Venture Capital Incentives
11 August 2011
Posted by: SAIT Technical
Business Day - SAPA
Venture Capital Incentives
In an effort to lure more venture capital funding to SA, national treasury has proposed a relaxation of some of the requirements necessary to qualify for tax incentives designed to encourage this particular type of investment.
The SA venture capital market, though small, with only R2,6bn invested in the sector over the past 10 years, is nonetheless a crucial provider of funding for many small and medium enterprises (SMEs) . Without venture capital funding — where, in general, investors are prepared to take on more risk and often invest in start-up businesses — these companies would not be able to raise finance.
National treasury plans to introduce amendments to current rules regulating venture capital financing in the draft Taxation Law Amendment Bill 2011. The taxation of such investments is legislated under the current venture capital companies (VCC) regime, which came into effect in 2009 and will be valid until end-June 2021. Paula Bagraim, partner at Maitland, a privately owned firm providing wealth services , says the original venture capital tax legislation hoped to encourage investment in small businesses and junior mining operations. Given the amount of venture capital investment in SA, it was not successful. Bagraim says the investment benefits granted under the current Income Tax Act are viewed as too small, with the qualification criteria for investors, small businesses, and junior miners too complex.
Under the regulations, venture capital companies are typically expected to acquire a majority stake in an SME or junior mine , selling this stake at a later stage when a certain level of growth — indicating a decent return on the original investment — was reached. These regulations allow for a tax deduction on the cost of acquiring the shares, subject to certain limits. They apply to individuals acting in their own capacity, listed companies, and private companies that are 70%-owned by listed companies. But unlisted companies and trusts are not entitled to the tax break. Making the incentive scheme more complicated, VCCs, SMEs and junior mining companies — the target of the existing legislation— also have to comply with a set of qualifying requirements (see table).
"The qualifying requirements are complex and restrictive and have deterred potential investors ,” says Bagraim. The new tax incentive will allow all interested investors, which now include unlisted companies and trusts, to benefit from the tax concession if they invest in a VCC. These investors will receive a full deduction from taxable income of expenditure incurred to acquire the shares . The deduction will be recouped when the shares are sold and gains will be subject to capital gains tax. The benefit will be to the investor’s cash flow.
Bagraim says the deduction will not be available to investors who become connected to the VCC as a result of, or upon completion of, the investment. For example, if the investor company holds at least 20% of the equity shares in the VCC, the investor company and the VCC will be connected parties. Bagraim says this aspect of the proposed amendments should be "carefully considered prior to making an investment in a VCC”.
The amendment has built in some other anti tax-avoidance provisions through setting out that the deduction will be allowed only if the investments in the VCCs are solely equity investments. There also has to be an understanding that the investment is placing the investor at risk. This means the investor must fund the investment from his/her own resources. If the investment stems from a loan, the investor must bear the risk of that loan.
Though there are still some restrictions in place to accessing the tax incentives to invest in venture capital companies, Bagraim says the regime now has a more realistic prospect of success.
However, to her mind, the proposed incentives would need to go much further if they were to be successful in significantly boosting venture capital funding when compared with similar provisions in other jurisdictions.
The changes, which will take effect as of January next year, should, nonetheless, be attractive to some who are willing to take on additional risk for above-average returns . This kind of investment should, in a small way, help to facilitate the much- needed flow of capital funds to small businesses and junior mining companies.