A look at how to navigate the section 12J tax break switch-off

• Pre-deadline investors should avoid a rush and have confidence in company fundamentals

In the last national budget finance minister Tito Mboweni announced that the section 12J tax deduction would end on June 30, less than two weeks from now. The deduction was not being used for the purpose for which it was intended, he said.

Section 12J was introduced in 2009, modelled on the UK’s venture capital tax break, and offers investors a 100% tax reduction for making an investment in small, medium and micro-enterprises (SMMEs) in selected industries. Yet many of the 12J projects cannot be described as either innovative or high risk. There is now a glut of hotels, for instance, particularly in the Rosebank area.

Granted, these hotels have all suffered since the March 2020 lockdown, but most would have been able to get bank finance at the time they were launched, particularly with shrewd businessmen such as aviation entrepreneur Gidon Novick or Capital Group head Marc Wachsberger in charge.

The 12J incentive is estimated to have attracted investment of well more than R10bn, largely from high net worth investors, and an argument can be made that with no 12J most of it would have gone overseas.

Dino Zuccollo of Westbrooke Alternative Asset Management says the incentive was always subject to a sunset clause (a closing date) as many incentives are. It was initially implemented for 12 years, after which the legislation was up for renewal. But Zuccollo says the Treasury was looking to increase tax collections, which may have been a factor in the decision not to renew the incentive, especially during the pandemic.

But larger 12J fund managers such as Westbrooke and Grovest have not stopped marketing the 12J funds they manage. “For a limited period only” you can invest in a range of their funds.

Grovest, for example, still provides an eclectic mix of investments. It has a cannabis fund, Silverleaf, which offers the chance to earn 20% a year from demand for the weed. That’s quite modest compared to other players in the cannabis food chain, but there is a large team of corporate finance experts helping you to get dependable returns. It also aims to enhance returns through exports.

There is also a chance to invest in the Pepperclub, probably the best-known 12J financed hotel in the Western Cape. Hotels can’t be called cutting edge venture capital, but they are significant employers. Another Grovest project, Mdluli Safari Lodge, has the added advantage of creating jobs in an impoverished rural area around the Kruger National Park.

Westbrooke still offers its R1.5bn Aria fund, which invests in a broad range of small- and medium-sized SA businesses as well as the catchily named Stac Preferred, a large student accommodation provider.

Zuccollo, who also chairs the Section 12J Association, says the caps on deductibility of R2.5m for individuals and trusts and R5m for companies remain, as do the industries that qualify and the minimum five-year hold period. There is substantially more capital gains tax to pay on exit. But he says there is no additional tax risk for investors who invest before June 30.

However, the cancellation of section 12J and the requirement to invest by the end of June, outside the traditional February “tax season”, does raise some important additional considerations.

Not all section 12J providers, he says, will be able to sustain their business models once the sunset clause becomes effective

— Westbrooke and Grovest have other products in their suite so they should be able to keep running their 12J funds.

Section 12J providers can broadly be classified as either asset managers or structuring houses, Zuccollo says. “Asset managers are likely a safer choice, especially if they have a larger business where section 12J is just one of the options offered.”

Structuring houses that were formed to create 12J structures could be more risky. Zuccollo advises investors to inquire about their commitment and the incentives they have to ensure their services continue four or five years from now.

He says promises of guaranteed income and buybacks should be carefully considered. Guarantees are only as valuable as the strength of the guarantor

— the balance sheet that underpins this guarantee. In addition, such promises may put your investment at risk as section 12J companies are required to invest in equity shares and not guaranteed instruments.

The mandate and industry you are investing in is as important as ever, he says, specifically as a large portion of section 12J investments have been made in hotels, now a tough sector. “Don’t forget that a section 12J investment is an investment in a private business in a specific sector — you should have a high degree of confidence in the investment fundamentals of the sector in which you invest, and not buy into a section 12J scheme purely for the tax incentive,” Zuccollo says.