The UK government established Venture Capital Trusts (VCTs) almost 20 years ago to encourage investment into smaller UK businesses. 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 have raised over £5.4bn according to the AIC, providing important support and funding to the UK’s SME sector.
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 (Source: AIC).
How VCTs work
In many ways, VCTs are similar to investment trusts but with additional investment rules in order to qualify for tax reliefs. VCTs are plcs 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.
There are several investment criteria underlying companies must meet to be VCT qualifying including, but not limited to:
- 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 3 years. The remaining 30% can be invested in non-qualifying investments, such as cash, listed equities, debt and investment funds.
Because 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 next week’s 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 £200k per investor and a five year minimum holding period. Furthermore, dividends paid are tax free and there is no capital gains tax (CGT) to pay when the VCT is sold.
Types of VCT
All VCTs invest into smaller UK companies however the market tends to split managers into four main types:
|Generalist VCTs||AIM VCTs||Specialist VCTs||Limited Life or Planned Exit VCTs|
|As the name suggests, they invest in a general portfolio of companies across the smaller and private equity universe, often across multiple sectors.||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 £88bn raised and a total of 1,100 companies.||Focus on companies in a specific sector, such as renewable energy, leisure, media or technology, where the manager believes they have an edge.
|Similar to Generalist VCTs but 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
Financial advisers should analyse the VCT market thoroughly before recommending them. The AIC website provides a lot of useful research and information in this regard.
What type of clients are VCTs suitable for? Firstly, VCTs should be considered on their investment merits rather than simply a way of accessing tax reliefs. Given their focus on smaller, less liquid companies, VCTs will not be suitable for every client.
However, for those UK tax payers that can accept a higher level of risk and the minimum holding period of five years, VCTs can play a useful role in their portfolio.
The 30% upfront tax relief makes VCT suitable for clients looking to offset a large income tax liability. 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.
Chris Hutchinson, Manager of the £100m Unicorn AIM VCT comments: “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.”