The final days leading up to the end of the 2017 tax year saw an increase in the number of Venture Capital Companies (VCCs) promoting the section 12J allowance to eager taxpayers looking to minimise their tax liability. However, it seems a number of further amendments are required to lure more investors to take advantage of the favourable allowance.
Essentially, section 12J of the Income Tax Act is a tax-based allowance designed to encourage investors to invest in VCCs. In turn, the VCCs invest in a range of smaller, higher-risk companies, which thus provides seed capital to the small and medium-sized business and junior mining exploration sectors.
The main draw card of section 12J is the potential of high returns together with the fact that an investor would receive an upfront tax deduction from their income, equal to the amount of expenditure incurred in acquiring a VCC share. A colloquial win-win situation.
However, while this regime does provide a platform and incentives for investors, additional measures are necessary to increase participation.
Currently, an investor that held the VCC shares for a minimum period of five years would, upon the eventual disposal of the VCC shares, be liable for capital gains tax (CGT) on the full amount of the proceeds. This is pursuant to the application of paragraph 20(3) of the 8th schedule to the Income Tax Act, which reduces the base cost of the VCC share by the deduction previously received. In other words, the base cost of the VCC share is equal to zero. With the recent amendment to include a super tax bracket at 45%, this will mean that a natural person in the highest tax bracket will be liable for an effective tax of 18% on the full proceeds upon disposal.
As a result of the high risk associated with this investment, it is submitted that an amendment to provide a specific exemption from CGT upon disposal of the VCC shares is required. Should such course of action not be feasible, National Treasury should, as a minimum, consider the amendment of the base cost reduction provisions set forth in paragraph 20(3).
Furthermore, clarification of certain terms is required. At present the VCC regime provides that if the Commissioner is “satisfied” that an approved VCC has failed to comply with the legislated requirements, the South African Revenue Service must, after “due notice” to the VCC, withdraw its approval if “corrective steps acceptable to the Commissioner” are not taken. The consequence upon revocation of a company’s status as a VCC is the inclusion in its taxable income of an amount equal to 125% of the money that was invested in the VCC. The meaning attributable to these terms, specifically the wide discretion of “corrective steps acceptable to the Commissioner” provides a further deterrent to VCC investors which needs to be clarified.
The liquidity of the VCC shares is also a contentious issue. In its current format, the legislation does not provide the upfront tax deduction to a purchaser of so-called ‘second hand’ VCC shares. The reason being that the legislation specifically refers to investors qualifying for the deduction in respect of expenditure incurred in acquiring VCC shares issued to that taxpayer, as opposed to a taxpayer acquiring shares from another taxpayer. This limits the tradability of the share in the VCC.
A possible solution will entail that the VCC provides a specific time horizon of fundraising, acquisitions, performance improvements and value creation. This time horizon can span anything between 5 to 10 years. Thereafter the VCC will realise its investments either through sale or listing of investments and exit its position by liquidating the VCC and distributing the profits to its shareholders.
Whilst recent amendments to the VCC regime have gone a long way in alleviating investor concerns, further amendments, as discussed above, may provide the necessary momentum required to lure additional investors to the VCC regime.
Senior Tax Consultant at Mazars
03 May 2017