What is a VCT (Venture Capital Trust)?

A Venture Capital Trust, or VCT offers investors a number of tax benefits in return for taking the risk of investing in UK smaller companies.

VCTs were once considered ‘niche’ investments, but recent events have put them on the radar of a much greater number of UK investors, explains Stuart Lewis of Octopus Investments.

There is a healthy appetite among UK investors for VCTs. In the last tax year, VCTs raised an impressive £542 million from investors, which is an increase of 18% from the previous year and the second-highest VCT fundraising year on record. This means there’s a total of £3.9 billion currently invested in the VCT market.¹

Serving a valuable purpose

VCTs were introduced in 1995, as part of a package of government measures aimed at encouraging investment in the UK’s small but growing businesses. The main aim of the legislation was to drive economic growth and job creation. VCTs support newer, entrepreneurial types of companies, which have traditionally been under-served by more conventional methods of company funding.

An attractive investment proposition

The tax benefits of a VCT can be quite attractive. You are able to claim up to 30% upfront income tax relief on the amount invested, provided you are willing to keep holding the VCT shares for at least five years. Another valuable benefit is that VCTs are able to pay tax-free dividends, although dividend payments are not guaranteed. Finally, should you decide to sell your VCT shares and you make a profit, the proceeds won’t be liable for capital gains tax.

Explaining the risks

It is always worth remembering that these tax benefits are there, in part, to offset the higher risk associated with investing in a VCT. And as with any investment, the value and any income from it can fall as well as rise. You may not get back the full amount you invest.

VCTs shares could fall or rise in value more than other shares listed on the main market of the London Stock Exchange. Your tax treatment will depend on your individual circumstances and tax incentives may change in the future. The tax reliefs also depend on the VCT maintaining its VCT-qualifying status.

In pursuit of complementary retirement planning strategies

One of the reasons why VCTs have gained in popularity is that many high earners, particularly those getting closer to retirement age, are now feeling far more constrained in how much they can put into their pension. Changes to the lifetime allowance have meant that a large number of investors have started looking at VCTs in a new light, as a means of complementing existing retirement planning strategies.

Tax relief for investors

HM Revenue and Customs (HMRC) offers tax relief to encourage individuals to invest in companies through a number of venture capital schemes. You can get tax relief when you invest in small UK companies and social enterprises that qualify for venture capital schemes. The amount and type of tax relief you can claim depends on what venture capital scheme you use to invest in a company and you meet certain conditions. You can get tax relief through the following venture capital schemes:²

Back in 2010, the lifetime allowance – the maximum amount that could be invested into a pension without triggering additional tax charges – was £1.8 million. But this amount has now almost halved to the current figure of £1 million. In a similar vein, the annual allowance – or how much a saver can contribute to a defined contribution pension scheme each year while still receiving tax relief – stood at £255,000 in 2010, but is now down to £40,000, and is reduced to as little as £10,000 for high earners.

Advisers have been telling us about clients who have accumulated significant pension pots over their lifetime, who have suddenly realised that they risk hitting the lifetime allowance even if they make only modest future pension contributions. As a result, they are interested in exploring how a VCT can complement their existing pension arrangements.

More generally, the pension freedoms that were announced in April 2015 – which scrapped the requirement for retirees to buy an annuity – have opened investor’s eyes to a world of opportunity and choice when it comes to planning for retirement. It’s important to stress of course that a VCT is a high-risk investment, and therefore shouldn’t be considered as a replacement for pension investments.

Landlords are also feeling the pinch

Historically, many people have opted to invest in property as a way to complement or even replace pension planning. However, a series of measures − including a 3% stamp duty surcharge on the purchase of buy-to-let properties and second homes and, more recently, the phased reduction in tax relief on mortgage interest – has made this less tax-efficient. One of the unfortunate outcomes is that many property owners who were paying income tax at the basic rate will likely be pushed into the higher-rate tax bracket, despite their effective income from the property staying the same.

VCTs with ‘the right stuff’

When it comes to finding the right VCT to invest in, there are a number of important factors that could help to narrow your search. You and your adviser should consider the following:

• Track record: how long has the VCT been in existence? How experienced is the VCT manager? A well-established VCT should be able to demonstrate a performance track record. However, newer VCTs can take longer to reach the size and scale required to start delivering meaningful returns for investors. They may also be invested in younger companies that could still be a few years away from potential profitability.
• Diversification: one of the best ways to manage the risks of investing in higher-risk smaller companies is to diversify and spread the risk. By the same token, even a VCT with good performance − if it’s small and not diversified – will have a higher concentration risk. It may be worth looking at more mature VCTs featuring diverse portfolios of companies that are already hitting their stride.
• Discount to Net Asset Value (NAV): VCT shares tend to have a limited secondary market, as second-hand shares don’t qualify for the 30% upfront income tax relief. Therefore it’s important that investors are able to find buyers for their shares when it comes time to sell them. There isn’t an active market for VCT shares in the way there is for shares in larger, listed companies. This means that should you decide to sell your VCT shares, it may take time to find a buyer, or you may have to accept a price lower than the NAV of the investment. Most VCTs will offer a share buyback facility, where the VCT itself offers to buy the shares back from the investor at a discount to NAV. A 5% discount is considered reasonable, but some VCTs will only buy back shares at a higher discount so it’s worth looking for established VCTs with a strong track record of buying back shares from investors at a small discount.

Important information

The contents of this article are correct as at 02.10.2017. The tax treatment of Venture Capital Trusts may be subject to change in the future.
The value of an investment, and any income from it, can fall as well as rise. Investors may not get back the full amount they invest. Tax treatment depends on individual circumstances and may change in the future.
Tax reliefs depend on the VCT maintaining its VCT qualifying status. VCT shares could fall or rise in value more than other shares listed on the main market of the London Stock Exchange. They may also be harder to sell. Personal opinions may change and should not be seen as advice or a recommendation. We do not offer investment or tax advice. We recommend investors seek professional advice before deciding to invest.
This information is based on our understanding of tax rules at September 2017.

1 The Association of Investment Companies, April 2017
2 http://www.gov.uk/guidance/venture-capital-schemes-tax-relief-for-investors