The 2008 Budget and Private Equity
Minister Manuel gives on the one hand and then takes away on the other…
In recognition of the phenomenal growth in the local private-equity industry and its potential to contribute to growth in the SMME sector, the Minister has focused some attention on this industry in this year’s Budget tax proposals. Although the local private equity industry is well developed and continues to grow, investors in this industry have somewhat shied away from venture capital (providing seed capital and funding to start-up companies and companies in their infancy stages) due to the inherent risks associated with this form of investment.
The main proposal comes in the form of a tax incentive to venture capital investors in qualifying small enterprises and start-up companies. Targeted investments in this regard are high-growth and high-tech companies with annual turnover of up to R14 million or gross assets of up to R7 million (R30 to R50 million for junior mining and exploration companies).
The beneficiaries of this proposed incentive are individual and corporate investors and venture capital funds. These investors will qualify for an upfront deduction of 30% of the capital invested. These annual deductions will be capped annually at R500 000 for individuals, R750 000 for corporations and R7.5 million for venture capital funds of their capital invested. Investments in junior mining exploration companies on the other hand will qualify for a 50% deduction of their capital invested, capped at R1 million for individuals and R10 million for corporations and venture capital funds.
The incentives, if implemented, will contribute to reducing the cost of funding for venture capital investors and thereby encouraging growth in this area. What is of interest is whether or not these incentives are meant to be as an alternative to the existing 3 year safe haven rules on the disposal of shares? In terms of these rules, where a taxpayer disposes of qualifying shares held for a continuous period of 3 years prior to disposal, such disposal is treated as being on capital account and subject to tax at a rate of 14.5% instead of 29% (now reduced to 14% and 28% respectively). The question is whether or not the same investor could qualify for both incentives in respect of the same shares, which is unlikely.
On the flip side, however, mention was made of the fact that certain aspects of private equity transactions and their impact on the tax system will be investigated. It seems the focus will primarily be on the deductibility of interest and the rewards of fund managers (in the form of shares) in highly geared leveraged buyouts. This envisages transactions where the investor acquires a stake in a mature company through the use of interest bearing debt. Under the current legislation, where interest bearing funding is obtained specifically to acquire shares in a company, such interest is considered unproductive and is therefore not deductible for tax purposes. This is on the basis that the interest expense is incurred in order to produce exempt income (in the form of tax exempt dividends that would flow to the investor) which is not taxable. To ensure a deduction, mechanisms are put in place by private equity investors to sever the link. The intention is to investigate the deductibility of interest in these circumstances and the tax treatment of such fund manager rewards. In this regard, a discussion document will be developed and circulated for public comment.
