Despite flaws, section 12J tax incentive had a positive effect
• Amendment benefited investors and has also helped small businesses to create jobs
Last month saw the sun set on a groundbreaking investment incentive, the section 12J amendment. It is not often one hears the words “groundbreaking” and “tax amendment” in the same sentence, but the intention of this legislation had the promise of making a real dent in the challenges of growth and job creation for small and mediumsized businesses (SMEs) in SA.
The section 12J structure was a revolutionary mechanism to catalyse investment into SMEs: investors could offset their investment in a 12J company against their taxable income. This meant investors could get up to 45% of their investment back in tax deductions.
The catch was that 12J companies had to follow a set of investment criteria to ensure funds were directed towards smaller companies to drive growth of this underfunded segment of companies.
Like most policy innovations there were a few flaws and loopholes. Pages could be written on how the 12J was exploited and the warning signs ignored, but I’d like to offer a postmortem view of what it can achieve when the 12J is used in the spirit in which it was intended.
Nombuso Nkambule, Brendan Mullen and I started Secha Capital to prove a new model for impact investing in Africa. Our goal was to invest in and grow SMEs, which would then have positive impact outcomes, one of which was job creation. Having the 12J structure allowed us as first-time fund managers to convince investors to take the risk and put their money towards a novel model.
In four-and-a-half years we have invested in 10 companies, created 180 new jobs and have seen 100 times revenue growth in our first investment. When considering the small size of this proof of concept fund (R50m) the impact it has had is pleasing to see. Secha Capital achieved this by focusing on sectors most investors ignore (consumer goods and agribusiness) but which are the highest job creators. Secha invested small, but in a way that made the most impact, and most importantly complemented the growth capital with human capital.
Central to our model is an operator-investor model: we hire the best and brightest to work alongside entrepreneurs, getting young and ambitious individuals to roll up their sleeves and get stuck in with entrepreneurs to solve challenges and create value.
Now that the 12J amendment sun has set, we look at the cost to the National Treasury and the financial outcomes. The direct cost to the SA Revenue Service (Sars) for the tax break for Secha investors is R13.5m. Based on our internal analysis across the 10 portfolio companies the average annual increase in tax payable to Sars is R3m a year when compared with the years before investment. This is made up of an increase in income tax due to improved profitability, increases in PAYE with the new employees hired and increased salaries, and the increased VAT due to the increases in revenue.
From the perspective of Sars that means a 4.5-year payback period for its “investment” in the SME ecosystem with the 12J structure. This excludes the larger capital gains tax expected when Secha sells its shares in the underlying portfolio.
The numbers tell only part of the story. About 150 people have new jobs and support families. Then there are the new business units launched, the indirect supply chain that supports many more employees, and the interns and associates that have been trained in the Secha ecosystem, some of whom have gone on to start their own businesses. One of the most significant areas has been the opportunity for a black-owned fund manager to prove its mettle.
Secha was fortunate enough to leverage the 12J structure and prove a novel model for investing in Africa. We are now raising our second fund, 10 times the size of our 12J fund. This is only possible because investors could take the risk on a new fund manager with the incentive structure of section 12J.
Aligned incentives are a key part of the Secha ethos. We live and breathe this way of thinking. To align incentives, we look at each party: investors want healthy returns with positive social outcomes, entrepreneurs want a partner in their business who brings capital and expertise for growth, and associates and principals want a meaningful experience by seeing the results of their work. Our three stakeholder ecosystem was supported by an innovative government structure that made sure each party was incentivised to grow the economy, with a net benefit to the fiscus.
Given the appetite for the section 12J among investors, I have no doubt a version of it has a space in the SA investing ecosystem. Hopefully it comes back to help more fund managers get their start, create more jobs in a struggling economy, and build a set of businesses and citizens who are firmly focused on the positive social impact they can have.
IN FOUR-AND-A-HALF YEARS WE HAVE INVESTED IN 10 COMPANIES, CREATED 180 NEW JOBS AND HAVE SEEN 100 TIMES REVENUE GROWTH
ONE OF THE MOST SIGNIFICANT AREAS HAS BEEN THE OPPORTUNITY FOR A BLACK-OWNED FUND MANAGER TO PROVE ITS METTLE