Beware the Section 12J hype

May 31, 2018

 

 

Ian Lessem, Chief Executive Officer of HAVAÍC, a Cape Town based investment and advisory firm, says the way in which S12J income tax legislation is sold to investors seeking tax relief is not too dissimilar to the cryptocurrency hype, and should be approached with caution.

 

 

 

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 the majority of public investors support these digital currencies without understanding and interrogating the substance of their investment; they are simply following the hype.

 

Being in the Venture Capital (VC) space in South Africa, I have daily discussions with entrepreneurs, strategic partners and other VCs, where the topic of Section 12J (S12J) of the Income Tax Act comes up like clockwork. It is an investment option which has gained popularity since 2014 among those looking to reduce their tax liability and find alternative sources of return in an uncertain economy.

 

The S12J 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 South African society by way of employment, wealth creation and additional tax revenue. Unfortunately, S12J Venture Capital Company (VCC) structures are often “sold” to investors in a manner which has created a lot of misguided hype - not too dissimilar that which surrounds Bitcoin.

 

The mechanics of S12J allow South African taxpayers an income tax deduction for investments in qualifying assets or companies. The premise is 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 dividend or capital gains tax from the investor when funds are paid out. This risk of foregoing something now in return for a possible big pay out in the future is similar to how a normal VC investor should think.

 

However, the popular narrative being used to promote some S12J investments is rather than pay tax, individuals should invest in a S12J VCC. Other than avoiding tax, little information is provided about the people who run the S12J VCC, the underlying investments, 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 S12J VCC entities offer low quality investments as 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. VC is risky, thus prospective investment opportunities need to offer the potential of fantastic returns and also hold up to be both credible and scalable. This means investing in real businesses, with real products and value, not just about chasing tax breaks and certainly not about following the hype.

 

Notwithstanding, there are many credible VCs that offer S12J structures. These funds are doing a great job and tick all the investment manager boxes. However, it’s the hyped-up funds and managers who sway investors with talk about instant returns and tax savings, serve it up with a big dose of “this is the next big thing”, that worries me. Just like cryptocurrencies, the noble intentions of S12J have largely been lost in a misguided investment thesis.

 

A good investment firm spends time and energy focusing on the right opportunities, before developing a successful strategy and finally working with and nurturing the entrepreneurs, with the main objective of maximising the monetary returns for stakeholders. This takes time, skill and investment savvy, and leaves no room for hype.

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