Welcome boost for smaller private equity investments

The Venture Capital Company (“VCC“) tax regime is regulated by section 12J of the Income Tax Act, 58 of 1962 which was first introduced 2009 in order to encourage investments into privately owned businesses. The section specifically aims to help the growth of small and medium sized businesses by increasing their access to equity finance.

There are a number of requirements which must be complied with before a VCC may obtain approval from South African Revenue Service (“SARS“) and qualify for the favourable tax regime. For example, it must be resident, its sole object must be the management of investments of qualifying companies as defined, its tax affairs must be in order and it must be licensed in terms of section 7 of the Financial Advisory and Intermediary Services Act, 2002.

The investments by the approved VCC also needs to be structured in a certain way. The approved VCC is firstly required to hold qualifying shares which are shares issued by a qualifying company, as defined. A “qualifying company” is defined to be a resident with its tax affairs in order, that is unlisted or a junior mining company and not carrying on an impermissible trade. A qualifying company’s investment income is limited to 20% of its gross income. The regime is therefore essentially aimed at direct investment in operational entities.

Further limitations in relation to the investment include that no more than 20% of the expenditure incurred by the approved VCC can be used to acquire shares in any one qualifying company (i.e. the VCC will need to own at least 5 investments) and at least 80% of the expenditure incurred by the approved VCC must be to acquire qualifying shares in qualifying companies having assets with a book value not exceeding R300 million for a junior mining company or R20 million for other companies. If all of the qualifying criteria are met, an investor will be allowed to deduct the expenditure incurred in acquiring shares in a VCC from its taxable income, creating a sizable incentive to invest. Continued compliance with the requirements will require careful management but the tax incentive effectively means that a VCC will get the return on 100% of the investment for 60% of the cost.

There has however been a limited uptake and approximately only 10 VCC companies were approved to date. One of the main reasons for the limited interest was as a result of the fact that the original qualifying asset limitation criteria set at R300 million for junior mining companies and R20 million for other companies were too low.

The SARS has recognised these limitations and the Taxation Laws Amendment Act of 2014 (the “Amendment Act“) has favourably improved section 12J of the Act. The most significant of these proposed changes are the increase in the abovementioned book value limit to R500 million for a junior mining company and R50 million for other companies. The amendments also provides that the deduction to a taxpayer for the expenditure incurred in acquiring shares in a VCC will no longer be recouped and taxable where the taxpayer sells the shares provided the taxpayer held the shares for a period longer than five years. The amendments will come into effect on 1 April 2015

These amendments have been welcomed by the private equity industry and is expected to have a positive effect on the economy by ensuring greater investments into small businesses and junior mining companies, which will stimulate job creation and economic growth.