In February, South Africa’s Treasury announced in its 2021 budget statement that it would not be renewing the country’s 12J investment tax incentive even though the clause has helped the startup ecosystem in South Africa grow quickly over the last few years. The Treasury has stated that the initiative hasn’t achieved its original objectives and will let it expire on June 30. Today I will walk through Section 12J, why it has been good for South Africa’s economy, and why getting rid of it altogether is a mistake.
In 2009, South Africa introduced Section 12J into its tax law to encourage investments into the establishment and growth of SMME’s (small-, medium-, and micro-enterprises) by incentivizing South African taxpayers to invest capital in local companies. This tax incentive aimed to help new businesses obtain funding that would otherwise not be available to them because much of the capital available for investment was either leaving the country or being placed in low-risk assets. With this law in place, individuals could register Venture Capital Companies (12J VCCs) and have taxpayers buy shares of those companies for a tax deduction of up to 100% on their investment. The taxpayers are essentially LPs in a venture capital fund requiring their shares to be tied up for a minimum of 5 years, at which point they can sell them if they choose. The VCC is limited to what they can invest in, with some of the criteria including technology companies, manufacturers, student residences, renewable energy companies, and general SMMEs who operate a majority of their business within South Africa and are not a financial institution.
So basically, tax-free investments into VC funds to invest in local innovation. Local entrepreneurs then use capital invested by the 12J VCCs to create companies, jobs, economic growth, and stability. Sounds pretty good, right? Last year, the Section 12J Association published a report claiming the tax incentive had achieved its goal. With total assets under management exceeding ZAR 9B, half of which VCCs invested into 360 small businesses and created over 10,000 jobs in industries spanning education, agriculture, renewable energy, hospitality, and tourism. Of the currently invested ZAR 5.5B (not all of the capital has yet been deployed), survey respondents revealed that 76% is incremental, meaning that ZAR 4.2B is money taxpayers wouldn’t have poured into VCCs and local startups without the incentive in place.
When the government put Section 12J into law, it came with a “sunset clause” in June 2021, meaning the government could choose not to renew the program. Given the successful numbers coming out of last year’s report, many were optimistic that the government would extend the tax incentive, which did not end up being a reality when the National Treasury decided to stop the benefits and let the sunset clause pass this upcoming June. After last year’s report by the 12J Association, the National Treasury launched an independent review of the incentive this year. The updated information showed that while the incentive attracted billions in investment dollars, only 37% of qualifying companies added new jobs after receiving venture capital funding. South Africa’s high unemployment rate further exacerbates this information at a high 30.8%. They claim that Section 12J did not work as intended to invest in small- and medium-sized businesses to create new jobs. Instead, it was taken advantage of by wealthy taxpayers investing in low-risk ventures, such as real estate, that they would generally have invested in regardless as they used to, except now, they are getting a free tax break.
But does this mean that 12J is entirely useless? Even if only 37% of companies did, in fact, create new jobs, they created over 10,000 of them. Proponents of 12J argue that the incentive led to creating legitimate VCCs that invest in innovative startups such as Knife Capital’s KNF Ventures, Kalon Venture Partners, Sanari Capital, Kingson, and Anuva Investments. South Africa’s startup scene led in the number of startup funding deals and startup funding amounts each year from 2015 through 2018 for the entire continent. Although falling behind Nigeria in recent years, it still remains a top startup ecosystem. The 12J Association’s Chairman, Dino Zuccollo, also pointed out that the law didn’t catch on until after changes were made in 2016 and didn’t ramp up until two years after. He believes that current datasets aren’t looking at a broad enough horizon given businesses’ timelines to grow and hire, and current investments need to mature to understand the outcomes.
So what’s next? Individuals can invest in a 12J VCC before June 2021 for the Feb 2022 Tax Year, after which no one can register new Section 12J VCCs. The sunset clause will not affect existing investors in a 12J, and existing VCCs may continue to invest their undeployed capital into qualifying companies after June. As for any new startup and VC funding? The money will likely find its way offshore like in the past, hurting innovation and growth in South Africa. Obviously, 12J isn’t perfect, but it’s clear that the incentive did keep money in the country and did help create VCCs investing in innovation, startups, and job creation. Even if there was a significant percentage of low-risk investments that did not spark job creation, the government could quickly fix the holes in 12J to ensure capital gets invested into companies that will create the outcomes they are looking for. It seems; instead, they are choosing to throw the baby out with the bathwater.