The 12J tax break: Did government jump the gun by scrapping it?

If you stand on a rooftop in Sandton — Africa’s richest square mile — you’ll see a skyline peppered with hotels. Many have been built with money that was invested thanks to a unique tax incentive, section 12J, which was launched in 2009 to entice the wealthy into financing start-up businesses.

There’s The Capital on the Park on Katherine Street, for example; opposite is the Mint Hotel; and there’s the as-yet-unopened Catalyst Hotel just a few blocks away.

All of these came into being as a result of the 12J tax break, which worked like this: if you invested R1m, say, in a qualifying "venture capital company" for a five-year period, you’d be able to deduct that full amount from your taxable income that year.

It proved to be a winner. Hotels and lodges were built around SA with part of the R11.5bn that had already flooded into these schemes by last June. Student accommodation was built, and small companies looking for money to grow leaned heavily on section 12J funding.

Until this week. In February, finance minister Tito Mboweni announced that the 12J scheme would come to an end on June 30, arguing that it had "not sufficiently" achieved its objectives of developing small business and creating jobs. Instead, he said, all it had done was provide a "significant tax deduction to wealthy taxpayers".

That’s just not true, say the many funds that offered these investments. In all, they say, the tax break funded 360 businesses, creating 10,500 much-needed jobs in the process. (The Treasury counters that of those 360 companies, only 37% added new jobs after getting funding.)

"SA is much poorer for this — it’s a short-sighted approach and it was premature of the government to stop it," says Grovest CEO Jeff Miller, one of the pioneers of section 12J investments in SA.

He says that by this week, when the scheme ended, there probably would have been about R14bn-R15bn raised through the incentive to help small companies grow.

"We were just getting started," he says. "It only came into its own in the past five years."

Mboweni’s ministry, on the other hand, argued that these sorts of investments were "low risk" and "would have attracted funding without the venture".

That’s not correct, says Dino Zuccollo, who chairs the 12J Association of SA and is principal of the largest of the funds, Westbrooke Alternative Asset Management. Hotels and tourism, he points out, have been "decimated by the pandemic and have certainly not enjoyed easy access to equity capital".

Covid has laid waste to the hospitality sector — and the announcement this week of a 14-day ban on alcohol and in-store dining will only increase the odds of more of these companies going to the wall. In March, tourist accommodation income was 45% lower than a year ago, according to Stats SA.

Nor has it been easy for any small businesses to extract funding from the banks during Covid. Considering that these smaller enterprises contribute nearly half of SA’s GDP, the end to the 12J scheme can only be seen as bad news.

Worse, scrapping the scheme, says Zuccollo, could also accelerate the flight of capital out of SA. "We cannot understand the rationale for cancelling one of the few mechanisms available to convince high net worth individuals to invest long-term capital in SA."

Zuccollo says 12J schemes helped create a heap of jobs, something you’d imagine the Treasury would want to encourage.

Even the Treasury’s more conservative statistics indicate that 8,239 jobs were created by the scheme within a few years. And Zuccollo believes that if it had been allowed to continue for another five years, it would have created 45,000 jobs.

Michael Jordaan, one of SA’s most prominent entrepreneurs who most recently launched data network Rain and Bank Zero, says the 12J scheme was a "great boost to the start-up sector, and past funding has built a foundation for many jobs that will still be created in future".

As for the idea that the funding will be easy to get elsewhere, Jordaan disagrees. "Those of us operating in the difficult venture capital segment of the market would argue that the incentive should have been refined rather than abolished," he says.

It’s a sentiment that’s shared by Business Unity SA CEO Cas Coovadia, who says there is "general disappointment" in the venture capital industry. He believes the consensus is that the Treasury should have refined the scheme, to ensure the right ventures got money, over terminating it altogether.

Capital Hotel Group CEO Marc Wachsberger tells the FM that 12J money helped his company grow from an upstart that launched during the 2010 Soccer World Cup, to a group with aspirations of opening 40 hotels across SA by 2028.

"Though the investments made were limited to R50m for each hotel, which is not a lot of money relative to the size of an average hotel, it was the risk capital portion that allowed us to unlock projects that may not otherwise have happened," he says.

In The Capital’s case, Westbrooke invested R450m in nine of its hotels. That created hundreds of permanent jobs: a standard 150-room hotel creates about 350 jobs during construction, and about 120 permanent jobs thereafter.

Wachsberger says investors relished the opportunity — he raised R100m in The Capital’s most recent 12J funding round, which closed in February.

The biggest slug of all the 12J cash — about 40% — went into hotels and lodges, from large hotels in Sandton to smaller safari lodges in the Kruger National Park. Today, that’s a part of the economy that’s wheezing badly under the strain of Covid.

But the money went further.

Second in the 12J pecking order were asset rental companies, which needed capital to rent out movable assets, from tractors to vehicles, pathology lab equipment and air conditioners.

Third was general private equity. One of the companies that was able to survive thanks to 12J cash was Cape Mohair, a business based in Elsies River, in Cape Town, which claims to be "the biggest mohair sock manufacturer in the world".

Cape Mohair says it wouldn’t have survived Covid and the "persisting difficult economic conditions" were it not for Anuva Investments, a section 12J company that provided it with working capital.

In last year’s section 12J industry survey, Cape Mohair said it would urge the Treasury and the SA Revenue Service (Sars) not to close one of the only equity sources available to small business.

Clearly, this plea fell on deaf ears.

Another company was Mobile Macs, which rents out motorbike fleets. It was formed in 2015 to "address the poor state of bike delivery fleets on SA roads".

It got a R19m boost from Westbrooke’s Aria fund, which allowed it to expand its services, and the number of people it employs, by 50%. Besides its full-time staff of 55, its fleet now consists of 2,100 scooters, creating 700 new jobs for scooter drivers.

Other 12J investments were in renewable energy, student accommodation in towns such as Potchefstroom, education, technology development, fintech and agriculture.

SilverLeaf, another 12J fund, was created specifically to invest in the cannabis industry.

In April, Bas Hochstenbach of Entrepreneurs for Entrepreneurs Africa wrote on Fin24 that scrapping the scheme would be a "huge mistake".

For one thing, he said, the scheme makes wealthier South Africans "feel comfortable entering the venture capital space — a space that is crucial for economic growth and innovation".

Souring the milk

This isn’t to say that some of the Treasury’s concerns are entirely unfounded. And it has at least extended the tax break for property developers of buildings in city centres for another two years.

It’s true that some of the 12J schemes skated close to the edge. Some created vehicles that allowed "investors" to get a tax break for buying a holiday home at the coast — clearly not what was intended.

The way this worked was that operators bought blocks of flats and argued that each flat was a "single business". They’d then put in place a "rental pool" to manage the investment, making it look almost like a hotel, while allowing "investors" to write off their purchase.

But Zuccollo argues that it would be unfair to suggest that everyone operated like this. He says there were two types of 12J managers: asset managers who created legitimate funds with lots of investors, and the structuring houses, which created funds "to apply 12J in ways to avoid paying tax".

One insider says that it may simply have been "too easy" to register as a section 12J company — a deep irony considering that in most cases, the local business environment is otherwise strangled in red tape.

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But here, all that was needed was a Financial Sector Conduct Authority licence and an application form to Sars — no questions asked.

"When there is the ability to avoid tax, you will always get people trying to be cute," the insider tells the FM. "You can only rely on legislation so much. Invariably any law will have loopholes, and 12J is a very small thing in a very big tax ecosystem."

Those funds that abused the tax break have now soured the milk for everyone.

Others have been critical, too. Back in 2019 Vinny Lingham, a Silicon Valley-based entrepreneur born in SA, described 12J funds that invest in property as a "tax dodge". He said many of these funds used "financial re-engineering" to help the rich avoid tax.

The way he saw it, many of the investors were simply "using tax money to get better gearing on their investments", which wasn’t really venture capital in the true sense.

He remains critical about the property side of the scheme.

"The point of venture capital is to create high-paying technology jobs, which create a wealth trickle down effect that we have witnessed in other countries," he tells the FM this week. "Hiring blue-collar labourers to build hotels does not recreate this effect."

When asked if he believes section 12J property funds have encouraged venture capital investment, he’s clear: "Absolutely not."

He adds: "The amount of money that went into true venture capital versus property investments via section 12J was insignificant. The largest section 12J funds doing true venture capital had R100m ($7m) in each of them, when a venture capital fund is really subscale at less than $20m."

Jordaan agrees that the property component "was indeed abused" at the expense of the creation of new ventures. But, if anything, this bolsters his argument that the 12J rules should have been amended, rather than scrapped altogether.

Nonetheless, he believes that the government can expand other legal avenues — such as regulation 28 of the Pension Funds Act — to help finance venture capital investments.

"Most portfolios can do with the higher long-term returns that come from the venture asset class," he says.

In response to criticism that the incentive has been abused, some section 12J providers argue that at least the scheme allowed wealthy investors to put money into the local economy — rather than deploying that cash into bitcoin or taking it offshore.

The industry also needed more time to properly reap the benefits. On this count, Zuccollo points to the UK, which has had a similar scheme in place for 20 years and has been able to create a wider ecosystem of investors in venture capital start-ups.

Research on the scheme last year showed that for every £1m invested in the UK venture capital market more than 10 years ago, there was an £8m increase in turnover.

This, of course, is lower for shorter time frames. Over five years, that £1m leads to a turnover increase of £3.9m — the SA association says this proves that "the incentive requires time before opinions can be formed".

Though section 12J companies held out hope that the window would be extended at the last minute, the deadline finally slipped past this week.

It means that many of the businesses that grew thanks to the incentive will have to go back to raising funds the old-fashioned way.

For The Capital Group, that means "[going] back to raising money the conventional way: from banks, private equity and shareholders", says Wachsberger.

For others, it’ll spell the closure of one of the few funding avenues remaining.

The Treasury says the scheme merely benefited rich investors, but many disagree and have facts to back their arguments

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