Foremost among these is the tax dilemma that has frequently determined the success, or otherwise, of the private equity investor’s acquisition criteria, with the age-old capital versus revenue conundrum impacting directly on the investment decision.
The resulting uncertainty has prompted dissatisfaction on the part of minority shareholders unable to determine with any degree of after-tax certainty the fairness or otherwise of an offer for their equity.The national budget has gone a long way to clearing the muddied private equity tax waters by spelling out the taxation treatment of gains on long-term equity investments.
Prior to Minister of Finance, Trevor Manuel’s pronouncement, gains realised on the sale of shares could have been taxed either as ordinary income or capital gains, depending on facts and circumstances.
An exit strategy
In a private equity context, a case could be made for the former, more punitive, treatment to apply, since it is in the nature of a private equity company to exit its investments.Almost invariably, private equity companies enter into transactions with an exit strategy, designed to realise a profit, as an integral part of the deal.
Even so, because the dividing line between income and capital gains has been so blurred, similar transactions were of ten accorded different tax treatment.
Receiving dividend not a priority
Adding to the complexity is that private equity companies seldom enter into investment transactions with a view to receiving dividends.Often applied in such a context is the symbolic tree and its fruit, with the former representing capital and the latter income.Private equity organisations generally tend to sell the tree without reaping the fruit.Should not, therefore, private equity companies be taxed on capital gains rather than income?
Different investment intentions
Another dimension arises on consideration of the flow of the proceeds through the fund managers to those who invested in the private equity company.Different investors – trusts, pension funds, local asset managers, foreign investors, even individuals – are subject to different tax treatment, with each perhaps having different investment intentions. How does one respond to this conundrum?
The new era dawned on October 1 this year, when, in the interests of treating all cases equitably, all shares sold after three years will qualify to be taxed as capital gains rather than income.
The new dispensation
The new dispensation will apply to listed and unlisted shares – hence the ruling’s particular application to private equity transactions, since although this might not be widely known, the vast majority of private equity acquisitions are in the unlisted arena.
According to the South African Venture Capital Association (SAVCA): "This is an important breakthrough for the industry, based on SAVCA’s engagements with National Treasury, as there is now clarity on the taxation of realised gains for private equity investors.
"SAVCA has also confirmed with National Treasury that realisations within the three-year period can be deemed of a capital nature in consultation with SARS.”
A significant spin-off from the veil of uncertainty having been removed is the benefit that will surely accrue to SMEs, with, implicitly positive ramifications for BEE.
Up to now, venture capital investors having been deterred from supporting those enterprises by the fear of incurring huge tax liabilities.Indeed, I suspect that it was with this benefit in mind that the minister travelled the extra mile on the three-year capital gains tax window.
Hopefully, however, the minister will not have been persuaded that he has done enough to encourage investment in SMEs.
FinMark Trust last year published a study on tax incentives for private investors in small businesses. The study concluded that there was clearly a case for tax incentives to modify the risk-reward profile of private equity investments in suitable small firms.
After consideration of incentives prevailing in several countries abroad, FinMark recommended as an effective incentive an upfront reduction of taxable income; an approach that would appeal to South Africa’s nearly 40 000 high net worth individuals."If we assume that 5% of these individuals’ investment portfolios would be invested in qualifying private equity, probably through a fund of funds or venture capital trust set-up, this could see a significant R11,3 billion allocated toward the sector,” the study maintained. Additionally: "The combination of an attractive tax incentive for what could be considered socially responsible investing is therefore likely to be quite appealing.”
Finally: "We also believe that, over time, providing tax incentives for investments could positively contribute to an increase in the savings rate of individuals – particularly if the impact of the incentive is felt upfront, and not only when the gains are realised.
"This upfront incentive is, we believe, important in the South African context, where generally speaking the population still have quite a short-term outlook and a high subjective discount factor.”
The potential is boundless; the prospective benefits to the economy and to SMEs limitless.The fond hope is that the minister has set the ball rolling by introducing tax clarity on capital and income. Dare we watch the space hypothetically allocated to tax incentives for those investing in SMEs?
Source: By Chris Lister-James (TaxTalk )