Innovate tax to support private investment in SMEs

SMEs are recognised as key contributors to both growth and employment, contributing 30% of the country’s GDP and 36% and almost 70% of private sector employment. Government intervention in this sector has included the provision of wholesale finance and non-financial support services. The 2005 and 2006 Budgets have also given support to SMEs through the tax system, streamlining VAT procedures and raising qualifying tax thresholds for small businesses.

Range of incentives

Yet private investors in many developed economies are able to take advantage of a range of tax incentives including an up-front income tax deduction, tax-free dividends, capital gains tax deferral, and so on.

Such individuals may be highly sophisticated professional investors – so-called business angels – or less sophisticated investors who prefer to invest in pooled funds managed independently by professional fund managers, as part of a long-term savings strategy.

However, both types of investor contribute to the supply of equity finance to small businesses, thus filling the “equity gap” which afflicts SMEs in many economies – namely, the absence of risk capital at a level that is higher than “friends and family” can provide but that is too low to attract traditional venture capital. Furthermore, private investors (whether directly or through a fund manager) tend to bring much-needed management support, governance, advice and mentoring to small businesses.

Increasing trend

In South Africa it is estimated that there are 37 000 individuals with more than R6 million in investable assets. At the same time, the private equity industry, a vibrant part of the financial system with some R43 billion in assets under management at the end of 2004, has seen an increasing trend towards larger transactions, a typical feature of private equity across the world.

Although a small number of firms, such as Business Partners, are actively investing in small businesses, there is an equity gap in SA (especially at investment size at R5 million or less) as there is elsewhere in the world. The focus on increasing the supply of debt finance (for example, through the banks’ commitments under the Financial Sector Charter) merely accentuates the need for equity finance at the level of the SME.

The question is: can tax incentives help to connect the potential supply of equity finance from private investors with the opportunities that exist in the SME sector, to the advantage of investors, SMEs and the economy generally?

Research conducted last year for FinMark Trust considered the role of tax incentives in various economies and their applicability to the South African context. It concluded that an appropriately structured incentive would encourage individuals to allocate perhaps as much as R11 billion towards SME investment, probably through intermediaries. The private equity industry, with the advantage of a cheaper source of funding, would be more encouraged to seek out investment opportunities in the SME sector. The downstream benefits to the fiscus in terms of SME growth and job creation would outweigh the upfront cost of tax foregone.

UK model

The UK offers a possible model. There, private individuals receive tax breaks for investing in small businesses whether directly or through investment vehicles called Venture Capital Trusts (VCTs) which are only allowed to invest in small businesses. Individuals receive an upfront income tax deduction (now 30%) and are exempt from income tax on dividends or capital gains tax, provided shares are held for three years.

Research has indicated that VCT-backed businesses created jobs at a far faster rate (32% per annum over a five- year period to 2002) than in the economy as a whole (a mere 1.5%). Eighty five percent of VCT-backed companies said they would not have existed at all, or would have grown less quickly, had it not been for VCT funds.

Significantly it has been estimated that between 52 - 87% of the finance raised through tax incentive schemes in the UK would not have been invested in small, private companies by investors if the schemes had not existed.

Strong case

Given the SA Government’s policy priorities, there is clearly a strong case for promoting a debate around this issue and for conducting further research that would help to guide the necessary changes to tax policy. This research, which the relevant government departments, including SARS, and the investment community should drive, must focus on the design of an appropriate structure that is easy to implement and works for SA, as well as quantify more accurately the likely level of demand for both the incentive and the equity investment.

It should also identify and tackle the disincentives to SME investment, especially tax-based or other regulatory disincentives, to ensure that the positive impact of a tax incentive is not undermined in practice. Finally, macroeconomic modelling highlighting the economic and fiscal benefit of increased SME investment should also be undertaken.

Back in 2001, the SMEs Access to Finance in SA Review identified that “the concept of a business angel is unknown in a fiscal sense in South Africa”. It is a pity that, five years on, this is still the case. However, with a resurgent revenue service and strong impetus at a policy level behind SME development, it is hoped that those business angels will soon be incentivised to reveal themselves, improving SMEs’ access to finance and supporting economic development across the country.