How to avoid the Naspers / Prosus capital gains tax event this financial year

It is old news that Prosus shareholders have found themselves in a situation where their share issue has left them with a tax event and as a consequence, unless tax efficient steps are taken before the end of February 2020, these shareholders will be required to pay capital gains tax.

For most of these shareholders, other than the annual R40 000 capital gains tax exclusion, the only option to reduce their capital gains tax liabilities would be to invest in a Section 12J investment. This is due to the fact that investors in Section 12J investments are allowed to deduct 100% of their Section 12J investments from their taxable incomes (subject to annual limits). This incentive would, therefore, allow Prosus shareholders to reduce their capital gains tax liabilities through a Section 12J investment.

Below is a comparison between a shareholder (who is taxed at the highest marginal tax rate)  who hasn’t invested in a Section 12J investment vs one who has. 

*the above assumes the shareholder is taxed at the highest marginal tax rate.

Michael Westcott, CEO of Absolut Wealth Management, explained that,

 “Section 12J has created an opportunity for a number of my clients and me personally to shield a capital gains tax event following the disposal of a share portfolio.” 

By way of example, if a client elects to sell R10 000 000 of his/her listed share portfolio and as a result, has a capital gain of R5 000 000 (less his/her annual exemption of R40 000), 40% (R2 000 000) must be included in his/her taxable income. The net effect is that the client would have a tax liability of approximately R900 000. 

The client now has an option to invest approximately R2 000 000 in a Section 12J investment and reduce his/her tax liability to zero. This example doesn’t just apply to listed equity but to the sale of any asset which would result in a capital gains tax event” 

Jonty Sacks, a partner at Jaltech, a specialist Section 12J fund manager, says that “there has been enormous interest from Prosus shareholders to understand how the Section 12J tax deduction can be used to reduce their capital gains tax liabilities and how our Section 12J investments have performed in relation to our competitors.

As an investment class, Section 12J investments have had a significant increase in popularity over the past 3 years. This surge in popularity is largely due to taxpayers becoming more familiar with the tax incentive and following a number of Section 12J investments yielding positive returns.” 

In an earlier article published by Ince, we set out a few investment fundamentals which investors should consider before making a Section 12J investment, namely:

Reasonable fees  

Fees charged during and at the end of the investment term can erode returns significantly. On close inspection, investors may discover that performance fees are much higher due to fees being charged on "capital at risk". 

For example, if an investor invests R100, and receives a tax refund of R45, the investor's "capital at risk" will be R55 (R100-R45=R55) as the investor's original investment is reduced by R45 through the tax refund. In this instance, the fund manager would earn a performance fee on any amount above the investor's capital amount of R55.  

If one ran a simple calculation in a scenario where an investor invests R100 and the investment grows to R120 over 5 years, the capital at risk performance fee would be R13 which amounts to an alarming 65% of the investor's profits.  

For most Section 12J investments, the fair approach is to charge a performance fee on any amount above the original investment amount (termed "gross capital performance fees"). Using the above scenario, the gross capital performance fee would be R4 which is only 20% of the investor's profits.  

Investment/deployment rate 

It is unlikely that investors will achieve the advertised targeted return if their capital is not invested within a reasonable period (6 to 12 months). Failure to do, so results in a "cash drag" and consequently low returns and potentially a longer investment term than expected, due to the investment taking longer to generate the anticipated returns. 

Investors should enquire what percentage of the capital under management has actually been invested by the fund manager, with special emphasis on the percentage of capital raised in the last year that has been re-invested. Should the percentage of non-deployed capital be high, investors may soon realise that the fund's performance will be low.  

Clear and effective exit mechanisms  

Section 12J investments are private equity in nature and unless the fund manager has a clear and effective exit strategy, it's likely that investors will be invested for longer than the anticipated investment term. The consequence is that the tax benefit associated with the Section 12J investment is spread out over a longer period of time, resulting in a lower effective tax benefit per year. 

The above sense checks will place an investor in a far better position to make an informed investment decision. Surprisingly, a large number of Section 12J funds lack these fundamentals, including some which have attracted significant capital. Given the wide variety of Section 12J investments in the market, investors can easily filter their next Section 12J investment, by requesting a fund fact sheet and by requesting information needed to determine whether the above fundamentals are present.