Section 12J: The secret to a more competitive tariff

April 8th, 2019, Published in Articles: Energize

Section 12J of the Income Tax Act was introduced by Treasury to encourage South Africans to invest in the local economy. This incentive is centred around the formation of a Section 12J Venture Capital Company (“Section 12J company”) which generally invests (similarly to private equity funds) into specific asset classes, be it, renewable energy, hospitality, private equity, mining etc. Once formed, taxpayers are incentivised to invest in Section 12J companies through a 100% tax deduction on the amount which they invest.

Jonty Sacks

Renewable energy developers have quietly been raising equity finance through Section 12J companies in order to increase their internal rate of returns and competitiveness in the South African market. This is achieved through a boost to investor’s returns as a result of the up-front tax deduction claimed by investors. By way of illustration, if an individual investor, in the highest tax bracket, invests R1 million into a Section 12J company, he/she will receive (upfront) up to R450 000 from SARS in the form of a tax refund.

The up-front tax refund can be up to 45% of the investor’s total investment. The tax refund over the lock-in period of five years (as required by Section 12J in order to retain the tax deduction), translates into an approximate annual return of 8% in the hands of the investor, this is before receiving returns from the underlying investment and after deducting capital gains tax.

From a developer’s perspective, the additional 8%, enhances the investor’s return on investment, thus allowing the developer to reduce returns to investors to as little as 6 to 8% per year thus lowering the cost of equity to an amount below the prime interest rate. With the lower cost of equity and the up-front tax deduction, developers are able to offer targeted after-tax returns of 15 to 18% per year in the hands of the investor.

Given the lower cost of capital due to the Section 12J incentive, developers can elect to lower their tariff which will improve competitiveness, and/or enjoy a higher return.

The up-front tax deduction, not only provides the investor with a return of up to 8% per year but also provides the investor with downside protection should the investment fail to perform. This is pursuant to an investor receiving up to 45% of his/her investment up-front. As a way of illustration, the investor in the example above would have invested R1-million, and would only be at risk for R550 000, notwithstanding the fact that the investor would have received a return on the full R1-million invested.

Although the incentive was introduced in 2009, only within the last few years (through multiple amendments to the tax legislation), has Section 12J become very attractive, with anticipated investments for 2019 being approximately R2 billion. Time is, however, running out for the incentive as Section 12J contains a sunset clause, which provides that investors have until 30 June 2021 to invest in Section 12J companies and claim a tax deduction.

Editor’s note: More information regarding Section J12 tax for venture capital companies (VCCs) is available on the SARS website: www.sars.gov.za/ClientSegments/Businesses/Pages/Venture-Capital-Companies.aspx

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