Be­ware of the hype over sec­tion 12J

Pretoria News Weekend - - NEWS -

CRYP­TOCUR­REN­CIES of­fer new ways of ex­chang­ing and stor­ing wealth, cre­at­ing in­cen­tive struc­tures and elim­i­nat­ing in­ter­me­di­aries that, rightly or wrongly, are seen as ex­ert­ing un­due in­flu­ence on a net­work or sys­tem.

How­ever, many ques­tions re­main unan­swered, and most in­vestors sup­port dig­i­tal cur­ren­cies with­out un­der­stand­ing and ques­tion­ing the sub­stance of their in­vest­ment; they are sim­ply fol­low­ing the hype.

Be­ing in the ven­ture cap­i­tal space in South Africa, I have daily dis­cus­sions with en­trepreneurs, strate­gic part­ners and other ven­ture cap­i­tal com­pa­nies where the topic of sec­tion 12J of the In­come Tax Act comes up like clock­work. It is an in­vest­ment op­tion that has gained pop­u­lar­ity since 2014 among those look­ing to re­duce their tax li­a­bil­ity and find alternative sources of re­turn in an un­cer­tain econ­omy.

The sec­tion 12J leg­is­la­tion was in­tro­duced to en­cour­age lo­cal di­rect in­vest­ment in early stage busi­nesses, driv­ing the de­vel­op­ment of a lo­cal entrepreneurial cul­ture and re­sult­ing in wider ben­e­fits to so­ci­ety by way of em­ploy­ment, wealth cre­ation and ad­di­tional tax rev­enue.

Un­for­tu­nately, sec­tion 12J ven­ture cap­i­tal com­pany (VCC) struc­tures are of­ten “sold” to in­vestors in a way that has cre­ated much mis­guided hype – not too dis­sim­i­lar from that which sur­rounds Bit­coin.

The me­chan­ics of sec­tion 12J al­low tax­pay­ers an in­come tax de­duc­tion for in­vest­ments in qual­i­fy­ing as­sets or com­pa­nies. The premise is that the South African Rev­enue Ser­vice fore­goes oth­er­wise payable in­come tax now, in re­turn for fu­ture in­come tax pay­ments from the in­vestee com­pany, cap­i­tal gains from the VCC on exit, and div­i­dends tax or cap­i­tal gains tax from the in­vestor when funds are paid out. This risk of fore­go­ing some­thing now in re­turn for a pos­si­ble big pay­out in the fu­ture is sim­i­lar to how a nor­mal ven­ture cap­i­tal in­vestor should think.

How­ever, the popular nar­ra­tive be­ing used to pro­mote some sec­tion 12J in­vest­ments is that in­di­vid­u­als should in­vest in a sec­tion 12J VCC in­stead of pay­ing tax. Apart from avoid­ing tax, little in­for­ma­tion is pro­vided about the peo­ple who run the sec­tion 12J VCC, the un­der­ly­ing in­vest­ments, and the in­vest­ment the­sis un­der­pin­ning the com­pany and how it will de­liver long-term fi­nan­cial value. There’s a fun­da­men­tal prob­lem with this: in­vestors ought to in­vest in real op­por­tu­ni­ties, with real clients and real prod­ucts, and, most im­por­tantly, in things they un­der­stand.

I have found that many sec­tion 12J VCC en­ti­ties of­fer low-qual­ity in­vest­ments, be­cause they fo­cus on the tax-sav­ing as­pects rather than the real ob­jec­tive of the tax con­ces­sion, which is nur­tur­ing cred­i­ble in­vest­ment op­por­tu­ni­ties and de­liv­er­ing long-term eco­nomic value.

Ven­ture cap­i­tal is risky, thus prospec­tive in­vest­ment op­por­tu­ni­ties need to of­fer the po­ten­tial of fan­tas­tic re­turns and be both cred­i­ble and scal­able. This means in­vest­ing in real busi­nesses, with real prod­ucts and value, not sim­ply chas­ing tax breaks and cer­tainly not fol­low­ing the hype.

Not­with­stand­ing, there are many

Many sec­tion 12J VCC en­ti­ties of­fer lowqual­ity in­vest­ments, be­cause they fo­cus on the tax-sav­ing as­pects rather than the real ob­jec­tive of the tax con­ces­sion, which is nur­tur­ing cred­i­ble in­vest­ment op­por­tu­ni­ties.

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