Navigating the proposed tax changes to venture capital companies

Vivian Spies ‒ Candidate attorney, Norton Rose

Venture capital investments are considered high risk with the potential of high reward and many investors often do not have sufficient appetite for this level of risk. Investing in small and medium enterprises (SME) is, however, indispensable to the economic growth of South Africa’s developing economy. In an effort to incentivise investment in SMEs and mitigate the risk of venture capital investments, in 2008, National Treasury introduced the Venture Capital Company (VCC) tax regime through section 12J of the Income Tax Act. 

Section 12J allows investors to claim an upfront income tax deduction equal to the cost of subscribing for shares in an approved VCC. In turn, the VCC must invest in qualifying SMEs or junior mining companies by subscribing for their shares. Effectively, this means taxpayers can reduce their taxable income in a year of assessment by up to 45% of the cost of the investment for individuals and 28% of the cost of the investment for companies. For example, for every R1 million invested in a VCC, an individual taxpayer will effectively receive a tax benefit of R450 000 and carry only 55% of the risk of the investment. 

Reaping this benefit, however, is contingent on compliance with the legislation. Failure to adhere to the requirements imposed by section 12J may have the onerous result of a tax recoupment for the VCC of 125% of the expenditure previously incurred by investors in acquiring the shares. As at February 2019, an estimated R3.6 billion had already been invested in section 12J funds in South Africa, highlighting its recent success and benefit to local SMEs.

National Treasury recently proposed changes to section 12J to curb “excessive tax deductions” and the perceived abuse of the regime. The proposed change will limit the tax deduction for investments in VCC shares to R2.5 million per annum per VCC shareholder, regardless of whether that shareholder is an individual or a juristic person. If the amendment is promulgated, it will have retrospective effect from 21 July 2019. A limit was built into the section 12J legislation at the time of its introduction in 2008 (at the time limited to R750 000 per tax year and R2 250 000 in an investor’s lifetime). This limitation was removed in 2011 to make the VCC regime more attractive. We have come full circle. 

The Section 12J Industry Association of South Africa has noted that changes have frequently been made to the regime and this makes it challenging for industry players to continually modify their business models to remain compliant. It also notes that the section 12J regime would most certainly be more alluring to investors with a stable foundation of policy certainty underlying the regime because many investors are hesitant to commit to the five-year lock-in of their capital into SMEs in a climate marred by perpetual changes. Given the record-high levels of unemployment in South Africa, discouraging investment into SMEs appears to be an ill-advised policy direction.

The incentive is subject to a sunset clause, which provides that the incentive will cease to be available to investors from 30 June 2021, unless extended by the government. The potentially limited duration of the section 12J regime makes the rationale for these frequent amendments even more difficult to understand from a policy perspective. 

If you or your business is interested in investing in a VCC to receive the benefits under the section 12J regime, holistic and professional legal and tax advice is essential