With the end of the financial year approaching fast, it is time to start optimising your income tax. One way of doing this is by investing in Tax-Free Savings Accounts (TFSAs) that I discussed in the article should I even bother with a TFSA? This option is geared towards the middle to low-income households. High-income earners will need additional investment vehicles. This is where Section 12J investments come in handy. The reason it is so attractive is that it has no contribution limit. This means that all contributions to a Section 12J investment are tax deductible. First though, let’s look at what the Section 12J tax act is.
What is Section 12J
Section 12J investment is a way to spend venture capital while getting a tax break for your contributions. There are three parties involved in the transaction. The investor doing the venture capital investment, the 12J company managing the fund and the companies they invest in. The companies can be anything from restaurants to laundromats as long as their market cap is less than R50 million and they do not fall into the following categories:
- Immovable property (excluding hotels)
- Financial services like banks
- Advisory services like law firms
- Alcohol, tobacco or firearms
Section 12J did not really take off until 2014 when SARS changed the regulation to void tax if you remain invested for 5 years. At this time, you can sell the investment. However, you pay capital gains tax on a base cost of zero. In other words, on the full amount.
Running the numbers
Let’s look at an example. Suppose you wanted to invest R100 000 and you are earning more than R1.5 million per year. You get a tax break for the full R100 000, which is at the top tax bracket of 45%. You avoid paying R45 000 so you would have only had R55 000 left after tax. However, you get to invest the full R100 000.
Section 12J companies do not need to take risks when choosing companies to invest in. The investor already gets the tax break and therefore do not need risky investments to turn a profit. Suppose that the investment only returns 5% over 5 years with a fee of 2% to the fund managers. That leaves the investor an amount of about R116 000 after 5 years.
You are taxed on the full amount when you sell, but it is the best type of tax, capital gains. With capital gains tax you get a tax break of R40 000, after which you are taxed on 40% of the remainder. In this instance, you pay tax on R30 400. If this is added to your salary and is taxed at the top bracket of 45%, you will pay R13 680. This is an effective tax rate of 11.7%. Even though capital gains are frequently quoted at 18%, you need to earn rock-star money for it to actually be 18%.
Your after-tax income is R102 300, with an investment of effectively R55 000. This is a return of 13.25% per year, which is about 1% better than you can do on our stock market in the long term. The question, however, is if this is worth the risk.
First off, there is always the risk of the companies going broke. Because the market cap of these companies is less than R50 million, they are small. Small companies are not necessarily notorious for their 99% success rates. This means you are at the mercy of the 12J company to choose your investments meticulously. You should spend time choosing your section 12J company carefully.
My biggest concern however is the exit. Who are you going to sell it to and on which market? How liquid are these investments going to be? A lot of these investments are reaching their 5-year investment term so we will find out soon enough. Some section 12J companies offer you an exit mechanism and I would confirm this before signing anything.
The minimum investment for a few of these funds is R100 000, with most requiring at least R1 million. So, it is not for the faint-hearted or low-income households. I think it is a great initiative with a lot of potential. However, the success will be heavily reliant on who you choose to invest with. The section 12J investments are only available until 2021 at which time it can be extended but nothing is confirmed. You have until the end of February if you still want to invest in this financial year.
Be safe out there,
Quote of the week"Venture capital is an inherently optimistic form of investment – which is both its primary strength and its primary weakness." – Neil Blumenthal Click To Tweet
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