There is lots of hype about s12J investments, but are they right for you?
Tax incentives aimed at enticing investors to make funding available to SMEs have resulted in the more than 140 so-called section 12J companies, all vying for your savings
S12J investment is not all that new — it has been around since 2009 when the government introduced amendments to the Income Tax Act to stimulate the private sector and the South African economy as a whole. This introduced tax incentives for investors (individuals and corporates) via tax-deductible s12J companies.
For five years, nothing much happened, but following further amendments to the act in 2014, which made the investor’s tax deduction permanent subject to certain strict conditions, the registration of s12J companies started to gain momentum. Today, there are more than 140 registered s12J companies
Tax incentives aimed at enticing investors to make funding available to small- and medium-sized entities (SMEs) have resulted in the more than 140 so-called section 12J companies, all vying for your savings. The name comes from section 12J in the Income Tax Act, which was introduced in 2009 to provide for these incentives.
Investors invest a sum of money to acquire shares in an approved and registered venture capital company (VCC) — the s12J company — which, in turn, invests the funds in qualifying investee companies. The s12J company may not invest more than 20% of all investments.
The section allows you to invest in an accredited VCC company known as a section 12J company, which in turn invests in investee companies. The investments you make in the s12J VCC companies are fully tax deductible within the tax year that your contribution is made.
So, how does the investment work and how risky is it?
- Funds are invested in the 12J qualifying VCC company
- The VCC company issues you with a certificate for the full investment amount
- You use the certificate to claim the investment amount against your taxable income effectively getting a refund at your marginal tax rate from the South African Revenue Service.
- The VCC company invests the invested amount (after deducting fees) in underlying investee companies via a private equity investment vehicle.
- The funds must remain invested for a full five-year term
Some words of caution:
- The risk of the investment will be directly related to the underlying investee companies. The less diversified the portfolio is the more risk it will likely carry. You need to ask, “Why does the investee company require a private equity investment”? Often this is the only way for the entity to raise money because banks do not want to finance their operations.
- Be careful of double taxation. When the VCC makes changes (selling shares of one company and buying into another) during the five-year period or the investor sells the investment after the five-year period, there will be capital gains tax (CGT) on the full value of the sale price since the base cost is considered as zero. As an investor, you will also pay tax on dividends declared by the VCC company during the five-year period.
- Since the investments will mainly be made into small to medium-sized private companies, there is a higher risk of capital loss. Venture capital investments are at the top end of the risk scale compared to other asset classes. You must ensure that the management team within the VCC companies have adequate experience and a demonstrable venture capital track record. The failure rates of SMEs are very high.
- Fee structures must be scrutinised. Private equity vehicles are synonymous with high upfront fees and high annual management fees often linked to additional performance fees. Currently there is a flood of new “12J companies” entering the market which must act as a cautionary.
When it comes to the opportunities that 12J ventures present, you should bear in mind that:
- These investments must be considered as the speculative portion of your investment portfolio, if you have the appetite to invest speculatively. These investments are not for conservative investors.
- You should probably limit investments in 12J projects to a maximum of 10% of your overall investment portfolio.
- If you have a high CGT liability (for example, from selling a second property with a high gain), the CGT can be eliminated by investing an equivalent amount in a VCC company.
However, s12J investments are suitable for only a select group of investors who are familiar with the capital risks and volatility of investing in unlisted small capitalisation and venture capital shares.
As an investor, you must make sure that you have enough liquidity outside of the the investment you make into VCC companies, since you have to invest for a minimum of five years to qualify for a s12J deduction.
If fact, the investment term may be considerably longer than five years since there is no guarantee of a buyer for your investment when the five-year term is over. VCC companies do not guarantee liquidity, it is up to the investor to find a buyer for his or her investment after five years — another reason to keep investments in section 12J opportunities to no more than 10% of your investable funds.
Investing in illiquid investments is not something we readily recommend. This follows our experience during the financial crisis in 2007-2008 where many investors lost money due to liquidity constraints within property syndication investments, hedge funds and private equity structures.
There are more than enough opportunities in well-structured collective investments where short-term liquidity is guaranteed and prices are determined daily.
You can invest in more riskier portfolios if you have the appetite and seek higher returns that come with higher risk. Portfolios that compete with VCC companies are small/mid-cap unit trusts. The difference is that the underlying companies in which these unit trusts invest are analysed properly and must qualify to be listed on the JSE or its sub-boards. The financials of the underlying companies within the unit trusts are available for public scrutiny whereas the financials of companies invested in by VCC companies are not that easy to come by.
• Van der Merwe is a director of WealthUp and was a runner-up for the Financial Planner of the Year in 2018.