The Removal Of Key Incentives Upsets South Africa’s Startup & VC Scene

In the year 2008, the South African government – in a bid to encourage investments that will catalyse the establishment and growth of small-, medium0, and micro-enterprises – came up with something loosely called Section 12J.

Section 12J actually refers to Section 12J of the Income Tax Act No. 58 of 1962.  It allows South African taxpayers to invest in local companies and to receive a tax deduction of up to 100 percent. The entire amount that is invested can be deducted from the investor’s taxable income.

In simpler terms, Section 12J is an incentive that encourages locals to invest in small businesses and it offers tax holidays as a benefit.

The aim of this tax incentive was to help new businesses to obtain funding that would otherwise not be available to them. And for many years, it has contributed significantly to the rise in locally-sourced capital which South Africa’s tech startup scene, especially, has witnessed.

However, it appears the government has opted to greenlit a reset that will alter the way things have worked for years, and some fear that all the progress made so far now stands the risk of becoming undone.

To state it as it is, South Africa’s National Treasury has decided to stop its Section 12J tax benefits. The reason? The authorities are leaning towards the rationale that the tax incentive hasn’t really yielded the desired effect, of which job creation is a primary focus.

It seems investors did embrace Section 12J, just not the way the government had hoped.

There are reports that the system may have been taken advantage of, such that wealthy taxpayers invest in long-existing low-risk ventures that they would generally invest in regardless, rather than newer businesses that can employ new hands and ease the unemployment burden in South Africa – now alarmingly high at 30.8 percent.

In a bid to ascertain whether the Section 12J incentive achieved its intended goals, National Treasury launched a review of its venture capital company tax incentive.

The review showed that ZAR 11.5 Bn (USD 754 Mn) had been invested using Section 12J on which a 100 percent tax deduction was applicable. However, while the incentive attracted billions in investments, only 37 percent of qualifying companies added new jobs after receiving venture capital funding.

“This was because many people abused the system. Instead of growing new companies, wealthy taxpayers are using the 12J incentive to invest in low-risk ventures,” reports Mybroadband.

“It was therefore not used to grow new small- and medium-sized enterprises, but rather to avoid tax on investments which would have happened anyway. As it failed to achieve its intended goals, the incentive will not be extended beyond its current sunset date of 30 June 2021.”

It can be said that one of the biggest casualties of the tax incentive withdrawal is South Africa’s venture capital and tech startup scene where the Section 12J vehicle has spurred significant investments over the years; some might even say Section 12J worked exactly as intended in this area.

“The decision to stop its Section 12J tax benefits is bad news for the South African tech start-up environment and will make it more difficult for new tech businesses to access funding,” says Clive Butkow, CEO of Kalon Venture Partners; a local VC firm in South Africa which operates under Section 12J of the Income Tax Act.

As further stated, “The country has excellent tech entrepreneurs with great business ideas, but access to capital is a challenge for these entrepreneurs. This is partly because international investors are hesitant to invest in South African tech start-ups before they have proven their business model and showed strong growth. The Section 12J venture capital tax breaks helped to overcome this hurdle by providing local tech startups with seed and growth funding to rapidly expand their operations.”

Barring the uncharacteristic slump of 2019 and the pandemic-shook year that was 2020, the startup ecosystem in Africa’s most advanced economy, South Africa, is one of the most vibrant in Africa.

South Africa’s startup scene led from the front in such areas as the number of startup funding deals and startup funding amounts in each of the four years between 2015 and 2018.

In 2015, African tech startups raised a total of USD 185.7 Mn in funding and 29 percent of that sum (USD 54.6 Mn) was raised by South African companies — no other country posted better numbers.

African startup funding generally plummeted in 2016 due to the economic recession, though only in terms of value as the number of deals recorded actually rose to 146, suggesting that more African startups were funded in 2016 than in 2015.

That year, the total amount raised by startups on the continent fell by 30.5 percent to USD 129 Mn. And even though South Africa saw funding for startups fall 14.6 percent to USD 46.8 Mn, the country still led the way in Africa in terms of funding amount and deal count.

In 2017, African startup funding hit USD 201 Mn and, as a recurring theme, South Africa again topped the charts in terms of funding with USD 39.60 Mn infused into its startups. South Africa also bagged the top country title with 74 startups getting funded that year. Nigeria and Kenya settled for the runner-up places as they had done in the years prior.

The year 2018, however, was something of a mixed bag. In WeeTracker’s African Venture Capital Report for 2018, USD 725.6 Mn was invested across 458 deals — a gigantic 300 percent leap in the total funding amount and over 127 percent increase in the number of deals compared to 2017.

While South Africa had to settle for second place on the deal count log, it still occupied the top spot on the funding amount leaderboard. In 2018, South African startups roped in USD 241.1 Mn in 108 deals. Nigeria, which recorded the highest number of deals with 136, only drew in USD 133.5 Mn.

So, there you have it — South Africa has always been in the thick of things, which makes it all the more baffling why 2019 (when it recorded USD 67.34 Mn from 96 deals) was such a low for the startup ecosystem in Mzansi. And an unexpected and unprecedented one at that.

The contribution of local investors in the progress of South Africa’s startup ecosystem has been immense. In fact, out of the 96 rounds in South Africa 2019, 53 were led by local South African venture capital (VC) firms. It’s a testament to how active local investors have become in a space that used to run almost exclusively on foreign-sourced capital.

Needless to say, the existence of the Section 12J legislation, as implemented by the government, has been quite instrumental in pushing the needle in terms of locally-sourced investments. So, it’s no surprise that the imminent discontinuation of the incentive has caused concern.

Indeed, a portion of a recent statement by the Southern African Venture Capital and Private Equity Association (SAVCA), laments thus;

“SAVCA is disappointed that the Section 12J VCC sunset clause is not being extended past 30 June 2021, essentially withdrawing the incentive in its entirety rather than amending the incentive to ensure National Treasury’s objectives are met. The Section 12J incentive has been very successful in raising funding from private individuals and corporates to invest in businesses meeting the Section 12J investment criteria as set out in the Income Tax Act.”

Featured Image Courtesy: ICTworks