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Venture Capital Trusts (VCTs)
An Excellent Tax Planning Opportunity
Venture Capital Trusts (VCTs) were introduced in the Finance Act 1995 specifically to encourage investment in small companies. There have been a number of changes to the rules governing VCTs since then, the last major change in April 2006.
This brief note has been completed in conjunction with Brooks Macdonald Financial Consulting, to provide a summary of the rules that apply to VCTs and the tax relief available. We have also provided comment on the current market and changes that companies have implemented to make VCTs more attractive to investors.
As a final point we have provided some thoughts as to what investors can do with their existing VCTs, particularly if they are now looking to realise the investments.
What are Venture Capital Trusts?
Venture Capital Trusts are similar to investment trusts in that they are pooled investment vehicles run by professional fund managers. They are set up as publicly listed investment companies, approved by the Inland Revenue and quoted on the Stock Exchange.
Current rules
Tax Relief
VCTs offer investors attractive tax concessions. The current rules, originally introduced in April 2006 are summarised below.
Subject to the overriding investment limit of £200,000 in any one year, the following reliefs apply:-
- Income Tax relief of up to 30%
- Dividends to investors are free of income tax
- Capital gains on the sale of investments within the VCT can be distributed as dividends
- Disposals of shares are free of capital gains tax but equally will not give rise to allowable losses.
Income tax relief is withdrawn if the shares are disposed of (other than between spouses or civil partners) within five years of issue or if the VCT loses its approval within this period.
By way of example the income tax relief would be applied as follows:
- Initial investment £200,000
- Income tax relief (30%) (£60,000)
- Effective cost of investment £140,000
The upfront tax relief is the lesser of 30% of the amount invested (up to £200,000) and the amount which reduces your income tax liability to nil. The relief, however, potentially reduces the cost of investment to 70p in the pound.
Underlying Investments
The funds raised by the VCT are invested in a portfolio of investments, at least 70% of which must be “qualifying investments”.
Qualifying investments are classified as newly issued shares of an unquoted company, which exists wholly for the purpose of carrying on a qualifying trade in the UK or be a parent company where the business of the group is substantially in carrying on of qualifying trades. At the time of investment the unquoted company must have gross assets of under £7 million and no more than 50 full time employees.
The “non-qualifying investments” can be invested as the fund manager sees fit and are often held in cash or other lower risk investments.
VCTs 2009/10 – The Current Market
The current rules as outlined above were introduced in April 2006. Prior to this, amongst other things, the income tax relief for investors was more generous and the investment restrictions less onerous.
VCT managers have therefore had to react to this and also to criticism from commentators and investors in older VCTs over their performance and liquidity.
Most have responded positively and from a pure investment perspective appear to be as competitive as they have ever been. The following gives an idea of some of these changes:
Risk & Capital Protection - Active steps are being taken to reduce investment risks using varying techniques. Several now offer guarantees of minimum returns after five years.
Charges - Management fees have been capped and in some cases, waived until the VCT has returned a minimum level of capital to investors. Initial issue costs are usually around 5 per cent and annual running costs typically are capped at 3.5 per cent.
Dividends - Given the tax free nature of dividends, many are committing themselves to more active dividend policies and distributing profits and capital on an ongoing basis.
Liquidity - Formal share buyback schemes and commitments to hold wind up votes, after the initial five year investment period are being announced to allow investors an exit route and the ability to sell their investments.
Underlying Investments - A change of rules concerning restrictions on the value of underlying investments gross assets mean new VCTs are not usually able to invest in AIM stocks. However, VCTs are able to co-invest with previous issues, to enable them to take larger stakes and gain greater control in an underlying investment.
Investors for whom VCTs may be suitable
VCTs may be suitable for many types of UK resident investor, including
- Those seeking exposure to venture capital and private equity markets
- Higher rate income tax payers
- Those seeking a tax-free income (e.g. alternative pension/annuity planning)
- Those who have maximised their pension contributions for the current year and are looking to invest further funds and benefit from tax relief.
- Individuals who are affected by recently introduced anti-forestalling measures, which are designed to cap pension tax relief at 20%.
Key issues to understand about Venture Capital Trusts
Realising existing VCT investments
Over £3bn has been invested in VCTs since they were originally introduced in 1995. Many investors seek to realise their investments once they are through the holding period. Historically, however, there has been little or no secondary market in VCTs and few had a stated buy back policy or commitment to wind up.
Whilst most managers will offer to buy back the investment with these older investments, it may be at a significant discount to what they are actually worth. There are currently a range of VCTs in the market which offer a limited life or planned exit strategies.
There are also a couple of alternative solutions available to investors who wish to exit.
Sell the VCT to their pension funds
Investors, who have a Self Invested Personal Pension (SIPP), could consider using funds within their SIPP to buy the VCT from themselves. This is particularly relevant where an investor needs short term cash but there is a good reason for keeping the VCT due to investment performance or because selling now would have to be done at a large discount.
Transfer the VCT to a Pension as a Contribution
Where an investor wants to sell the VCT outright, they could consider transferring the VCT “in specie” to a pension scheme as a contribution (assuming they have scope for further pension funding obviously subject to anti-forestalling measures, previously mentioned). If they are a higher rate tax payer, they could get income tax relief on the value of the VCT contribution at up to 40%. This would go some way to offsetting any discount if they then wanted to sell the VCT.
Risks
Although some VCTs are building in risk management techniques, due to the nature of the underlying assets (i.e. small unquoted companies) any investment in VCT should generally be viewed as a higher risk investment.
In order to benefit from the income tax relief, investors must hold any new investment in a VCT for a minimum of five years. Any investment should therefore be viewed with a medium to longer term view.
Currently there is a limited secondary market for VCTs, so investors may find it difficult to sell their shares at a satisfactory time and value. Any buy back policies offered by managers are ultimately subject to market liquidity.
Potential investors should remember that past performance is not a guide to future performance and the value of an investment can go down as well as up.
We strongly recommend that any potential investor seeks advice from an independent financial adviser or fund manager prior to investing to ensure it is suitable for them.
This document provides a guide to some of the relevant areas that individuals should consider discussing with an authorised adviser in relation to their specific circumstances, it does not constitute individual advice. As a result no action should be taken or refrained from being taken as a result of its content.
What to do next
If you would like further information or would like to discuss the other ideas outlined in this document, please speak to your usual contact at Saffron Tax Partners LLP.
March 2010