Changes expected for venture capital incentive

Sluggish uptake of an attractive venture capital tax incentive for investments in small businesses once again forces Treasury back to the legislative table.

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Pretoria - The sluggish uptake of an attractive venture capital tax incentive for investments in small businesses has once again forced National Treasury back to the legislative table.

Government acknowledged the application of certain provisions on venture capital companies "may result in potential investors abandoning plans to take up this incentive", it said in the February budget review.

The venture capital company regime became effective in 2009, aiming to encourage equity funders to invest in small businesses. To date there are only 31 registered venture capital companies. In 2013 only three companies were active.

In terms of the incentive, investors receive an upfront tax deduction from their income equal to the amount they spent on acquiring shares in the venture capital company.

The venture capital company may acquire shares to the value of R500 million in any junior mining company, or R50 million in any other small private company.

Etienne Louw, Senior Tax Consultant at Mazars, says although their experience with the regime has been limited, uncertainty about the application of some of the provisions seems to discourage a rigorous uptake.

Treasury said in the February budget review measures to mitigate "unintended consequence" relating to the "application of certain provisions" will be explored.

Treasury did not respond to questions on what these unintended consequences were, or which provisions were being referred to.

According to the South African Revenue Service (SARS) website the venture capital company must be a resident; the sole object of the company must be the management of investments in qualifying companies, its tax affairs must be in order; and it must be licensed in terms of the Financial Advisory and Intermediary Services Act.

Penalties

Louw says the status of a venture capital company can be revoked at the discretion of SARS and the commissioner if it does not comply with the requirements.

Once issued a notice of non-compliance, the company must take corrective steps. If the steps are not "acceptable" to the commissioner, the venture capital status can be revoked.

"When a company's status is revoked, an amount equal to 125 percent of the money that was invested in the company will be included in its income. This is draconic."

Louw admits he is not aware of any company whose status has been revoked. However, snags like this make investors "run for the hills" when they become aware of them.

He also believes the lack of certainty about the deductibility or transferability of the upfront tax deduction affects the liquidity of the shares.

It could be that nobody wants to buy the shares, or they do not want to pay market value since the seller of the shares received a huge tax deduction on the initial price.

"It is vital for any investor to have liquidity in their shares, the alternative will be to buy shares on the stock exchange which could be traded at any time," Louw says.

Lock-in

In terms of the venture capital company regime the shares have to be held for a minimum period of five years for the tax deduction to become permanent. This only became effective last year. Previously the amount spent on acquiring the shares was recouped immediately when the shares were sold.

Louw adds there are several anti-avoidance measures that may also have unintended consequences.

One is that expenditure incurred by the VCC to acquire shares in a qualifying company must not exceed 20 percent. The company will be seen as a "connected person" and the tax deduction will be disallowed.

According to Louw venture capitalist have suggested that the "connected person" test is retained in the legislation, but that investors are allowed to exceed the 20 percent shareholding threshold initially. This can then be diluted to 20 percent over a specific period.

Keith Engel, CEO of the South African Institute of Tax Professionals, says the continued lack of success on this area stems from the very nature of the policy instrument itself.

"Most investors want a fund that eliminates the potential for multiple taxation. Hence, most investors opt for flow-through partnership vehicles [or trusts] - not companies."

Engel adds that the "real money" is in private equity as opposed to venture capital, unless the venture capital can show high-profit potential [often without the immediate creation of jobs]. The regime seems to waiver between the two.

"At the end of the day, the goal is seed-capital. Tax incentives by themselves may not be sufficient to attract the desired upfront cash," he says.

IOL