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Venture Capital Trusts

Venture Capital Trusts (VCTs)

VCTs can be an invaluable financial planning tool, both leading up to and in retirement. After ISA and pension allowances have been used, VCTs could be the next port of call for tax-efficient investing.

VCTs

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What is a VCT?

A VCT is a company whose shares trade on the London stock market, just like Barclays or Vodafone. However, rather than banking or telecoms, a VCT aims to make money by investing in other companies. These are typically very small companies which are looking for further investment to help develop their business.

This is a vital area of the economy, and without funding from venture capitalists many companies we consider household names would never have been able to grow their businesses.

A VCT typically invests in around 20 such businesses. These are chosen by the VCT manager – an expert in identifying opportunities amongst fledgling companies, and negotiating attractive deals for investors.

To encourage investment in this crucial area, the government offers generous tax benefits to investors, including tax relief of up to 30% when investing. Tax rules can change and any benefits depend on personal circumstances.

Profits are generally paid to VCT investors as tax-free dividends, which are the primary source of return for VCT investors. The VCT manager will also provide expertise to help their chosen firms expand and provide better returns for their investors. They normally look to sell their share of the business three to seven years after investing and reinvest the capital in the next opportunity.

Investing in this dynamic area makes VCTs an exciting investment proposition, but it also means they are inherently higher risk, as smaller companies can be prone to failure. VCT shares are difficult to buy and sell – the market price may not reflect the value of the underlying investments. The value of the shares will fluctuate, income is not guaranteed and you could get back less than you invest. VCTs are therefore aimed at wealthier, sophisticated investors who can afford to take a long-term view. The prospectus of each VCT will give full details of the risks and should be read thoroughly before making an investment.

  • To ensure VCTs achieve their objectives; are compliant with European and UK legislation; and remain eligible for tax relief, VCT managers must adhere to a number of rules, some of which were amended in 2015.

    • The amendments impose stricter limits on the investments which may be made by VCTs. They are designed to encourage VCTs to only make investments intended to grow and develop small businesses at an early stage of their life.

      As with any legislation the full details are complex. The most significant changes include VCTs no longer being able to invest in companies more than 7 years old (10 years old for knowledge intensive companies); certain types of transaction, including management buy-outs (MBOs - where VCT funds are used to help existing management buy shares from a founder or other major shareholder), are no longer permitted; and VCTs cannot invest more than £12 million in any one company (£20m for knowledge intensive companies).

  • VCTs invest in small, fledgling companies in need of capital. HMRC rules require that, from 6 April 2019, at least 80% of a VCT's assets are invested in 'qualifying holdings'. There are a number of rules surrounding what constitutes a qualifying holding, but the main ones are that the company must not have net assets of more than £15m, and must have fewer than 250 employees.

    A number of companies which have benefited from VCT investment have grown to become household names.

  • There are a number of different types of VCT.

    Generalist VCTs are the most common, and the most popular with investors. They invest in a broad range of companies in different sectors and at different stages of development.

    AIM VCTs invest predominantly in companies listed on AIM, or those which are about to list on AIM.

    Specialist VCTs tend to invest in just one sector, such as technology. Specialist VCTs are becoming less common.

    Limited Life VCTs are designed to be lower risk and lower return than other VCTs and aim to wind up and distribute assets to shareholder five to seven years after launch, although there are no guarantees.

  • It's a common misconception that because VCTs invest in smaller companies, the returns are likely to come in the form of capital growth. In fact, the majority of returns are paid as tax-free dividends during the life of the VCT.

    In order to achieve a steady flow of dividends, VCT managers often structure investments in the underlying companies in a way that emphasises income generation. They do this by providing a proportion of the investment as a loan with the remainder in shares. The repayments on the loan provide a regular income to the VCT while loans also rank ahead of equity in the event the business fails, making the deal less risky if the business has assets which can be sold.

    The capital value of their investment should be a secondary concern for investors. We suggest holding VCTs for the long term – a 10-year plus time horizon is ideal – in order to benefit from the tax-free dividends as the portfolio matures.

    How do I sell?

    If you sell your VCT shares in the first five years you will have to repay any tax relief you have received. Furthermore, because there are very few buyers and sellers of VCT shares in the secondary market, liquidity is poor. This means that the price you can obtain often doesn't reflect the value of the underlying assets.

    To realise their investment many investors wait for the VCT manager to offer to buy back their shares (a frequent occurrence) or simply wind up the VCT and return the capital as a final tax-free dividend.

What are the risks?

Although some VCTs may be viewed as less speculative than others, investors should remember that as a whole they are exposed to substantially higher risks than mainstream equities.

VCTs should only be considered by sophisticated investors with significant investment portfolios who can take a long-term view and are comfortable with higher risks. The Financial Conduct Authority (FCA) suggests a sophisticated investor is somebody with an annual income in excess of £100,000 or investable assets of more than £250,000. Even then we feel VCTs should account for no more than 10% of a well-diversified portfolio.

VCTs are unlikely to be suitable for mainstream investors who may need access to their money in the short term, or for whom loss of the investment will cause financial hardship. This website does not constitute personal advice. We assume investors will make their own assessment of their expertise and the suitability of VCTs for their circumstances. Those with any doubts should seek expert advice.

They invest in smaller, sometimes fledgling, companies, some of which could struggle or fail altogether, meaning losses for investors. The VCT manager may also have trouble selling the underlying investments. Investors should also be aware that VCT shares are illiquid. This means they can be difficult to sell (and buy) on the secondary market. Although shares are fully listed on the London Stock Exchange, there might be only one ‘market maker’ for the shares, which means investors may have difficulty selling at a price that fairly reflects the value of the underlying holdings or, in extreme circumstances, at any price.

Often the VCT manager will offer to buy back investors’ shares at a target discount to the value of the underlying holdings. Details of any such buyback schemes can be found in the prospectus. They are subject to conditions and not guaranteed.

A long-term horizon is essential with VCT investing. Aside from ‘limited life’ VCTs that look to wind up after a 5-7 year time period, a ten-year time horizon is desirable. This is because it takes time for expanding businesses to fully realise their potential.

Investors should also be aware of risks affecting specific VCTs and VCT types. For instance, a further issue arises from smaller VCT funds who fail to raise sufficient money at launch. The resulting portfolio of investments may be more concentrated and it could increase the risks and charges. It is also worth noting that all VCTs tend to have higher charges than other types of fund and usually have performance fees.

As well as investment risks, it is possible that HMRC could withdraw the tax status of the VCT if it fails to meet the qualifying requirements. If this happens any tax rebate may have to be repaid. Each VCT will issue a prospectus at launch which gives details of specific risks and it should be read thoroughly before considering an investment. If you are at all unsure of the suitability of VCTs for your circumstances, please seek personal advice.

  • VCTs aren't for everyone.

    They are high risk, and difficult to sell, meaning they are only really appropriate for investors who already have significant portfolios of more conventional investments. In short, you need to accept the risk of losses, and also take a very long-term view. We therefore feel that at most they should account for 5 to 10% of your equity portfolio.

    Nevertheless, for those who can accept the risks, they can be a rewarding investment, especially for those who need their capital to generate an income – perhaps to supplement their pension in retirement. Indeed they can appeal to a variety of investors.

    Remember that if you have any doubts as to whether VCTs are right for you, you should seek expert advice.

What are the tax benefits?

To encourage investment in an area vital to the economy, and in recognition of the risks and complexities of VCTs, the government offers certain tax benefits to VCT investors.

This makes them particularly attractive to those seeking to reduce their tax bill and generate income from their capital.

  • Up to 30% income tax relief for subscriptions in new VCT fund raisings
  • Dividends paid by VCTs are free of tax
  • No capital gains tax (CGT) to pay when you dispose of the VCT

The income tax relief means if you invest £10,000, and have paid sufficient income tax, you could either receive a cheque from the taxman for £3,000 or an adjustment in the income tax you pay. This applies to anyone, regardless of the rate of tax you currently pay.

You can invest up to £200,000 in VCTs each tax year and benefit from this tax relief. However, the maximum tax rebate is the amount of income tax you pay (see examples below).

Example 1:
Mr Smith invests £50,000 in a VCT. He will pay £20,000 in income tax this tax year, so he is entitled to the full 30% tax rebate of £15,000.

Example 2:
Mrs Smith invests £50,000 in a VCT. She will pay £10,000 in income tax this tax year, so the maximum tax rebate to which she is entitled is £10,000.

You must hold the shares for five years to keep the tax rebate. The rebate is only available when you invest in a new issue of shares in a VCT or a top-up, not on any VCTs you buy on the open market. However, VCTs bought on the secondary market count towards the £200,000 allowance for the tax year in which you buy them, despite the fact you don't get the income tax break. All tax treatments are subject to change and any benefits depend on personal circumstances. If the VCT manager fails to meet the relevant investment rules the tax benefits could be withdrawn retrospectively.