Section 12J: snag that tax break
Section 12J schemes should be doing much more to lift the economy, and there’s still time to get involved
It is hard to read about any new hotel which has not been funded through section 12J investors, whether its the voco hotel being built in Rosebank, Johannesburg, or the Pepperclub in central Cape Town.
But the tax break is much more than just a way to get invested in some flashy property.
And, used together with skills transfers, it should be a much more cost-effective and efficient boost for the economy than many other worthy schemes on offer, says Pavlo Phitidis of Aurik Business Accelerator.
He runs 12J investments through the Aurik fund, and says that on a visit to the UK he could see the success of its Enterprise Investment Scheme.
With tax benefits, private investors are encouraged to provide finance to small businesses which the banks are usually reluctant to fund. Without bank support, individuals given generous tax breaks help fill the gap.
"The UK became the go-to place in Europe for innovation, before Brexit at least," Phitidis says.
"Corporates are hoping to move the needle through initiatives such as the Youth Employment Scheme, but few small businesses have the time or the bandwidth to train and manage youngsters."
Junior mining was the original target for section 12J.
But while it was changed to invest in a wide range of venture capital activities in 2009, it has attracted significant flows only over the past two years, mainly into property.
In 2017 there was just R1.8bn invested.
This had moved up to R8.3bn by the end of 2019, but just R3.7bn had been invested into underlying companies; the rest remains in cash.
As we approach the end of the financial year on February 29, there are few opportunities to minimise our tax payout.
Section 12J schemes are one way of doing so.
Sure, up to 27.5% of tax is deductible in retirement annuities and pensions combined, but there is a cap of R350,000 which won’t be the answer for the very wealthy.
Tax-free savings accounts are a useful option for the broader public, but it is just R33,000 and not tax deductible upfront.
The current 12J regime has a finite lifespan: it ends in June 2021, though existing schemes will be in run-off for the next five years.
Jaltech CEO Jonty Sacks believes that if section 12J is revived after the sunset date, it will exclude hospitality investments.
"Section 12J was not intended to be so heavily skewed towards hotels. I think the only property investment still allowed will be student accommodation."
Phitidis agrees that building and running hotels should not be the core activity of a venture capital company.
But Neill Hobbs of Anuva Investments, a leading 12J promoter, says different pools should appeal to various investors’ interests and risk appetites. Anuva has a technology fund managed by former Dimension Data CEO Brett Dawson, for example.
Gadi Cohen, MD at Optomise, says some true venture funds could lead to a total return of 1,000%.
"We can double your money over five years, with an internal rate of return of 8.3% but with much more certainty. In some of our funds there are capital guarantees given by the property developer."
A popular 12J venture has been to hire out scooters to delivery drivers.
Famous Brands now outsources its fleet to 12J-backed companies.
Optomise funds also arrange vehicle finance for Uber drivers through a rent-to-buy scheme. After five years drivers have the option to buy the vehicle for R30,000.
Hobbs says a weakness of 12J is that it was designed purely to provide equity capital, and entrepreneurs could end up losing control of their companies. "But we can get around this by capping our stake at 49% and taking the balance in a hybrid such as pref shares."
The tax break could also lead to a glut of hotel properties, particularly in Rosebank, where the Monarch Hotel is in business rescue.
Dino Zuccollo, who chairs the 12J Association of SA, says there were abuses when a few individuals got together to claim a section 12J deduction on their holiday homes even though they did not operate as hotels or even B&Bs.
Now these deductions are only valid if they are done through established 12J fund managers.
"Abuses are also much less likely now that there is a R2.5m deduction cap for individuals every year," says Zuccollo.
There was no cap prior to July 2019 but he says that it is no bad thing as it encourages fund managers to look for a spread of investors to build up assets.
Initially much of the 12J finance came from founders, friends and family.
Now it comes from a far wider base — those who are looking for a tax deduction with at least R100,000 to invest. Sacks says that notable supporters have been the wealth managers at Standard Bank, FNB, Investec and Alexander Forbes.
While the plethora of hospitality investments using 12J tax breaks has drawn criticism, Jeff Miller, CEO of Grovest, another leading 12J promoter, says hospitality is a very strong job promoter, and accounts for the majority of the 27,000 jobs the schemes have created.
"In fact, even though [it is] lower risk than classic business start-ups, banks aren’t lending to the hotel sector, after getting their fingers burnt in projects such as a golf estates," he says.
Another large subset of 12J — perhaps 15% of funds — has been into renewable energy distribution, which now looks more urgent than ever.
Only one outfit offers a diversified fund of section 12J funds, to external investors: MeTTa Capital.
Administered by Grovest, it invests in funds of competitors such as Optomise and Westbrooke, as well as some junior mining ventures.
Over two years, the MeTTa Moderate Risk Fund has given a flat return (other than the tax benefit itself), but this has been in an environment in which listed small caps have fallen 25%.
Section 12J funds pay themselves in the standard alternative investments style, often 2% upfront, then 2% a year and 20% of profit.
But Hobbs argues the fee should not be compared to a fund: it is a public company which must issue a prospectus every time it asks for share subscriptions below R1m and it is a hands-on investor, not a share buyer sitting behind the screen.
What is section 12J?
Individuals and trusts can invest up to R2.5m in approved venture capital companies in any tax year.
The investment is fully tax deductible in the financial year in which it is made. It cannot be redeemed in the first five years, and the catch is that after five years capital gains tax applies to the full amount accrued — including the initial investment.
It excludes investment in all property except hotels and lodges, all forms of banking, insurance and management consulting as well as liquor, tobacco and ammunition.
More than half of 12J activities relate to hospitality, with related alcohol and tobacco sales outsourced to separate businesses.