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Tax Incentives to Invest in Small Business: The Clock is Ticking

08/09/2020 14/05/2021

National Treasury is reviewing all of its business tax incentives to determine to what extent they are contributing to policy objectives. One such incentive under review is the “Section 12J” incentive, which allows an investor a deduction of the full amount invested in a Section 12J VCC (Venture Capital Company), provided certain requirements are met, from its taxable income.

The VCC regime was introduced in 2009 with the objective of boosting economic growth and job creation by assisting small businesses that cannot obtain financing from financial institutions to access equity finance.

The regime is subject to a 12 year sunset clause that ends on 30 June 2021 – if your small business needs venture capital funding, the clock is ticking!

“Creating an environment in which SMMEs can thrive is inextricably linked to creating conditions in which all businesses can thrive.” (National Treasury, 2019 Economic Strategy document)

The VCC (Venture Capital Companies) incentive allows a holder of shares to claim a 100% tax deduction of the cost of the shares issued by an approved VCC, provided certain requirements are met. The deduction is subject to recoupment if the VCC shares are held for less than five years.

VCCs have been investing in small and medium-sized businesses (SMEs) that include education, agriculture, renewable energy, hospitality and tourism, and student accommodation. Many of them are especially hard-hit by the strict lockdown regulations imposed on businesses.

Funding has always been a major stumbling block for start-ups, and small businesses wanting to expand. They will find it far more difficult post-COVID-19 to get access to funding. Without the tax incentive it is possible that investments may flow offshore – investors will take their money where the rewards match the risks.

According to SARS, there were 180 registered and approved VCCs which had raised R8.3 billion at 28 February 2019.

The VCC industry body, 12J Association of South Africa, conducted its own survey on the impact investments have made to date. It released the results in June this year.

Responses were received from 12J managers that collectively manage 106 VCCs and R9.3bn in assets under management to date.

The R9.3bn industry assets under management has been raised from over 5,500 investors, equating to an average investment amount of R1.7m per investor.

The survey report shows that the Section 12J capital raised has been invested into more than 360 small, medium and micro-sized entities which in turn support 10,500 jobs (50% of them permanent) across dozens of industries.

According to the survey the incentive has been cost-effective at an average cost per job of approximately R126,000 for each current job created. This is in contrast to current job creation focused incentives in South Africa, which allow for a required cost per job of up to R450,000.

Getting the investors

When the VCC tax incentive was introduced these companies were to be the “marketing vehicles” to attract retail investors with the tax incentive as a major advantage.

There was an initial investment limit of R750,000 per tax year and a lifetime limit of R2.25m. This limit was removed around 2011 in order to make the incentive more attractive.

However, due to several amendments to the Act, aimed at combatting perceived abuse, the incentive only really gained traction after 2015.

In July last year new caps were introduced. Investments by a natural person and trusts were capped at R2.5m and for companies investments were capped at R5m in a tax year.

Small businesses – the clock is ticking!

The regime is subject to a 12 year sunset clause that ends on 30 June 2021.

Many of the industries qualifying for VCC investments were hard hit by the impact of the COVID-19 pandemic. Survey participants expect COVID-19 to have a negative impact on the ability of SMEs to obtain equity capital over the next year and even the next two years. This is likely to manifest itself in a far higher unemployment rate and corresponding lower growth in the South African economy.

More than 75% of the participants in the industry survey said investors would not have invested their capital in SMEs, had it not been for the attractiveness of the Section 12J tax incentive.

The 12J Association of South Africa suggests that the tax incentive should be extended until at least 2027.

SMMEs will now need more support than ever before, and if your small business is struggling to find funding, ask your accountant now for advice on applying to a VCC. Unless the June 2021 sunset clause on tax incentives for section 12J funding is extended, support from investors will soon dwindle – the clock is ticking!

This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. Errors and omissions excepted (E&OE)

Take Advantage of the Venture Capital Company Allowance While You Can

13/02/2020 14/05/2021

Here’s some good news in the form of a way to save tax (a lot of tax), make a good investment, and directly boost both our economy and our SMEs – all in one go.

That’s where the VCC (Venture Capital Company) Allowance comes in. We’ll have a look at the substantial savings you (or your trust or company) can achieve by using the allowance correctly; at how it works both initially and subsequently; at the need to beware of costs; and at how “finding a gem” could give you a (very) substantial after-tax return.

We share some practical examples to illustrate, and end off with a warning to act quickly – the allowance is planned to fall away at the end of June 2021.

“There are two systems of taxation in our country: one for the informed and one for the uninformed” (U.S. Judge Learned Hand)

Small and medium-sized enterprises (SMEs) have limited access to capital markets. As SMEs are considered to be the cheapest and most cost-effective sector in creating jobs, the Revenue authorities sought to address this by creating an attractive allowance for Venture Capital Companies (VCC) in 2009.

The VCC allowance gave a massive boost to venture capital in South Africa, and also to SMEs who have received R6 billion in investment since 2009. Venture capital now accounts for 2% of GDP (in the USA this is 4%).

For you the taxpayer it offers an attractive way to reduce your tax as you are allowed to deduct R2.5 million from your taxable income if you invest in a VCC. This is in your own capacity or via a trust; if you use a company to make the investment, it can deduct R5 million.

How it works initially

Note: The examples below relate to an investment in your own personal name, and different tax rates and net returns will apply if you invest through a trust or company.

Assume you have R2.5 million in taxable income. It is 20 February, you have little more than a week before you will have to pay provisional tax and you want to reduce your tax liability and make a good investment.

You have researched the VCCs and decide to invest R2.5 million in a VCC which invests in solar power.

You have saved yourself R1.125 million in tax.
To avoid having this tax deduction of R1.125 million reversed, you will need to be invested with the VCC for five years.

How it works in subsequent years
The VCC onward invests the R2.5 million in a qualifying SME (the SMEs need to be registered with SARS) which then installs solar power in, say, a block of flats. Of interest here is that the SME also gets a 100% deduction on the R2.5 million.

If you cash in on the investment after 5 years, this will be the position:

In summary, you received a tax deduction of R1.125 million and 5 years later paid R450 000 in capital gains tax. Your investment of R2.5 million has been refunded to you. If you discount these cash flows, this equates to an after-tax return of just over 10% over five years which is pretty good as inflation is currently just below 4%, i.e. a real return of 6%. As a comparative the stock market delivered a return of just below 6% in the last decade.

This excludes any costs you may be charged.

Beware of costs
There are many VCCs out there and they charge varying fees, so be very careful of these costs as they come in many guises such as performance fees, administration costs, annual charge etc.

It is worth getting your accountant to check these costs.

Look for the gems
As we saw above, the qualifying SME (the entity that installs the solar power), gets a 100% upfront write-off of the investment (R2.5 million in this example for a tax saving of R700 000). Some creative VCCs have used this tax saving to return income to you the investor. Take the example of a residential complex where the qualifying company installs solar power in the complex and then charges the owners of the complex for the electricity they consume using solar power (this charge is at a substantial discount to Eskom’s rate). The qualifying company returns this charge to the VCC which then pays these amounts as dividends to you, the investor.

Thus, everybody scores:

Residents of the complex don’t pay for the installation of the solar power and get cheap electricity,
The qualifying company takes its profit out of the R2 500 000 investment and tax saving of R700 000,
The VCC makes money from charging you fees, and
You, the investor, get a return (after-tax and net of all costs) of over 20% over the 5 year period, which is excellent.

Don’t delay, the clock is ticking!
The only downside to this is that the allowances will fall away in June 2021. VCC companies are lobbying government to extend this program past June 2021, but even if they are unsuccessful, you have just under 18 months to take advantage of this scheme.

Of course this sort of investment isn’t for everyone; ask your accountant whether it might suit you.