A Guide To Venture Capital Trusts (VCTs)

As part of our alternative investment series, we look at the types, benefits and risks of investing in VCTs.

WHAT IS THE VENTURE CAPITAL TRUST SCHEME?

The Venture Capital Trust scheme was introduced on 6th April 1995 with aim of encouraging individuals to invest into smaller companies, whose shares and securities are not listed on the main stock exchange, and benefit from their investment through tax efficient advantages. They are open to anyone who is over 18 years of age and a UK resident.

VCTs are themselves listed on the London Stock Exchange and any money raised from individual investors is pooled by the VCT to acquire several different investments with the aim of spreading risk across the VCT’s portfolio.

The maximum amount on which tax benefits can be claimed is £200,000. Investors who subscribe to the issue of new VCT shares will receive tax relief upfront, subject to a minimum investment period of five years. The VCT allowance is in addition to an investor’s pension and ISA allowances for the current tax year.

HOW DO VCTs WORK?

VCTs provide finance to small, expanding businesses, which are not listed on a major exchange, with the aim of making capital returns for investors. To retain Government approval as a VCT, the VCT manager must invest at least 70% of raised money in ‘qualifying holdings’ within three years. These are defined as shares or securities, including loans of at least five years duration, in unquoted companies and those whose shares are traded on the Alternative Investment Market (AIM) and PLUS Markets. These companies must carry out a qualifying trade wholly or mainly in the UK. The balance of 30% can remain invested in other ‘non-qualifying’ holdings.

HOW DO INVESTORS CLAIM TAX RELIEF?

After investing in a VCT, individuals will receive a share certificate and a tax certificate, which they need to send to HMRC to claim income tax relief. If the individual pays tax under PAYE then they have two options depending on the timing of the purchase. They can have their tax code adjusted immediately and start paying less tax or, if it is the end of the tax year, they can apply for an immediate repayment or claim through self-assessment.

THE COMPANIES VCTs INVEST IN

HM Revenue & Customs (HMRC) sets rules on what business activities are allowed, how big the companies can be and the limit on how much a VCT can invest.

ALLOWABLE BUSINESS ACTIVITIES

Companies must carry out what HMRC calls a ‘qualifying trade’ to receive VCT funds – most trades are allowed, with a few exceptions, such as land dealing, financial activities, forestry, farming and running hotels. The company must also have a permanent establishment in the UK. If excluded trades make up more than a fifth of a company’s activities, it can’t receive VCT funding.

COMPANY SIZE

VCTs can invest in a company if the gross assets are £15 million or less at the time of the investment (or £16 million immediately afterwards) and they have fewer than 250 full-time
employees. If a company later lists on the London Stock Exchange, it can continue to be treated as a qualifying VCT investment for up to five years.

INVESTMENT AMOUNTS

A VCT has three years to invest at least 70% of its money in qualifying small businesses. It can invest by a combination of buying shares and making loans, which must last at least five years. A VCT can invest up to 15% of its money in a single company, while each company is allowed to receive up to £5 million of VCT funding in a twelve-month period. The £5 million figure has to take into account any investment via the Enterprise Investment Scheme (EIS) or Seed Enterprise Investment Scheme (SEIS) as well as any other investment the company has received via any measure covered by the European Commission’s Guidelines on State aid to promote Risk Capital Investment in Small and Medium-sized Enterprises.

TYPES OF VCT

Each VCT is set up with its own individual parameters, reflecting how long they are designed to last, whether the companies they invest in are unquoted or quoted on AIM and what their investment focus is.

Some are set up to last indefinitely (often called ‘evergreen’ VCTs) to provide long-term capital growth or a stream of tax-free dividends – or both. Others will be created as limited-life VCTs, which will be wound up as soon as possible after the minimum five-year holding period for shares and any accumulated assets distributed amongst the shareholders.

INVESTING IN UNQUOTED OR AIM QUOTED COMPANIES

Some VCTs invest in small, dynamic businesses that are still in the early stages of development and are not quoted on any exchange. Other VCTs, however, choose companies that trade on the Alternative Investment Market (AIM).

INVESTMENT FOCUS

A generalist VCT invests across a range of different industries. In contrast, specialist VCTs focus on specific industry sectors, such as healthcare or technology. Concentrating on a single sector can involve more investment risk but could also offer higher returns if the chosen sector does particularly well.

BENEFITS OF VCTs

INVESTING IN GROWING UK BUSINESSES

By investing in a VCT you could be helping smaller companies to create jobs, generate wealth and contribute to the UK’s economic growth. These types of businesses also offer the potential for significant long-term growth if the companies in your VCT are successful.

TAX BENEFITS

One of the most attractive features of a VCT for potential investors is the range of tax reliefs:

• You can claim 30% upfront tax relief on an investment of up to £200,000 in a tax year – the amount of your relief can’t be more than the income tax you are due to pay in the tax year of your VCT investment.
• If your VCT pays dividends, you will not have to pay tax on them.
• If you sell your shares, any profit you make on them won’t be liable for capital gains tax. (If you sell within five years the upfront income tax relief will be withdrawn).
• If you die, even within the first five years, your estate will not have to pay back any income tax relief you have claimed. Dividends will still be tax-free and there won’t be any capital gains tax to pay on any growth your shares might achieve.

DIVERSIFYING YOUR INVESTMENTS

Smaller companies typically follow different investment cycles from other parts of the market, so VCTs can bring extra diversification to your investment portfolio. Of course, you need to be comfortable with the risk involved in smaller companies – there is more information about this on page 9.

A DIFFERENT TYPE OF INCOME GENERATING INVESTMENT

VCTs can provide a great option to complement your pension plans or other long-term investments, such as ISAs, particularly if you cannot invest as much as you would like in your pension because of the lifetime or annual allowances, which have both come down in recent years. Once invested, the tax-free dividends paid by many VCTs can be a useful way to boost the income you receive from pensions or other sources.

WHAT ARE THE RISKS OF INVESTING IN A VCT?

Like any investment a VCT involves risks, and it is important that investors understand these risks before deciding whether a VCT is the right investment vehicle for their needs. Investors must be prepared for the value of their VCT shares to go down as well as up, meaning they may not get back as much as they invested. Furthermore, the past performance of investments made by the VCTs should not be regarded as a guide to future performance.

SMALLER COMPANIES ARE LIKELY TO BE MORE VOLATILE

VCT shares are likely to have higher volatility and liquidity risk than other types of shares quoted on the London Stock Exchange Official List because businesses in the early stages of development can have a higher failure rate than more established businesses. In addition, they can change value more quickly and more significantly than larger companies.

VCTS ARE FOR THE LONGER TERM

If you sell your VCTs before you have had them for five years, you will have to repay any income tax relief you have claimed (unless you sell them to your spouse or you die). As such, VCTs should be viewed as a long-term investment.

In some cases, it may also be difficult for you to find a buyer for your shares, although most fund managers offer buy-back schemes. Whichever way you sell your shares, it is likely that the price will be lower than the overall value of the companies in the VCT’s portfolio.

THE TAX ADVANTAGES MAY CHANGE

As with many other types of investment, such as ISAs and pensions, HMRC may change the rules on VCT tax relief in the future. The availability of tax relief also relies on the investee companies maintaining their qualifying status. The setup of your own personal investment portfolio will also determine how much you can benefit from VCT tax relief.

IMPORTANT INFORMATION

This guide does not offer investment or tax advice. You should only invest on the basis of the information in a VCT’s prospectus, brochure and terms and conditions, and we recommend that you take independent financial advice before making your decision.