23 September 2016 by Tax and Exchange Control Alert

Funding for small and medium-sized enterprises

The Venture Capital Company (VCC) Tax Regime was introduced into the Income Tax Act 58 of 1962 (Act) to encourage investment into small and medium-sized enterprises (SMEs) and junior mining companies. Since its inception in 2008 and despite subsequent amendments in 2011, there has been limited take-up in the market, with only a handful of VCC funds having become fully funded and operational.

Section 12J of the Act provides for the formation of an investment holding company, described as a VCC. Investors subscribe for shares in the VCC and claim an income tax deduction for the subscription price incurred. It was stated in Annexure C to the 2016 National Budget Review that Government is aware that the application of certain provisions of s12J “may result in potential investors abandoning plans to take up this incentive. As such, measures to mitigate this unintended consequence will be explored”. National Treasury proposed such a measure in the Draft Taxation Laws Amendment Bill published by on 8 July 2016, which dealt with the revision to the “connected person” test in s12J(3A) of the Act. Although a very welcome measure, this article explores some of the current shortcomings of the VCC regime:

Returns of capital are taxed

Section 12J(9) of the Act provides that “notwithstanding section 8(4), no amount shall be recovered or recouped in respect of the disposal of a venture capital share if that share has been held by the taxpayer for a period longer than five years”.

More often than not, the VCC is designed as a finite investment vehicle – the investors subscribe for shares; the VCC invests in qualifying companies; the VCC sells its investments; and the after-tax realisation proceeds are distributed to the investors.

It is therefore intended that the investors will realise their returns by way of distributions from the VCC (and not by way of disposing the shares in the VCC). These distributions could be in the form of dividends or returns of Contributed Tax Capital (CTC). Returns of CTC will trigger a recoupment (in terms of s8(4) of the Act) of the income tax deduction (in terms of s12J(2) of the Act) allowed for the initial investment, even if they occur after five years.

This is problematic in that it dilutes the incentive to investors, and in certain instances would offset the incentive completely and make it tax disadvantageous to invest in the VCC. It is also incongruent with the statement in s12J(9) of the Act that “no amount shall be recovered or recouped in respect of the disposal of a venture capital share if that share has been held by the taxpayer for a period longer than five years”.

Our view is that this could be addressed by excluding returns of CTC after five years from the ambit of the recoupment provisions.

Delayed tax relief for natural persons

The s12J investment opportunity is ideal for high net worth individuals who are paying tax at the maximum marginal rate. Many of these individuals are salaried employees whose taxable income comprises mainly of “remuneration” which is subject to employees’ tax per the Fourth Schedule to the Act.

In an environment of price volatility and low growth in listed investments and other asset classes, high net worth individuals are looking for new investment alternatives for their savings. The VCC provides these individuals with the opportunity to (i) obtain upfront income tax relief for their investment; (ii) have surplus cash available for investment; and (iii) encourages investment in a higher risk investment category (an illiquid, private investment in SMEs) which is important for inclusive economic growth.

However, high net worth individuals increasingly choose to place their investments offshore or in liquid assets instead of investing in VCCs, as they are not prepared to wait until an audit is completed and they are finally assessed and refunded. This creates a material disincentive for salaried investors and is a significant deterrent from a fundraising perspective (i.e. the delay from investment to refund, coupled with the need for an audit, is viewed as a significant deterrent by potential investors).

This can be remedied by allowing employees to reduce their employees’ tax by submitting their VCC certificates to their employers. The employees will therefore receive the tax benefit almost immediately by means of reduced employees’ tax rather than have to wait until their tax return is assessed.

Double tax

The most fundamental shortcoming of s12J is illustrated when one contrasts an investment into an underlying portfolio company by (i) an individual; and (ii) a VCC. When an individual invests into an underlying portfolio company and disposes of the assets in such company, the taxpayer will pay capital gains tax (CGT) at an effective tax rate of 16.4%. By interposing a VCC to invest in the same company, CGT at the effective rate of 22.4% is paid by the VCC in addition to dividends tax at 15%. As such, the VCC incentive gets eroded because “double tax” is paid when investing through a VCC as compared to investing via fiscally transparent fund structures or directly into the invested company.

Stated differently, given the choice of investing directly into a company or investing through a VCC, the former would more likely yield a higher after-tax return, even with the s12J upfront deduction. This could be addressed in a number of ways, such as extending the VCC regime to partnerships, treating the VCC as fiscally transparent or providing an exemption for one layer of tax.


The VCC regime would probably gain significantly more momentum if the abovementioned shortcomings are addressed.

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