South Africa’s tech startup industry to take a hit after Section 12J tax change

National Treasury’s decision to stop its Section 12J tax benefits is bad news for the South African tech start-up environment and will make it more difficult for new tech businesses to access funding.

This is the view of Clive Butkow, CEO at Kalon Venture Partners, which operates under Section 12J of the Income Tax Act.

The government introduced the J12 venture capital tax incentive in 2008 to encourage the establishment and growth of small-, medium-, and micro-enterprises.

The 12J incentive encouraged South African taxpayers to invest in local companies by giving them a tax deduction of up to 100% on their investment.

The aim of this tax incentive was to help new businesses to obtain funding that would otherwise not be available to them.

To see if the Section 12J incentive achieved its intended goals, National Treasury launched a review of its venture capital company tax incentive.

The review showed that R11.5 billion had been invested using Section 12J on which a 100% tax deduction was applicable.

While the incentive attracted billions in investments, only 37% of qualifying companies added new jobs after receiving venture capital funding.

This was because many people abused the system. Instead of growing new companies, wealthy taxpayers using the 12J incentive to invest in low-risk ventures.

It was therefore not used to grow new small- and medium-sized enterprises, but rather to avoid tax on investments which would have happened anyway.

As it failed to achieve its intended goals, the incentive will not be extended beyond its current sunset date of 30 June 2021.

This is bad news for the South African tech start-up industry where the J12 incentive worked exactly as intended.

Kalon Venture Partners’ Butkow said the country has excellent tech entrepreneurs with great business ideas, but access to capital is a challenge for these entrepreneurs.

This is partly because international investors are hesitant to invest in South African tech start-ups before they have proven their business model and showed strong growth.

The Section 12J venture capital tax breaks helped to overcome this hurdle by providing local tech start-ups with seed and growth funding to rapidly expand their operations.

Kalon’s J12 venture capital investments are a case in point. Their funding helped Sendmarc and Mobiz to grow more than triple digits over the last year.

After rapid growth is achieved, it enables local start-ups to approach international investors for further funding in a Series A funding round.

Without seed capital to enable rapid growth, an important steppingstone for South African start-ups will be removed.

National Treasury’s assessment of the venture capital company incentive

Over the past year, the National Treasury solicited information from 100 VCCs and 360 qualifying companies on the performance of the VCC incentive.

The results showed that R11.5 billion had been invested at VCC level (on which a 100 per cent tax deduction was applicable), with R4.2 billion invested at qualifying company level.

The total tax contribution from qualifying companies was R207 million for 2019/20, half of which was VAT. Qualifying companies employed 8,239 people, of which 4,035 people were in direct employment.

In total, only 37 per cent of qualifying companies added new jobs after receiving VCC funding. Over 50 per cent of the investments appeared to be in low-risk moveable asset rental structures, low-risk income-producing investments and guaranteed-return real estate investments.

The National Treasury findings broadly correspond with the 12J Association’s own survey, but differ from modelled predictions on job creation and tax estimates, with the association’s estimates more optimistic than the actual responses.

Since 2015/16, total tax revenue foregone due to the incentive was R1.8 billion, of which R1.7 billion went to individuals who had a taxable income and VCC investment above R1.5 million per year.

Revenue foregone in 2018/19 was R745 million before the deduction cap of R2.5 million was introduced.

Based on this information, the incentive seems to give a significant tax deduction to high net-worth taxpayers that cannot be justified given its limited economic impact.

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South Africa’s tech startup industry to take a hit after Section 12J tax change