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Grandfathering problems for venture capital companies

1 November 2019
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In the Taxation Laws Amendment Bill released on 30 October, SARS introduced limits to the deductions that may be claimed by venture capital company (VCC) investors. The maximum deduction claimed by an investor in terms of section 12J, now may not exceed ZAR5 million for a company, and ZAR2.5 million for any person other than a company.  This limitation applies with effect from 21 July 2019, the date of the introduction of the draft Taxation Laws Amendment Bill (Draft TLAB).

The Draft TLAB proposed a maximum deduction of ZAR2,5 million for investors in VCCs.

In the comments to the Draft TLAB, it was pointed out that the limitation would prejudice VCCs with larger investors, “given the:

  • inability of other big potential investors to match the amount due to the cap, or
  • the VCC’s inability to attract a sufficient number of smaller investments in time before the end of the relevant 36-month period which, potentially, can be immanent.”

Take the example of a VCC who has already accepted two investors who each invested ZAR20 million in a share class and who has received commitments from 3 other investors to each invest ZAR20 million.  Based on these commitments, once all investors have been issued VCC shares, each one will own not more than 20% of the shares in that class, as required by section 12J(3B). However, with the introduction of the deduction limits, the VCC will have to find 12 corporate investors investing ZAR5 million each, or 24 other investors investing ZAR2.5 million each, in order to ensure that the VCC complies with the requirement that no shareholder will be a connected person in relation to the VCC (section 12J(3A)) or that no shareholder will own more than 20% of the equity shares in a class (section 12J(3B)).

The Response Document indicated that the comments were accepted.  The National Treasury response was that “legislative changes will be proposed in the 2019 Draft TLAB in order to mitigate any non-compliance risk on the current VCCs as a result of the proposed 2019 legislative amendments.”

VCC’s thus expected to see some form of ‘grandfathering’ to ensure that the introduction of the deduction limits will not force existing VCC’s into non-compliance in respect of sections 12J(3A) and (3B).  However, the TLAB does not provide for any kind of grandfathering.

Section 12J(6A) provides for a ‘review’ of the investments made by a VCC after a 36-month period.  The TLAB now provides that this review will only take place after 48 months.  However, this will not assist with the ‘grandfathering’ in respect of sections 12J(3A) and (3B): the ‘extra’ 12-months will provide a VCC with more time to find investments and spend its money, but not with more time to find investors.   It may have been an oversight that the 36-month period in only section 12J(6A) was extended, and not also the 36-month period in sections 12J(3A) and (3B).

The amendment as contained in the TLAB thus creates a substantial risk that VCC’s will be forced into default by the amendment, despite the assurance by National Treasury that the non-compliance risk would be mitigated.

It is important that this should be corrected before the promulgation of the legislation, as failure to comply with sections 12J(3A) and (3B) could have catastrophic consequences for a VCC and its investors.