In an attempt to encourage investment of equity into SMEs and junior mining companies, the Venture Capital Company (“VCC”) tax regime was introduced into the Income Tax Act 58 of 1962 (“Act”) in 2009.
Section 12J of the Act encompasses the relevant legislation governing VCCs and provides for the formation of an investment holding company, described as a VCC, through which investors can provide equity funding to a portfolio of SMEs. More specifically, investors subscribe for shares in the VCC and claim an income tax deduction for the subscription price incurred. The VCC, in turn, invests in “qualifying companies”.
Various legislative amendments to section 12J have given rise to an increased participation in the asset class, evidenced by the increasing number of approved VCCs. As at 24 January 2018, the South African Revenue Service (“SARS”) website indicates that 90 companies have been approved as VCCs, while 2 have had their VCC status withdrawn.
This article provides a high-level overview of specific aspects of section 12J. It is advisable for SMEs and investors to obtain independent tax advice when considering utilising this investment vehicle.
Requirements for qualifying companies
The sole object of an approved VCC must be the management of investments in “qualifying companies”. The question of whether a potential investee company constitutes a “qualifying company” is a factual one and must be considered in light of the specific circumstances of that entity.
A “qualifying company” must comply with several requirements, some of which include:
- the company must not be a “controlled group company” in relation to a group of companies; and
- the company must not carry on an “impermissible trade”.
A “controlled group company” is a company that has a corporate shareholder that holds, directly or indirectly, at least 70% of the shares in that company. Accordingly, this requirement limits the share investment that a VCC can make in a “qualifying company” to a maximum of 69%. This means that at least 31% of the shares in a “qualifying company” must be held by persons other than the VCC.
The definition of “impermissible trade” encompasses a number of trades, such as trades in respect of immovable property (other than hotel keeping), financial or advisory services, gambling and trades carried on mainly outside of South Africa. It must be noted that a number of these trades are defined with reference to other pieces of legislation and due consideration should be given to those Acts. Again, the question of whether a “qualifying company” conducts an “impermissible trade” is a factual one which should be determined on a case-by-case basis.
Tax benefit for investors
The upfront income tax deduction, which lessens some of the investment risk for investors, is available for share subscriptions only. The deduction is only available in the year of assessment during which it is incurred and no deduction will be allowed in respect of shares acquired after 30 June 2021.
Any South African taxpayer (i.e. natural persons, companies, trusts and partnerships) can benefit from the tax deduction, however, the deduction is subject to anti-avoidance provisions, such as:
- where an investor has used any loan or credit to finance the expenditure incurred to acquire shares in the VCC, the amount of the deduction is limited to the amount for which the investor is deemed to be at risk on the last day of the year of assessment; and
- no investor can be a “connected person” in relation to the VCC after the expiry of a period of 36 months commencing on the first date of the issue of the venture capital shares.
In addition to the above anti-avoidance provisions, investors need to be aware of the restrictive framework offered by section 12J. For example, to the extent that the investment is realised (i.e. disposal of shares in the VCC or a return of capital) before the end of a five-year period, the deduction previously allowed must be included in the income of the investor in the year of assessment during which the investment was realised.
In addition, there are some shortcomings in the VCC regime, which National Treasury will hopefully address in due course. For example, it is more tax efficient for a natural person to subscribe for shares directly in a “qualifying company” rather than the VCC, for the following reasons:
- capital gains tax (“CGT”), at the effective rate of 22.4%, is paid by a VCC on gains realised upon the sale of shares in a “qualifying company”. In addition, dividends tax at the rate of 20% is incurred when the VCC declares a dividend to a shareholder who is a natural person.
- should the natural person
- subscribe for the shares in the qualifying company directly, the natural person will only incur CGT at the rate of 18%. The benefit of the upfront deduction may therefore be ‘tainted’ by this ‘double tax’.
National Treasury has acknowledged the need to make further changes to section 12J which will assist SMEs in achieving profitable growth.
Please note that there are other requirements which have not been addressed in this article.
As a rule, natural persons are “connected persons” in relation to a company to the extent that they individually or together with any “connected person” in relation to themselves, hold at least 20% of the equity shares or voting rights in the company. A corporate investor will be a “connected person” to the extent that –
- it holds at least 50% of the equity shares or voting rights in the VCC;
- it holds at least 20% of the equity shares or voting rights and no other person holds the majority of the voting rights; or
- any other company is managed or controlled by any person who is a “connected person” to the corporate investor.