Despite furious lobbying for its extension, leading into the National Budget in February, National Treasury decided to allow the sun to set on the section 12J incentive that has seen roughly R11bn raised by fund managers from private investors to deploy into qualifying venture capital companies.
It was a disappointing end to what was largely seen as a highly successful incentive, but not entirely unsurprising to those close to the sector who had seen some managers abuse the spirit of the incentive.
As COVID-19 causes South Africa’s fiscal deficit to bulge even further, perhaps a little less than anticipated, thanks to the recent better than expected tax take numbers for November and December, and into the first quarter of 2021, the question remains: what role should and could incentives such as s12J play in supporting SMEs through this crisis?
As National Treasury points out in its 2019 Economic Strategy document: ‘Creating an environment in which SMMEs can thrive is inextricably linked to creating conditions in which all businesses can thrive.’
One of the main challenges to the growth of small and medium-sized businesses is access to equity finance.
To assist these sectors in terms of equity finance, Government implemented a tax incentive for investors to invest in these businesses, called s12J, which has really blossomed over the last few years.
The tax benefit fundamentally changes the target return profile of the investment. If you take a R1m investment into a s12J company for a person with a marginal tax rate of 45%, that essentially means that the individual makes a net investment of R550 000. This is because the tax man is essentially funding the R450 000; instead of paying SARS R450 000, you are investing it in an s12J company.
But there is a small catch. When you sell your investment at the end of five years, you will be liable to pay capital gains tax, with the entire investment calculated as a gain.
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Dino Zuccollo, chair of the 12J Association of South Africa, sums up the reaction to the announcement in one word: “Disappointing.”
“I think when one analyses National Treasury’s views around s12J, it's fair to say that they made a number of good points and that certainly their reasoning wasn't totally incorrect,” says Zuccollo.
But he hastens to add that there were also many issues that they missed.
“If you take a look at the rationale, there were three points that they made. The first was that, in their opinion, many of the investors into the s12J companies were investing with no risk and, in [Treasury’s] view, excess capital, irrespective of whether the incentive was there or not.”
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Zuccollo doesn’t necessarily agree with the reasoning, and he believes that many of these businesses, such as hotels, required equity injections due to COVID-19 and the concomitant impact on the tourism sector, by way of example.
“And just a principal issue that I didn't like was that rich people and high net worth individuals were gaining a tax deduction through section 12. And again, that is an accurate point, but I don't think it paints the whole picture. Being in the asset management business, I can assure you that high net worth capital in South Africa at the moment is going offshore in unbelievably large quantities. And frankly, any incentives that can convince people to keep their money in South Africa, to benefit South Africa, should be retained in some shape or form.”
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Jonty Sacks, a partner at a boutique fund management and administration business specialising in s12J, Jaltech, has a slightly different take.
“The non-extension of s12J came as a huge surprise to the industry. Particularly given that the s12J Association’s report indicated that more than 15 000 jobs were supported by the incentive, and more than 350 SMMEs received equity funding,” says Sacks. “On reflection, however, it appears that the industry has itself to blame for the non-extension, particularly around the failure by a number of fund managers who failed to deploy capital under management.
“As an industry, had more capital been invested in SMMEs, then the argument for an extension would have been far more convincing, as one would assume that the job creation numbers would have been significantly larger, tax revenue collected from the SMMEs would have been significantly higher, and so on.
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“It is therefore no surprise that National Treasury’s statement read that ‘the incentive has not adequately achieved its objectives’. How could it, given that only approximately R4bn of the total R11bn raised by the industry has been invested into the SMME market?”
The question now becomes, what happens to the funds come exit time, when potential buyers will be aware of the stampede for the exits, and while the industry will battle to retain talent?
“The first thing that's worth pointing out is that s12J is not being scrapped with regards [to] funds that are already there,” explains Zuccollo. “What happens is from June of this year, no new s12J funds can be created and
so investors still have until June of this year to take advantage of the tax incentive and to get their tax breaks. I think the biggest issue now, though, comes to the people managing s12J funds. Obviously, the question is, have you invested with a fund that has the skills and expertise [to effectively manage the fund]? But now in the face of s12J changing, the question is, who's going to be around in four years’ time to manage your money and to ensure an orderly and hopefully profitable unwind of your investments?”
That’s one of the most important points for investors to consider if they do want to invest in s12J before the deadline of 30 June, to make sure that their managers are part of a larger business that will endure the test of time.