Buy your franchise with a tax deduction

s12JUnder section 12J of the Income Tax Act, investors can invest in qualifying venture capital companies (VCCs) and receive a 100% tax deduction on the amount invested, as long as the investment is held for a period of five years.

This has been a great opportunity for high-net-worth investors to diversify their investment portfolios into growth sectors such as junior mining and renewable energy, but it also creates a tax-effective opportunity for small businesses ‒ especially for franchises, hotel and student accommodation, and asset-rental businesses.

“The uptake of the structure has been phenomenal among the more financially informed, but the wider market needs to be educated on the incentive and how to use it, as it will empower small business and individuals as well,” says Jonty Sacks of Jaltech, a boutique financial consulting firm with expertise in the formation and management of section 12J (s12J) VCCs.

Sacks explains that if you wanted to buy into a franchise business, for example, normally you would pay the franchisor directly and receive no tax deduction on the price paid. By utilising s12J, you could invest the money into a VCC which in turn purchases the franchise, allowing you to deduct the purchase price from your taxable income.  If the franchise costs R2 million, by investing through the VCC, that R2 million would be fully tax deductible from your income. Depending on your tax rate, that could save you as much as R900 000, making the investment far more affordable.

Sacks explains that the investor receives a specific ‘A-class’ shareholding in the VCC, which gives the investor/shareholder the right to instruct the VCC to make investments on behalf of the A-class shareholders. All economic benefit (growth and dividends) is ring-fenced for the A-class shareholders. The investor still has control of the franchise, except that they have received a significant tax deduction for the investment.

Qualifying investments

Certain businesses may not benefit from section 12J so you need to first check that the business you wish to acquire does not contravene these rules:

  • The gross value of the target company may not exceed R50 million
  • It may not earn more than 20% of its income from investment income
  • The majority of its trade must be within South Africa
  • In terms of immovable property, only hotels, serviced apartments, holiday homes and student residences are allowed.
  • The financial services sector, or any trade in financial or advisory services, is not included, except for investing in technology within this sector
  • No trade is allowed in respect of gambling, liquor, tobacco, arms or ammunition.

Using tax deductions to encourage people to invest in new businesses will have a knock-on effect of stimulating the growth in jobs and the economy. This is particularly beneficial for asset-rental businesses such as car fleets used for either car rental or Uber-type businesses. Sacks says while one can predict the cashflow from an asset-rental business, typically these are lower-risk, lower-return investments. However, by providing the tax deduction, the net effect to the investor is to boost the internal rate of return (IRR) by an additional 9%, assuming a personal tax rate of 45%.

Student and hotel accommodation is another popular area for VCCs. Sacks has created a student accommodation and hotel fund where investors can buy a unit in a development, benefit from the rental income but be able to write off the initial investment against their income.

There are costs in using a VCC so you need to take these into account. Jaltech charges 4% of funds invested in the Section 12J. That means instead of receiving a 45% tax deduction, the investor receives 41%. There is also a 1.5% fee on funds under management per year. For an investment of R1m there would be an annual fee of R15 000.

For the passive investor

If you are not looking to buy your own business but want to invest tax efficiently in new growth opportunities, there are several venture capital asset managers. Two such companies are Grovest Venture Capital Company, South Africa’s first operational venture capital fund which has a strong focus on energy-related companies, and Westbrooke Alternative Asset Management, which accounts for about half of the VCC market and which recently launched a student accommodation fund and an alternative tourism fund.

The Westbrooke student accommodation fund invests in strategically located hotspots across South Africa including Pretoria, Johannesburg, Cape Town and Stellenbosch, while the Alto (alternative tourism) fund has a portfolio of decentralised, residential hotel properties situated across Cape Town. Westbrooke Aria (alternative rental-income assets) invests in a portfolio of asset-backed rental businesses with contractual revenue streams. For example, Westbrooke provides growth capital to a company that rents, services and maintains scooters used by Famous Brand franchisees.

As the tax deduction is only available for primary funding (you do not get the tax deduction if you buy shares from an existing VCC investor) the funds close once sufficient funding has been received.

If you are interested in investing ask to be put on their mailing list, however, you do need to be aware that s12J companies by their very nature tend to be high risk so you need to understand the risk of the underlying investments.

Understand the risks

Jonti Osher and Dino Zuccollo, fund managers at Westbrooke Alternative Asset Management, provide a list of risks to assess when considering an investment in an s12J company.

  1. Risk / return appetite: Not all s12J companies are created equal; there can be significant differences in the nature of the underlying investments of the various s12J companies as well as the strategies that their investment managers employ. You should therefore look to invest in an s12J company that has a clearly defined investment risk strategy and approach that supports your risk appetite relative to the investment return profile. Investors should seek an investment that generates attractive risk-adjusted
  2. Tax risk: Given that one of the main incentives for making an s12J investment is the 100% upfront tax deduction in the financial year of your investment, ensure that the s12J investment manager you choose fully understands and complies with the rules and regulations that are required to obtain – and then maintain – its s12J status. The last thing you want is to find out that the s12J company in which you have invested loses its s12J status due to regulatory non-compliance and is therefore penalised by SARS. This could have the effect of reducing your investment returns which effectively could result in the creation of a return profile as if you didn’t receive the upfront tax benefit.
  3. Expertise and management risk: Look for an s12J company that has the depth of investment, finance and private-equity expertise you would expect from any professional asset manager. Factors to take into consideration include: whether the manager’s fee structure is aligned to performance, whether the s12J company is subject to an external audit, whether a third-party compliance function is in place, who the legal and tax advisors are, etc. In addition, if the strategy of the s12J company is to invest alongside entrepreneurs at the investee level, ensure that investee management is required to retain a significant equity investment in the investee company, so as to ensure proper alignment.
  4. Investment risk: Qualifying companies – the name given to compliant s12J investee companies – may sometimes be young companies that have an inherently higher investment risk compared to more mature, larger businesses. Lower-risk, asset-backed investments which offer predictable returns can go a long way towards mitigating this start-up risk.
  5. Liquidity risk: The current s12J legislation requires investors to hold their shares in the s12J company for no less than five years to make the up-front tax deduction permanent. Ensure that you can hold your investment for this period, or you will have to repay SARS the upfront tax benefit which you enjoyed when making your initial s12J investment.
  6. Exit risk: At the end of the five-year holding period, it may not be easy to liquidate your s12J shares as the nature of the underlying qualifying companies are often illiquid, private equity-style investments. It is therefore essential that any investment in an s12J vehicle comes with a clearly defined exit mechanism and/or path to liquidity that you, as an investor, can understand.
  7. Capital risk: The risk of losing capital exists in any equity investment. An investor seeking a lower risk profile should seek to invest money in an s12J company whose investment strategies are focused on capital preservation. These strategies can, for example, include asset-backed investments and investments with predicable revenue streams.
  8. Cash flow risk: Some investors may find five years a long time to wait for a return of capital. You could opt for an investment in an s12J company that aims to provide an annual or semi-annual dividend throughout the investment period.
  9. Diversification risk: Whilst the s12J legislation inherently requires companies to be diversified (by requiring the s12J company to invest in a minimum of five investee companies), spreading your allocation across different s12J companies is a strategy worth considering.
  10. Compliance risk:  Ensure that the s12J company in which you invest is registered with SARS and is the holder of a valid FSB category II licence. This is required prior to investment to ensure that you will receive your upfront tax benefit. The compliance of the s12J company can be verified on the SARS website.

This article first appeared in City Press.

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