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Introduction
This is the first in a series of articles on venture capital companies, a tax-favoured investment vehicle regulated by section 12J of the Income Tax Act, 1962 (“ITA 1962”). The venture capital company (“VCC”) scheme, introduced in 2009, is a tax-based scheme designed to encourage individual and corporate investors to invest in a range of smaller, higher-risk trading companies by investing through the VCCs.
Overview
- VCCs can provide access to portfolios of potentially high growth companies with the benefit of generous tax concessions
- Up to 40% income tax relief on VCC subscription for individual investors
- 28% corporate income tax relief on VCC subscription for corporate investors
- 40% trust income tax relief on VCC subscription for trust investors
- Under certain circumstances, subscriptions to VCCs may be considered as part of retirement planning, particularly in the light of forthcoming retirement funding restrictions
- VCC tax relief may be claimed against all forms of income (but not capital gains)
Background
The 2008 South African National Budget Review identified access to equity finance by small and medium-sized businesses as one of the main challenges to the growth of this sector of the economy. Although South Africa has a well-developed private equity industry, its appetite for start-up, early stage and seed capital type transactions is low. To meet the challenge of access to venture capital for small and medium-sized enterprises, government introduced the section 12J of the Income Tax Act (‘the Act’) tax incentive for individual investors, corporate investors and venture capital funds in qualifying small enterprises and start-ups. The tax incentive took effect from 1 July 2009.
Since its inception and despite amendments in 2011 to enhance its attractiveness, the uptake for this tax incentive has been very limited. In the 2014 National Budget Review, Government announced that it will propose one or more of the following amendments to the venture capital company regime:
- making tax deductions permanent if investments in the VCC are held for a certain period of time;
- allowing transferability of tax benefits when investors dispose of their VCC holdings;
- increasing the total asset limit for qualifying investee companies (i.e. companies in which the VCC may invest) from R20 million to R50 million, and from R300 million to R500 million in the case of junior mining companies; and
- waiving capital gains tax on the disposal of assets by the VCC, and expanding the permitted business forms.
The purpose of this series of articles is to examine the impact of the VCC tax incentives on the investors, the VCC itself and the qualifying investee companies. This article will give a general overview of the VCC scheme while subsequent articles will deal with each of the role players in increasing levels of detail.
What is a VCC?
A section 12J approved VCC is a company designed to provide individual and corporate investors with access to a range of trading companies which have the potential for growth. The VCC aims to make money by investing in these smaller trading companies. The VCC raises funds by issuing equity shares to investors and the money is then allocated to those businesses that the managers judge to have the best prospects.
What are the risks of VCC investments?
There are significant risks associated with investing in venture capital backed companies. These risks fall in two categories: investment risk and liquidity risk.
Investment risk
They will generally be at an earlier stage than more developed quoted companies and will often carry a higher risk of failing than their blue chip counterparts. Although VCCs are long-term investments there is no minimum holding period to take advantage of the upfront income tax relief (which is discussed below). However, a minimum holding period has been proposed to qualify for the permanent tax deduction.
Liquidity risk
At present an investor may recapture the upfront income tax relief if the VCC shares are sold at a gain. Accordingly, it is proposed that investors must hold VCC shares for a minimum time in order for investors to retain the income tax relief. Even after the holding period, VCC shares may not be easy to sell at full value. Purchasers of “second-hand” VCC shares will not benefit from upfront income tax relief unless the proposal to transfer tax benefits is implemented and even then it is not clear whether the upfront income tax relief will be one of the transferable tax benefits.
Venture capital companies – the investment process
The diagram below depicts the various role players. The following articles in this series will examine the roles of the following entities:
- The tax treatment of the individual and corporate investors in VCCs;
- The VCC itself – the requirements, conditions and limiting factors to be taken into account when structuring the VCC; and
- The investee companies – the profile the underlying investee companies in which the VCC is permitted to invest its funds.
The articles will not look at the role and the tax treatment of the VCC manager.
Overview of the tax treatment
VCCs are taxed in the following way:
- capital gains on qualifying investments disposed of by the VCC are currently taxable but may become exempt if the proposal in the 2014 Budget is implemented;
- dividends received from the companies making up the portfolio are exempt from dividends tax; and
- interest income is taxable.
The possible exemption on capital gains is a key exemption shared with other types of investment funds such as Real Estate Investment Trusts (“REITs”) (another tax favoured investment vehicle regulated by section 25BB of the Act). Currently VCCs are subject to 18.6% capital gains tax (“CGT”) on shares sold by the VCC. The removal of CGT at the VCC level will improve returns to investors by 18.6%.
The dividends tax exemption is a consequence of the provision that dividends paid to SA resident companies are not normally taxable (section 64F(1)(a) of the Act), not by virtue of any special exemption applicable to VCCs. The dividends tax exemption applies regardless of the period for which the investor holds the VCC shares. Dividends paid by the VCC to SA resident individuals remain subject to the dividends tax.
Upfront income tax relief
An investor which subscribes for VCC shares receives an immediate tax deduction equal to 100% of the amount invested with no annual limit or lifetime limit. The relief is available provided that the investor subscribes for equity shares, as opposed to buying them second hand from other investors. There is no minimum holding period. Unlike shares in REITS there is no statutory requirement for VCC shares to be listed. Thus, VCC shares tend to be highly illiquid.
The attraction of the upfront income tax relief is that it effectively reduces the cost of the investment, thereby boosting overall returns. For example, VCC shares priced at R1, have an effective cost of 60c after tax relief for individual investors (or 72c where the investor is a company). The VCC shares only need to rise by 20c (or 44c where the investor is a company) and the investor’s investment has doubled. Furthermore, the VCC shares need to fall by at least 40c (or 28c where the investor is a company) before a loss is incurred (not counting any dividends).
Taxable recoupment
The current rules provide for a taxable recoupment of the section 12J deduction if the investor disposes of the VCC shares and recovers the previous deduction. The upfront income tax relief is therefore temporary. According to the 2014 National Budget Review a proposal will be considered making the deduction permanent if the VCC shares are held for a certain period of time.
No dividends tax relief
Dividends on VCC shares are subject to the 15% dividends tax unless the investor qualifies for an existing dividend tax exemption. For instance, investors which are SA resident companies will enjoy the company-to-company dividend tax exemption.
No capital gains tax relief
CGT is payable when investors sell their VCC shares at the rate applicable to the relevant investor (13.3% for individual investors; 18.6% for corporate investors and effective 26.6%for investors which are trusts). However, there is tax relief for capital losses. Capital losses on the disposal of VCC shares can be set off against investors’ capital gains. It is not possible to set off capital losses against the investors’ income.
No reinvestment relief
It is not possible for an investor to defer the gain on another investment by applying the sale proceeds to subscribe for VCC shares. Thus, investors that sell their, say, Sasol or MTN shares in order to reinvest the proceeds in VCC shares will be subject to CGT on the sale of the Sasol or MTN shares. The after-tax proceeds from the sale of those shares will be invested in VCC shares.
The venture capital scheme is temporary
The VCC regime, introduced in 2009 is subject to a 12 year sunset period that ends on 30 June 2021. The upfront income tax relief will only apply to VCC shares acquired on or before 30 June 2021.
In the next article I will look at the tax treatment of the investors in greater detail.
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