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South Africa: Tax incentive for venture capital investments (section 12J investments)

South Africa: Tax incentive for venture capital

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.

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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.

Background

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:

  • Trading between the VCC investor who has invested in a VCC and a qualifying company in which that VCC takes up shares
  • The VCC shareholder having beneficial control through shares in a VCC or voting rights/participation in the underlying qualifying company
  • An existing business being broken up into several segments which essentially replicate the existing business when the current shareholders get the benefit of an upfront 12J deduction that they would not have otherwise been entitled to National Treasury has moved to limit what it views are abusive structures. More amendments are expected to limit the application of the incentive.


Read a June 2019 report [PDF 121 KB] prepared by the KPMG member firm in South Africa

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