Articles

Tax breaks for venture capitalists

The Professional Accountant September 2008/Business Law & Tax Review November 2008
By Alastair Morphet

About two years ago there was media coverage about SA adopting something similar to what the Canadian tax regime has, namely, a form of flow-through company. The idea behind this company was to assist the development of junior mining companies by passing the tax breaks which a mining company is eligible for to its shareholders in the period before the mining company generates sufficient taxable income from production to utilise the costs generated by its mining activities.

If SA had adopted such a proposal it would have marked a radical break with the fundamental principles of our tax system.

However, in the Draft Revenue Laws Amendment Bill 2008, the South Africa Revenue Service (SARS) has made provision for the creation of an alternative in the legislation for the introduction of a so-called venture-capital company in a new section 12J. The intention behind this law is to provide a tax incentive for investors in small and medium-sized enterprises. This venture-capital company is intended to attract retail investors, thus providing the funding for an investment management company to invest in new opportunities in the small business sector.

An investor in such an approved company will be entitled to deduct 100% of the amount he has invested in such shares, but capped at an amount of R750 000 for any year of assessment in which the investment is made. The deduction is only available for contributions to the venture-capital company in exchange for newly issued shares: thus if an investor sells his shares in the secondary market he will recoup the deductions which he has previously obtained. The purchaser of such shares will be subject to normal principles.

SARS' basic principle is that companies should not be able to invest in these venture-capital companies save for a listed company or one of its group companies, which can deduct the full 100% contribution it makes to such an entity provided that the company or its controlled group companies do not hold more than 10% of the equity share capital of a venture-capital company.

Corporate investors can hold more than 10%, but they will only qualify for the tax deduction on the first 10%. In treasury's responses to the parliamentary committee on finance, the reason they will not permit investment through unlisted companies is that the authorities do not want individuals routing their investment through companies.

Readers need to note that the deduction will only be available to the investors who are in possession of a venture-capital company investor certificate (I suspect that getting this certificate will be along the lines of a section 18A certificate issued by a public benefit organisation).

So, a venture-capital company will need to apply for approval from the SARS commissioner in much the same way that a public benefit organisation obtains the commissioner's approval from the tax exemption unit. The draft legislation provides that the commissioner must approve a venture-capital company if it has submitted a copy of its business plan to the commissioner and that he is satisfied that within 36 months of its incorporation it will comply with all of the conditions contained in the definition of "qualifying company". These are that the expenditure incurred by the company in acquiring qualifying shares will be at least R50m, or if the company acquires qualifying shares in any junior mining company, at least R250m. The gross income of the venture-capital company has to be derived solely from financial instruments (ie equity securities in those investee companies, or debt instruments such as debentures), although the treasury has acknowledged provision will need to be made within limits for the company to earn some proportion of management fees.

At least 10% of the venture-capital company's expenditure in acquiring qualifying shares will be from companies with a market value not exceeding R5m immediately after their issue; and that at least 80% of its expenditure will be for the shares of companies that hold assets not exceeding R10m, unless that company is a junior mining company in which case it will not exceed R100m; that no more than 15% of its expenditure is in acquiring qualifying shares issued to it by any one qualifying company; that the company together with any connected person to it cannot hold more than 49% of the equity share capital of any one qualifying company; and that the company is licensed in terms of section 7 of the Financial and Intermediary Services Act.

If in any year of assessment the commissioner is satisfied that the venture-capital company has failed to comply with the provisions, he must, after due notice to the company, withdraw that approval. If the commissioner withdraws this approval, then the company is deemed to recover or recoup during the year of withdrawal an amount equal to the lesser of the sum of all expenditure incurred by the company in the current or any previous year to acquire any qualifying shares; or the sum of all deductions allowed to any person in the current or any previous year in respect of expenditure incurred for the issue of shares by the company (ie investors will suffer the consequences of the deemed recoupment).

There is provision for a company that has failed to qualify in a subsequent year, rectifying such non-compliance to the satisfaction of the commissioner, in order to retain its venture capital company status.

The definition of qualifying share means an equity share held by a venture-capital company that is issued to that company by a qualifying company, unless the company has an option to dispose of the share for an amount other than the market value of the share at the time of that disposal. The venture-capital company cannot therefore hedge its risk with forward contracts or other derivative instruments.