Sourcing alternative returns in uncertain markets

The introduction of Section 12J investments has provided local investors with a unique opportunity to invest in tax-deductible investment vehicles. Here’s what you need to know.

When the government added Section 12J to the South African Income Tax Act in 2009, the aim was to afford small- and medium-sized entities (SMEs) equal access to funding. Only in recent years, however, has this opportunity captured the interest of local retail investors.

Essentially, the objective of this ruling was to provide a catalyst for equity funding towards SMEs, which would contribute to the drive for future economic growth. By investing in these vehicles, investors not only qualify for a full deduction of the total investment amount from their taxable income in the relevant tax year, but can play an indirect role in supporting the national economy.

How does the process work in practice?

A tax-paying entity – this includes trusts and companies – approaches an accredited venture capital company (VCC) with their investment (see the SARS website for a list of approved VCCs). The recipient 12J company then invests this money in underlying investee companies via a private equity investment vehicle.

In return they issue investors with a certificate for the full invested amount. This certificate allows the investor to deduct the value of the investment from their taxable income in the same tax year, which essentially provides the tax payer with a tax-free investment opportunity.

For provisional tax payers who submit tax returns at end-February, the tax benefit can be deducted from the tax liability before provisional payments are made.

Unavailable on Glacier platform, but worth evaluating if suitable for client

Access to private equity vehicles isn’t currently available on the Glacier platform.

The challenge in hosting these vehicles is similar to that of hosting hedge funds, where the platform is faced with little or no price discovery and there are often unfavourable lock-in periods applicable to prospective investors. In addition, alternative investments are generally subject to far less regulation than traditional collective investment schemes (CISs) – this includes private equity vehicles such as 12J VCCs.

Despite these constraints, the opportunity remains an option for appropriate investors. Below we discuss who such an investment may be suited to, as well as key considerations to be aware of.

Double-edged sword: understand the tax implications

The first catch relates to the potential issue of double taxation.

When the VCC makes changes within the portfolio during the investment term, or if the investor wishes to sell the investment after the compulsory five-year period, capital gains tax (CGT) will apply to the sale, with the entire investment calculated as a gain. Investors will also pay applicable taxes when dividends are paid by a Section 12J vehicle.

It’s crucial to note that the base for capital gain will be zero on maturity of the investment – this is due to the benefit of 100% tax deductibility.

A hypothetical example

To illustrate this concept, Westbrooke Alternative Asset Management provides the following examples:

Investor X has a marginal tax rate of 45% and makes a R1 million investment in a Section 12J fund – the actual net investment from the investor’s point of view will effectively be worth only R550 000, as SARS will be funding the remaining R450 000 via the tax credit.

Now assume the 12J fund merely returns the capital amount of R1 million to the investor after five years, thus generating no capital growth over that period. This amount will be multiplied with an inclusion rate (40% for individuals and 80% for trusts and companies) and then by the investor’s marginal tax rate. For Investor X that would equate to a CGT liability of R180 000, which means they’ll receive R820 000 after tax at the end of the five-year period.

The result for the investor would be the equivalent of an 8,3% return on the investment per annum (the effective initial investment of R550 000 compounded by 8,3%, for five years, would return R820 000).

This is an attractive return considering zero capital growth, and could be enhanced further by any returns generated by the underlying investee companies – see below table, assuming the fund also generates capital growth of 10% over the five-year period.

Section 12J investments can also be very handy in counteracting current CGT events that may apply to an investor.

Let’s consider Investor X as an example once more. Assume he’s sold his beach house for R5 million, and the base cost was R3 million. He’s now liable for CGT on R2 million of gains.

At his marginal tax rate of 45%, and an inclusion rate of 40%, the investor will be due R360 000. If he uses the opportunity to invest R360 000 in a Section 12J fund, however, his resultant taxable income in that year would be R0, due to the R360 000 tax credit on offer.

Risk of capital loss – do your homework

There are significant portfolio benefits on offer for investors, but it’s important to note that there remains the risk of capital loss. As a result it’s critical to ensure there’s sufficient expertise and private equity experience within the team managing such a vehicle.

Because we don’t currently host these funds on our platform, we can’t vet a fund through our standard due diligence and fund approval procedures. Much of the due diligence onus now falls to the intermediary, who needs a clear understanding of the fund structure, the underlying holdings and the nature of leverage being used within such a fund or by the investee companies.

In addition, the intermediary needs to be comfortable that the management team has a demonstrable VC track record as there are sure to be many new players looking to capitalise on the Section 12J ruling.

Understand upfront and annual fees

Prospective investors should also scrutinise the fee structure applicable to these vehicles. Private equity vehicles are often synonymous with high upfront and annual management fees. In addition, significant performance fees may apply to the investment.

These fees shouldn’t necessarily be a deal-breaker, as long-term returns could be commensurate – but you need to be fully aware of the structure to communicate effectively with your client and ensure investment transparency.

Consider the asset class and time horizon

Next, you need to think about the asset class in question. Private equity – and VC is just a form of this asset class – sits on the highest end of the risk-return spectrum (see below risk return indicator).

As a result both the client and the intermediary should be fully aware of the lock-in period that applies, as well as the resultant longer time horizon required when investing.

Source: Invest12J.co.za

What about the applicable risk?

Other than the considerations mentioned above, there are two major areas of risk for investors. Invest12J broadly classifies these as investment risk and liquidity risk.

The investment risk portion deals with the fact that VC investments are made into investee businesses that are generally not well established and often in their infancy. Naturally, there’s a greater risk of failure with these businesses, as opposed to investing in more traditional companies with a demonstrable track record of generating profit.

The liquidity risk factor speaks to the lock-in period applicable to these investments – SARS requires Section 12J investors to be invested for a minimum of five years in order to reap the tax benefit on offer. And even once this five-year period has elapsed, the investment return may well take further time to materialise because another buyer needs to be found before exiting the investment.

In addition, it often takes a long time for these companies to mature to the level that investors can benefit. As is always the case with greater levels of risk, however, the potential for larger-than-usual returns remains.

Despite the various challenges and risks highlighted above, we believe the examples discussed clearly demonstrate the potential value that such a vehicle could add to an investor’s portfolio – when managed appropriately.

Selective and strategic investments in Section 12J-approved vehicles can definitely be beneficial for well-suited and informed investors. These investors will generally have surplus wealth and often be in high tax brackets.

Importantly, the investor needs to be able and willing to be strategically invested without material time horizon and drawdown constraints. For these investors, Section 12J investing can provide considerable income tax relief, and could potentially provide valuable investment diversification opportunities, in the appropriate circumstances, via the introduction of uncorrelated and alternative asset classes.

Written by Dean de Nysschen, Research and Investment Analyst at Glacier by Sanlam