Some taxpayers in South Africa are favoring shorter-term investments that are known as “section 12J investments” in an effort to reap higher returns. Section 12J investments are enhanced by an up-front tax deduction.
However, there is greater uncertainty with regard to section 12J venture capital investments because: (1) these investments are typically considered as “higher-risk” in the market; and (2) there is heightened focus by the National Treasury for potential abuse with regard to such investments. Accordingly, prudent taxpayers would consider obtaining tax advice before investing in section 12J structures.
To provide incentives for equity financing, a venture capital regime (section 12J of the Income Tax Act) was implemented during 2009. The objective of section 12J was to create and maintain employment and to grow the economy and ultimately the tax base. Section 12J was introduced with a “sunset clause” that takes effect on 30 June 2021. It is not clear whether the incentive would be extended.
Mechanics of section 12J
Upon investment in an approved venture capital company (VCC), a taxpayer is entitled to claim an income tax deduction in respect of the expenditure actually incurred to subscribe for VCC shares. For example, if an investor subscribes for shares in an approved VCC for R100,000, that taxpayer will be entitled to an income tax deduction of R100,000 against taxable income.
At marginal tax rates, the investor yield is computed against an investment of 55%. The deduction can be claimed when the investor receives an investor certificate from the VCC (to the extent a loan or credit was used by the taxpayer to finance the acquisition, certain limitations apply). The up-front tax deduction, in essence, is intended to compensate the investor for the inherent risk linked to the investment and enhance any potential returns.
However, when the taxpayer claims an income tax deduction in terms of section 12J, the taxpayer will be required to reduce the base cost of the VCC shares by the amount claimed. Thus, the VCC shares will have a base cost of zero, and on exit from the investment, the taxpayer will be liable for capital gains tax on the full proceeds received.
Statistics reveal that the value of venture capital investments grew by 33% to R1.160 billion in 2017. The popularity of these investments is clear, and understandable given the high tax burden on individuals. Section 12J was intended to facilitate investment into so-called “pooled schemes” (when the risk and return is spread among the underlying qualifying companies of the VCC). However, it appears that many VCCs are in fact structured as “targeted schemes” (when the risk and return of an investor is linked to one or a few specific underlying qualifying companies under the VCC umbrella).
National Treasury has been reviewing section 12J to prevent abuse of the regime, and has identified certain abusive behaviors due to the mismatch between the growth in venture capital investment compared to the 12J deductions claimed by taxpayers such as:
Read a June 2019 report [PDF 121 KB] prepared by the KPMG member firm in South Africa
The KPMG logo and name are trademarks of KPMG International. KPMG International is a Swiss cooperative that serves as a coordinating entity for a network of independent member firms. KPMG International provides no audit or other client services. Such services are provided solely by member firms in their respective geographic areas. KPMG International and its member firms are legally distinct and separate entities. They are not and nothing contained herein shall be construed to place these entities in the relationship of parents, subsidiaries, agents, partners, or joint venturers. No member firm has any authority (actual, apparent, implied or otherwise) to obligate or bind KPMG International or any member firm in any manner whatsoever. The information contained in herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. For more information, contact KPMG's Federal Tax Legislative and Regulatory Services Group at: + 1 202 533 4366, 1801 K Street NW, Washington, DC 20006.