GEOFFREY CHALLINOR of wealth management firm Saunderson House explains the pros and cons of investing in venture capital trusts.
High earners and wealthy individuals can be subject to high income tax and capital gains tax liabilities. There are a number of government-backed investment initiatives which enable individuals to save tax efficiently but are often overlooked. Venture capital trusts (VCTs) are an important feature in this landscape.
The UK government has made a number of tax reforms in recent years to increase tax revenue and reduce the fiscal deficit. Most notable among these are changes to pension legislation, with people earning more than £150,000 a year (including their employer pension contribution) seeing their pension annual allowance drop to £10,000 per year and, unless they hold one of the forms of Lifetime Allowance Protection, their lifetime allowance fall to £1m. ISAs remain an attractive investment vehicle, although with annual contributions restricted to £20,000 they only provide a limited tax shelter.
Buy-to-let investing has been a successful strategy for some, providing a steady level of income in retirement and, in many areas, strong capital growth too. However, increases in stamp duty on buy-to-let properties (and second homes) and restrictions to landlords’ mortgage interest relief now make this less appealing. Finally, with asset prices having risen sharply since the ‘nil rate band’ was fixed at £325,000 in April 2009 (where it will remain until at least 2020/21), family members and beneficiaries are increasingly left with inheritance tax bills to pay.
This changing landscape is driving investors to look at other tax-efficient investment schemes, namely venture capital trusts (VCTs), enterprise investment schemes (EISs) and business property relief (BPR). An overview of the tax reliefs for each scheme is shown in the following table. Here we cover the different types of VCT and their performance over the last ten years, before commenting on VCT fund raising and related considerations for investors. We then list some of the risks and drawbacks of investing in a VCT and, finally, present a case study of a generic VCT investor. It is important to note that VCTs will not suit everyone and they are not substitutes to more conventional tax shelters such as pensions, ISAs, CGT allowances and dividend allowances. However, they can be effective when used appropriately and, for high earners and wealthy individuals, should be included in wider financial planning discussions.
Overview of tax reliefs
*£2,000,000 for “knowledge-intensive” companies.
Venture Capital Trusts
VCTs were introduced in 1995 to encourage investment into small UK companies. They are closed-ended investment companies listed on the London Stock Exchange. They pool investors’ money and employ a professional manager to make investments in unquoted companies or companies whose shares are traded on the AIM and PLUS Markets. These companies must carry out a qualifying trade and, at the point of investment, be less than seven years old (with certain exceptions), have fewer than 250 employees (or fewer than 500 for a ‘knowledge-intensive’ company) and have no more than £15m in assets. To retain government approval as a VCT, it must invest a minimum 70% of its assets in qualifying holdings, rising to 80% for accounting periods beginning on or after 6 April 2019. The balance can remain in non-qualifying investments.
* The investment will be subject to initial fees and annual management charges, while performance fees are common.
VCTs may raise money for new share pools or existing ones. Established VCTs will typically raise money for an existing share pool, providing access to a portfolio of maturing investments which has the benefit of immediate diversification and, in most instances, is already paying dividends. As of 5 April 2018, at least 30% of all new funds raised must be invested in qualifying holdings within 12 months of the accounting period in which the VCT issues shares, with the remaining funds invested by the end of year three.
VCT Tax Benefits
There are three main tax benefits available on investments of up to £200,000 per tax year:
- Income tax relief at 30% on the purchase of newly issued VCT shares* (received upfront), allowing investors to reduce their income tax liability in that tax year.
- Tax-free dividends, providing the potential for a regular stream of tax-free income.
- Tax-free capital gains, meaning investors have no tax to pay on gains when shares are sold.
VCTs are therefore among the most tax-efficient investment vehicles available and can be a useful option for investors looking to complement their pension plans or other long-term investments, such as ISAs. It is worth adding that investing in small UK businesses offers the potential for significant long-term growth if the companies in the VCT are successful. They may also bring extra diversification to an investor’s portfolio.
Types Of VCT
While all VCT managers must follow the same qualifying investment criteria, each has a slightly different objective and investment focus and will employ a different investment strategy in order to achieve their goals. The different types of VCT fall into one of three broad categories:
- Generalist VCTs invest in a wide range of (predominantly) unquoted companies across different sectors. They are ‘evergreen’ in nature – i.e. they don’t have predetermined wind-up dates – and tend to focus on high-growth, high-risk investments. They aim to deliver tax-free income and/or capital growth, with the bulk of an investor’s return likely to come from the former (paid from the sale of portfolio holdings as well as income produced within the portfolio).
- AIM VCTs invest in companies whose shares are traded on AIM. Like generalist VCTs, they are diversified across different sectors, focus on rapidly growing businesses, are evergreen in nature and aim to deliver tax-free income and/or capital growth.
- Specialist VCTs concentrate on just one sector, such as media or technology. Their risk profile is determined by the sector that they invest in and, related to this, the business models of investee companies. Those at the lower-risk end are often branded ‘planned exit’ or ‘limited life’ VCTs, both sharing the same objective of returning the invested capital at a modest profit at a predetermined date, typically as soon as possible after the company has passed its five-year qualifying period. However, with the introduction of a ‘capital at risk’ condition to the VCT rules in the 2018 Finance Act, these lower-risk strategies are no longer viable.
The VCT market has total assets of £4.3bn,* which is spread across 85 VCTs (including different share pools) and 27 different managers (note that some managers run more than one type of VCT). Generalist VCTs are the most common type, representing 77% of assets across 54 VCTs and 16 managers. AIM VCTs represent 17% of assets across 8 VCTs and six managers, while specialist VCTs represent 6% of assets across 23 VCTs and nine managers. The largest VCT, with £613m of assets, is OCTOPUS TITAN VCT (generalist).
The track records of VCTs vary widely, with some performing very well and others very badly. Of course, the year in which an investor purchases VCT shares will influence the returns that they experience, although more important for long-term investors is the manager that they select. Investors should undertake (or seek an adviser that undertakes) thorough due diligence to understand the manager’s investment strategy and evaluate the likelihood of them successfully executing it.
According to figures from Financial Express Analytics, over the ten years to 31 August 2018 the VCT sector as a whole is up 120% on a share price total-return basis. This does not include tax reliefs. By comparison, the FTSE All-Share index of companies listed on the UK’s main market is up 106% (on a total-return basis). The figures show that the top-20-performing VCTs are up an average 191% over the period, which includes average dividend payments of 71p per share. Looking at the performance of different strategies, 16 out of the top 20 are generalist, three are AIM and one is specialist. It is important to note that the data only considers VCTs that are open, and thus does not capture the worst-performing VCTs, which have closed.
VCT Fund Raising
VCTs have traditionally launched share offers shortly before the tax year-end, with fund raisings in recent years filling up quickly as demand for the strongest-performing VCTs has outstripped supply.
For the 2017/18 tax year, the VCT sector raised £728m, the second-highest amount on record and the highest at the current level of 30% income tax relief. The highest ever fund raising was £779m in the 2005/06 tax year, when upfront tax relief was 40%.
For the 2018/19 tax year, we expect to see a fall in the amount raised, as although demand is likely to remain strong (given current pension limits), we anticipate less supply across the sector. The changes to VCT rules announced in the 2018 Finance Act mean that, with certain ‘specialist’ strategies no longer viable, these VCTs will no longer be raising capital. Further, even for those VCTs whose strategies have not been impacted by the new rules (in the same manner at least), given the large sums raised last year, there is a meaningful amount of capital to deploy and therefore limited need for new money. We suspect that a figure closer to the £542m raised in 2016/17 is more likely than a repeat of the 2017/18 fund raising. As such, interested investors should be prepared to act promptly to subscribe in this year’s most in-demand offerings.
Risks And Drawbacks
VCTs have a higher-risk profile than an investment in larger companies. Businesses in the early stages of their development have a higher failure rate than more established businesses and can change value more quickly and more significantly than larger companies. Investors therefore have a greater risk of losing their capital and dividends can be reduced or suspended altogether.
Although VCTs are listed on the London Stock Exchange and in theory can be bought and sold at any time, as only newly issued shares qualify for income tax relief, the secondary market is illiquid. This means that even if a buyer can be found, many VCT shares trade at substantial discounts to their respective NAVs. Further, as the price of shares bought on the secondary market is determined by supply and demand, should these not align (as is often the case), the difference between the buying and selling price (the spread) may be wide. Disposing of a VCT holding in the secondary market may therefore only be possible at a price significantly below the NAV of the shares. A large number of VCT managers do, however, offer share buyback schemes, which they typically undertake at a 5–15% discount to NAV.
It is important to note that income tax relief is clawed back if the shares are not held for at least five years. Investors should be prepared to invest for at least this long and a longer time frame is advisable. It is worth adding that how much an individual benefits from the tax reliefs will depend on their particular circumstances and HMRC may change the rules at any time. Investors should also note that the ongoing charges associated with VCTs are typically higher than those for mainstream collective investments, while it is common for them to have a performance fee.
Who Might Consider Buying VCT Shares?
VCTs are most suitable for individuals with a balanced or adventurous attitude to risk, with surplus cash available to invest for the long term and a large income tax liability. Pension and ISA allowances should already have been fully utilised, as well as any tax-free growth available using dividends allowances and annual capital gains tax exemptions.
David is a high earner and comfortable taking a higher level of investment risk. He makes full pension and ISA contributions, although is looking at other tax-efficient ways to supplement his income in retirement. He plans to work for another five years and will have considerable surplus income over that period.
After meeting with his financial adviser, David agrees to invest £50,000 per year for the next five years into a range of generalist and AIM VCTs. For this example, for the sake of simplicity it is assumed that the VCTs have an average target dividend yield of 5%, which is achieved every year in perpetuity, and there is no movement in capital values.
When David enters his first year of retirement, he has a VCT portfolio of £250,000 at a net cost of £175,000 (after 30% income tax relief). He has received £37,500 in tax-free dividends (5% on the sum invested over five years) and stands to receive a further £12,500 in tax-free dividends each year thereafter. The tax-equivalent yield of £12,500 in dividends to an additional rate taxpayer on a net investment of £175,000 is 13.0%. David must remain invested for five years into retirement to keep all of the tax breaks provided (as the income tax for each contribution invested for fewer than five years would otherwise be repayable), so this should be seen as part of a long-term holding and capital to which he does not need access. The VCT holdings could be sold if required, although David understands that this would be at a discount to NAV.
For a well-managed generalist or AIM VCT, a 5% dividend yield together with some uplift in capital value over the long term is a reasonable expectation. However, dividends may be higher or lower in any single year depending on market conditions and the level of realisations, while portfolio values are also likely to fluctuate.
In recent years it has become more difficult for high earners and wealthy people to shelter their income and capital from the taxman. VCTs help investors to mitigate future tax liabilities and receive tax-free income and gains by making long-term investments in risky start-up and growing businesses. The scheme is well-established and we anticipate growth in this area as investors look for additional financial planning options given restrictions to more conventional tax shelters. However, it should be noted that HMRC has changed the rules governing the schemes in the past and may do so again in the future.
It is important to recognise that VCTs are not suitable for all individuals and investors must understand and be comfortable with the level of investment risk inherent in the offerings. Their high-risk nature should not automatically be viewed as a negative, since the track records of some managers show strong investment returns even before the tax reliefs are factored in. We recommend that interested investors seek information and advice from specialist financial professionals before making a subscription.
* Under the latest VCT rules (since 5 April 2018), income tax relief is restricted where an investor sells shares in a VCT and subscribes for new shares in the same VCT within a six-month period.
* Figures from the Association of Investment Companies as at 31 August 2018.
GEOFFREY CHALLINOR CFA is an investment analyst at Saunderson House.