By Andy Higgins | January 14, 2018
What is a Section 12J Venture Capital Company?
Section 12J Venture Capital Companies (VCC) are companies that have been approved by SARS, enabling tax incentives for retail investors when making investments into the VCC.
Typically, a VCC would be structured as follows:
This tax incentive for the investor is available to any taxpayer but this post will focus on individuals that are investing in their personal capacity. For an individual, if for example you earned R1 million in taxable income for a particular tax year, you would be able to invest R1 million in a VCC and not have to pay any tax in that year. So in short, the amount invested in a SARS approved VCC is tax deductible in the same way that contributions to a pension fund / RA are tax deductible (up to certain limits).
It should be noted that there are some limitations with regards to which industries a VCC may invest in. For example, the company being invested in cannot be operating in the following sectors: fixed property, financial services, consulting or other advisory type services as well as any of the “sin” industries (liquor, tobacco, arms or gambling).
It should also be noted that the investor has to hold the investment for a minimum of 5 years in order to receive the full tax benefit.
I am interested in comparing the tax implications of a very specific case. Assuming I had the opportunity to invest directly in a particular company, taking the whole investment life cycle into account, would I be better off from a tax point of view if the investment was made directly in my personal capacity or via a VCC?
It turns out this is not a simple comparison and depends on a number of factors. For this I will make a number of assumptions:
- My personal taxable income is R1 million for the year in question. This is taxable income, so after any allowed deductions such as RA contributions but also includes 40% (i.e. the individual inclusion rate) of any capital gain made in the tax year.
- I am investing R1 million (based on the before-tax amount).
- I expect to receive a 300% return on my investment after 5 years (as long as it is positive, the actual return does not matter but it is useful to include a value to show some potentially realistic numbers).
- The VCC charges 2.5% per year in management fees.
- The VCC applies carried interest of 20% (this is the percentage of the “profit” they take as a performance bonus).
Investment via VCC
- This amount is used to subscribe for shares in the VCC.
- All the management fees a VCC are likely to charge is not clear, therefore this calculation assumes maximum fees of 20% (as allowed by SARS) in total over the lifetime of the fund are exercised. While this is not entirely accurate as all the fees will not be taken upfront, in the same way the carried interest will not all be taken at the end of the investment period and these two therefore effectively cancel each other out allowing for a simpler calculation with very similar results to if one were to annualise the fees / carried interest.
- This is the amount that is actually available to be invested in portfolio companies (after fees).
- Based on the expected 300% return of the underlying investments.
- 20% Carried Interest is paid to the VCC managers as a performance bonus.
- Effective Company CGT rate of 22.40% (80% inclusion rate and 28% company tax rate). This is assuming the underlying companies are exited with the proceeds treated as capital gains.
- Less the CGT amount.
- Dividend tax of 20% (assuming proceeds are distributed as a dividend). In this case no further tax would be payable in the hands of the individual. If this instead effectively ended up as a capital gain in the individual’s personal capacity, then they would pay up to 18% CGT with similar end results.
- This is the after tax return the investor can expect to receive excluding their initial investment.
- Because the original R1 million was 100% tax deductible, SARS requires the base cost of the investment to be zero thereby triggering individual CGT on the initial investment amount as well (assumed to be 18%).
- The total amount the investor will receive including their initial investment after all taxes have been paid.
This means if I invested R1,000,000 via a VCC and the underlying investments received a return of 300% over 5 years, I could expect to receive R2,011,936 back after all taxes have been paid including my original investment.
Investment as an Individual
Assuming I had access to invest directly in my personal capacity, I would have to make that investment with after tax money. Therefore in order to do a fair comparison, I need to use the after tax amount for the initial investment and compare the total amounts I would receive back at the end of the investment period.
The key here however is I need to use my average tax rate and not my marginal tax rate to do this calculation as I am investing the full amount of taxable income I received during the tax year.
- On R1 million taxable income, based on the 2018 individual tax tables for under 65, you will pay R314,989.90 in income tax (i.e. an average tax rate of 31.5%).
- To be a direct comparison with the VCC example above, we need to start with the same amount of R1 million before tax
- Subtract the income tax payable to SARS.
- This is the amount available to invest in the underlying portfolio companies.
- Based on the expected 300% return of the underlying investments.
- Individual capital gains tax. For simplicity, I have assumed that personal CGT will be at 18% (45% marginal tax rate multiplied by 40% inclusion rate). If your marginal tax rate is less than 45% this value would be slightly less.
- Amount after tax returned excluding the initial investment.
- The total amount the investor will receive including their initial investment after all tax has been paid.
This means if I invested R1,000,000 of before tax money in my personal capacity and the underlying investments received a return of 300% over 5 years, I could expect to receive R2,370,100 back after tax including my original investment (slightly more than when investing via the VCC).
Note however that if for example you earned R2.5 million of taxable income in a tax year and you invested R1 million of that in a VCC then the results look different i.e. the current threshold for paying 45% tax is R1.5 million so in this case the effective tax rate on the R1 million investment would be the full marginal tax rate of 45%.
In this case, investing in my personal capacity, I would receive less compared to what I would have received, had I invested via the VCC.
Obviously the above comparison is not exactly an “apples with apples” comparison as there are many other factors to take into consideration:
- Scouting of deals. The managers of a VCC may be in a better position to find good deals.
- A considerable amount of time goes into assessing and the carrying out of due diligence of any deals.
- There is potential ongoing value-add and expertise provided by the VCC to portfolio companies i.e. hopefully their management fees and carried interest is earned.
- If you were to invest directly in a company, it is likely to take up some of your time, which may not be the case when investing via a VCC with professional management.
- Investing via a VCC is likely to provide greater diversity to your investment as they will more than likely spread your money over more investments than you can do in your personal capacity.
- SARS requires the investor to invest in the VCC upfront (unlike other funds that call on committed capital as required). There is normally a delay from when a VCC receives funds to when it is deployed resulting in the possibility of a large portion of your funds not going to work for some time.
Based on the above calculations, it seems that once you are paying an average tax rate of over 41% on the funds used to invest via a VCC then, from a pure tax point of view, it is more beneficial to do so through a VCC than in your personal capacity. This however does not take into account all the other potential benefits one gets when investing in a VCC. Therefore, if you have faith in the investment choices a VCC are going to make, you are probably better off investing in the VCC even if your average tax rate as discussed above is less than the 41%. Of course, if personal income taxes increase in the future, this 41% threshold will decrease.
As a side note, there are cases like this where government has provided very attractive mechanisms to potentially save on tax but the bottom line is, as government has moved to close any loopholes that may have existed in the past, from a pure tax point of view it is hard to pay less tax by using some kind of fancy structure. There may be other reasons to structure investments through companies or trusts such as estate pegging or protection from potential creditors, but when looking at the pure tax benefits, there is still no better way to hold an investment than in your personal capacity.
One final thought, do not invest in a VCC purely for the tax benefit. Yes, this is a great incentive to do so but ultimately, like any other investment, first and foremost only invest if you believe in the underlying investment story the VCC managers are telling.