Faith Glasgow takes a closer look at venture capital trusts (VCTs)
Venture capital trusts, with their focus on small and unlisted businesses, have a reputation as relatively risky places to put your money. Nonetheless, they have significant attractions, for wealthier investors in particular – and these are likely to strengthen in the coming months as the rules around capital gains and dividend tax allowances change.
So let’s go back to basics and take a look at what VCTs are, their attractions and drawbacks, and the kind of investors they’re most likely to suit.
VCTs are a type of specialist investment trust, with shares listed on the stock market and an independent board of directors to which the investment manager is answerable.
They invest in early-stage, growth-focused companies that are either unquoted or issue shares on AIM. These companies must meet various criteria in terms of their size at the time of investment, the way they will use funds received, and the areas they operate in.
Small, unlisted or AIM businesses are inherently relatively high-risk and illiquid. But VCTs have latterly been forced into even more volatile territory by rule changes introduced between 2015 and 2018, as Jason Hollands, managing director of broker Bestinvest, explains.
“While VCTs have been restricted to investing in very small companies since the inception of the scheme, it is only over the last several years that they have also been restricted to young companies,” Hollands says.
“There is very little trading of VCT shares on the secondary market, in part due to the fact that anyone selling their shares in the first five years will have to repay the tax credit received”.
“VCT-qualifying companies must now not normally be more than seven years old, with exceptions for those that meet additional criteria and are classified as knowledge intensive companies. Companies tend to be revenue-earning with a proven concept, rather than start-ups, at the stage a VCT invests in them; but they are often not yet profitable.”
Typically, a fund will hold 30 to 40 such companies, adds Ben Yearsley, investment director at Shore Financial Planning. “Making a new investment can take up to six months for a VCT, as unlike investments such as BP or Shell which the manager can sell if she changes her mind, you can't easily sell unlisted investments.”
To incentivise investors to put their money into such uncertain prospects, VCTs offer generous tax breaks. Provided you subscribe to a new issue and hold the shares for at least five years, you receive a 30% income tax credit, and in addition any capital gains or dividends are tax-free.
As Hollands points out, this means that in practice, “there is very little trading of VCT shares on the secondary (stock) market, in part due to the fact that anyone selling their shares in the first five years will have to repay the tax credit received”.
It’s also important to understand the kind of returns you’ll receive when you invest in a VCT. As Yearsley observes: “There is a misconception that they are a capital growth investment, as they invest in small, dynamic companies. But they aren’t: instead, when a VCT invests in a company and successfully sells it a few years later, any gains are paid out as a tax-free dividend instead of being retained and reinvested. VCT capital values therefore tend to stay largely static.”
Hollands makes the further point that because most of the total returns come through dividends, VCTs can be useful as part of a tax-free income portfolio. “Investors who don’t need the income are often able to reinvest the dividends into newly created shares, thus providing them with another opportunity to achieve a 30% income tax credit,” he adds.
Interest in VCTs is likely to further gather pace following a series of swinging changes to tax thresholds and reliefs that will see many investors paying larger tax bills over the coming years.
In April, the 45% income tax threshold will be slashed from £150,000 to £125,140, the annual capital gains tax exemption will be more than halved to £6,000 (and halved again the following tax year), and the dividend allowance will also be halved. The 40% income tax threshold has already been frozen at £50,270 until tax year 2027/28.
But no matter how attractive the tax breaks may seem in the light of these changes, VCTs are not for everyone and should only be a small part of a wider investment portfolio.
As Hollands warns: “They should only really be considered by investors who are subject to the higher rates of tax, already fully using ISAs and pensions, but have additional funds to invest, and are able to tolerate a higher degree of risk.
