Venture capital companies – summary of the latest tax rulings

capetownAuthor: Mansoor Parker and Anuschka Wischnewski (ENSafrica).

Introduction

The venture capital company (“VCC”) regime was introduced in 2009, with an aim to encourage investors, by way of substantial tax benefits, to invest in small South African trading companies. VCCs are private investment companies, although they need not be, as the Income Tax Act does not prevent VCCs from listing their shares on the Johannesburg Stock Exchange.

The past two years have seen a phenomenal increase in the number of VCCs. There are now 36 South African Revenue Service (“SARS”) approved VCCs, of which 29 were approved in the past two years.


The increase in the number of VCCs has also seen the emergence of VCC-specific advance tax rulings. The advance tax ruling system was introduced in 2006. Its purpose is to promote clarity, consistency, and certainty regarding the interpretation and application of tax legislation. An advance tax ruling is a written statement on how SARS will interpret and apply specific provisions of the applicable tax legislation. SARS publishes redacted versions of these advance tax rulings on its website.

On 11 September 2015, SARS issued binding private ruling 205, which dealt with the meaning of a “controlled group company” and “equity share”. More recently, on 15 June 2016, SARS issued BPR 242 which, like BPR 205, also dealt with the meaning of a “controlled group company” and “equity share”. However, BPR 242 goes further than BPR 205 in that it also considers the R50-million book value threshold and whether the qualifying company carried on business as a hotel keeper.

The guidance provided by these rulings is important as they deal with the rules governing the type of investments that can be made and the conditions VCCs must satisfy in order to raise funds from investors. In this article, we will deal with three issues that arose from these rulings: the controlled group company concept, the equity share requirement and the book value threshold.

Before dealing with these rulings, we recap the typical venture capital structure:

Controlled group company limitation

The VCC may not invest in a qualifying company if it is a controlled group company in relation to a group of companies. A controlled group company in relation to a group of companies is a company where at least 70% of its shares are held by a controlling group company or by other controlled group companies within the group of companies.

This structure is not permissible as the VCC (controlling group company) holds 70% of the shares in the qualifying company (controlled group company). This structure is not permissible as the other investor (controlling group company) holds 70% of the shares in the qualifying company (controlled group company).

A very simple strategy to avoid the qualifying company becoming a controlled group company in relation to the VCC, is to ensure that the VCC subscribes for less than 70% of the shares in the VCC. But what about situations where the VCC would like to contribute, for example, 85% of the qualifying company’s issued share capital? The applicants in BPR 205 and BPR 242 were faced with this problem.

In both BPR 205 and BPR 242, the applicants successfully avoided having the qualifying companies classified as controlled group companies. This was achieved because the qualifying companies issued different classes of shares. In BPR 205, the applicant subscribed for 20% of the qualifying company’s issued shares (Class A ordinary shares) at a subscription price equalling 75% of the qualifying company’s entire issued share capital. The other investors subscribed for Class B and C ordinary shares, respectively.

In BPR 242, the applicant subscribed for A class ordinary shares and the co-investor subscribed for B class ordinary shares in the qualifying company. The applicant held less than 70% of the total number of shares in issue in the qualifying company, but contributed more than its proportionate share in monetary terms to the qualifying company’s share capital.

In BPR 205 and BPR 242, SARS issued rulings that the qualifying company was not a controlled group company in relation to a group of companies despite the fact that the VCC contributed more than its proportionate share in monetary terms to the qualifying company’s share capital. These rulings confirm that the test is the number of shares that the VCC holds in the qualifying company, not the VCC’s economic interest (i.e. the value of those shares) in the qualifying company. It is possible for classes of shares to be created where the value of those shares are disproportionate to the value of those shares.

Equity share requirement

Where the qualifying company issues different classes of shares, then careful attention must be paid to whether the different classes of shares are equity shares. For instance, assume that a VCC subscribes for 60% of the shares in a qualifying company while two other investors subscribe for the remaining 40% of the shares in the qualifying company. If the shares held by the two investors are not equity shares, then the VCC will, in fact, hold 100% of the equity shares in the qualifying company.

For tax purposes, equity shares are any type of share in a company, excluding any share that, neither as respects dividends nor as respects returns of capital, carries any right to participate beyond a specified amount in a distribution. Thus, the equity share definition excludes certain types of shares. The rationale for excluding these types of shares is that they have more features in common with a debt instrument, and are therefore a “safer” form of investment.

The words “any right” imply that a shareholder must be restricted from participating in distributions from a qualifying company in all respects in that there must be a restriction on both the right to a dividend distribution and a capital distribution before the share will not be an equity share. Put differently, if a shareholder is entitled to unlimited participation in any company distributions (whether dividends or returns of capital), the share will constitute an equity share.

In BPR 205:

  • As the applicant contributed a disproportionate amount of share capital, the Class A ordinary shares were entitled to a first distribution of profits or capital equal to the capital invested and a return to the equivalent of prime plus 2%.
  • Upon settlement of the Class A ordinary shares, the Class B and Class C ordinary shares subscribed for by  Company A and Investor B, respectively, will be entitled to a second distribution of profits or capital equal to a return to the equivalent of prime plus 2%, paid in proportion to their respective shareholding.
  • Thereafter, the Class A, B and C ordinary shares will rank pari passu in all respects.

In BPR 242, the A and B class shares will carry the following distribution rights:

  • The A class shares will be entitled to a profit distribution on an annual basis in an amount equal to the guaranteed earnings before interest, taxes, depreciation and amortisation, less any third party debt payments.
  • The B class shares will be entitled to a distribution of the remaining profits on an annual basis.
  • On exit, the holders of the A and B class shares will be entitled to a return of capital distribution of their respective amounts contributed together with a cumulative compound annual return linked to prime, with the A class shares ranking ahead of the B class shares.
  • The A and B class shares will then participate in the remaining assets of the qualifying company on a pari passu basis, pro rata to their number of shares held. The B class shares may receive, as a distribution in specie, the common areas in lieu of the cash distribution.
  • These rulings confirm that a class of shares can still be preferential in nature, without losing their “equityness”. It is possible to structure a particular class of shares so that the shares carry preferential rights to dividends. The VCC was clearly better off than the holders of the other classes of shares who have to wait in the queue. But in spite of the preferential nature of the VCC’s holdings, the shares held by the VCC remain equity shares by virtue of the equity share definition.

The R50-million book value threshold

The R50-million book value threshold applies to all qualifying companies (other than junior mining companies) where the book value threshold is increased to R50-million. The legislation requires the qualifying company’s assets to be valued at book value not market value. The book value determination must be made at the time the VCC acquires the equity shares in the qualifying company.

Book value is the price that the qualifying company paid for its assets. It differs from market value, which is the price at which the qualifying company could sell its assets. The book value determination is based on the original cost of the qualifying company’s assets less any depreciation, amortisation or impairment costs made against its asset. In many cases, the carrying value of the qualifying company’s assets and their market value will differ greatly.

Provided that the book value threshold is satisfied at the time the VCC subscribes for the shares in the qualifying company, any subsequent increase in the book value of the qualifying company’s assets will not impact the VCC’s tax status. In BPR 242, the qualifying company will acquire sectional title units in two tranches. The combined value of the sectional title units will exceed R50-million which, on the face of it, suggests that the qualifying company will not comply with the R50-million book value threshold.

However, in the first tranche, the qualifying company will use the cash proceeds from the share issue to the VCC to acquire sectional title units with a value below R50-million. Thereafter, the qualifying company will obtain debt funding to acquire additional sectional title units. At the time of the VCC’s investment, the qualifying company’s book value will be below R50-million despite the fact that it has an option to acquire additional sectional title units. The qualifying company’s later purchase of the additional sectional title units does not taint the VCC’s initial share subscription in the qualifying company.

SARS ruled that the existence of the option granted to the qualifying company to acquire additional sectional title units will not constitute non-compliance with the R50-million book value threshold nor will the exercise of the option after the acquisition of the first sectional titles constitute non-compliance with the R50-million book value threshold.

 

Mansoor Parker

tax | executive
mparker@ENSafrica.com
+27 83 680 2074