Section 12 J Investments
The main Points:
- A taxpayer can make an investment in a Section 12J company and this investment is 100% tax deductible if held for a period of 5 years or longer.
- If the taxpayer is an individual with a marginal tax rate of 45% or a trust, the taxpayer can invest R1 million and will effectively be paying R550 000 (R1 million – R450 000) for the investment since the full investment amount is tax deductible in the year of investment (provided the taxpayer has taxable income of R450 000 or more).
- A company (excluding a Small Business Corporation which will be taxed at different rates) can invest R1 million and effectively be paying R720 000 (R1 million – R280 000) for the investment since the full investment amount is tax deductible in the year of investment (provided the company has taxable income of R280 000 or more).
- When the section 12J investment is realised in the future, the base for the capital gain will be 0 due to the initial benefit of 100% tax deductibility.
- There is no annual limit, but investors should not invest more than their taxable income.
What is a section 12J Company?
The government has identified small and medium-sized entities (SMEs) as a major contributor to future economic growth. One factor that hampers the growth of SMEs is a lack of access to equity funding. In order to alleviate this problem, the government has added Section 12J to the South African Income Tax Act as a catalyst for equity funding for SMEs. Section 12J provides a marketing vehicle to venture capital companies (VCCs) due to the tax incentive.
A Venture Capital Company (VCC) is a company that accepts investments from any taxpayer (individual, trust or company). The VCC manages the collective investment and make investments in SMEs.
Who can invest in Section 12J companies? And what is the minimum investment?
Any taxpayer qualifies to invest in an approved VCC. From what can be seen in the market, Section 12J investments start at around R100 000.
Other tax obligations?
As with any other investment on realization the taxpayer will be liable for capital gains tax (CGT). However, if the investor utilized the Section 12J deduction when they purchased the shares, the base cost will be reduced to zero on realization. Therefore, the capital gains tax liability is higher than it would have been for the same investment where the Section 12J deduction was not applied.
Taking the CGT into account, is an investment in a Section 12J company still beneficial?
Below is a theoretical comparison of a traditional investment in listed shares versus an investment in a Section 12J company. For the sake of argument the following are assumed for both investments: a 10% annual growth in value, a 5-year investment term, an individual tax payer with the maximum marginal tax rate of 45% and all other factors are constant.
Considering the tax benefit, it changes the target return profile. Using the example, a R100 000 investment in section 12J company for a person with a marginal tax rate of 45% essentially means the individual makes a net investment of R55 000. This is because the tax man is essentially funding the R45 000, because instead of paying SARS R45 000, you are investing in a Section 12J company. Using the example, the total return for the section 12J investment is R32 062/R55 000= 58% over 5 years (excluding costs) compared to the listed investment’s R50 062/R100 000= 50% over 5-years (excluding costs).
For this potential higher return there’s added risks such as:
Venture Capital Companies are usually young companies and therefore not yet established. This means they carry a higher risk of failure compared to more mature businesses.
The current Section 12J legislation requires the VCC shares to be held for a period of 5 years in order to make the tax deduction permanent. This means that capital may be tied up while this holding period expires. But in addition to this, even after the holding period, it may not be easy to sell VCC shares at their full value as a willing buyer will need to be found. Purchasers of these “second-hand” VCC shares will not benefit from upfront income tax relief unless the proposal to transfer tax benefits is implemented.
How to choose the Section 12J that’s right for you.
Investors should avoid being blindsided by the attractive upfront tax deduction and should focus time and effort into understanding the investment strategy of the 12J companies under consideration.
If the investor is looking for high returns, there are riskier 12J companies that invest in pure venture capital investments. If the investor is looking for capital preservation, there are property-backed hospitality assets offering stable returns.
Lastly, if the investor is looking for exposure to established businesses, there are 12J companies investing in private equity.
Investors should invest in a 12J company that meets their risk profile and should not be driven to invest purely for the tax benefit.
Assuming after 5 years the fund made no gains and lost none of the initial investment of R100 000. Capital gains tax liability would equate to R 18 000 for an investor paying tax at the maximum marginal rate of 45%. Which means the investor would receive R 82 000 after tax at the end of the 5-year investment period. The annualized return for the investor in such a scenario equates to 8.3% per annum (R 55 000 compounded by 8.3% annually for five years will reach R 82 000). The recommendation would be to invest for capital preservation for example property-backed hospitality assets offering stable returns