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Consider investment merits first, then tax.

VCTs turned 21 this year but how many advisers are offering them the key to the door of client portfolios? In the latest in his series of tax-planning articles, Jack Rose takes a closer look at the product.

The UK government established venture capital trusts (VCTs) 21 years ago in a bid to encourage investment into smaller UK businesses. The generous tax benefits offered are intended to compensate for the increased risk associated with investing in smaller, less liquid companies.

From their introduction in 1995 to the end of the 2015/16 tax year, VCTs have raised more than £6bn, according to the AIC – along the way providing important support and funding to the UK’s SME sector. Despite a number of rule changes last year – and as the following graph shows – VCTs continue to enjoy strong demand, with just under £500m raised in the 2015/16 tax year.

Annual VCT sales since launch (including indication of tax relief changes)

Source: AIC

Historical performance has also been good, with the average total return for a VCT investment of £100 to 31 December 2015 growing to £160 over five years and £187 over 10 years, according to the AIC.

In many ways, VCTs are similar to investment trusts, albeit with additional investment rules in order to qualify for tax reliefs. VCTs are public 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.

To be VCT-qualifying, underlying companies must meet several investment criteria including:
* Companies must be unquoted or AIM-listed
* The maximum value of a company’s gross assets (before VCT investment) is £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.

As a result of the numerous rules to which VCTs must adhere in order to qualify for tax breaks, it is important to choose an experienced manager. We will be going into more detail on what to look for in a VCT manager in our next article.

VCTs have a number of attractive tax benefits for investors. Initial investments can qualify for 30% income tax relief, subject to a maximum of £200,000 per investor per tax year 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 is sold.

While all VCTs invest into smaller UK companies, the market tends to split managers into four main types:

* Generalist VCTs: As the name suggests, these invest in a general portfolio of companies across the smaller and private equity universe, often across multiple sectors.

* AIM VCTs: These focus on companies listed on the AIM market. These are the only listed companies (daily priced) that ‘qualify’ under VCT rules. AIM has been around since 1995 and is now a mature exchange, with more than £90bn raised and a total of some 1,100 companies currently listed.

* Specialist VCTs: These focus on companies in a specific sector, such as renewable energy, leisure, media or technology, where the manager believes they have an edge.

* Limited life or planned exit VCTs: While similar to generalist VCTs, these tend to focus on lower-risk, lower-return companies with the main objectives of capital preservation and providing liquidity as soon as possible after the minimum five-year holding period.

The Role Of A VCT In An Investor’s Portfolio

Before going any further, it is worth stressing that financial advisers need to analyse the VCT market thoroughly before recommending them. The AIC website provides a lot of useful research and information in this regard. There are also other good sources of independent information such as The Tax Efficient Review, Intelligent Partnership’s VCT Industry Report and The Tax Shelter Report.

What type of clients are VCTs suitable for? First, VCTs should be considered on their investment merits rather than simply as a way of accessing tax reliefs. Given their focus on smaller, less liquid companies, VCTs will not be suitable for every client.

It is also worth noting, however, that given the VCT industry has been running for more than 20 years, it is possible to find VCTs with large and mature portfolios. Many of these have started to develop the hallmarks and traits of a smaller companies investment trust and, if investors can gain access to a top-up offer within one of these portfolios, it can help potentially to lower the investment risk.

Given the changes to pension legislation over the last couple of years, there seems to an ever-increasing demand from investors for VCTs that have capped out on either the lifetime limit or their annual contributions. With their upfront income tax relief at 30% and tax-free dividends, you can see the attraction for people using them as a supplementary pension-planning option – building a diversified portfolio of different VCTs over time, to sit alongside their pension.

As Chris Hutchinson, the manager of the £150m Unicorn AIM VCT, puts it: “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.”

Jack Rose is business development director for tax products, LGBR Capital

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