Articles

Venture capital company regime

Business Brief February/March 2009
By Alastair Morphet

About two years ago there was a lot of media coverage about South Africa adopting something similar to what the Canadian tax regime has namely, a form of flow-through company. The idea behind this company was to assist the development of junior mining companies, by passing the tax breaks which a mining company is eligible for to its shareholders in the period before the mining company generates sufficient taxable income from production to utilise the costs generated by its mining activities.

Radical break
If South Africa had adopted such a proposal, this would have marked a radical break with the fundamental principles of our tax system. However, in the Draft Revenue Laws Amendment Bill 2008, SARS has made provision for the creation of an alternative, in the legislation for the introduction of a so-called venture capital company (VCC). The intention behind this legislation is to provide a tax incentive for investors in small and medium sized enterprises. This VCC is intended to attract retail investors, thus providing the funding for an investment management company to invest in new opportunities in the small business sector.

Deduction
An investor in such an approved VCC will be entitled to deduct 100% of the amount he has invested in such shares, but capped at an amount of R750 000 for any year of assessment in which the investment is made. The deduction is only available for contributions to the VCC in exchange for newly issued shares: thus if an investor sells his shares in the secondary market, he will recoup the deductions which he has previously obtained. The purchaser of such shares will be subject to normal principles.

SARS' basic principle is that companies should not be able to invest in these VCCs, save for a listed company or one of its controlled group companies, which can deduct the full 100% contribution it makes to such a VCC; provided that the company or its controlled group companies do not hold more than 10% of the equity share capital of a VCC. Corporate investors can hold more than 10%, but they will only qualify for the tax deduction on the first 10%. In National Treasury's responses to the Parliamentary Committee on Finance, the reason they will not permit investment through unlisted companies is the authorities do not want individuals routing their investment through companies. Readers need to note that the deduction will only be available to the investors who are in possession of a venture capital company investor certificate.

Approval
So, a VCC will need to apply for approval from the Commissioner in much the same way that a public benefit organisation obtains the Commissioner's approval from the Tax Exemption Unit. The draft legislation provides that the Commissioner must approve a VCC if it has submitted a copy of its business plan to the Commissioner and that he is satisfied that within 36 months of its incorporation, it will comply with all of the conditions contained in the definition of "qualifying company": these are that the expenditure incurred by the company in acquiring qualifying shares will be at least R50 million, or if the company acquires qualifying shares in any junior mining company, at least R250 million.

The gross income of the VCC has to be derived solely from financial instruments (i.e. equity securities in those investee companies, or debt instruments such as debentures), although Treasury has acknowledged provision will need to be made within limits, for the company to earn some proportion of management fees.

At least 10% of the VCC's expenditure in acquiring qualifying shares will be from companies with a market value not exceeding R5 million immediately after their issue; and that at least 80% of its expenditure will be for the shares of companies that hold assets not exceeding R10 million, unless that company is a junior mining company in which case it will not exceed R100 million; that no more than 15% of its expenditure is in acquiring qualifying shares issued to it by any one “qualifying company”; that the company together with any connected person to it cannot hold more than 49% of the equity share capital of any one qualifying company (a change debated in the Committee), and that the company is licensed in terms of section 7 of the Financial and Intermediary Services Act.

Trader in shares
In essence this VCC is a trader in shares. But, what is significant is that investors in the venture capital company's shares will be treated as traders, even if they hold their shares for longer than three years. But this deduction is only open to primary offer investors. It will need to be made clear in the final legislation that this venture capital company does not fall in the definitions of what is going to be a passive holding company.