An Overview of the South African Venture Capital Company Regime
14 Jun 2017
In 2008, the South African Minister of Finance (“the Minister”) in his Budget Review introduced a tax incentive to encourage venture capital equity investments in small and medium-sized entities and junior mining companies. The tax incentive is intended to be used as a marketing strategy to attract financing for small and medium sized entities as well as junior mining companies.
As a result of the Minister’s Budget Review, the South African Revenue Service and National Treasury, with effect from 1 July 2009, introduced section 12J to the Income Tax Act, 58 of 1962 (“the Act”) to cater for investments in venture capital companies (“VCCs”).
Section 12J of the Act allows a person who invests in venture capital shares through a VCC to claim an upfront tax deduction of a 100% of the amount invested. However, as an anti-avoidance measure section 12J is subject to strict requirements that must be adhered to by both VCCs and investors. Furthermore, the VCC regime is subject to a 12 year sunset clause and accordingly ends on 30 June 2021.
Prior to 1 January 2015, the VCC allowed investors to deduct the value of their investments from their taxable income. However, upon disposal of their investments, those deductions would need to be recouped.
As at 1 January 2015, investors who are not connected persons in relation to a VCC qualify for a permanent tax deduction and accordingly, such investors may qualify for an upfront deduction from their taxable income, consequently the initial investment will not be subject to income tax as a recoupment in the hands of the investor, provided that the investment has been held for a minimum of five years. If an investment in a VCC exceeds the investor’s taxable income in the year that the investment is made, the tax loss created may be carried forward to subsequent years. This tax relief mitigates the investment risk and significantly enhances the potential return.
In order to qualify for the tax deduction investors must directly subscribe for equity shares in the VCC, investors must ensure that the VCC is approved as such by the Commissioner for the South African Revenue Services (“the Commissioner”) and investors must remain invested in the VCC for a minimum period of 5 years.
On the other hand, in order to be approved by the Commissioner, the VCC’s sole object must be the management of investments in “qualifying companies”. A qualifying company is defined in the Act as a South African resident private company in which the VCC or any other person, does not hold more than 70% of the equity shares.
The VCC regime has received some criticisms mainly due to the stringent requirements that VCCs must adhere to. For instance, while there may be good financial reasons to do so if, for example, an investor withdraws from its investment in the VCC by selling its shareholding, prior to 5 years from the date of its initial investment into the VCC, the initial invested amount on which the investor claimed a full deduction, may be subject to income tax.
In addition, SARS has the power to withdraw the VCC status of a company for non-compliance and to include 125% of the total amounts received by the VCC from investors into the VCCs taxable income.
Since SARS has the ability to impose strict penalties for non-compliance (potentially resulting in a total loss of profits for the VCC), companies wishing to register VCCs or persons wishing to invest in VCCs must ensure that they obtain legal advice in order to understand the requirements placed on VCCs in terms of section 12J of the Act.