There’s more to Section 12J than ‘45% immediate tax relief’
Beware the pitfalls.
With the tax year end just more than a month away, there has been a growing marketing effort aimed at luring investors to Section 12J venture capital and private equity investments.
The Section 12J tax incentive is a government initiative aimed at assisting small and medium-sized businesses to access equity finance in the hope of creating jobs and boosting economic activity.
Investors can write off 100% of an investment into an approved 12J vehicle against their taxable income. Against the background of meaningful tax hikes and growing concerns about wastage of taxpayer money, this may seem like a no-brainer – effectively it means that investors can get ‘up to 45% immediate tax relief’.
And with the JSE moving sideways for more than four years, investors may easily be swayed by targeted returns of ‘40% per year or more’ in some of these funds.
But while some of these investments may be suitable for a specific type of investor, interested parties should make sure they understand the risks, tax benefit and liquidity constraints involved. There are now more than 100 registered Section 12J companies in South Africa, which have attracted more than R3.6 billion in total.
Dino Zuccollo, fund manager at Westbrooke Alternative Asset Management and founder member of the Section 12J Association of South Africa, says there is a spectrum of different quality asset managers and investments in the market.
While Section 12J offers a fantastic tax break, it is not good enough to just invest for the tax, he says. Investors should invest with an experienced manager with a track record of success, and need to do a due diligence on the manager to get comfort around their ability to deliver.
Craig Gradidge, investment and retirement planning specialist at Gradidge-Mahura Investments, says the firm does make use of the incentive for clients, but is very careful to ensure that clients understand the risk, tax benefit and liquidity constraints.
Higher risk profile
These investments have a much higher risk profile than traditional equity investments. There is usually very little diversification (unless it is a fund-of-fund) and investors must stay invested for a minimum of five years. If there isn’t a successful exit strategy in place, they may be locked in for longer, he adds.
While offers largely focus on the immediate tax relief of up to 45%, investors also need to realise that all the capital returned on exit will be subject to capital gains tax (CGT), even if this is less than the amount that was initially invested. The base cost is deemed to be zero.
“If you put in R1 million and it is a bad investment and you get R500 000 out, that [full] R500 000 is subject to capital gains tax.”
Importantly, investors should note that the targeted investment returns quoted on 12J brochures are based on the capital at risk and not the capital invested. They generally also assume that individuals pay tax at the highest marginal income tax rate of 45%.
In other words, if an investor invests R1 million in a 12J vehicle and gets a tax break of R450 000 from Sars in that tax year, the investment return quoted will be calculated on R550 000, not R1 million. Where a manager is quoting a targeted return of 18%, roughly 8% will be the result of the tax benefit. Moreover, someone who is paying income tax at a marginal rate of 30% won’t get the same type of return as someone paying at 45%.
Zuccollo says investors must ensure that if the manager is basing the returns on the net risk capital (thus accounting for the upfront tax deduction in their return calculation) they are also accounting for the CGT at exit.
He concedes that the way returns are calculated is complicated, but says it is necessary as the tax break is such a significant element of the return profile.
If someone invested in student accommodation and ordinarily received a 10% return per annum, a 12J investment in a similar venture would be done with the same amount of risk, but at almost double the return due to the tax break, he argues.
“I think you need to show that to an investor.”
Impact on retirement deduction
Investors should also consider how their retirement funding may impact their situation, Peter Hewett, managing director of Hewett Wealth, notes. An investor who earned R1 million during the tax year and who contributed R275 000 to a retirement annuity (the full 27.5% deductible contribution allowed) as well as R1 million to a 12J vehicle, will see their RA deduction being disallowed in that tax year.
“It will be carried forward to future years – you won’t be allowed to use it in that year because you didn’t earn taxable income. So you’ve got to be careful when you do your tax planning to make sure that you take into account what your true taxable income will be after you’ve made provision for your retirement funding contributions,” Hewett explains.
Other considerations include how long the fund manager and the projects have been around, what the projects entail, the audited financials of the entities and how the capital will be deployed.
Investors should also understand the costs involved. In line with other alternative investments, fees are generally higher than traditional unit trust-type investments and investors should get this set out in writing. Aggressive commissions should be cause for concern.
Hewett says the tax break is quite nice and that these may be suitable investments for certain clients, but they have to understand that this is effectively a private equity type of investment where they have very limited control of the risks they are exposed to.
Adds Gradidge: “It’s not for everybody. You’ve got to have that long-term view and you must be prepared to be invested for seven years at the minimum in case there are issues at exit. It is for someone with risk tolerance.”
Given that these are alternative assets, investors really shouldn’t have more than 5% to 10% of their portfolios invested in these assets, he adds.
February 6, 2019
The Wealth Room