plant, equipment and machinery leasing and car rental companies require significant capital outlay to purchase assets and can benefit from section 12 J to expand their businesses and investments in the hotel industry may benefit tourism as a whole.

12 J was originally introduced in 2009 but after amendments in 2014 made it a more attractive provision. It is currently estimated that the assets in the 12 J venture capital industry is worth approximately ZAR 2.5 billion- ZAR3 billion. It is hoped that the s12J’s application will be extended from the current sunset date of 30th of June 2021 as its main purpose is to invigorate the economy and job creation.

This section is of course developed under the income Tax Act rather than Financial Services legislation and from the perspective of the operator of a VCC, has rigid tax requirements and, as mentioned earlier, a sunset clause. Some areas of the section require further clarification and development.

The VCC must be registered with the Financial services Conduct authority (“FSCA”) and must have a venture capital company license from the South African Revenue Services. There are numerous benefits discussed for investors however, the administrative burden and some of the restrictions (particularly the gross asset value limitation) can make it rather unwieldy structure and not suitable to certain Private Equity/ Venture Capital or other investment managers.


Investors in VCCs

Section 12 J allows investors to deduct up to 100% of their investment into a section 12 J approved VCC from their taxable income in the year in which the investment is made. There is no cap on the amount of funds an investor may invest and the investment could thus be paid in line with the Investor’s income for a particular tax year so long as 12J is applicable. The investor must stay invested in the VCC for five years, failing which, the tax deduction is recouped. The tax incentive is designed to reduce the risk of investment into a more risky asset class. The benefit of structuring an investment using a section 12 J is that it significantly increases the return of investment since it effectively translates into a discount through a tax duction of between 28% (in the case of the company) and 45% (in the case of individual) on the investments. At present capital gains tax is payable upon the sale of the VCC shares.

The minimum investment of 5 years to obtain the full tax benefit may be an issue for some investors but private equity investments’ terms are generally 5 years or more and the idea is to forgo the liquidity in favour of increased returns.

A review of some of the current VCC investments available has demonstrated the wide variety of investment options available and interesting fees/cost structures depending on the asset class. Some VCC’s have minimum investments at ZAR150,000 while other are at ZAR3M and other VCCs are private investment vehicles. Some VCCs employ the standard private equity fees of 2% and 20% of profits and others in industries such as property charge 1.5% annually. The fees are generally industry dependant.


12 J Requirements

It is not a requirement to be registered with the South African Venture Capital Association, but many VCC managers are advocating it and also recommending the IPEV (International Private Equity Valuation) or South African Venture Capital Valuation (“SAVCA”) guidelines although this would not be suitable in certain industries like property. Regulation of 12 J through SAVCA is being recommended to ensure the industry is well managed (and to protect its future).

International Venture Capital and Private Equity managers may be somewhat surprised by the very stringent requirements set out in 12J for example:


The VCC:

  • a minimum of 80% of the expenditure incurred by a VCC to acquire assets has to be for qualifying shares
  • the gross assets value of the target company may not exceed ZAR50 million book value or ZAR500 million book value in the case of a junior mining company
  • may not acquire shares in an investee company which exceeds 20% of its income from investments
  • must invest into five qualifying ventures with in its first three years of issuing venture capital shares

The Investee company:

  • must be a South African company
  • must carry on the majority of its activity within the borders of South Africa (which might immediately exclude certain industries but perhaps the matter of job creation in South Africa is a key point to consider)
  • cannot be a controlled group company in relation to a group of companies. No VCC may own 70% or more of the investees company’s shares
  • tax affairs must be in order

There is also a list of impermissible trading activities for the Investee company:

  • trades carried out mainly (around 80%) outside of South Africa
  • any trade carried on in respect of immovable property other than a trade carried on as a hotel, bed and breakfast or student accommodation (to create service jobs)
  • any financial services which includes banking, insurance, money lending and hire purchase agreements. (This means that certain industries might be excluded in the event that a product is deemed to be primarily banking or insurance even though it developed out of another industry, so it would be best to take advice in this area and consider businesses operations carefully to insure there are no underlying business activities causing the trade to be impermissible.)
  • financial and advisory services which includes legal, tax accounts, audits, management consulting and stockbroking
  • gambling, liquor, tobacco arms or ammunition. (This subsection is also problematic when one considers hotels would normally also provide have a liquor license.)

As with most Private Equity and Venture Capital companies the investee company may not be listed however Junior mining companies may be listed on the alternative exchange of the JSC.

12J provides for penalties if the VCC does not take appropriate corrective steps to rectify with any issue within the specified by written notice from the SARS and the venture capital status could be withdrawn. This would negatively affect the investors in such a VCC scheme as an amount equal to 125% of the total amount contributed by the VCC will also be included in the VCC’s income in the same year of assessment as which such approval is withdrawn.

There is a heavy administrative burden on VCCs and it is their responsibility to maintain a record of all its investors and investee companies and submit this information to SARS.


Conclusion

Exits are important to consider, depending also on the nature of the underlying investments. This provision is designed to hold investments for five years or more however, several VCCs for example in the hotel trade and more professional VCC managers are developing exit mechanisms to provide liquidity at the end of the investment period. Note 12J requires the investor be issued new shares in the investee company and the tax benefit will not apply to sales of shares so there will be no secondary market of private investors however it is hoped the growth of the investee companies should attract Private equity managers, funds or possibly result in stock exchange listings.

The structure of the VCC is essential. Foreign managers will note it’s a company and not a limited partnership which is a more commonly employed vehicle in Venture Capital and Private Equity but, with careful structuring a similar effect can be obtained. For some it may be appropriate to set up and manage the whole VCC structure including acquiring the FAIS license and for others it may also be possible to collaborate with existing VCC managers.