On 24 July 2017, the South African Revenue Service (SARS) released binding class ruling 057 (BCR 057) which deals with, inter alia, the eligibility of a partner in an en commandite partnership to claim a deduction in respect of venture capital shares acquired by the partnership.
In order to place BCR 057 into context, it is imperative that a brief background of the Venture Capital Company (VCC) tax regime be provided. The VCC tax regime, which was introduced into the Income Tax Act, No 58 of 1962 (Act) in 2009, is aimed at encouraging investment into small and medium-sized enterprises and junior mining companies. Section 12J of the Act encompasses the relevant legislation governing VCCs and provides for the formation of an investment holding company, described as a VCC. Investors subscribe for shares in the VCC and claim an income tax deduction for the subscription price incurred. The VCC, in turn, invests in “qualifying companies” (ie investee companies).
The deductibility of expenditure incurred by an investor in acquiring shares in an approved VCC is subject to anti-avoidance provisions. Firstly, where an investor has used any loan or credit to finance the expenditure incurred to acquire shares in the VCC, the amount of the deduction is limited to the amount for which the investor is deemed to be at risk on the last day of the year of assessment (s12J(3)(a)). The investor is deemed to be so at risk to the extent that (having regard to any transaction, agreement, arrangement, understanding or scheme in this regard) the incurral of expenditure or the repayment of the loan or credit would result in economic loss to the investor, where no income is received by or accrued to the investor in future years from the disposal of any venture capital share issued to such investor as a result of that expenditure (s12J(3)(b)). However, a proviso to s12J(3)(b) provides that an investor will not be at risk if the loan or credit is not repayable within five years or if such loan or credit is granted to the investor by the approved VCC itself.
Secondly, s12J(3A) of the Act provides that if, at the end of any year of assessment, after the expiry of a period of 36 months commencing on the first date of the issue of the venture capital shares, an investor has incurred expenditure in acquiring any venture capital share issued to such investor by a VCC and, as a result of such acquisition, that investor is a connected person in relation to that VCC:
- no deduction will be allowed in respect of such expenditure;
- the Commissioner for SARS (Commissioner) must, after due notice to the VCC, withdraw the approval of the company as a VCC; and
- an amount equal to 125% of the expenditure incurred in the acquisition of the company’s shares by any person must be included in the income of the company, in the year of assessment in which the approval is withdrawn, if corrective steps, acceptable to the Commissioner, are not taken by the company within a period stated in the notice given by the Commissioner.
In accordance with s12J(4) of the Act, a claim for a deduction by an investor must be supported by a certificate issued by the VCC stating (i) the amounts that were invested and (ii) confirming that the relevant company was approved as a VCC.
Section 12J(5) sets out the requirements that must be met before a company can be approved as a VCC. More specifically, a company will acquire VCC status if the Commissioner is satisfied that the sole object company, which must be a resident of South Africa, is the management of investments in qualifying companies. In addition, the company, which must be licensed in terms of s7 of the Financial Advisory and Intermediary Services Act, No 37 of 2002, must have complied with all the relevant laws administered by the Commissioner and must have its tax affairs in order.
Recent legislative amendments to s12J have given rise to an increased participation in the asset class and use of the investment vehicle, evidenced by the increasing number of rulings that have been issued by SARS in relation thereto. BCR 057, which is discussed in more detail below, is the latest of these rulings.
Description of the proposed transaction
The applicant, a company incorporated in and resident of South Africa (Applicant) is “engaged in the provision of trust services”. An en commandite partnership (Partnership) is formed amongst the Applicant (as the general partner) and between ten and twenty commanditarian or limited partners (Class members).
The Partnership is formed to invest exclusively in approved VCCs. The Partnership will not borrow from third parties, but will obtain cash contributions from the Class Members. A Class Member’s share in the income and capital of the Partnership will be in proportion to that Class Member’s contribution to the capital of the Partnership.
It is proposed that the Partnership will, at the outset, invest in two approved VCCs which will be managed by a company incorporated in and a resident of South Africa (ManCo). Notwithstanding that the investments in each of the VCCs will be made by the Partnership, the Applicant and ManCo will arrange that each individual Class Member be entered into the register of investors in the books of the relevant VCC. Furthermore, each individual Class Member will be issued a certificate contemplated in s12J(4) of the Act (Investor Certificate) in accordance with that Class Member’s proportionate investment in the Partnership.
Applicable law in relation to partnerships
En commandite partnerships are fiscally transparent vehicles for South African tax purposes. Each partner must account for its undivided share of the tax effects of a partnership’s income statement and assets. In particular, s24H provides the following in regard to the South African tax treatment of a partnership:
- In terms of s24H(2) read with s24H(5) of the Act, each partner is deemed to carry on the trade or business of the partnership. Any income received by or accrued to the partnership is deemed to have been directly received by or accrued to the partners, in accordance with the participation rights set out in the partnership agreement, and on the same date as the income was received by or accrued to the partnership. Any deductions or allowances that can be claimed against such income for expenditure incurred by the partnership, can be claimed by the partners in their own hands (in the same ratio as their participation rights).
2. In terms of s24H(3) read with s24H(4) of the Act, the tax deductions for a limited partner are in aggregate limited to the sum of that partner’s capital contributions plus its share of the partnership income. Any excess tax deductions can be carried forward to subsequent years of assessment.
SARS ruled that subject to sections 12J(3) and (3A), each Class Member will be entitled to claim the deduction under s12J(2) read with s24H, pro rata to that Class Member’s proportionate share of the investment in the Partnership.
In addition, the proposed Investor Certificates to be issued to the Class Members will be acceptable for purposes of s12J(4).
It is important to note that rulings are issued to taxpayers to provide guidance on how SARS interprets and applies the tax law to specific transactions. It is therefore important for taxpayers to be cautious when relying on rulings issued by SARS as persons not party to the ruling cannot bind SARS thereto.
BCR 057 is valid for a period of five years from 30 June 2017.