1 Legal framework
1.1 Which general legislative provisions have relevance in the private equity context in your jurisdiction?
Private equity funds are not regulated as a separate asset class in South Africa and the applicable legislation will depend on the structure used by the fund.
Generally, the following legislation will be relevant in the context of private equity in South Africa:
- the Companies Act of 2008, including the Companies Regulations (‘Companies Act'), being the key piece of legislation regulating private and public companies in South Africa;
- the Financial Advisory and Intermediary Services Act of 2002, which stipulates, among other things, that fund managers and administrators must obtain authorisation from the Financial Sector Conduct Authority to provide financial services;
- the Competition Act of 1998, which regulates mergers of acquiring and target firms;
- the Broad-Based Black Economic Empowerment Act of 2003 and the Codes of Good Practice issued pursuant to the act, regulating black economic empowerment (BEE);
- the Income Tax Act of 1962, which regulates the tax consequences flowing from various structures;
- the JSE Limited Listings Requirements, which regulate public listed companies;
- the Financial Intelligence Centre Act of 2001, which regulates the verification of investors and their ultimate owners in South Africa, and other applicable anti-money laundering legislation; and
- the Exchange Control Regulations,1961, which regulate, among other things, cross-border transactions and the flow of funds into and from South Africa, monitored by the Financial Surveillance Department of the South African Reserve Bank (SARB).
1.2 What specific factors in your jurisdiction have particular relevance for and appeal to the private equity market?
South Africa has a well-developed and well-regulated banking system. SARB is the central bank. South Africa also has a few large and stable banks and investment institutions (both foreign and domestic), as well as a number of smaller banks.
The Department of Mineral Resources and Energy released an integrated resources plan to try to solve the country's energy crisis through various sources, including renewable energy. This forecasts a move to renewable energy by 2030. There may thus be opportunities for private equity investment in the renewable energy space.
In South Africa, arbitration is a well-established mechanism for commercial dispute resolution. The International Arbitration Act incorporates the United Nations Commission on International Trade Law Model Law on International Commercial Arbitration 1985 into South African law. We have seen a significant increase in the number of international arbitrations held in South Africa.
South Africa has exchange controls that regulate all flows of capital in and out of the country, which are administered by SARB and authorised dealers (commercial banks that have been appointed to act as agents of SARB in respect of certain transactions).
Amendments to the tax legislation have been made to prevent the activities of South African investment managers from creating a permanent establishment for domestic tax law purposes, and a dispensation has been introduced affording favourable tax treatment to investors in venture capital companies.
The need to comply with BEE is top of mind in South Africa and serves as a catalyst for private equity investment through black-empowered investors.
2 Regulatory framework
2.1 Which regulatory authorities have relevance in the private equity context in your jurisdiction? What powers do they have?
The functions of the Takeover Regulation Panel (TRP) include regulating ‘affected transactions' set out in Parts B and C of Chapter 5 of the Companies Act (‘Takeover Regulations') that involve ‘regulated companies' (as defined). When a particular transaction falls within the purview of the TRP, it may not be implemented unless the TRP has either:
- issued a compliance certificate in respect of such affected transaction; or
- exempted the affected transaction from compliance.
The Competition Commission and Competition Tribunal regulates competition between firms in the market and specifically in this context mergers and acquisitions, provided that certain statutory thresholds are met. Any transactions that meet such thresholds must be approved by the Competition Commission or the Competition Tribunal, depending on the categorisation.
Among other things, the Broad-Based Black Economic Empowerment (BEE) Commission assesses and monitors compliance, levels of transformation and the extent to which benefits of ‘major BEE transactions' flow to the black persons who are part of these transactions in compliance with the objectives of the BEE Act. Major BEE transactions must be registered with the BEE Commission.
The South African Reserve Bank (SARB) and its authorised dealers regulate all flows of capital in and out of the country.
The Financial Sector Conduct Authority regulates the provision of financial services through the issuance of different categories of licences.
2.2 What regulatory conditions typically apply to private equity transactions in your jurisdiction?
Private equity funds are not subject to specific regulations and there is no government agency that exercises regulatory oversight specifically over such funds.
Where the target is a ‘regulated company' (as defined), the Takeover Regulations will apply. If the proposed transaction constitutes an ‘affected transaction' (as defined), it may not be implemented unless the TRP has issued either:
- a compliance certificate; or
- an exemption for the affected transaction.
The approval of the TRP is typically a condition precedent.
Where the proposed transaction involves a change of control of the target and meets the threshold for an intermediate or large merger in terms of the Competition Act, the approval of the Competition Commission or the Competition Tribunal will be required prior to implementation. Such approval is typically a condition precedent.
Where the proposed transaction constitutes a ‘major BEE transaction' (as defined), it must be registered with the BEE Commission within 15 days of conclusion. The BEE Commission need not approve such transaction and it is not necessary to include this as a condition precedent.
Investments in the equity of South African companies by non-residents must be reported to an authorised dealer and share certificates evidencing such investment must be endorsed ‘non-resident'. Pre-approval is required for loan capital introduced by non-residents. Private equity funds that are members of the South African Venture Capital Association may apply to SARB for approval to invest offshore.
3 Structuring considerations
3.1 How are private equity transactions typically structured in your jurisdiction?
A private equity fund may take the form of a South African private company, an en commandite partnership or a bewind trust. Companies are generally not favoured as private equity vehicles because of the tax implications associated with them. The most popular vehicles are en commandite partnerships or trusts. An en commandite partnership is a partnership that has two categories of partners – a general (disclosed) partner and the limited (undisclosed) partners – and is established by way of a partnership agreement. Bewind trusts enable the legal ownership of assets to be separated from the enjoyment of the benefits that flow from the assets.
Once the vehicle for the private equity fund has been established, it will typically invest directly or indirectly in the target and/or a holding company of the target.
3.2 What are the potential advantages and disadvantages of the available transaction structures?
Companies are generally not favoured as private equity vehicles because a company incorporated or effectively managed in South Africa is a resident for South African tax purposes. Such companies are subject to income tax at a rate of 28% and capital gains tax at an effective rate of 22.4%. In addition, dividends to shareholders attract dividends tax at a rate of 20%.
The advantage of an en commandite partnership is that it is fiscally transparent and the individual partners are taxed separately on their partnership profits. An attractive feature of a partnership is that the definition of ‘permanent establishment' in the Income Tax Act includes a carve-out for ‘qualifying investors' that invest passively through a South African partnership as limited partners without being actively involved in managing the partnership.
The beneficiaries of a bewind trust are owners of the assets held by the trust and are taxed as such. Income and capital gains received by the trust are deemed to be received by or accrued by the beneficiaries, and expenditure is allocated in the same manner.
A disadvantage of an en commandite partnership and a bewind trust may arise in the case of exiting partners or the admission of new partners. Every time a new partner or beneficiary enters the partnership or bewind trust, each of the partners or beneficiaries technically disposes of a portion of the underlying investments to the new partner or beneficiaries, which may be subject to tax in their hands.
3.3 What funding structures are typically used for private equity transactions in your jurisdiction? What restrictions and requirements apply in this regard?
Private equity transactions are usually funded by way of shareholder loans, preference share capital and ordinary share capital provided by the private equity fund. Third-party debt financing is also used; this will generally be sourced as secured term loans or preference share funding from the major banks, insurance companies and other funding institutions in terms of which the balance sheet of the portfolio company may be used as collateral. Although convertible instruments are not commonly used, these do feature and take the form of shareholder loans that are convertible into shares after a certain period or on the occurrence of a particular event. Bridge financing is also used.
3.4 What are the potential advantages and disadvantages of the available funding structures?
The risk appetite of senior debt providers is limited and there is a scarcity of mezzanine funding in the South African market.
Careful attention is required in respect of the income tax treatment of the various funding instruments. For example, there are provisions which limit the deductibility of interest of certain hybrid debt instruments and also provisions that reclassify dividends as interest.
3.5 What specific issues should be borne in mind when structuring cross-border private equity transactions?
Where a transaction is cross border, the Excon Regulations will apply and South African Reserve Bank (SARB) approval may be required prior to implementation.
Private equity funds that are members of the South African Venture Capital Association, mandated to invest outside the Common Monetary Area of South Africa, Namibia, Lesotho and Eswatini, may apply to SARB for approval to invest offshore.
Institutional investors and authorised dealers must be aware that in terms of the ‘look-through' principle, any offshore acquisitions held indirectly via the local private equity fund must be marked off against their respective foreign investment allowances.
3.6 What specific issues should be borne in mind when a private equity transaction involves multiple investors?
It is important to consider the different tax and prudential investment requirements that apply to different investors. Investors will typically expect that transaction costs will be shared among them in proportion to the size of their investments. The return and exit expectations of investors may differ and it is important to ensure that the transaction structure is sufficiently flexible to accommodate different needs while not creating conflicts of interests between investors.
In a private equity transaction that involves multiple investors, the investors will seek to ensure that their rights are adequately protected in the constitutional documents of the target. They may also want to ensure that they have sufficient rights to exit/dispose of their shares in the target, depending on their own requirements. For example, if an investor is a fund structured as an en commandite partnership, it may have a limited investment horizon and be required to dispose of their shares after a period of five years. If so, it will have to negotiate this right with the other investors/ existing shareholders. Other rights that it may want to have adequately protected could include:
- the ability to determine the manner in which funding is raised by the target;
- specially protected matters/veto rights;
- non-dilution rights in respect of funding;
- pre-emptive rights;
- tag-along and drag-along rights; and
- non-compete undertakings given by the other investors/existing shareholders.
4 Investment process
4.1 How does the investment process typically unfold? What are the key milestones?
Typically, the investment process will commence by the investor being approached by or approaching the target/sellers for a potential acquisition by the investor. The initial discussions will mostly likely relate to the essential terms of the potential acquisition, in terms of which pricing, timing and other material terms may be agreed upon, which may be recorded in a term sheet or memorandum of understanding. A due diligence investigation may then be conducted into the business and affairs of the target. Initially, this will include a thorough review of the financial statements of the target for the most recent financial years, as well as the management accounts, if any, and any other relevant financial information to ensure that the investor is satisfied with the financial position of the target. Generally, if the investor is satisfied as to the financial position, the investor will continue the due diligence investigation to satisfy itself from a tax, legal and operational perspective. Following the due diligence investigation, the investor will approach its investment committee/board of directors/shareholders for approval to proceed with the proposed investment. Thereafter, transaction agreements will be negotiated and executed by the relevant parties; and once any suspensive conditions have been fulfilled, the proposed transaction will be implemented. Some of these processes may take place in parallel.
4.2 What level of due diligence does the private equity firm typically conduct into the target?
The level of due diligence investigation depends on:
- investor preferences;
- the size of the potential transaction; and
- the nature of the business of the target.
Typically, the private equity investor will conduct certain aspects of the due diligence internally and will instruct external legal (and potentially accounting) firms to conduct limited red-flag due diligence on targeted aspects identified by the investor in consultation with its advisers.
4.3 What disclosure requirements and restrictions may apply throughout the investment process, for both the private equity firm and the target?
The target will be required to disclose whether there are any breaches of warranties or interim period undertakings furnished to the investor.
Information will also have to be disclosed by both the private equity firm and the target for purposes of preparing a filing for the Competition Commission and/or any other regulatory bodies that may be necessary in the context of the transaction.
Both parties have a common law duty to act in good faith throughout the investment process, which will naturally entail disclosing any such information that a reasonable person would disclose to the other party in transactions of similar nature.
4.4 What advisers and other stakeholders are involved in the investment process?
Typically, the investor will appoint lawyers to assist with the due diligence investigation and represent it in the transaction. The investor may also appoint an auditing firm to assist with the financial due diligence. The target will also appoint lawyers to represent it in the transaction. The parties may also appoint corporate advisers to assist in structuring the transaction. The company secretary of the target will attend to the company secretarial work required to implement the transaction and, where the transaction has a black economic empowerment (BEE) component, a ratings agency may be appointed to advise on BEE aspects.
Increasingly, vendors may make use of a bidding process to sell target companies. Corporate advisers or the investment banking arms of the major banks typically advise vendors in such circumstances.
5 Investment terms
5.1 What closing mechanisms are typically used for private equity transactions in your jurisdiction (eg, locked box; closing accounts) and what factors influence the choice of mechanism?
Closing mechanisms in South Africa include the locked box and closing accounts mechanisms. A number of factors – such as investor/seller preferences and the nature of the target's business – will determine which mechanism is used in a particular transaction. The locked box mechanism is becoming more prevalent than closing accounts, as this provides price certainty in a transaction. As regards a locked box mechanism, if it is envisaged there will be a longer period between signing and closing, it is increasingly common for the seller to negotiate a rate of escalation on the purchase price from a fixed date up to the closing date of the transaction.
5.2 Are break fees permitted in your jurisdiction? If so, under what conditions will they generally be payable? What restrictions or other considerations should be addressed in formulating break fees?
Break fees are permitted in South Africa. Break fees are typically imposed by a purchaser and payable by a seller/target if the proposed transaction does not proceed (other than as a result of an act or omission of the purchaser). This is subject to negotiation and agreement, but a break fee may become payable, for example, where:
- the seller/target commits a breach of the transaction agreement(s);
- the conditions precedent are not met (eg, Competition Commission approval); or
- the seller/target accepts a competing offer.
The converse may also apply, so that a break fee is payable by the purchaser in similar circumstances.
5.3 How is risk typically allocated between the parties?
As with any M&A transaction, the allocation of risk is primarily subject to negotiation and agreement by the parties to the transaction. Typically, a seller and/or the target will furnish comprehensive warranties coupled with indemnities, where claims can be brought within a limited timeframe and are capped at a fixed amount or percentage of the purchase price. The seller may prepare a detailed disclosure schedule and a portion of the purchase price will generally be held in escrow as security for warranty and indemnity claims. This retention is often coupled with or replaced by warranty and indemnity insurance.
5.4 What representations and warranties will typically be made and what are the consequences of breach? Is warranty and indemnity insurance commonly used?
The nature of the business will dictate the types of warranties and indemnities sought by the purchaser. Common examples of warranties include warranties in respect of:
- the title, capacity and authority;
- claims and proceedings;
- tax; and
- the financial position and solvency of the target.
In a scenario where there is more than one seller, the purchaser tends to seek joint and several liability of the sellers for any representations and warranties made. Conversely, the sellers may seek to limit their liability in respect of representations and warranties given to the purchaser by giving such representations and warranties pro rata to their shareholding in the target. Often, the warranties and indemnities provided are for a limited timeframe and capped at a fixed amount or percentage of the purchase price. Breach of a warranty will result in the purchaser having a claim against the seller for losses incurred as a result of the breach and the seller will be liable to pay to the purchaser the amount of the claim. Sellers are increasingly requiring warranty and indemnity insurance as part of the sale package, allowing the purchaser to claim against an insurer for any breach under an insured warranty and/or indemnity. Warranty and indemnity insurance fundamentally bridges the gap between the protection (ie, the ‘market-standard' warranties and indemnities) that the purchaser requires in connection with an acquisition and the protection that the sellers are willing to provide.
6 Management considerations
6.1 How are management incentive schemes typically structured in your jurisdiction? What are the potential advantages and disadvantages of these different structures?
In addition to employment remuneration and key performance indicator-based incentives, managers are usually incentivised by way of equity ownership or participation. In South Africa, management incentive schemes are typically structured as employee share ownership plans or phantom share schemes. An ownership plan entitles participating employees to acquire shares in the company, commonly through an employee share trust, conferring on them shareholder rights such as voting rights and economic rights in respect of distributions declared and proceeds realised from an exit or other liquidity event. In a phantom scheme, participants do not hold actual shares in the company and do not become shareholders. Instead, they hold notional shares or units which confer upon them economic rights that are linked to the economic benefits attaching to the issued shares of the company. Phantom schemes are generally preferred because these are administratively easier to manage while delivering the same incentives and economic results as traditional share option schemes.
6.2 What are the tax implications of these different structures? What strategies are available to mitigate tax exposure?
In the case of an employee share ownership plan, the participating employee will be taxed on any gain made when such shares vest for income tax purposes. The timing of the vesting for tax purposes depends on whether the shares are subject to certain types of restrictions, including:
- any restriction that prevents the employee from freely disposing of the share at market value (other than a restriction imposed by law); or
- a restriction that could result in the employee forfeiting ownership otherwise than at market value or being penalised financially for not complying with the terms of the agreement for the acquisition of the shares.
The taxable gain will be determined as the difference between the market value of the shares as at the date of vesting and any consideration paid, and the gain must be included in the employee's income. Such gain is accordingly subject to income tax. Certain other payments in respect of restricted shares (eg, payments linked to the repurchase of the shares and/or the liquidation of the company) may also be taxable as income. Depending on the commercial considerations, including the retention of employees, the tax may be mitigated by early vesting or the payment of dividends. All amounts received by participating employees in respect of phantom schemes will be taxable as income.
6.3 What rights are typically granted and what restrictions typically apply to manager shareholders?
These are subject to negotiation between the parties to a transaction. The participation of management shareholders in a portfolio company may take various forms, including:
- continued involvement in the portfolio company through employment arrangements;
- participation in employee incentive schemes; or
- a combination of both.
Transactions typically involve a lock-in mechanism for the existing management shareholders in order to retain their expertise in the business, especially where such expertise is central to the continued success and development of the business operations of the portfolio company. The retention of management shareholders is also often achieved by concluding non-compete agreements with the management shareholders preventing them from competing with the business of the target for a certain period after their employment with the target terminates. Management shareholders, when retaining a portion of the shares held by them, also retain ordinary shareholder rights, such as voting rights, the right to appoint a director to the board and economic rights. The rights of the management shareholders are typically curtailed in terms of the constitutional documents of the target by the inclusion of certain reserved matters, as well as veto rights in favour of the investor(s).
6.4 What leaver provisions typically apply to manager shareholders and how are ‘good' and ‘bad' leavers typically defined?
Typically, when a management shareholder's employment terminates (whether for good or bad reasons or because of incapacity), the company may have an option to repurchase the management shareholder's shares at a repurchase consideration determined in accordance with a pre-agreed formula applicable to each scenario. If the termination of employment is for bad reasons, the management shareholder's shares will typically be repurchased at a discount. If the company does not exercise the aforesaid option, the remaining management shareholders and other remaining shareholders (usually being the investor) may also require a right to purchase the shares in accordance with a pre-agreed formulation.
A ‘good leaver' is typically defined as the termination of the management shareholder's employment in circumstances including:
- normal or late retirement;
- early retirement with the approval of the board;
- retrenchment; or
- voluntary resignation with the approval of the board.
A ‘bad leaver' is typically defined as the termination of the management shareholder's employment in circumstances including:
- dismissal for misconduct or poor performance;
- dismissal for committing a material breach of a material obligation in terms of the employment agreement;
- fraud or material misappropriation of the company's business or assets; or
- the commission of a crime punishable by imprisonment without the option of a fine.
7 Governance and oversight
7.1 What are the typical governance arrangements of private equity portfolio companies?
The governance arrangements of portfolio companies will be recorded and regulated in the constitutional documents of that company, being the memorandum of incorporation and the shareholders' agreement. The memorandum of incorporation and the shareholders' agreement will generally include provisions on:
- the composition of the board, which will depend on the shareholding structure of the company and will typically include a nominee(s) of the investor and/or the appointment by the investor of an observer to the board;
- the conduct of board and shareholders' meetings, including quorum requirements for board and shareholders' meetings, which will typically require representation for the investor;
- a list of significant corporate decisions that require a high threshold of board or shareholder approval. This threshold will normally be set at a level that requires the approval of the investor or its board nominee (as the case may be) in order to be met; and
- veto rights in favour of the investor or its board nominee in respect of certain fundamental matters.
7.2 What considerations should a private equity firm take into account when putting forward nominees to the board of the portfolio company?
It is important to appoint nominees with appropriate experience or other skills to add value to the management and governance of the portfolio company. A private equity firm may choose to nominate directors or observers to the board of a portfolio company. Directors are subject to common law and statutory duties which are owed to the company (essentially the entire body of shareholders and not just the shareholder that nominated the director). The common law duties are partially codified in Section 76 of the Companies Act. The duties of directors include, for example:
- the duty to avoid conflicts of interest;
- the duty of disclosure; and
- the duty to exercise powers and perform functions in good faith and for a proper purpose in the best interest of the company.
Section 77 of the Companies Act imposes personal liability on directors for damages, losses or costs sustained by the company as a result of breach of these duties, any provision of the Companies Act or the company's memorandum of incorporation. Before accepting an appointment as a director, it is important to understand the nature and extent of the duties placed on directors of companies and the potential liability that directors may attract. Observers are persons who are permitted to attend and participate in board meetings, but are not permitted to vote. Observers also do not owe formal fiduciary duties to the company. The right to appoint an observer is usually granted in lieu of or in addition to the right to appoint directors. It would be advisable for a private equity firm to check whether the portfolio company has adequate directors & officers insurance in place or whether the private equity firm has sufficient directors & officers insurance cover for its director appointees to the board of the portfolio company.
7.3 Can the private equity firm and/or its nominated directors typically veto significant corporate decisions of the portfolio company?
Typically, such ‘veto' rights are encapsulated in a list of significant corporate decisions that require a high threshold of board or shareholder approval in order to carry. This threshold will normally be set at a level that requires the approval of the investor or its board nominee (as the case may be) in order to be met. These will typically include:
- the approval of any annual capital expenditure budget;
- the appointment or removal of the CEO or any other key members of management of the company;
- the dissolution, liquidation or winding-up of the company or the discontinuance of the main business activities of the company;
- the listing of the shares or any share options in the company on any recognised stock exchange;
- the institution of any court action or any legal proceedings outside of the ordinary and regular course of business; and
- the making of any loans to directors or senior executives of the company.
7.4 What other tools and strategies are available to the private equity firm to monitor and influence the performance of the portfolio company?
Under South African company law, the private equity firm, as a shareholder of the portfolio company, will be entitled to receive and inspect the books and records of the portfolio company, including the constitutional documents of the company and financial statements/records of the company. This will facilitate its monitoring of the portfolio company.
The private equity company may also require that the board of the portfolio company present the annual financial statements for its approval. In addition, the private equity company may require the right to appoint and remove the auditors of the portfolio company. The private equity company may also require the right to approve the annual budget and business plan of the portfolio company.
8.1 What exit strategies are typically negotiated by private equity firms in your jurisdiction?
An exit may be achieved, for example, by way of:
- a buy-out by a new strategic or financial investor (including possibly another private equity fund);
- a listing or initial public offering on a stock exchange;
- a share buyback by the portfolio company; or
- a sale to the company's management team.
A sale to a strategic buyer will usually yield a higher price; whereas a financial buyer will look at standalone cash-generating capability and the capacity for earnings growth and determine the price on that basis.
A sale to a strategic buyer may mean that current management ownership and participation cannot continue; whereas a sale to a financial investor may accommodate this.
Exits through listings and initial public offerings are not common in South Africa, in light of:
- the substantial costs involved;
- the decline in the number of listings on the JSE in recent years; and
- the lack of certainty on valuations.
8.2 What specific legal and regulatory considerations (if any) must be borne in mind when pursuing each of these different strategies in your jurisdiction?
Regardless of whether the sale is to a strategic buyer or a financial buyer, all exits must be considered in light of the memorandum of incorporation of the company and any shareholders' agreement in place, as well as any regulatory approvals, exemptions and notifications that may be necessary, including from the Takeover Regulation Panel, the Competition Commission and the Broad-Based Black Economic Empowerment Commission. The applicable regulatory approvals are determined on a case-by-case basis, having regard to the structure of the transaction and the industry requirements applicable to the target. In the case of a listing or initial public offering, the Listings Requirements of the applicable exchange are of particular importance. In terms of the Listings Requirements, a company seeking to list on the main board of the JSE must meet certain minimum value thresholds and must satisfy certain criteria to be eligible to list. AltX, an alternative board, may be more suitable for smaller companies if compliance with the requirements of the main board is not practical. The Listings Requirements impose additional obligations on listed entities, which include additional corporate governance measures.
9 Tax considerations
9.1 What are the key tax considerations for private equity transactions in your jurisdiction?
South Africa taxes residents on their worldwide income (ie, receipts or accruals that are revenue in nature), whereas non-residents are taxed in South Africa only on income from a South African source. Broadly speaking, a receipt or accrual will be revenue in nature if the asset is acquired and held with the intention of making a gain by disposing thereof in a scheme of profit making; whereas it will be capital in nature if the asset is acquired and held as a long-term income-producing asset.
South African investors in a limited liability partnership (LLP), foreign partnership or bewind trust (see question 3) will be required to include amounts of a revenue nature generated in respect of their underlying assets in their gross income. For income tax purposes:
- companies are currently taxed at a rate of 28%;
- trusts at the rate of 45%; and
- individuals at a maximum rate of 45%.
South African pension funds are exempt from income tax. Non-South African investors will be required to include amounts generated from their underlying investments only if the income is from a South African source, subject to relief available in terms of a double tax agreement. Where the private equity fund is housed in a South African company (eg, a permanent capital vehicle), the company will be required to include income generated from the underlying assets in its gross income.
Capital gains from the disposal of the underlying assets may give rise to capital gains tax implications in the hands of South African investors in an LLP, foreign partnership or bewind trust. Capital gains realised by a private equity fund housed in a company may give rise to capital gains tax implications for such company (as opposed to the investors in the company). Generally, non-resident investors will be subject to capital gains tax on the disposal of an asset only if they have a permanent establishment in South Africa. For capital gains tax purposes, capital gains are taxed at rate of:
- 22.4% in respect of companies;
- 36% in the case of trusts; and
- 18% in the case of individuals.
Dividends are subject to dividends tax in South Africa at the rate of 20%.
South African sourced interest is subject to withholding tax on interest which is levied at 15%.
9.2 What indirect tax risks and opportunities can arise from private equity transactions in your jurisdiction?
Securities transfer tax is levied on the transfer of any security in a company incorporated in South Africa or a company incorporated outside South Africa which is listed on a recognised South African stock exchange. Broadly speaking, securities transfer tax is levied at the rate of 0.25% on the higher of the market value or consideration payable of the security on the date transfer.
Value-added tax (VAT) is often an irrecoverable cost in private equity structures in South Africa. This includes, among other things, costs associated with due diligence and legal fees for the agreements. This is because these expenses are not incurred for the purposes of making taxable supplies as part of the target's VAT enterprise activities. Similarly, there is a VAT liability under the imported services provisions in respect of fees paid to foreign advisers.
There are a limited number of mechanisms to achieve a VAT recovery on these costs by applying the principles of apportionment. This does require a taxable supply, for VAT purposes, in the form of a management fee; but generally, where the only receipts are interest and dividends, VAT is an expense that forms part of the cost of investing in and maintaining a private equity structure.
9.3 What preferred tax strategies are typically adopted in private equity transactions in your jurisdiction?
There are three common structures or vehicles in which to house a private equity fund investing in South Africa:
- an LLP;
- a bewind trust; and
- an unlisted investment holding company (or a so-called ‘permanent capital vehicle').
The chosen structure or vehicle will determine the key South African tax considerations in relation to a private equity transaction. We deal with some of these considerations below.
Both an LLP and a bewind trust constituted in terms of South African law are fiscally transparent for South African tax purposes – that is, all the tax implications in respect of the underlying investments of these entities will arise directly in the hands of the relevant investors in these entities (in accordance with the tax regime applicable to each investor). A ‘foreign partnership' as defined in terms of the Income Tax Act is also a fiscally transparent entity. A company (eg, a permanent capital vehicle) is a taxpayer in its own right for South African tax purposes (ie, a company is not fiscally transparent).
Please see question 9.1. The preferred tax strategies will be driven and determined by the particular vehicle chosen in which to house the private equity structure or investment.
10 Trends and predictions
10.1 How would you describe the current private equity landscape and prevailing trends in your jurisdiction? What are regarded as the key opportunities and main challenges for the coming 12 months?
The prevailing economic conditions in South Africa, and specifically the lack of growth, have resulted in a general decline in deal making and fundraising in the territory. The COVID-19 pandemic has added to economic stress and has had a significant adverse impact on many portfolio companies and, consequently, the private equity funds invested in them. Currently, we are experiencing restructures and recapitalisations as opposed to exits and new investments. This is unlikely to change in the short to medium term.
Where funds will likely continue to be raised is in sectors such as renewable energy, healthcare, technology, black economic empowerment and others that have weathered (or even thrived throughout) the pandemic.
There have been several public-to-private transactions of JSE-listed companies in private equity transactions and this trend may well continue.
10.2 Are any developments anticipated in the next 12 months, including any proposed legislative reforms in the legal or tax framework?
In the February Budget Speech earlier this year, the National Treasury proposed a complete overhaul of the exchange control systems to modernise the same and reduce some of the burdensome and unnecessary administrative approval processes, in the form of a new capital flow management system.
The features of the new capital flow management framework will include the following:
- a shift from exchange controls to capital flow management measures to regulate cross-border capital flows;
- a more modern, transparent and risk-based approval framework;
- stronger measures to fight illegitimate financial cross-border flows and tax evasion;
- strengthened cooperation between the Financial Intelligence Centre, the Reserve Bank, the tax authorities and other law enforcement agencies; and
- enhanced cross-border reporting requirements.
To implement the new capital flow management system, new capital flow management regulations must be drafted, along with the implementation of relevant tax amendments. It is anticipated that this will likely take place during the course of 2021.
11 Tips and traps
11.1 What are your tips to maximise the opportunities that private equity presents in your jurisdiction, for both investors and targets, and what potential issues or limitations would you highlight?
With parts of the world, including South Africa, still experiencing the threats of the COVID-19 pandemic or further waves, the future investment landscape looks uncertain. The trend is for businesses and investors to reflect on the market, products and opportunities of the future. We are seeing businesses rethink how they operate and find ways to adapt to stay relevant.
Social, environmental and political awareness have increased in 2020. Impact investing and ESG (environmental, social and governance) factors are emerging trends. Family offices are increasingly playing a role in private equity in South Africa. As the younger generations come through the ranks, they will influence the types of investments that their offices make and are likely to shift the focus to include impact investing and ESG factors.
The increased revenues of those businesses that have thrived during the COVID-19 pandemic will not necessarily be sustained. Many of the businesses that have been negatively affected by the pandemic will recover, but some will take longer than others. In identifying potential targets, investors will have to test viability and sustainability and perform careful projections in anomalistic conditions.
In the current climate, given the low GDP growth environment facing the South African economy, investors will find value in businesses that have focussed on managing financial risks and return on capital, as opposed to simply growth in earnings. Ultimately, businesses will be assessed more holistically and those that are offering deep value, low business and financial risks, clear strategy, good governance and long-term prospects will stand out.
Given the macro environment in South Africa, foreign investors are often questioning whether to invest capital in South Africa, especially where returns may be impacted by a deteriorating local currency over the long-term. This has resulted in a reduction of capital into the local private equity market.
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