By Brian Butchart, Managing Director and CFP®
Why we don’t get excited when alternative investments go up for sale
Cryptocurrencies, venture capital vehicles and all kinds of fintech oddities are offering new and alternative ways of exchanging wealth and/or creating incentive structures to cut out undue influence on a value system.
Unfortunately, in many cases a layman investor simply gets entangled in the hype of new lavish investment options. Especially during times of market turmoil or an expected economic downturn, without fully understanding the intricacies or limitations of such investments and find themselves stuck in a bubble just waiting to burst.
The Section 12J Venture Capital Company (VCC) tax regime – which has attracted a lot of media attention recently – is one such option. As tax authorities are honing in on returns achieved on various alternative options attracting attention, for instance crypto currencies, opportunities that offer tax relief are gaining in popularity.
There are more than 100 registered Section 12J companies in South Africa and it is estimated that the market has raised more than R3.6 billion in investments at the end of 2018.
Although it has been around since 2009, the allure gained traction in 2014 when tax rules were amended and, considering the ever-increasing high tax burden on individuals, the tax break seems particularly appealing.
No wonder investors are being drawn in and finding this option way more interesting than the slow and steady long-term approach of a diversified portfolio across asset classes, industries and regions.
But like the hype created around other alternative investments going on sale, I have a similar risk-averse view of Section 12J VCC schemes.
Section 12J was introduced into the Income Tax Act to provide individuals, companies and trusts with a tax incentive to invest in VCCs. These fund small- and medium-sized enterprises that are believed to have long-term growth potential in economic sectors that are often hard-pressed for financing. The aim was to encourage investors to participate in the capitalisation of these businesses, which will stimulate economic growth and create jobs.
The reality is, however, most people cannot make use of this tax break, because VCCs require a minimum investment of at least R100 000 – more often R500 000. Therefore, the likely investor is someone in the top marginal tax bracket of 45% (a taxable income of R1.5 million or more a year) who wants to reduce his or her taxable income after making full use of tax-efficient options like contributions to a retirement fund or tax-free savings accounts.
Furthermore, Section 12J may encourage an investor to invest in enterprises which they may not have previously considered, or fully understand. There are also limitations as to the industries in which a VCC can invest in order to qualify for the rebate, with the main challenge being ensuring that the VCC has the necessary compliance processes in place, to take full advantage of the tax incentive, while not falling foul of any related provisions.
We have been approached by a number of 12J offerings to guide investors to use this option, yet we have not seen one that excites us or that we would want to recommend. Our advice is to think very carefully before selecting this as an investment. Although some funds are ticking all the investment manager boxes, it’s the puffery and promotion of instant returns and tax savings that are swaying investors and not necessarily the fundamentals required of a solid long-term investment strategy. And it seems that the noble design of the incentive is largely lost to yet another dose of ‘too good to be true’ methodology.
A reliable investment firm puts in effort and energy on finding suitable windows of opportunities that fit the risk profile of their clients and which will produce long-term sustainable returns for the venture and its capital. This takes dedication, expertise, experience and investment savvy, and leaves little room for some of the hoo-hah being punted out there.
It does beg the question why investors don’t get as excited when shares, bonds, property or commodity investments are on sale?
Yes, it is taking a longer-term view, but the irony of the Section 12J hype is that investors must also be prepared to tie up their money for at least five years. If they sell their shares before then, they forfeit the tax deduction and have to pay back the money.
Furthermore, tax deductions should not make for an investment case alone. Like with retirement annuities and tax-free savings accounts the benefit should be considered a bonus – not the driving force behind the decision. In this case the tax benefit is upfront and only applies in the tax year in which the investment is made. However, you will still be liable for withholding tax when dividends are paid to you and you will be liable for capital gains tax when you sell your shares in the VCC.
A Section 12J investment is in no way a total tax-free ride.
The upfront tax deduction also has some tight qualifications – for instance, the tax deduction cannot be claimed if you are a ‘connected person’ when, or immediately after, you buy shares in the VCC. And if you take out a loan to buy shares in a VCC, the deduction is limited to the amount you actually transfer to the VCC, not the total loan amount, to name a few.
Legitimacy concerns are also at play here. Are the investment managers recognised by the Financial Sector Conduct Authority as being competent to make discretionary investment decisions? Are VCCs keeping sufficient records of all their investors and the entities in which they invest, and are they submitting these records to Sars twice a year? And even though it’s not mandatory, are you dealing only with VCCs that belong to the South African Venture Capital and Private Equity Association?
Then there is the consideration of costs. Fees associated with a section 12J investment can include once-off upfront, or capital-raising fees; annual fees, performance fees and exit fees.
And what happens if you want to sell your shares once the five years are up? Qualifying companies are often illiquid, private equity-style investments, and, unlike with listed equity investments, there is no ready-made secondary market for VCC shares. There are also no tax breaks for secondhand buyers.
Potential investors should be knowledgeable enough to understand the potential rewards and risks of a VCC’s underlying investments. Tax breaks may be appealing, but a committed long-term financial plan and investment strategy, in my view, remains the better option.