While the introduction of a sugar tax and a tyre levy as well as adjustments to the capital gains tax inclusion rates were the talk of the day, there was also mention of yet another revision to the current venture capital company (VCC) provisions. By Greg Tarrant
On 24 February 2016, the Minister of Finance, Pravin Gordhan, delivered the 2016 budget speech. Gordhan acknowledged that ‘funding remains one of the biggest challenges for small businesses’ and while 31 venture capital companies (VCCs) have been registered to date, there are concerns that the application of certain provisions will deter investors in the VCCs. Gordhan has indicated that measures to mitigate the unintended consequences of the application of these provisions of the legislation will be explored.
BACKGROUND TO THE VCC INCENTIVE
The VCC provisions, as set out in section 12J of the Income Tax Act 58 of 1962, provide for a tax deduction in the hands of the investor on the subscription of equity shares in a VCC.
The deduction is afforded as part of a government incentive to provide targeted assistance to companies in need of equity finance by way of angel investing. The incentive achieves this by requiring the VCC to utilise the proceeds of its share issue(s) by making investments in ‘qualifying’ companies.
As a consequence of the poor reception to the introduction of the VCC provisions in 2009, the provisions have been successively relaxed over the past seven years in order to eliminate unintended consequences of the legislation and make the incentive more attractive. However, these past amendments have clearly been insufficient to address investors’ concerns, hence the proposal for further amendments in 2016.
Fundamental to the poor reception of the incentive are the investment rules which are overly restrictive. Whilst the type of businesses which may be invested in are broad,1 it is the restriction on the amounts which may be invested in any given investment and the number of investments which must be made within a prescribed period which are problematic. For example, in order for a VCC to retain its qualifying status, it must invest 80% of its funds in qualifying companies, measured at the end of the year of assessment 36 months after the VCC issues its first shares. Further, and more critically, it may not invest more than 20% of its capital in any single investment.
The investment rules effectively mean that a VCC must invest in at least four investments (the remaining 20% can be retained in cash) within a four-year period.2
The overly restrictive investment rules make true angel investment difficult as VCCs are not in a position to accurately predict their capital uptake and no one investment is the same as another. Quite clearly, the VCC provisions will continue to perform poorly as a targeted angel investment mechanism unless these rules are relaxed.
There are also a number of anti-avoidance provisions contained in section 12J that are aimed at preventing the VCC provisions from being used for unintended purposes. Two of these rules are critical to the proper functioning of the incentive. They are the connected party rule and the controlled group company rule.
The connected party rule penalises an investor for taking up more than a 20% interest in the VCC. Typically a subscription of shares in a VCC will afford the subscriber a deduction in calculating taxable income. However, where, either immediately before or as a consequence of the subscription, the shareholder is a connected party in relation to the VCC, no deduction will be allowed. This means that either six unrelated investors must subscribe for shares in equal proportion at the outset, or a ‘protector’ must be identified which holds sufficient shares from inception to ensure that no individual becomes a connected party. This requirement could create difficulties, at least initially, should a single investor seek to invest a considerable sum.
The controlled group company rule prohibits the VCC from taking up more than a 50% equity interest in the target investment.
VCCs OF THE FUTURE
Whilst it remains to be seen what the proposed amendments will be, one would hope that there is a significant relaxation in the investment rules, perhaps by way of an increase in the maximum investment limit in qualifying companies, making VCCs a more attractive investment vehicle going forward.
1 Investments in banking, professional services, real estate investment, gambling and the tobacco, liquor and arms/ammunition industries are prohibited.
2 Where the VCC issues shares on the first day of its financial year the period effectively translates into 48 months.
AUTHOR |Greg Tarrant, Associate Director, PwC Tax Services