Member Article

The 2016 Budget Review contained a most welcome – if cryptic – statement for venture capital companies (“VCCs”) and their investors. The statement reads as follows:

“Venture capital funding for small businesses

Funding remains one of the biggest challenges for small businesses. To encourage equity funders to invest in small businesses, the venture capital company regime was introduced in 2008. Currently, 31 venture capital companies are registered. Government is aware that the application of certain provisions on these companies may result in potential investors abandoning plans to take up this incentive. Measures to mitigate this unintended consequence will be explored.”

Before commenting on this statement, below are preliminary observations about the venture capital company regime.

Why are VCCs attractive to investors?

VCCs invest in shares issued by “unlisted” companies, i.e. companies not listed on a stock exchange. Most private investors neither have access to these types of investments, nor the expertise to assess opportunities and hence, they are often the preserve of institutional investors. VCC investors can benefit from the opportunity to “get in on the ground floor” and reap the rewards if the VCC’s investments increase in value.

The upfront tax deduction is a significant tax benefit for the VCC investor. The table below illustrates the benefit of the upfront tax deduction.

 
Vagueness of the statement

The initial impression of the budget statement is that it is very vague when compared to the statement that appeared in the 2014 Budget Review. In 2014, Government announced that it would consider the following proposals to enhance the flexibility of the venture capital regime:

• Making deductions permanent if investments are held for a certain period of time.
• Allowing transferability of tax benefits when investors dispose of their holdings.
• Increasing the total asset limit for qualifying investee companies from R20-million to R50-million, and from R30- million to R500-million in the case of junior mining companies.
• Waiving capital gains tax on the disposal of assets, and expanding the permitted business forms.

The first and the third proposals found their way into legislation. The second and the fourth proposals did not. The current statement in the 2016 Budget Review gives no indication of the proposals that will be considered. Perhaps those proposals in the 2014 Budget Review that were not legislated at that time will now be considered.

Impact of the new CGT rates

The 2016 Budget stated that, for individuals, the maximum effective rate of CGT is increased from 13.7% to 16.4%; for companies, the rate is increased from 18.6% to 22.4%, and for trusts, from 27.3% to 32.8%.

The VCC investor does not enjoy any VCC-specific CGT exemption on the disposal of the VCC shares. Accordingly, CGT is payable upon the sale of the VCC shares.

The problem for VCC investors is that they must reduce the base cost of the VCC shares by the amount of the upfront tax deduction. Base cost is very important for holders of assets, as base cost provides a tax shield which will reduce the amount of capital gain that is subject to tax. Where a VCC investor claims the section 12J tax deduction on the subscription price for the VCC shares, then the base cost of the VCC shares will be reduced to 0. As a result, the investor will not have any base cost in the VCC shares to shield the subsequent proceeds from CGT. An exemption from CGT on the disposal of the VCC shares is needed.

The table below shows the difference in tax treatment between the 2016 tax year (which ended on 29 February 2016) and the 2017 tax year (which ends on 28 February 2017).

 
Although the taxpayer receives the upfront tax deduction of R41 000 on the acquisition of the VCC shares, the taxpayer will, in the aforementioned example, pay CGT of R42 640 on the disposal of the VCC shares. Thus, SARS will recover the upfront tax deduction through the later CGT payment albeit that SARS will only receive the CGT many years later on a disposal of the VCC shares.

Connected person rule

The initial version of the VCC regime contained monetary ceilings where investors had to invest below the ceiling. Those ceilings were removed and replaced with the connected person test. The section 12J venture capital deduction will not be available to investors who become connected persons to the VCC as a result of, or upon completion, of the investment.

As a practical matter, the connected person test is generally triggered at a more than 50% level or 20% level depending upon the facts. What many investors may not be aware of is that VCC shares purchased by the investor’s relatives (within the 3rd degree of consanguinity) are taken into account when determining whether the investor is a connected person.

In order to illustrate the practical impact of this below is an image listing the relatives falling within the 3rd degree of consanguinity of the investor. Bear in mind that anyone related to his/her spouse within the 3rd degree of consanguinity is also a connected person. In addition, any spouse of these connected persons also becomes a connected person.

This rule is problematic where investors are not aware that their relatives may also be investors in the VCC. Investors should also be aware that the connected person test also takes into account direct and indirect shareholdings. Thus, investors who are shareholders of companies, members of close corporations, partners in a partnership or beneficiaries of a trust must bear in mind that all these entities shareholding in a VCC will be taken into account to determine whether an investor is a connected person in relation to the VCC.