What is Section 12J?

Treasury (through multiple amendments to Section 12J of the Income Tax Act) is incentivising South African taxpayers to invest in the local economy, via a tax deduction on the investment amount, provided the investment is made into an approved Section 12J Venture Capital Company (Section 12J VCC).

The benefit to the investor for making the investment in a Section 12J VCC, is a return on the investor’s full investment and a tax deduction on the amount invested.

By way of illustration, if an investor (an individual in the highest tax bracket) invests R1 million in a Section 12J VCC, the investor will receive a tax credit of up to R450 000 at the end of his/her financial year. What this means is that an investor will receive a return on 100% of their investment but only have exposure on 55% of their original investment amount.

Description Individuals/Trusts Corporates
Initial investment R 10 000 000 R 10 000 000
Tax relief (in the tax year of initial investment) (R4 500 000)* (R2 800 000)
Net investment (risk capital) R5 500 000 R7 200 000

*assumes individual is in the highest marginal tax bracket

The tax relief can be carried over where the investor is a company, and in circumstances where the investor is an individual or trust, the tax relief (in most instances) is limited to the tax year of investment and can therefore not be carried over.

What is a Section 12J VCC?

A Section 12J VCC is a company which has been registered as Financial Service Provider (FSP) with the Financial Sector Conduct Authority (FSCA) and been approved by the South African Revenue Service as a Venture Capital Company. The sole objective of the Section 12J VCC is to manage investments in qualifying companies, which should stimulate local investment in small to medium enterprises (SMEs) and address unemployment in South Africa. This is done by providing the investor (South African taxpayers) with a tax incentive for investing in a Section 12J VCC.

There are two types of Section 12J VCCs into which an investor can invest, namely:

1. Third Party Section 12J VCC
Third Party Section 12J VCCs are managed by fund managers who raise third-party finance for the Section 12J VCC and identify the investment opportunities. Third Party Section 12J VCCs offer various levels of returns based on the risk profile of the underlying asset class.  Examples of Third Party Section 12J VCCs can be found at www.12Jmarketplace.co.za

2. Ring Fenced Section 12J VCCs
Ring Fenced Section 12J VCCs allow South African taxpayers to indirectly invest in qualifying investments which they have identified and benefit from the tax deduction associated with Section 12J, whilst having exposure only to their specific investment through a specific class of share.

A Ring Fenced Section 12J VCC, therefore, allows angel investors, seed investors and/or entrepreneurs with a higher risk appetite to invest in qualifying investments which they understand and which in many cases would not be of interest to other investors.

What investments can a Section 12J VCC invest in?

A Section 12J VCC can invest in most sectors, however, the legislation outlines which sectors are prohibited. Accordingly, a Section 12J VCC would need to determine whether any of the following elements exist and if so, the Section 12J VCC would be prohibited from investing:

  1. The gross asset value of the target company exceeds R50 million on the date of the investment (R500 million in the case of a junior mining company) from the Section 12J VCC;
  2. The target company earns more than 20% of its income from investments  (for example, an investment in an investment holding company would not be permissible);
  3. The target company operates with a majority of its trade outside of South Africa;
  4. The target company carries on one of the following “Impermissible Trades”:
    1. any trade carried in respect of immovable property, other than a trade carried on as a hotel keeper (i.e. an investment in hotels, serviced apartments, and student residences may very well comply);
    2. any trade in the financial services sector (for example, banking, insurance, money lending, hire-purchase arrangements, however, this does not prevent a Section 12J VCC from investing in technology within this sector);
    3. any trade carried on in respect of financial or advisory services, including trade in respect of legal services, tax advisory services, stock broking services, management consulting services, auditing or accounting services; and
    4. any trade carried on in respect of gambling, liquor, tobacco, arms or ammunition.

On the premise that an investment does not fall into one of the categories above, there is an opportunity to make use of the Section 12J associated tax benefit.

Taking the  above into account, Section 12J VCCs can invest in most businesses with a gross asset value of less than R50 million (R500 million in the case of mining companies), examples of qualifying businesses include (but are not limited to):

  1. mining and contract mining businesses;
  2. agriculture businesses;
  3. franchises;
  4. hotel, lodge, student residences and B&Bs;
  5. manufacturers;
  6. renewable energy businesses; and
  7. general SMEs.

What are the limitations associated with Section 12J?

From an investors perspective, there are two main limitations:

  1. In order to retain the tax deduction, an investor must hold the shares in the Section 12J VCC for a minimum period of 5 years. If the investor disposes of these shares prior to the 5-year period, the investor would be required to pay back the full tax deduction with no interest or penalties incurred.
  2. When an investor exits the Section 12J VCC, the investor’s base cost for capital gains tax (CGT) purposes will be reduced to zero. This means the investor will pay CGT on their investment amount as well as any growth on the investment. By way of example, if the initial investment amount is R1 million and the investment fails to increase in value, the investor will incur CGT on the R1 million.

What are the exit options?

Should an investor wish to exit the Section 12J VCC, the investor has two options, namely:

  1. The Section 12J VCC, on a best endeavours basis, will liquidate or sell a portion of the underlying investment and utilise the funds to purchase the shares from the investor; and/or
  2. The investor could sell the Section 12J VCC shares to a third party.

Renewable Energy

Section 12J is extensively used by a significant number of renewable energy investors, and engineering, procurement and construction companies (EPCs), to increase their competitiveness in the South African market.

These project developers are using Section 12J structures to significantly boost their return on investment (ROI) on renewable energy investments, via the associated tax deduction.

Having structured multiple renewable energy projects in both the wind and solar sector, we have seen the enhanced returns associated with renewable energy projects structured through a Section 12J VCC.

ROI BOOST

There are ways for project developers to achieve an even larger uptick in return through additional adjustments in the finance structure of an investment.

One example includes where a Section 12J VCC is structured in a way that the project developers would still benefit from the Section 12B deduction specific to renewable energy projects.

Having the right structure in place can significantly boost the project’s ROI by more than 20%. 

Hotels, lodges, student residence or serviced apartments

Section 12J is very attractive if you are looking to invest in or develop a hotel, lodge, guesthouse or student residence. Effectively, Section 12J can provide enhanced returns due to the tax deduction of between 28% to 45% on your investment into opportunities that fall within the Income Tax Act’s definition of “hotel keeper”.

To qualify for the tax deduction, the investment must fall outside of the definition of an “impermissible trade” under Section 12J (1)(b). An extract of Section 12J (1)(b) reads as follows:

an “impermissible trade” is “any trade carried on in respect of immovable property, other than a trade carried on as a hotel keeper”.

Section 12J (1)(b) prohibits immovable property investments made by a Section 12J VCC, unless the immovable property is utilised in a “trade carried on as a hotel keeper”. To understand the requirements of the definition of “hotel keeper”, one would have to consider Section 1 of the Act which defines a “hotel keeper” as:

any person carrying on the business of hotel keeper or boarding or lodging house keeper where meals and sleeping accommodation are supplied to others for money or its equivalent”.

Taking into consideration the above definition as well as a binding private ruling issued by the South African Revenue Service, for an investment to meet the requirements of “hotel keeper” in terms of the Act, the investee company must (amongst other) meet the following minimum requirements:

  • let out a room for short term stay
  • offer a meal served on the premises
  • provide a furnished room
  • service the rooms daily
  • all guests must pay for the use of the rooms
  • There are no times when a room is not available to guests for use – i.e. the room cannot be closed for business when an investor may potentially use it

The above indicates that, if structured in the correct manner, the following investments opportunities can attract the tax deduction associated with Section 12J:

  • hotels
  • student accommodation
  • lodges
  • guesthouses

Franchises

Franchisors have started taking advantage of Section 12J by offering franchisees/investors the opportunity to structure their investments into the franchise, through a Section 12J VCC.

The benefit to the franchisees/investors would mean that by structuring their investment through a Section 12J VCC they would receive a tax deduction (28% for companies and up to 45% for individuals and trusts) on their investment.

The benefit is not only limited to potential franchisees/investors. Franchisors looking to expand their existing stores can use the same structure to invest in new branches and receive the associated tax deduction.

Private equity firms and family offices

Private equity firms, family offices, private individuals and companies who have invested in start-ups or mature businesses during 2017 may have missed out on higher returns if they didn’t consider investing through a Section 12J VCC.

At first glance, sophisticated investors may be convinced that Section 12J has no application to their investments, however, if they are South African taxpayers, the chances are extremely high that their investments may well qualify for the Section 12J associated deduction.

The benefit of structuring an investment using Section 12J is an enormous boost to return on investment. The Section 12J benefit effectively translates into a discount (through a tax deduction) of between 28% to 45% on the investments.

Investors can utilise Section 12J to structure investments in a variety of industries and sectors, provided none of the following elements exists in a transaction:

    • the gross asset value of the target company exceeds R50 million (unless a unique structure can be identified);
    • the target company earns more than 20% of its income from investments (for example, an investment in an investment holding company would not be permissible);
    • the target company carries on the majority of its trade outside of South Africa;
    • the target company carries on one of the following “Impermissible Trades”:
      • any trade carried on in respect of immovable property, other than a trade carried on as a hotel keeper (i.e. an investment in hotels, serviced apartments, holiday homes in specific estates and student residences in many cases will comply);
      • any trade in the financial services sector (for example, banking, insurance, money lending, hire-purchase arrangements etc.);
      • any trade carried on in respect of financial or advisory services, including trade in respect of legal services, tax advisory services, stock broking services, management consulting services, auditing or accounting services; and
      • any trade carried on in respect of gambling, liquor, tobacco, arms or ammunition.

On the premise that an investment does not contain any of the above elements, there is a real opportunity for investors to take advantage of the Section 12J associated tax benefits.

Mining

One of the main reasons for the implementation of Section 12J by National Treasury was to promote investment in the junior mining sector in South Africa. Treasury’s intention to favour the mining sector through the implementation of the legislation is two-fold:

    • firstly, mining is the only sector where the gross assets limitation of R50 million has been increased to R500 million (see Q&A for more details); and;
    • secondly, the legislation contains an extremely wide definition as to which companies qualify as junior mining companies, the definition reads

“junior mining company” means any company that is solely carrying on a trade of mining exploration or production which is either an unlisted company as defined in section 41 or listed on the alternative exchange division of the JSE Limited;

Accordingly, most mining companies fall within this definition, however, one needs to be mindful of that fact that the maximum investment amount that can be made by a Section 12J VCC in the mining sector is R500 million. This restriction will therefore limit the application of the incentive for investments in large mining companies but not investments made by large mining companies.

In other words, large (and small) mining companies can structure their qualifying investments or mining explorations through a Section 12J VCC and claim the associated tax deduction.Taking the above into account, mining companies are able to utilise Section 12J across various aspects of their business, including the acquisition of mines, plant and equipment.

Unit 19,1 Melrose Blvd, Melrose Arch
Gaurav Nair  |  Director email: gaurav@jaltech.co.za
Derrick Hyde  |  Director email: derrick@jaltech.co.za
Jonty Sacks  |  Director email: jonty@jaltech.co.za

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