No hype, just solid numbers outlining the impact of the tax breaks on your investment returns when using a Section 12J vehicle.

Jerry Maguire (portrayed by Tom Cruise) will go down in film history for his memorable quote when he shouted, “Show me the money!”

However, while I’m unlikely to achieve anywhere near a similar level of fame, when it comes to the tax savings that purveyors of Section 12J investments love to shout about from the rooftops, my response to them is, “Show me the numbers!”

My assumptions

My number-crunching exercise (and this article) was prompted by the real-life example of a friend of mine who placed R500,000 into such an investment back in May 2018.

At the time he made the investment, his marginal rate of tax was at the top tier of 45%. When I completed his tax return for the year ended 28 February 2019, he was very pleased with the large refund that he received from SARS as a consequence of having made this investment.

However, he was rather perturbed when I informed him (after he had committed the funds) that the flipside of the upfront tax deduction is the fact that unlike with after-tax investments where the base cost (for Capital Gains Tax purposes) is normally the initial amount invested, with Section 12J investments the base cost is deemed to be zero.

This, of course, means that at the end of the five-year period, CGT is payable on the full proceeds of the investment—even if the investment has shown a loss in nominal cash terms. As it turned out, the latter is exactly what happened in this case – more on that below.

Questioning whether he had made a wise decision, he asked me to calculate and compare the net returns based on an investment made via the Section 12J wrapper, versus a similar investment made in the normal manner (i.e. from after-tax funds).

For the purposes of this exercise, I assumed that income tax rates, the CGT inclusion rate, and the annual CGT exemption remained unchanged during the entire investment period. While income tax rates did change slightly over the five-year period, the CGT inclusion rate and annual exemption both remained constant.

At the time I wrote the original article in November 2019, proposals contained in the 2019 Taxation Laws Amendment Bill sought to limit investments into Section 12J instruments to an annual limit of R2.5 million in order to curb perceived abuses of this tax break.

However, while this amendment would certainly have had an impact on the seriously wealthy, for the purposes of this exercise (given that the amount involved falls well under the proposed limit), I ignored this in my calculations.

I also assumed at the time that the investment would grow by 30% over the five-year period, recognising that this translated to a relatively paltry annualised growth rate of 5.09%—bearing in mind that one can get around 8% on a five-year fixed deposit if you shop around (which translates to around 7.3% after tax on a R500 000 investment, assuming a 45% marginal rate and no other interest income).

I actually wanted to use growth of 100% over five years, given the risky nature of a typical Section 12J investment (which translates to roughly 14.4% per annum before tax using the ‘Rule of 72’ method), but my friend felt that this was optimistic given the investment climate at the time.

As it turned out, the investment actually decreased in value. After having R500,000 locked away for five years, he received R466,334 when it matured five years later – and to add insult to injury, the full proceeds were treated as a capital gain (see calculations below).

Hindsight, as always, is an exact science …

The projected results

The table below indicates that for a normal investment from after-tax funds (i.e. with no upfront tax deductions and normal CGT rules applying at the end of the investment term), the projected net after-tax return in this example was 5.09% per annum.

This hypothetical ‘normal’ investment was compared to my friend’s actual investment via the Section 12J wrapper. In his particular case, he benefited from the tax deduction in Year 1 but did not reinvest the refund. In other words, the net cash outlay (after tax) was R275,000 rather than the R500,000 net outlay he would have had if he’d gone into a normal investment.

Investment returns were thus calculated based on the R275,000 in this case, and after taking into account the CGT at the end of the term, his after-tax return on the R275,000 (bearing in mind that R500,000 actually went into the investment, but he got R225,000 back from SARS) was expected to be 14.91% per annum.

In other words, if the investment were to grow by 30% over the five years, he would have effectively doubled his R275,000 in five years.

To satisfy my own curiosity, I decided to repeat the exercise, this time assuming that the anticipated tax refund would be added to the investment up front.

Using an iterative process whereby reinvesting the tax saving would result in a further tax saving, and so on, I worked out that an up-front investment of R909 091 would bring about a tax saving of R409 091. The net cash investment after the tax saving would thus be R500,000—the same amount that would be invested into a ‘normal’ investment.

To be honest, the net result was somewhat surprising, in that the annualised after-tax rate of return came out slightly lower at 14.57% per annum (for a 5-year return of 97.42%). However, the slight difference can be attributed to the fact that the annual CGT exemption is fixed at R40,000, with the impact diminishing as the taxable capital gain increases.

However, from a cash point of view, reinvesting the tax saving would (in theory) have put the investor in a better position than if the savings were not reinvested.

If the projected returns had been achieved, with the net upfront cash outlay in both cases (i.e. Section 12J and the ‘normal’ investment) being R500,000, one would have to more than double one’s money in the ‘normal’ vehicle to match a 30% growth in a Section 12J vehicle.

Of course, being venture capital, the risk is a lot higher in a Section 12J vehicle—as is the potential return.

The actual results

As indicated above, my friend invested R500,000 and got back R466,334 when his investment matured five years later. Had this been a normal investment made from after-tax money, his investment would have shown a capital loss of R33,666.

Such a loss would have been shown on his 2024 tax return, and set off against any capital gains made during that tax year – but ignoring the CGT exemption amount, this would have reduced his CGT bill by (at most) R6,060 if his marginal rate of tax had remained at 45%.

Needless to say, given that he has since retired, his marginal tax rate would have been no more than 26% for the 2024 tax year, with the reduction in his CGT bill being a mere R3,501. He would have therefore sustained a net (i.e. after-tax loss) of R30,165 on this investment had it not been made within a Section 12J wrapper.

The fact that Section 12J applied changes the picture quite significantly.

It’s important to remember that in the year in which his R500,000 was invested, SARS refunded him R225,000 when his 2019 return was assessed. This meant that the net amount invested was reduced to R275,000.

When the investment matured in the 2024 tax year, the full proceeds of R466,334 was included as a taxable capital gain (i.e. the base cost was Rnil). Applying the 40% inclusion rate (but ignoring the R40,000 exemption as he had other capital gains during the year), R186,534 would be subject to normal tax at his marginal rate.

Including this gain put my friend into the 36% tax bracket, which makes his CGT bill on this particular capital gain R67,152. Subtract this from the gross proceeds makes the net proceeds on this investments R399,182, which means that he actually made money on this investment!

Wait … what? That’s impossible! If he invested R500,000 and got back a net R399,182, surely he’s lost just shy of a hundred grand? Except he didn’t invest R500,000 – thanks to the tax refund, he actually only invested R275,000. He therefore ended up being R124 182 (or 45.16%) better off!

The annual return (after tax) works out to 9.03%. Not too shabby, Nige! That said, this surprising return on what was actually a losing investment ended up costing SARS (and thus South African taxpayers) R157,848 in this individual case.

It would be interesting to know what the outcome was for SARS across the entire gamut of Section 12J investments over the past five years, and whether the investments involved have left South Africa as a whole better off. Sadly, I have some serious doubts as to whether Section 12J achieved its intended aim.

 

WRITTEN BY STEVEN JONES

Steven Jones is a retired tax practitioner and member of the South African Institute of Professional Accountants.

While every reasonable effort is taken to ensure the accuracy and soundness of the contents of this publication, neither the writers of articles nor the publisher will bear any responsibility for the consequences of any actions based on information or recommendations contained herein. Our material is for informational purposes.