If you are looking to buy a small business, make sure you are using the tax breaks available, writes Maya Fisher-French
Under section 12J of the Income Tax Act, individuals can invest in qualifying venture capital companies (VCCs) and receive a 100% tax deduction on the amount invested, as long as the investment is held for five years.
This has been a great opportunity for high-net-worth investors to diversify their investment portfolio into growth sectors, such as junior mining and renewable energy.
It also creates a tax-effective opportunity for small businesses, especially for franchises, hotel and student accommodation and asset-rental businesses.
“The uptake of the structure has been phenomenal among the more financially informed, but the wider market needs to be educated on the incentive and how to use it, as it will empower small business and individuals,” says Jonty Sacks of Jaltech, a boutique financial consulting firm with expertise in the formation and management of section 12J venture capital companies.
Sacks explains that, for example, if you wanted to buy into a franchise business, normally you would pay the franchisor directly and receive no tax deduction on the price paid. By using section 12J, you could invest the money into a VCC which, in turn, purchases the franchise, allowing you to deduct the purchase price from your taxable income.
If the franchise costs R2 million, by investing through the VCC, that amount would be fully tax deductible from your income. Depending on your tax rate, it could save you as much as R900 000, making the investment far more affordable.
Sacks explains that the investor receives a specific A-class shareholding in the VCC, which gives the investor/shareholder the right to instruct the VCC to make investments on behalf of the A-class shareholders.
All economic benefit (growth and dividends) is ring-fenced for the A-class shareholders.
The investor still has control of the franchise, except that they have received a significant tax deduction for the investment.
Using tax deductions to encourage people to invest in new businesses will have a knock-on effect of stimulating growth in jobs and the economy. This is particularly beneficial for asset rental businesses such as car fleets used for either car rental or Uber-type businesses.
Sacks says while one can predict the cash flow from an asset rental business, typically these are lower-risk, lower-return investments.
However, by providing the tax deduction, the net effect to the investor is to boost the internal rate of return by an additional 9%, assuming a personal tax rate of 45%.
Student and hotel accommodation are another popular form of venture capital companies. Sacks has created a student accommodation and hotel fund through which investors can buy a unit in a development, benefit from the rental income and are able to write off the initial investment against their income.
There are costs in using a VCC, so you need to take these into account. Jaltech charges 4% of funds invested in the 12J. That means that instead of receiving a 45% tax deduction, the investor receives 41%.
There is also a 1.5% fee on funds under management per year. For an investment of R1 million, there would be an annual fee of R15 000.
Certain businesses may not benefit from section 12J, so you need to first check that the business you wish to acquire does not contravene these rules:
- The gross value of the target company may not exceed R50 million;
- It may not earn more than 20% of its income from investment income;
- The majority of its trade must be within South Africa;
- In terms of immovable property, only hotels, serviced apartments, holiday homes and student residences are allowed;
- The financial services sector, or any trade in financial or advisory services, is not included, except for investing in technology within this sector; and
- No trade is allowed in respect of gambling, liquor, tobacco, arms or ammunition.
FOR THE PASSIVE INVESTOR
If you are not looking to buy your own business, but want to invest tax-efficiently in new growth opportunities, there are several venture capital asset managers. These include Grovest Venture Capital Company, South Africa’s first operational venture capital fund, which has a strong focus on energy-related companies. Another is Westbrooke Alternative Asset Management, which accounts for about half of the VCC market and which recently launched a student accommodation fund and an alternative tourism fund.
The former invests in strategically located hot spots across South Africa including Pretoria, Johannesburg, Cape Town and Stellenbosch. The Westbrooke Alto (alternative tourism) is a fully tax-deductible investment into a portfolio of decentralised, residential hotel properties across Cape Town.
Westbrooke Aria (alternative rental income assets) invests in a portfolio of asset-backed rental businesses with contractual revenue streams. For example, Westbrooke provides growth capital to a company that rents, services and maintains scooters used by Famous Brands franchisees.
As the tax deduction is only available for primary funding (you do not get the tax deduction if you buy shares from an existing VCC investor) the funds close once sufficient funding has been received.
If you are interested in investing, ask to be put on their mailing list. However, you do need to be aware that section 12J companies, by their very nature, tend to be high risk so you need to understand the risk of the underlying investments.
10 tips to manage the 12J investment
Jonti Osher and Dino Zuccollo, fund managers at Westbrooke Alternative Asset Management, list 10 factors that should be assessed to manage the 12J investment risk:
1. Risk/return appetite: Not all section 12J companies are created equal; there can be significant differences in the nature of the underlying investments of these companies as well as the strategies that their investment managers employ. You should invest in a 12J company that has a clearly defined investment risk strategy and approach that supports your risk appetite relative to the investment return profile. Investors should seek an investment that generates attractive risk-adjusted returns.
2. Tax risk: Given that one of the main incentives for making a 12J investment is the 100% upfront tax deduction in the financial year of your investment, ensure that the investment manager you choose understands and complies with the rules and regulations that are required to obtain – and then maintain – its 12J status. The last thing you want is to find out that the 12J company in which you have invested loses its status due to regulatory non-compliance and is therefore penalised by the SA Revenue Service (Sars). This could have the effect of reducing your investment returns, which effectively could result in the creation of a return profile as if you didn’t receive the upfront tax benefit.
3. Expertise and management risk: Look for a company that has the depth of investment, finance and private equity expertise you would expect from any professional asset manager. Factors to take into consideration include: whether the manager’s fee structure is aligned to performance, whether the 12J company is subject to an external audit, whether a third-party compliance function is in place, and who the legal and tax advisers are.
In addition, if the strategy of the 12J company is to invest alongside entrepreneurs at the investee level, ensure that investee management is required to retain a significant equity investment in the investee company, to ensure proper alignment.
4. Investment risk: Qualifying companies – the name given to compliant 12J investee companies – may sometimes be young companies that have an inherently higher investment risk compared to more mature, larger businesses. Lower risk, asset-backed investments which offer predictable returns can go a long way towards mitigating this start-up risk.
5. Liquidity risk: The current section 12J legislation requires investors to hold their shares in the company for no less than five years to make the upfront tax deduction permanent. Ensure that you can hold your investment for this period, or you will have to repay Sars the upfront tax benefit which you enjoyed when making your initial 12J investment.
6. Exit risk: At the end of the five-year holding period, it may not be easy to liquidate your 12J shares, as the nature of the underlying qualifying companies is often illiquid, private equity-style investments. It is therefore essential that any investment in a 12J vehicle comes with a clearly defined exit mechanism and/or path to liquidity that you, as an investor, can understand.
7. Capital risk: The risk of losing capital exists in any equity investment. An investor seeking a lower-risk profile should seek to invest money in a 12J company whose investment strategies are focused on capital preservation. These strategies can, for example, include asset-backed investments and investments with predicable revenue streams.
8. Cash flow risk: Some investors may find five years a long time to wait for a return of capital. You could opt for an investment in a 12J company that aims to provide an annual or semi-annual dividend throughout the investment period.
9. Diversification risk: While the 12J legislation inherently requires companies to be diversified (by requiring the 12J company to invest in a minimum of five investee companies), spreading your allocation across different companies is a strategy worth considering.
10. Compliance risk: Ensure that the company in which you invest is registered with Sars and is the holder of a valid Financial Services Board (FSB) category II licence. This is required prior to investment to ensure that you will receive your upfront tax benefit. The compliance of the 12J company can be verified on the Sars and FSB websites.
Source: Westbrooke Alternative Asset Management