Many investors do not fully understand the tax incentive and structure of a Section 12J venture capital investment, says Zane De Decker, managing director of Section 12J company Flyt Hospitality.
Section 12J of the Income Tax Act enables investors already at the highest marginal tax rate of 45%, to deduct the full amount of an investment in a qualifying business from his or her tax liability in the year in which it is made.
Sectors which qualify include hospitality, renewable energy and manufacturing.
"The glaring misconception is that S12J merely delays tax and investors get 'nailed in the end' with Capital Gains Tax (CGT), but this is not the case at all," says De Decker.
An investment in a Section 12J fund is treated as an "expense" or tax deduction, therefore "reducing" the amount of taxable income. The confusion comes about when an investor is looking to cash in.
An investment into the The Flyt Hospitality fund, for example, is locked in for the legally required five-year period and the amount invested will be subject to capital gains tax calculated at 40% of the gain.
Reduced tax burden
"What is also important to remember, is that not only have you reduced your tax burden, but you have delayed it too, by a minimum of five years. If you opt to stay in the investment fund after the five-year period, you have avoided paying that tax until such time as you do sell," explains De Decker.
"In the meantime, you enjoy the full benefits - capital growth and dividends - of the full investment amount. If you don't sell your shares in the fund, you never pay the tax."
Michael Westcott, CEO of Absolut Wealth Management, says Section 12J has created an opportunity for a number of his clients to shield a capital gains tax event following the disposal of a share portfolio.
"The upfront benefit of investing in a Section 12J fund is that the investor, whether a provisional taxpayer or not, is entitled to deduct 100% of the investment against his or her taxable income," explains Westcott.
"As capital gains fall within a taxpayer's taxable income, financial advisors are able to balance a disposal of a listed equity, unit trust portfolio, property and/or business interest with a Section 12J investment in order to reduce the capital gains tax liability by as much as R1 125 000 for an individual investor."
He notes that one must be mindful that a Section 12J investment is not comparable from a risk profile to a listed equity investment. However, if the investor's intention is to exit investments, a Section 12J investment has its place in terms of shielding the tax liability and potentially earning a return from asset exposure that meets the investor's risk appetite, according to Westcott.
Like De Decker, Westcott also says one aspect of Section 12J which is often misunderstood is the capital gains tax event on exit.
"Unlike with most other investments, when calculating capital gains tax, a Section 12J investment's base cost must be reduced to zero. In other words, an investor at the highest marginal tax rate will likely pay 18% capital gains tax on his or her original investment amount when exiting the Section 12J investment," he explains.
"Most people, however, fail to take into consideration the fact that the same investor received 45% of his or her investment "back" in the form of an upfront tax refund."
Brian Butchart, managing director of Brenthurst Wealth Management, says it is important for investors to do their homework well beforehand in order to make sure the Section 12J incentive is a suitable investment. One must also make sure to understand the risk associated with each Section 12J investment.
He says investors must ensure the S12J company or fund complies with all the legal requirements. Investors must also realise that their money will be "tied up" for at least five years.
The tax incentive of S12J should not be the only reason for making the investment, emphasises Butchart.
R8.3 billion invested
Jonty Sacks, a partner at Jaltech Fund Managers, says by the end of February 2019, more than R8.3 billion had been invested by South African taxpayers into section 12J investments.
"During the initial years, the main driving force for many investors was the upfront tax benefit associated with Section 12J investments, and very little consideration was had for the investment characteristics or the performance of the investments. A major contributing factor to this was due to earlier years very few, if any, of the Section 12J investments had a track record," says Sacks.
"Having considered several funds fact sheets across multiple Section 12J investments, I can confirm that there are a number of investments which are providing investors with attractive returns. The positive returns currently in the market range from between 9% to 12% per annum and when one includes the Section 12J tax benefit (which is about 8.3% p.a. for taxpayers at the highest marginal rate), the returns balloon to between 17% to 21% per annum."
In his view, positive returns are good signs of a maturing and developing investment class. He suggests that, when reviewing a Section 12J fund fact sheet, investors have to be mindful that this type of investment needs a trained eye to understand how returns and fees are calculated in order for an investor to make an informed decision.
Gaurav Nair, an investment actuary at Jaltech Fund Manager, says it is important to understand the returns.
As with any investment, if the fund fact sheet reflects negative performance, investors should be cautious before making an investment. This includes factors such as whether the Section 12J investment’s net asset value (NAV) has decreased and/or whether actual returns are below targeted returns.
Also understanding what factors can erode returns or are signs of eroding returns. These can include fees and the investment of capital under management.
Look at the track record of the fund manager in running the Section 12J investment; the business case of the particular investment; and the costs which need to be covered in order to attain the IRR projected. Be particularly careful of performance fees which should not be benchmarked too low to the detriment of investors.
Also look at the critical mass of capital raising which will allow for deployment of the capital within the prescribed 36-month period; liquidity at the end of the 5-year term and being able to claim the full tax deduction.