VCT Investments: The low down on potential high profits

01 November 2016, at 12:00am

Dylan Jenkins explains how investing in smaller business via venture capital trusts can reap huge rewards if done right.

THE SWORD OF DAMOCLES ONCE AGAIN HANGS over pension tax relief. We are by now well used to the usual pre-Budget/Autumn Statement newspaper speculation over the future of the UK’s current system, whereby contributions and investment growth are tax-free and withdrawals (above 25% of the fund value) are taxed at the saver’s marginal rate. 

Former Chancellor George Osborne (remember him?) set in motion reforms that, at the extreme end, could ip the UK’s pension tax architecture on its head, with contributions – rather than withdrawals – taxed. However, these plans were shelved (but not quashed completely) ahead of the EU referendum on 23rd June that ultimately precipitated the downfalls of both Osborne and David Cameron.

In the wake of the Brexit vote, and with policymakers potentially needing to raise cash if investment and growth stall, tax relief could once again be in the crosshairs of the Treasury. 

Since 2010, politicians have had a nasty habit of cutting back pension tax perks, with the annual allowance hacked back from £255,000 to just £40,000 and the lifetime allowance chopped from £1.8 million to £1 million. In addition, there’s the horrendously complex annual allowance “taper”, designed to steadily reduce the yearly allowance from £40,000 to £10,000 for those earnings above £150,000.

And the controversial "Pension ISA" option has still not been ruled out fully. 

Given this pressurised environment, we have recently had to seriously consider viable alternatives to pensions if Chancellor Philip Hammond does take the axe to tax relief in his Autumn Statement on 23rd November.

VCTs - an attractive alternative?

One option that may attract certain clients is investing in smaller businesses through Venture Capital Trusts. VCTs allow investors to tap into the growth of small firms – although businesses can, of course, fail as well as succeed.

According to the latest data from the Office for National Statistics, the number of UK business “births” increased by 1.2% from 346,000 to 351,000 between 2013 and 2014. The 351,000 business births in 2014 were the highest recorded since comparable records began in 2000.

However, the flipside is that the number of UK business “deaths” increased by 3.5% from 238,000 to 246,000 between 2013 and 2014, compared with the decrease of 5.9% 

in 2013 (from 252,000 to 238,000). So a slight reversal in fortunes, but still over 100,000 more businesses created than killed off. The VCT structure is designed to tempt investors to invest in small and medium-sized enterprises – the engines of economic growth.

VCTs could be suitable for those clients who are seeking capital appreciation, income or a combination of the two, especially if there is a good chance they will bump up against the newly enforced £1 million lifetime allowance for pension savings (or the Government reduces this allowance yet further). They also come with some tax advantages.

How VCTs work

VCTs are closed-ended funds that are quoted on the London Stock Exchange. They invest in small, up-and-coming businesses in need of extra cash to grow. There are a variety of VCT Structures to pick from:

  • Generalists who invest across a range of companies and are in effect publicly-traded providers of private equity.
  • Vehicles which target AIM-quoted firms (since these companies are treated by the tax authorities as “private” since the platform is exchange-regulated).
  • Specialists who focus on certain industries such as renewable energy, technology and healthcare.

Individuals who invest in VCTs could potentially generate substantial returns – although this is by no means guaranteed. If the fund managers’ portfolios of fledgling firms survive and then thrive, they will churn out the pro ts and cash which in turn enable the fund to grow its net asset value and pay dividends to its investors. Several VCT specialists can point to strong track records of value creation – but this is by no means an easy money-making machine. 

Many hours of research, professional experience of the sectors in which they are investing and a good legal team are just three of the ingredients offered by successful VCTs, besides the ability to raise and effectively allocate capital.

Investing in very young rms is, as I mentioned earlier, a risky business. Things can, do and will go wrong, so you need to have your eyes well and truly open before taking the plunge.

As well as investment risk, investors must be aware of the fee structures of VCTs. They tend to have higher running costs than standard investment companies and can also charge performance fees, so it is important you are made aware of all the expenses involved before considering any potential investment.

Tax incentives

To encourage savers to use VCTs and thus provide capital to the smaller firms which are so vital to the UK’s overall economic health, the Government does permit investors to glean some tax benefits in recompense for the risks involved.

If a client subscribes to new VCT shares:

  • The maximum investment in any tax year is £200,000 
  • There is 30% tax relief on the initial investment, if the VCT’s shares are held for a minimum of five years 
  • No higher rate tax on dividends 
  • No Capital Gains Tax

The £200,000 annual cap on investment will interest some clients considering alternatives to a traditional pension or SIPP. However, it is important people are fully comfortable with the VCT as an investment in its own right and aren’t just following the tax breaks. It’s also worth remembering that, as things stand, tax relief on pensions remains extremely generous, particularly for higher earners.

Charges are also usually much lower, depending on your choice of tax wrapper and investments. Furthermore, just as pension tax relief could well come under pressure at the Autumn Statement, so too could VCT relief.

The Government has previously sought to crack down on what it termed “abuse” of the VCT system by investigating whether they should be allowed to invest in industries which receive subsidies.

In addition, VCTs can now only hand out dividends within the first three years of their life if these payments come from profits on investments, rather than the cash initially handed over by investors. This means patience is required and individuals must be prepared to lock up their cash for at least five years in order to bene t fully and retain their initial income tax relief.

Growing in popularity

The latest gures from the Association of Investment Companies show VCTs have grown in popularity in recent years. The VCT sector raised £457.5 million in the 2015/16 tax year, compared to £429 million in 2014/15. VCT funds under management were a healthy £3.6 billion at 5th April 2016.

Well-known rms operating in the VCT arena include Octopus Investments, Unicorn Asset Management and Amati Global Investors. The track records of VCT fund managers, and details of their fees, can be found on the website of the AIC.