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Venture Capital Trusts offer a raft of attractive reliefs which higher-rate taxpayers cannot afford to ignore, explains Jack Rose, Business Development Director for Tax Products at LGBR Capital.
The UK government established Venture Capital Trusts (VCTs) almost 20 years ago to encourage investment into smaller UK businesses. To explain their rationale in short, the generous tax benefits offered compensate for the increased risk associated with investing in smaller, less liquid companies.
Since their introduction in 1995 to the end of the 2013/14 tax year, VCTs raised over £5.4bn, according to the Association of Investment Companies, providing important support and funding to the UK’s SME (small and medium sized entreprise) sector.
VCT assets raised
Source: theaic.co.uk
Research from the AIC also suggests historical performance has been strong. The average total return for a VCT investment of £100 to 31 December 2014 was £164 over 5 years and £197 over 10 years.
How VCTs work
In many ways, VCTs are similar to investment trusts, but with additional investment rules which have to be adhered to in order for investors to qualify for tax reliefs. VCTs are publically-limited companies and are listed on the London Stock Exchange. Investors subscribe for shares in a VCT, which will then look to invest into a portfolio of “qualifying” companies – these are known as underlying investments.
There are several investment criteria underlying companies must meet to be VCT-qualifying including, but not limited to:
- Companies need to be either unquoted or AIM-listed
- The maximum value of a company’s gross assets (before VCT investment) is limited to £15m
- The company cannot have more than 250 employees (before VCT investment)
At least 70% of a VCT’s cash must be invested in qualifying companies within three years. The remaining 30% can be invested in non-qualifying investments, such as cash, listed equities, debt and investment funds.
Because of the various rules to which VCTs must adhere in order to qualify for tax breaks, it is important to choose an experienced manager. While the tax reliefs on offer can be compelling, the strife which can be caused from poorly thought-out or mismanaged attempts at tax-efficient investing can be severe.
Tax benefits
VCTs have a number of attractive tax benefits for investors, so do not be put off by any worries about tax wrangles as an experienced investment manager will have this side of things covered. Initial investments can qualify for 30% income tax relief, subject to a maximum of £200,000 per investor and a five-year minimum holding period. Furthermore, dividends paid are tax free and there is no Capital Gains Tax to pay when the VCT investment is sold.
Types of VCT
All VCTs invest into smaller UK companies, however the market tends to split managers into four main types of investment vehicle:
Generalist VCTs:
These generalists invest in a widely diversified portfolio of companies across the smaller and private equity universe, often across multiple sectors.
AIM VCTs
These vehicles focus on AIM-listed companies -the only listed (daily priced) companies that qualify under VCT rules. AIM has been around since 1995 and is now a mature exchange featuring over a thousand companies.
Specialist VCTs
These VCTs focus on companies in a specific sector, such as renewable energy, leisure, media or technology, where the manager believes they have an edge. It goes without saying that in esoteric sectors having specialist knowledge can be invaluable in picking companies with good prospects.
Limited life or planned exit VCTs
These VCTs are like generalists, but tend to focus on lower-risk, lower-return companies as part of their main aim to preserve investors’ capital and provide capital liquidity as soon as possible after the minimum five-year holding period.
The role of a VCT in an investor’s portfolio
It goes without saying that investors and their advisers should get a thorough handle on the VCT market before any investments are made; luckily, this is a familiar area to most wealth managers. Additionally, we would always advise that VCTs be looked at in terms of their investment merits rather than simply as a way of garnering tax reliefs. Given their focus on smaller, less liquid companies, VCTs will not be suitable for every client and it is likely that you would only ever allocate a fairly small proportion of your assets to them
Those caveats said, for UK taxpayers that can accept a slightly higher level of risk and a minimum holding period of five years, VCTs can play a useful role in their portfolio.
The 30% upfront tax relief makes VCTs suitable for clients looking to offset a large income tax liability and so can form a very useful part of the tax planning armoury. VCTs can also provide an option for investors seeking tax-free gains, especially if they have already maxed out their ISA and pension contributions for the year.
Furthermore, because they offer tax-free dividends, the majority of VCTs will focus on providing regular income alongside capital gains. As such, VCTs can complement an investor’s income portfolio. Seeing all your investments “in the round” – that is assessing how correlated they are, what risks they represent and what their tax implications may be – is a huge part of what your wealth manager is for.
As Chris Hutchinson, Manager of the £100m Unicorn AIM VCT, recently said: “VCTs are sometimes mistakenly considered as being solely focused on achieving returns through capital growth, but in reality many VCTs deliver attractive returns via regular tax-free dividend payments.”
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