S12J is one of the leading investor topics at the moment, as the run in to the tax year end approaches.
This article unpacks some of the frequently asked questions regarding s12J including the following:
- What is s12J?
- Why do s12J companies raise capital in February?
- How does s12J work?
- What are you actually buying?
- What are you saving?
- How do you exit?
- What about the fees?
What is s12J?
S12J refers to a section of The Income Tax Act.
This section allows an investor to deduct the full cost of their investment into an approved s12J company against their taxable income. This benefit is available to individuals, companies and trusts and can be utilised against normal income as well as Capital Gains tax.
The section allows an approved s12J manager to invest in any small business (less than R50m in Net Asset Value) in South Africa excluding fixed property (except hotel keeping), banking, insurance and financial services, gambling, liquor, tobacco and arms businesses.
The objective behind this initiative from SARS is to promote investment into small and medium enterprises with the specific objective of increasing job creation.
Why is capital for s12J companies generally raised in February each year?
The vast majority of capital raised by s12J companies has come from high net worth individuals.
Given that the tax year for individuals and trusts ends in February each year, the benefit of timing the investment to be coterminous with the tax year end is highly attractive for investors and hence the industry has clustered their capital raise activities around this period.
How does s12J work?
S12J companies are regulated by both SARS and the FSCA (previously known as the FSB).
There are many requirements that s12J companies need to meet to comply with these regulations. From an investor’s point of view, the only major limitation is that the investment needs to be held for a minimum of 5 years in order for the tax deduction to become permanent and not subject to recoupment.
What are you actually buying?
As an investor into a s12J company, you are buying shares in an unlisted company.
The success of this investment therefore depends on 3 factors:
- What is the business strategy of the s12J company?
- Does the management team have experience in managing money for other people?
- How do you exit from this investment?
As mentioned above, there are very few limitations placed on s12J companies. As a result, the strategies adopted by these companies are widely varied in both risks and targeted returns. As an investor, you need to be comfortable with the underlying investments as these investee companies (defined as Qualifying Companies in terms of s12J) will be generating the cash flows to pay you dividends and return your capital plus growth to you.
It is therefore incumbent upon you as the investor to ensure you understand the strategy and inherent risks before you invest.
What are you saving?
Given that you are able to deduct the full amount of your investment against your taxable income, the amount that you are saving will depend on your marginal tax rate.
For example, individuals with taxable income in excess of R1.5m will be saving tax at the marginal rate of 45% as will trusts. As the Corporate tax rate is lower, companies will save 28%. This goes a long way to reduce your risk in this type of investment as you will have a significantly lower portion of your capital at risk.
In the case of the individual who invests (say) R1m, they will receive a tax saving of R450,000 and therefore only have R550,000 at risk. This is referred to as risk capital. Most s12J companies will use this concept of ‘risk capital’ to charge their fees as well as to report their returns. Bright Light Solar VCC reports their returns on Investment Capital (the full R1m investment) and does not charge fees on your tax saving.
How do I exit?
As every s12J strategy is different, it is critical that you understand how you will be able to exit your investment from year 6 onwards and what the assumptions are that the manager has used to calculate your forecast returns.
Is your liquidity subject to the manager selling the underlying investments? Do you have a choice to either exit or remain invested? How certain are you that the manager will be able to provide the liquidity to facilitate your exit?
These are vital questions in differentiating between s12J companies. Investors need to bear in mind that any capital returned will be subject to CGT with a base cost of zero.
What about the fees?
Many s12J companies have very high fees. In most cases, the s12J manager is charging you a performance fee on your tax saving, so you are not actually saving 45%, but rather 45% less the fee that is being charged on your tax saving.
In most cases, this is as high as 20% of your tax saving. Bright Light Solar VCC has one of the lowest fee structures in the s12J industry. Bright Light Solar VCC does not charge any fees on your tax saving, nor does it charge fees on assets under management (normally 2 to 2.5%). Whilst most s12J companies charge a performance fee of 20%, Bright Light Solar VCC’s performance fee is 17.5%.
S12J offers an outstanding opportunity to investors to access investment strategies not commonly available to private investors, as well as to gain a substantial reduction in your tax payable.
As with any investment, investors must be prudent in their selections by asking the s12J manager the tough questions around fees, experience, exit strategies and the risks involved in that particular company.